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Managerial Economics_ Unit 1


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Notes on Unit I of Managerial Economics

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Managerial Economics_ Unit 1

  1. 1. UNIT 1: BASIC CONCEPTS AND PRINCIPLES • Contents: (6 Hrs) • 1.1 Definition • 1.2 Nature and Scope of Economics-Micro Economics and Macro Economics. • 1.3 Managerial Economics and its relevance in business decisions. • 1.4 Fundamental Principles of Managerial Economics – a) Incremental Principle, b) Marginal Principle, c) Opportunity Cost Principle, d) Discounting Principle, e) Concept of Time Perspective. f) Equi-Marginal Principle. • 1.5 Utility Analysis. Cardinal Utility and Ordinal Utility. 9/10/2016 1 Deepak Srivastava
  2. 2. 1.1 DEFINITION • Economics • In General way, economics is a social science which deals with the production, distribution and consumption of goods and services. There are a large number of economist give their different definitions. Some say that there is no requirement of definition of economics this is because economics growing continuously. But most of the economists agree with the view that defining economics is must. On the basis of these economist, the definition of economics is divided into four parts such as: 9/10/2016 2 Deepak Srivastava
  3. 3. Definition of Economics Wealth Definition Adam Smith J S Say L C Mill Senior Welfare Definition Marshall Cannon Beveridge Penson Scarcity Definition Lord Robbins Scitovosky Stonier and Hague Harvey Growth- oriented Definition Prof. Samuelson Benhem C E Fergeuson Prof. J K Mehta 9/10/2016 3 Deepak Srivastava
  4. 4. WEALTH DEFINITION • Adam Smith says “The self-interested pursuit of wealth may not be individually satisfying but leads to an aggregate increase in wealth that is in the best interests of a nation.” • Adam Smith- Economics is an enquiry into the nature and causes of wealth of nation. • J.B. Say- Economics is the science which treats of wealth. • J.S. Mill-Economics is the practical science of the production and distribution of wealth. • Senior- The subject treated by political economics is not happiness but wealth. 9/10/2016 4 Deepak Srivastava
  5. 5. WELFARE DEFINITION • Alfred Marshall was born in London, on26 July 1842. Professor of Political Economy at the University of Cambridge from 1885 to 1908, he was the founder of ·the Cambridge School of Economics which rose to great eminence in the 1920s and 1930s. Alfred Marshall’s magnum opus, the Principles of Economics was published in 1890. Marshall relates the definition of economics with material welfare. • Marshall-Economics is the study of mankind in the ordinary business of life; it examines that part of individual and social action which is most closely connected with the attainment and with the use of material requited for well being. • Cannan-The aim of political economy is the explanation of general causes on which the material welfare of human being depends. • Beveridge-Economics is the study of the general methods by which men co- operate to meet their material needs. • Penson-Economics is the science of material welfare. 9/10/2016 5 Deepak Srivastava
  6. 6. SCARCITY DEFINITION • Lionel Robbins was a peculiar Englishman in the economics world of the 1920s. His tools were the London School of Economics and a famous 1932 essay on economic methodology. It was his 1932 Essay on the Nature and Significance of Economic Science where Robbins made his Continental credentials clear. He redefines the scope of economics to be “the science which studies human behavior as a relationship between scarce means which have alternative uses.” • Lionel Robbins-Economics is a science which studies human behaviour as a relationship between ends and scarce means which have alternative uses. • Scitovosky-Economics is the science concerned with the administration of scarce resources. • Stonier & Hague-Economics is the fundamentally a study of scarcity and the problem which gives rise. • Harvey-Economics is the study of how men allocate their resources to provide for their wants. 9/10/2016 6 Deepak Srivastava
  7. 7. GROWTH ORIENTED DEFINITION • Paul A. Samuelson has personified mainstream economics in the second half of the twentieth century. Paul Samuelson has not been unjustly considered the incarnation of the economics ‘establishment’- and as a result, has been both lauded and vilified for virtually everything right and wrong about it. Paul Samuelson’s most famous piece of work, “Foundations of Economic Analysis” (1947), one of the grand tomes that helped revive neoclassical economics and launched the era of the mathematization of economics. Samuelson was one of the progenitors of microeconomics and the Nee-Keynesian Synthesis in macroeconomics during the post-war period. 9/10/2016 7 Deepak Srivastava
  8. 8. CONTINUED… • Prof. Samuelson-Economics is the study of how people and society end up choosing with or without the use of money, to employ scarce productive resources that could have alternative uses, it produce various commodities over time and distributes them for consumption, now or in the future, among various persons and groups in society. It analyses cost and benefits of improving patterns of resource allocation. • Benham-Economics is the study of the factors affecting employment and standard of living. • C. E. Ferguson-Economics is the study of the economic allocation of scarce physical and human means (resources) among competing ends, an allocation that achieves a stipulated optimizing or maximizing objectives. • Porf. J.K. Mehta-Economics is a science which studies human behaviour as a means to reach in a situation free of wants. 9/10/2016 8 Deepak Srivastava
  9. 9. 1.2 NATURE AND SCOPE OF ECONOMICS-MICRO ECONOMICS AND MACRO ECONOMICS • Economics as a Science: • if it is so, is it a positive or a normative science? • A science is a systematised body of knowledge ascertainable by observation and experimentation. It is a body of generalisations, principles, theories or laws which traces out a causal relationship between cause and effect. • For any discipline to be a science; • (i) it must be a systematized body of knowledge; • (ii) have its own laws or theories; • (iii) which can be tested by observation and experimentation; • (iv) can make predictions; • (v) be self-corrective; and • (vi) have universal validity. • If these features of a science are applied to economics, it can be said that economics is a science. 9/10/2016 9 Deepak Srivastava
  10. 10. NATURE OF ECONOMICS • Economics as an Art: • Art is the practical application of scientific principles. Science lays down certain principles while art puts these principles into practical use. To analyze the causes and effects of poverty falls within the purview of science and to lay down principles for the removal of poverty is art. Economics is thus both a science and an art in this sense. • “Economics should not be considered as a tyrannical oracle whose word is final. But when the preliminary work has been truly done, Applied Economics will at certain times on certain subjects speak with the authority to which it is entitled.” Economics is thus regarded both a science and an art, though economists prefer to use the term applied economics in place of the latter. 9/10/2016 10 Deepak Srivastava
  11. 11. SCOPE OF ECONOMICS • Microeconomics • Macroeconomics • International economics • Public finance • Development economics • Health economics • Environmental economics • Urban and rural economics 9/10/2016 11 Deepak Srivastava
  12. 12. MICRO & MACROECONOMICS • Subject- matter of economics can be sub- divided in to Microeconomics and Macroeconomics. • These terms were first coined and used by Ragnar Frisch. • Acc. To K E Boulding: • “Microeconomics is the study of particular firms, particular households, individual prices, wages, incomes, individual industries, particular commodities.” • “Macroeconomics deals not with individual quantities as such but with aggregates of these quantities, not with individual incomes but with national income; not with individual prices but with general price level; not with individual output but with national output.” 9/10/2016 12 Deepak Srivastava
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  14. 14. 1.3 MANAGERIAL ECONOMICS AND ITS RELEVANCE IN BUSINESS DECISIONS. • To quote Mansfield, "Managerial Economics is concerned with the application of economic concepts and economic analysis to the problems of formulating rational managerial decisions." • According to McNair and Meriam, "Managerial economics is the use of economic modes of thought to analyse business situations." • "Managerial Economics is concerned with the application of economic principles and methodologies to the decision making process within the firm or organisation under the conditions of uncertainty," says Prof. Evan J Douglas. • Spencer and Siegelman define it as "The integration of economic theory with business practice for the purpose of facilitating decision making and forward planning by management." • According to Hailstones and Rothwel, "Managerial economics is the application of economic theory and analysis to practice of business firms and other institutions." 9/10/2016 14 Deepak Srivastava
  15. 15. MANAGERIAL ECONOMICS • Coordination • An activity or an ongoing process • A purposive process • An art of getting things done by other people. Management • Human wants are virtually unlimited and insatiable, and • Economic resources to satisfy these human demands are limited. Economics • Thus managerial economics is the study of allocation of resources available to a firm or a unit of management among the activities of that unit. Managerial Economics 9/10/2016 15 Deepak Srivastava
  16. 16. SCOPE OF MANAGERIAL ECONOMICS There are four groups of problem in both decision making and forward planning. Resource allocation Inventory and queuing problem Pricing problems Investment problems 9/10/2016 16 Deepak Srivastava
  17. 17. RELATIONSHIP OF MANAGERIAL ECONOMICS WITH DECISION SCIENCES • Economics is linked with various other fields of study like: • Operation Research • Theory of Decision Making • Statistics • Management Theory and Accounting • Satisficing instead of maximizing • Managerial Accounting Economics and other Disciplines 9/10/2016 17 Deepak Srivastava
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  19. 19. 1.4 FUNDAMENTAL PRINCIPLES OF MANAGERIAL ECONOMICS – a) Incremental Principle, b) Marginal Principle, c) Opportunity Cost Principle, d) Discounting Principle, e) Concept of Time Perspective. f) Equi-Marginal Principle. 9/10/2016 19 Deepak Srivastava
  20. 20. MARGINAL AND INCREMENTAL PRINCIPLE • Incremental concept is similar to the concept of marginal value, but with a difference. Marginal principle is theoretical while incremental concept is practical in nature. • Marginal concept is used when calculating per unit costs for bulk purchases, the principle of incrementalism comes in to play when the inputs are large units like in case of airplane. • The use of incremental concept in business decision making is known as incremental reasoning. • IC is used more often in business decision making than MA. 9/10/2016 20 Deepak Srivastava
  21. 21. OPPORTUNITY COST PRINCIPLE • The idea is that anything you must give up in order to carry out a particular decision is a cost of that decision. This concept is applied again and again throughout modern economics. • Scarcity: According to modern economics, scarcity exists whenever there is an opportunity cost, that is, where-ever a meaningful choice has to be made. • Production Possibility Frontier: The production possibility frontier is the diagrammatic representation of scarcity in production. • Comparative Advantage: A very important principle in itself and a key to understanding of international trade the principle of comparative advantage is at the same time an application of the opportunity cost principle to trade. • Discounting of Investment Returns: Another application of the opportunity cost principle that is very important in itself, this one tells us how to handle opportunities that come at different times. 9/10/2016 21 Deepak Srivastava
  22. 22. 1.5 UTILITY ANALYSIS. CARDINAL UTILITY AND ORDINAL UTILITY. •After Demand Analysis…! 9/10/2016 22 Deepak Srivastava
  23. 23. 1.5 UTILITY ANALYSIS. CARDINAL UTILITY AND ORDINAL UTILITY. • Utility Analysis • The decision of a consumer depends upon the concept of individual benefit, also known as utility. If consumer gets more benefit from the product he will ready to spend more on the product and the vice-versa. • Consumers are able to order their preference depending on the utility they get from the consumption of the particular product. Utility can be difficult to measure. • No consumer is able to measure the utility in quantitative terms. But he can order his preference according to the satisfaction from the consumption goods. Thus, there are two class of thoughts about the measurement of utility. • One states that utility can be measured in numbers or monetary terms, another says that satisfaction utility derived from the consumption of goods can only be ordered. These two distinctions are called cardinal utility and ordinal utility. 9/10/2016Deepak Srivastava 23
  24. 24. CARDINAL UTILITY AND ORDINAL UTILITY • Utility is an economic term referring to the total satisfaction received from consuming a good or service. For example, satisfaction you get by consuming a cup of tea is the utility of that cup of tea. If this measure is given, one may think of increasing or decreasing utility, and thereby explain economic behavior in terms of attempts to increase one’s utility. Changes in utility are sometimes expressed in fictional units called utils. There are mainly two kinds of measurement of utility implemented by economists: cardinal utility and ordinal utility. 9/10/2016Deepak Srivastava 24
  25. 25. CARDINAL UTILITY AND ORDINAL UTILITY • Utility was originally viewed as a measurable quantity, so that it would be possible to measure the utility of each individual in the society with respect to each good available in the society, and to add these together to yield the total utility of all people with respect to all goods in the society. Society could then aim to maximise the total utility of all people in society, or equivalently the average utility per person. This conception of utility as a measurable quantity that could be aggregated (summed up) across individuals is called cardinal utility. 9/10/2016Deepak Srivastava 25
  26. 26. CARDINAL UTILITY • Cardinal utility quantitatively measures the preference of an individual towards a certain commodity. Numbers assigned to different goods or services can be compared. • Example: For a coffee addict, a utility of 100 utils towards a cup of cappuccino is twice as desirable as a cup of tea with a utility level of 50 utils. • The concept of cardinal utility suffers from the absence of an objective measure of utility. • For example, the utility gained from consumption of a particular good by ‘A’ will be different than ‘B’. 9/10/2016Deepak Srivastava 26
  27. 27. ORDINAL UTILITY • Ordinal utility represents the utility, or satisfaction derived from the consumption of goods and services, based on a relative ranking of the goods and services consumed. With ordinal utility, goods are only ranked only in terms of more or less preferred, there is no attempt to determine how much more one good is preferred to another. 9/10/2016Deepak Srivastava 27
  28. 28. ORDINAL UTILITY • Example: You may prefer to consume or buy more apples than bananas while your friend may prefer to consume or buy more bananas than apple. • The modern economists have discarded the concept of cardinal utility and have instead employed the concept of ordinal utility for analysing consumer behaviour. The concept of ordinal utility is based on the fact that it may not be possible for consumers to express the utility of a commodity in absolute terms but it is always possible for a consumer to tell introspectively whether a commodity is more or less or equally useful as compared to another. • Example: A consumer may not be able to tell that an ice cream gives 5 utils and a chocolate gives 2 utils. But he or she can always tell whether chocolate gives more or less utility than ice cream. • This assumption forms the basis of the ordinal theory of consumer behaviour. Ordinal utility is the underlying assumption used in the analysis of indifference curves. 9/10/2016Deepak Srivastava 28
  29. 29. MARGINAL UTILITY ANALYSIS • Marginal utility is the additional amount of satisfaction obtained from consuming one additional unit of a good. Total utility is the overall amount of satisfaction obtained from consuming several units of a good. While the maximization of total utility represents the ultimate goal of consumption, the analysis of consumer behaviour gives greater emphasis on the marginal utility. As consumer proceeds with his consumption total utility increases as more of a good is consumed, but the marginal utility decreases with the consumption of each additional unit. The decrease in marginal utility with an increase in the consumption of a good reflects law of diminishing marginal utility. 9/10/2016Deepak Srivastava 29
  30. 30. THE LAW OF DIMINISHING MARGINAL UTILITY: MARSHILLIAN APPROACH • Marginal utility refers to the change in satisfaction which results when a little more or little less of that good is consumed. • The law of diminishing marginal utility says that with the increase in the consumption of a good there is a decrease in the marginal utility that person derives from consuming each additional unit of that product. 9/10/2016Deepak Srivastava 30
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  33. 33. INDIFFERENCE CURVES • An indifference curve may be defined as the locus of points. Each point represents a different combination of two substitute goods, which yields the same utility or level of satisfaction to the consumer. Therefore, he/she is indifferent between any two combinations of goods when it comes to making a choice between them. Such a situation arises because he/she consumes a large number of goods and services and often finds that one commodity can be substituted for another. This gives him/her an opportunity to substitute one commodity for another, if need arises and to make various combinations of two substitutable goods which give him/her the same level of satisfaction. If a consumer faced with such combinations, he/she would be indifferent between the combinations. 9/10/2016Deepak Srivastava 33
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  36. 36. ASSUMPTIONS • The following assumptions about the consumer psychology are implicit in indifference curve analysis: • Transitivity: If a consumer is indifferent to two combinations of two goods, then he is unaware of the third combination also. • Diminishing marginal rate of substitution: The rarer the availability of a good, the greater is its substitution value. For example, water has a high substitution value as it is a scarce resource. • Rationality: The consumer aims to maximise his total satisfaction and has got complete market information. • Ordinal utility: Utility in this approach is not measurable. A consumer can only specify his preference for a particular combination of two goods, he cannot specify how much. 9/10/2016Deepak Srivastava 36
  37. 37. PROPERTIES OF INDIFFERENCE CURVE • Indifference curves have the four basic characteristics: • 1. Indifference curves have a negative slope • 2. Indifference curves are convex to the origin • 3. Indifference curves do not intersect nor are they tangent to one another • 4. Upper indifference curves indicate a higher level of satisfaction. • These characteristics or properties of indifference curves, in fact, reveal the consumer’s behaviour, his choices and preferences. They are, therefore, very important in the modern theory of consumer behaviour. Now, we will observe their implications. 9/10/2016Deepak Srivastava 37
  38. 38. BUDGET LINE • THE BUDGET CONSTRAINT Having described preferences, next we determine the consumer’s alternatives. The amount of goods he can purchase depends on his available income and the goods’ prices. Suppose the consumer sets aside Rs. 200 each week to spend on the two goods. The price of good X is Rs. 40 per unit, and the price of Y is Rs. 20 per unit. Then he is able to buy any quantities of the goods (call these quantities X and Y) as long as he does not exceed his income. If he spends the entire Rs. 200, his purchases must satisfy: 9/10/2016Deepak Srivastava 38 40X + 20Y = 200
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  40. 40. CONSUMER EQUILIBRIUM • If we superimpose the indifference map and budget line as in Figure shown above, we find that a consumer has to decide to purchase a particular combination (C) as it falls on his budget line, though a different combination (D) would be more desirable as it will give a higher level of satisfaction. At his point of equilibrium C, the price line is touching the indifference line tangentially meaning that the slopes are equal. The slope of indifference curve indicates the marginal rate of substitution between X and Y, and the slope of budget line indicates the ratio of price of X to that of Y. Thus the principle of consumer's equilibrium works out; the marginal rate of substitution between X and Y must be proportional to the ratio of price of X to that of Y. 9/10/2016Deepak Srivastava 40