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| Sachin Kumar | Asian School of Business | pg. 1 |
Managerial Economics
BBA - V
Fundamental Economic tools
Opportunity cost concept
Opportunity Cost Principle: Heaberler and Taussing have developed this important cost principle. This
principle studies about the various alternatives and their benefits. According to this principle the
managerial decision must be such that from the selected alternative benefits.
The opportunity cost of a good or of performing an action, also known as the greatest cost, is the lost
value of alternate options that could have been chosen, rather than the one that was chosen. If A gives
twice as much pleasure as B, and there is no C that gives more pleasure than B and is comparable (such
as uses time, effort, or some other resource), then A's opportunity cost is the benefit of B because that is
the difference in resulting happiness. In this particular scenario, the opportunity cost of A is not a good
indicator of its value, because it says that A is worth only as much as B, which is not the case.
Normally, there would be many alternate uses for the resources of A/B, so that there would not be such
a notable difference, and so A and B would be similar in benefits, B and C would be similar in benefits,
etc. In such a case where the differences are minor, the opportunity cost of A would be similar to that of
B, and that would reflect their similar benefits.
Oftentimes, opportunity cost is seen as what one would have to give up for something else:
Opportunity cost of A (in terms of B) = -
∆𝐵
∆𝐴=1
where
∆𝐴is the gain of marginal utility because of a gain of A = 1
∆𝐵 is the loss of marginal utility because of a loss of B
Opportunity costs can also be thought of as the resources lost, or alternate products forgone, through
taking a particular action or producing a certain product. The lost resources could be time, effort, money,
goods, etc.
Incremental concept
The incremental concept is closely related to the marginal costs and marginal revenues of economic
theory. Incremental concept in managerial economics involves two important activities which are as
follows:
2
 Estimating the impact of decision alternatives on costs and revenues.
 Emphasizing the changes in total cost and total cost and total revenue resulting from changes in
prices, products, procedures, investments or whatever may be at stake in the decision.
The two basic components of incremental reasoning are as follows:
 Incremental cost: Incremental cost may be defined as the change in total cost resulting from a
particular decision.
 Incremental revenue: Incremental revenue means the change in total revenue resulting from a
particular decision.
The incremental principle in economics may be stated as under:
A decision is obviously a profitable one if;
 It increases revenue more than costs
 It reduces costs more that revenues.
 It decreases some costs to a greater extent than it increases other costs
 It increases some revenues more than it decreases other revenues
Some businessmen hold the view that to make an overall profit, they must make a profit on every job.
Consequently, they refuse orders that do not cover full cost (labor, materials and overhead) plus a
provision for profit. Incremental reasoning indicates that this rule may be inconsistent with profit
maximization in the short run. A refusal to accept business below full cost may mean rejection of a
possibility of adding more to revenue than cost. The relevant cost is not the full cost but rather the
incremental cost.
A simple problem will illustrate this point.
Suppose a new order is estimated to bring in additional revenue of Rs. 5,000. The costs are estimated as
under:
Labor 1500
Material 2000
Overhead (Allocated at 120% of labor cost) 1800
Selling administrative expenses
(Allocated at 20% of labor and material cost)
700
Total Cost 6,000
The order at first appears to be unprofitable. However, suppose, if there is idle capacity, which can be,
utilised to execute this order then the order can be accepted. If the order adds only 500$ of overhead (that
is, the added use of heat, power and light, the added wear and tear on machinery, the added costs of
supervision, and so on), Rs. 1,000 by way of labour cost because some of the idle workers already on the
payroll will be deployed without added pay and no extra selling and administrative cost then the
incremental cost of accepting the order will be as follows.
3
Labor 1500
Material 2000
Overhead 500
Total Incremental cost 4000
While it appeared in the first instance that the order will result in a loss of Rs. 1,000, it now appears that
it will lead to an addition of Rs. 1,500 (Rs. 5,000- Rs. 3,500) to profit. Incremental reasoning does not mean
that the firm should accept all orders at prices, which cover merely their incremental costs. The
acceptance of the 5,000$ order depends upon the existence of idle capacity and labor that would go
underutilized in the absence of more profitable opportunities. Earley’s study of “excellently managed”
large firms suggest that progressive corporations do make formal use of incremental analysis. It is,
however, impossible to generalize on the use of incremental principle, since the observed behavior is
variable.
Principle of time perspective
a decision by the firm should take into account of both short-run and long-run effects on revenues and
cost & maintain the right balance between the long run and short run.
According to this principle, a manger/decision maker should give due emphasis, both to short-term and
long-term impact of his decisions, giving apt significance to the different time periods before reaching
any decision. Short-run refers to a time period in which some factors are fixed while others are variable.
The production can be increased by increasing the quantity of variable factors. While long-run is a time
period in which all factors of production can become variable. Entry and exit of seller firms can take place
easily. From consumer’s point of view, short-run refers to a period in which they respond to the changes
in price, given the taste and preferences of the consumers, while long-run is a time period in which the
consumers have enough time to respond to price changes by varying their tastes and preferences.
Suppose there is a firm with a temporary idle capacity. An order for 5000 units comes to management’s
attention. The customer is willing to pay Rs 4/- unit or Rs.20000/- for the whole lot but not more. The
short run incremental cost (ignoring the fixed cost) is only Rs.3/-. Therefore, the contribution to overhead
and profit is Rs.1/- per unit (Rs.5000/- for the lot) Analysis: From the above example the following long
run repercussion of the order is to be taken into account:
If the management commits itself with too much of business at lower price or with a small contribution
it will not have sufficient capacity to take up business with higher contribution.
If the other customers come to know about this low price, they may demand a similar low price. Such
customers may complain of being treated unfairly and feel discriminated against.
4
In the above example it is therefore important to give due consideration to the time perspectives. “a
decision should take into account both the short run and long run effects on revenues and costs and
maintain the right balance between long run and short run perspective”.
Here the principle of time perspective applies, where maintains right balance between long run and
short-run markets.
Discounting principle
The discounting principle requires you to look at the value of a sum of money in the present day and
compare it to the value of the money after an amount of time. You need to do this if you are in a situation
where you will use the money at a future date. The value of the future amount of money is known as the
present value. To find the present value, you need to discount the amount of interest the money could
earn if you were to place it in an interest earning account. The formula used to find the discount factor is
PV = Amount/ (1+i). PV means "present value," and "i" stands for the interest on the account.
An example of when the discounting principle comes into play is saving money in a bank account that
earns interest. If you receive $100 from someone and place it in an account that earns 10 percent interest
yearly, you will have $110 in a year's time. But if you wanted to have $100 next year in that same 10
percent interest account, you would need to deposit $90 in the account today.
Equi-marginal principle
This principle is also known the principle of maximum satisfaction. According to this principle, an input
should be allocated in such a manner that the value added by the last unit of input is same in all uses. In
this way. this principle provides a base for maximum exploitation of all the inputs of a firm so as to
maximise the profitability.
The equi-marginal principle can be applied in different areas of management. It is used in budgeting.
The objective is to allocate resources where they are most productive. It can be used for eliminating waste
in useless activities. It can be applied in any discussion of budgeting. The management can accept
investments with high rates of return so as to ensure optimum allocation of capital resources. The equi-
marginal principle can also be applied in multiple product pricing. A multi-product firm will reach
equilibrium when the marginal revenue obtained from a product is equal to that of another product or
products. The equi-marginal principle may also be applied in allocating research expenditures.
Rule:
This principle suggests that available resources (inputs) should be so allocated between the alternative
options that the marginal productivity gains (MP) from the various activities are qualized.
Example: students allocating limited available days for existing subjects during examinations for getting
best percentage. 14 days to go for examinations and having 7 subjects. Students may not always allot 2
5
days for each subject, they may allot more days for hard subject and less days for easy subject to maintain
good percentage.
Definitions
In the words of Ferguson, "Law of equi-marginal utility states that to maximise utility, consumers way
allocate their limited incomes among goods and services in such a way that the marginal utilities per
dollar (rupee) of expenditure on the last unit of each good purchased will be equal"
According to Marshall, "if a person has a thing which he can put to several uses, he will distribute it
among these uses in such a way that it has the same marginal utility in all"
Lipsey is of the view that, "The consumer maximising his utility wilt so allocate expenditure between
commodities that the utility derived from the last unit of money spent on each is equal"

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Principles of economics | Fundamental of Economics

  • 1. | Sachin Kumar | Asian School of Business | pg. 1 | Managerial Economics BBA - V Fundamental Economic tools Opportunity cost concept Opportunity Cost Principle: Heaberler and Taussing have developed this important cost principle. This principle studies about the various alternatives and their benefits. According to this principle the managerial decision must be such that from the selected alternative benefits. The opportunity cost of a good or of performing an action, also known as the greatest cost, is the lost value of alternate options that could have been chosen, rather than the one that was chosen. If A gives twice as much pleasure as B, and there is no C that gives more pleasure than B and is comparable (such as uses time, effort, or some other resource), then A's opportunity cost is the benefit of B because that is the difference in resulting happiness. In this particular scenario, the opportunity cost of A is not a good indicator of its value, because it says that A is worth only as much as B, which is not the case. Normally, there would be many alternate uses for the resources of A/B, so that there would not be such a notable difference, and so A and B would be similar in benefits, B and C would be similar in benefits, etc. In such a case where the differences are minor, the opportunity cost of A would be similar to that of B, and that would reflect their similar benefits. Oftentimes, opportunity cost is seen as what one would have to give up for something else: Opportunity cost of A (in terms of B) = - ∆𝐵 ∆𝐴=1 where ∆𝐴is the gain of marginal utility because of a gain of A = 1 ∆𝐵 is the loss of marginal utility because of a loss of B Opportunity costs can also be thought of as the resources lost, or alternate products forgone, through taking a particular action or producing a certain product. The lost resources could be time, effort, money, goods, etc. Incremental concept The incremental concept is closely related to the marginal costs and marginal revenues of economic theory. Incremental concept in managerial economics involves two important activities which are as follows:
  • 2. 2  Estimating the impact of decision alternatives on costs and revenues.  Emphasizing the changes in total cost and total cost and total revenue resulting from changes in prices, products, procedures, investments or whatever may be at stake in the decision. The two basic components of incremental reasoning are as follows:  Incremental cost: Incremental cost may be defined as the change in total cost resulting from a particular decision.  Incremental revenue: Incremental revenue means the change in total revenue resulting from a particular decision. The incremental principle in economics may be stated as under: A decision is obviously a profitable one if;  It increases revenue more than costs  It reduces costs more that revenues.  It decreases some costs to a greater extent than it increases other costs  It increases some revenues more than it decreases other revenues Some businessmen hold the view that to make an overall profit, they must make a profit on every job. Consequently, they refuse orders that do not cover full cost (labor, materials and overhead) plus a provision for profit. Incremental reasoning indicates that this rule may be inconsistent with profit maximization in the short run. A refusal to accept business below full cost may mean rejection of a possibility of adding more to revenue than cost. The relevant cost is not the full cost but rather the incremental cost. A simple problem will illustrate this point. Suppose a new order is estimated to bring in additional revenue of Rs. 5,000. The costs are estimated as under: Labor 1500 Material 2000 Overhead (Allocated at 120% of labor cost) 1800 Selling administrative expenses (Allocated at 20% of labor and material cost) 700 Total Cost 6,000 The order at first appears to be unprofitable. However, suppose, if there is idle capacity, which can be, utilised to execute this order then the order can be accepted. If the order adds only 500$ of overhead (that is, the added use of heat, power and light, the added wear and tear on machinery, the added costs of supervision, and so on), Rs. 1,000 by way of labour cost because some of the idle workers already on the payroll will be deployed without added pay and no extra selling and administrative cost then the incremental cost of accepting the order will be as follows.
  • 3. 3 Labor 1500 Material 2000 Overhead 500 Total Incremental cost 4000 While it appeared in the first instance that the order will result in a loss of Rs. 1,000, it now appears that it will lead to an addition of Rs. 1,500 (Rs. 5,000- Rs. 3,500) to profit. Incremental reasoning does not mean that the firm should accept all orders at prices, which cover merely their incremental costs. The acceptance of the 5,000$ order depends upon the existence of idle capacity and labor that would go underutilized in the absence of more profitable opportunities. Earley’s study of “excellently managed” large firms suggest that progressive corporations do make formal use of incremental analysis. It is, however, impossible to generalize on the use of incremental principle, since the observed behavior is variable. Principle of time perspective a decision by the firm should take into account of both short-run and long-run effects on revenues and cost & maintain the right balance between the long run and short run. According to this principle, a manger/decision maker should give due emphasis, both to short-term and long-term impact of his decisions, giving apt significance to the different time periods before reaching any decision. Short-run refers to a time period in which some factors are fixed while others are variable. The production can be increased by increasing the quantity of variable factors. While long-run is a time period in which all factors of production can become variable. Entry and exit of seller firms can take place easily. From consumer’s point of view, short-run refers to a period in which they respond to the changes in price, given the taste and preferences of the consumers, while long-run is a time period in which the consumers have enough time to respond to price changes by varying their tastes and preferences. Suppose there is a firm with a temporary idle capacity. An order for 5000 units comes to management’s attention. The customer is willing to pay Rs 4/- unit or Rs.20000/- for the whole lot but not more. The short run incremental cost (ignoring the fixed cost) is only Rs.3/-. Therefore, the contribution to overhead and profit is Rs.1/- per unit (Rs.5000/- for the lot) Analysis: From the above example the following long run repercussion of the order is to be taken into account: If the management commits itself with too much of business at lower price or with a small contribution it will not have sufficient capacity to take up business with higher contribution. If the other customers come to know about this low price, they may demand a similar low price. Such customers may complain of being treated unfairly and feel discriminated against.
  • 4. 4 In the above example it is therefore important to give due consideration to the time perspectives. “a decision should take into account both the short run and long run effects on revenues and costs and maintain the right balance between long run and short run perspective”. Here the principle of time perspective applies, where maintains right balance between long run and short-run markets. Discounting principle The discounting principle requires you to look at the value of a sum of money in the present day and compare it to the value of the money after an amount of time. You need to do this if you are in a situation where you will use the money at a future date. The value of the future amount of money is known as the present value. To find the present value, you need to discount the amount of interest the money could earn if you were to place it in an interest earning account. The formula used to find the discount factor is PV = Amount/ (1+i). PV means "present value," and "i" stands for the interest on the account. An example of when the discounting principle comes into play is saving money in a bank account that earns interest. If you receive $100 from someone and place it in an account that earns 10 percent interest yearly, you will have $110 in a year's time. But if you wanted to have $100 next year in that same 10 percent interest account, you would need to deposit $90 in the account today. Equi-marginal principle This principle is also known the principle of maximum satisfaction. According to this principle, an input should be allocated in such a manner that the value added by the last unit of input is same in all uses. In this way. this principle provides a base for maximum exploitation of all the inputs of a firm so as to maximise the profitability. The equi-marginal principle can be applied in different areas of management. It is used in budgeting. The objective is to allocate resources where they are most productive. It can be used for eliminating waste in useless activities. It can be applied in any discussion of budgeting. The management can accept investments with high rates of return so as to ensure optimum allocation of capital resources. The equi- marginal principle can also be applied in multiple product pricing. A multi-product firm will reach equilibrium when the marginal revenue obtained from a product is equal to that of another product or products. The equi-marginal principle may also be applied in allocating research expenditures. Rule: This principle suggests that available resources (inputs) should be so allocated between the alternative options that the marginal productivity gains (MP) from the various activities are qualized. Example: students allocating limited available days for existing subjects during examinations for getting best percentage. 14 days to go for examinations and having 7 subjects. Students may not always allot 2
  • 5. 5 days for each subject, they may allot more days for hard subject and less days for easy subject to maintain good percentage. Definitions In the words of Ferguson, "Law of equi-marginal utility states that to maximise utility, consumers way allocate their limited incomes among goods and services in such a way that the marginal utilities per dollar (rupee) of expenditure on the last unit of each good purchased will be equal" According to Marshall, "if a person has a thing which he can put to several uses, he will distribute it among these uses in such a way that it has the same marginal utility in all" Lipsey is of the view that, "The consumer maximising his utility wilt so allocate expenditure between commodities that the utility derived from the last unit of money spent on each is equal"