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Economics as a tool for decision making


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Economics as a tool for decision making

  1. 1. Economics as a tool for decision making1) Opportunity cost principle:By the opportunity cost of a decision is meant the sacrifice of alternatives required by thatdecision.For e.g.a) The opportunity cost of the funds employed in one‟s own business is the interest that could beearned on those funds if they have been employed in other ventures. b) The opportunity cost ofusing a machine to produce one product is the earnings forgone which would have been possiblefrom other products) The opportunity cost of holding Rs. 1000as cash in hand for one year is the10%rate of interest, which would have been earned had the money been kept as fixed deposit inbank. Its clear now that opportunity cost requires ascertainment of sacrifices. If a decisioninvolves no sacrifices, its opportunity cost is nil. For decision making opportunity costs are theonly relevant costs.2) Incremental principle:It is related to the marginal cost and marginal revenues, for economic theory. Incrementalconcept involves estimating the impact of decision alternatives on costs and revenue,emphasizing the changes in total cost and total revenue resulting from changes in prices,products, procedures, investments or whatever may be at stake in the decisions. The two basiccomponents of incremental reasoning are1) Incremental cost2) Incremental Revenue Theincremental principle may be stated as under:“A decision is obviously a profitable one if – a) itincreases revenue more than costs b) it decreases some costs to a greater extent than it increasesothers) it increases some revenues more than it decreases others and) it reduces cost more thanrevenues”3) Principle of Time PerspectiveManagerial economists are also concerned with the short run and the long run effects ofdecisions on revenues as well as costs. The very important problem in decision making is tomaintain the right balance between the long run and short run considerations.For example,Suppose there is a firm with a temporary idle capacity. An order for 5000 units comes tomanagement‟s attention. The customer is willing to pay Rs 4/- unit or Rs.20000/- for the wholelot 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 intoaccount:1) If the management commits itself with too much of business at lower price or with a
  2. 2. small contribution it will not have sufficient capacity to take up business with highercontribution.2) If the other customers come to know about this low price, they may demand asimilar low price. Such customers may complain of being treated unfairly and feel discriminatedagainst. In the above example it is therefore important to give due consideration to the timeperspectives. “decision should take into account both the short run and long run effects onrevenues and costs and maintain the right balance between long run and short run perspective”.4) Discounting Principle:One of the fundamental ideas in Economics is that a rupee tomorrow is worth less than a rupeetoday. Suppose a person is offered a choice to make between a gift of Rs.100/- today or Rs.100/-next year. Naturally he will chose Rs.100/- today. This is true for two reasons-i) The future isuncertain and there may be uncertainty in getting Rs. 100/- if the present opportunity is notavailed of ii) Even if he is sure to receive the gift in future, today‟s Rs.100/- can be invested so asto earn interest say as 8% so that one year after Rs.100/- will become 1085) Equi - marginal Principle:This principle deals with the allocation of an available resource among the alternative activities.According to this principle, an input should be so allocated that the value added by the last unit isthe same in all cases. This generalization is called the equi-marginal principle. Suppose, a firmhas 100 units of labor at its disposal. The firm is engaged in four activities which need laborsservices, viz, A,B,C and D. it can enhance any one of these activities by adding more labor butonly at the cost of other activities.Relationship between managerial economic, economic, and other subjects :Economics andmanagerial economic:Economics contributes a great deal towards the performance of managerial duties andresponsibilities. Just as the biology contributes to the medical profession and physics toengineering, economics contributes to the managerial profession. All other qualifications beingsame, managers with working knowledge of economics can perform their function moreefficiently than those without it. What is the basic function of the managers of the business? Asyou all know that the basic function of the manager of the firm is to achieve the organizationalobjectives to the maximum possible extent with the limited resources placed at their disposal.Economics contributes a lot to the managerial economics.Mathematics and managerial economics:Mathematics in ME has an important role to play. Businessmen deal primarily with concepts thatare essentially quantitative in nature e.g. demand, price, cost, wages etc. The use of mathematicallogic In the analysis of economic variable provides not only clarity of concepts but also a logicaland systematical framework.
  3. 3. Statistics and managerial economics:Statistical tools are a great aid in business decision making. Statistical techniques are used incollecting processing and analyzing business data, testing and validity of economics laws withthereal economic phenomenon before they are applied to business analysis. The statistical toolsfor e.g. theory of probability, forecasting techniques, and regression analysis help the decisionmakers in predicting the future course of economic events and probable outcome of theirbusiness decision. Statistics is important to managerial economics in several ways. ME calls formarshalling of quantitative data and reaching useful measures of appropriate relationshipinvolves in decision making. In order to base its price decision on demand and costconsideration, a firm should have statistically derived or calculated demand and cost function.Operations Research and Managerial Economics:It‟s an inter-disciplinary solution finding techniques. It combines economics, mathematics, andstatistics to build models for solving specific business problems. Linear programming and goalprogramming are two widely used OR in business decision making. It has influenced MEthrough its new concepts and model for dealing with risks. Though economic theory has alwaysrecognized these factors to decision making in the real world, the frame work for taking theminto account in the context of actual problem has been operationalised. The significantrelationship between ME and OR can be highlighted with reference to certain importantproblems of ME which are solved with the help of OR techniques, like allocation problem,competitive problem, waiting line problem, and inventory problem.Management theory and Managerial economics:As the definition of management says that it‟s an art of getting things done through others. Betnow a days we can define management as doing right things, at the right time, with the help ofright people so that organizational goals can be achieved. Management theory helps a lot inmaking decisions.ME has also been influenced by the developments in the management theory. The centralconcept in the theory of firm in micro economic is the maximization of profits. ME should takenote of changes concepts of managerial principles, concepts, and changing view of enterprisesgoals.Accounting and Managerial economics:There exits a very close link between ME and the concepts and practices of accounting.Accounting data and statement constitute the language of business. Gone are the days whenaccounting was treated as just bookkeeping. Now its far more behind bookkeeping. Cost and
  4. 4. revenue information and their classification are influenced considerably by the accountingprofession.Meaning of Economics:Economics can be called as social science dealing with economics problem and man‟s economicbehavior. It deals with economic behavior of man in society in respect of consumption,production; distribution etc. economics can be called as an unending science. There are almost asmany definitions of economy as there are economists. We know that definition of subject is to beexpected but at this stage it is more useful to set out few examples of the sort of issues whichconcerns professional economists.Example:For e.g. most of us want to lead an exciting life i.e. life full of excitements, adventures etc. butunluckily we do not always have the resources necessary to do everything we want to do. Thereforechoices have to be made or in the words of economists “individuals have to decide-----“how toallocate scarce resources in the most effective ways”. For this a body of economic principles andconcepts has been developed to explain how people and also business react in this situation.Economics provide optimum utilization of scarce resources to achieve the desired result. Itprovides the basis for decision making.Economics can be studied under two heads:1) Micro Economics2) Macro EconomicsMicro Economics:It has been defined as that branch where the unit of study is an individual, firm or household. Itstudies how individual make their choices about what to produce, how to produce, and for whomto produce, and what price to charge. It is also known as the price theory is the main source ofconcepts and analytical tools for managerial decision making. Various micro-economic conceptssuch as demand, supply, elasticity of demand and supply, marginal cost, various market forms,etc. are of great significance to managerial economics.Management Decision Problems Economic Concepts Decision Science ManagerialEconomicsOptimal Solution to Managerial Decision Problems
  5. 5. Managerial Economics bridges the gap between purely analytical problems dealt withineconomic theory and decision problems faced in real business and thus helps out in makingrational choices to yield maximum return out of minimum efforts and resources by making thebest selection among alternative course of action .How does managerial economics differ fromregular economics?•There is no difference in the theory; standard economic theory providesthe basis for managerial economics. •The difference is in the way the economictheory is applied.• Economics in its broadest sense means what economists do. They providesolutions to various economic problems (inflation, unemployment etc). The one main rootcause of all economic problems isSCARCITYand managerial economics is the use of economic analysis to make business decisions involvingthe best use of organization‟s scarce resources.Unlimited Wants Limited resources or meansScarcityWhat to produce? How to produce? For whom to produceHuman wants are virtually unlimited and insatiable and economic resources to satisfy them arelimited which give rise to choices between what to produce, how to produce and for whomto produce.MANAGERIAL ECONOMICS = Economics + Decision Science + Business ManagementManagerial economics has evolved by establishing link on integration between economic theoryand decision sciences along with business management in the theory and practice for the optimalsolution to business decision problems. It deals with the application of economic principles andmethodologies to the decision making process within the firm, under the given situation.Chief Characteristics•Managerial Economics is micro economic in character: This is because the unit of study is afirm; it is the problem of a business firm which is studied and it does not deal with the entireeconomy as a unit ofstudy.•Managerial Economics largely uses economic concepts and principles: Managerial Economicslargely uses economic concepts and principles. •Managerial Economics is pragmatic: Itavoids difficult abstract issues of economic theory but involves complications ignored ineconomic theory to face the overall situations in which the decisions are made. •ManagerialEconomics belongs to normative rather than positive economics: Positive economics derivesuseful theories with testable propositions about „what is‟ and normative economics provides thebasis for value judgment on economic outcomes, „what should be‟. In other words
  6. 6. it is prescriptive rather then descriptive. It is known as the „normative micro economics of thefirm. •Macro Economics is also useful to managerial economics: Macro economics provides anintelligent understanding of the environment in which the business unit must operate. Thisunderstanding enables a business executive to adjust in the best possible manner with externalforces over which he has no control but which play a crucial role in the well being of hisconcern.Scope of Managerial Economics:Scope is something which tells us how far a particular subject will go. As far as ManagerialEconomic is concerned it is very wide in scope. It takes into account almost all the problems andareas of manager and the firm .ME deals with Demand analysis, Forecasting, Productionfunction, Cost analysis, Inventory Management, Advertising, Pricing System,Resource allocation etc. Following aspects are to be taken into account while knowing the scopeof ME:1. Demand analysis and forecasting:Unless and until knowing the demand for a product how can we think of producing that product.Therefore demand analysis is something which is necessary for the production function tohappen.Demand analysis helps in analyzing the various types of demand which enables the manager toarrive at reasonable estimates of demand for product of his company. Managers not onlyassess the current demand but he has to take into account the future demand also.2. Production function:Conversion of inputs into outputs is known as production function. With limited resources wehave to make the alternative uses of this limited resource. Factor of production called as inputsis combined in a particular way to get the maximum output. When the price of input rises thefirm is forced to work out a combination of inputs to ensure the least cost combination.3. Cost analysis:Cost analysis is helpful in understanding the cost of a particular product. It takes into account allthe costs incurred while producing a particular product. Under cost analysis we will take intoaccount determinants of costs, method of estimating costs, the relationship between cost andoutput, the forecast of the cost, profit, these terms are very vital to any firm or business.4. Inventory Management:What do you mean by the term inventory? Well the actual meaning of the term inventory isstock. It refers to stock of raw materials which a firm keeps. Now here the question arises howmuch of the inventory is ideal stock. Both the high inventory and low inventory is not good for
  7. 7. the firm. Managerial economics will use such methods as ABC Analysis, simple simulationexercises, and some mathematical models, to minimize inventory cost. It also helps in inventorycontrolling.5. Advertising:Advertising is a promotional activity. In advertising while the copy, illustrations, etc., are theresponsibility of those who get it ready for the press, the problem of cost, the methods ofdetermining the total advertisement costs and budget, the measuring of the economic effects ofadvertising ---- are the problems of the manager. There‟s a vast difference between producinga product and marketing it. It is through advertising only that the message about the productshould reach the consumer before he thinks to buy it. Advertising forms the integral part ofdecision making and forward planning.6. Pricing system:Here pricing refers to the pricing of a product. As you all know that pricing system as a conceptwas developed by economics and it is widely used in managerial economics. Pricing is also oneof the central functions of an enterprise. While pricing commodity the cost of production has tobe taken into account, but a complete knowledge of the price system is quite essential todetermine the price. It is also important to understand how product has to be priced underdifferent kinds of competition, for different markets.7. Resource allocation:Resources are allocated according to the needs only to achieve the level of optimization. As weall know that we have scarce resources, and unlimited needs. We have to make the alternate useof the available resources. For the allocation of the resources various advanced tools such aslinear programming are used to arrive at the best course of action