Module -1

Managerial Economics
• Module -1
Module 1: The Nature and Scope of Managerial Economics:
Definition of Managerial Economics, Relationship to Economic Theory,
Relationship Decision Sciences, The Basic process of Decision making.
Theory of the Firm: Reasons for the existence of Firms and their
Functions, Objective and Value of the Firm, Constraints on the
operation of firm, Limitations of the Theory of the Firm. Business
versus Economic Profit.
• Theories of Profit. Functions of Profit. International Framework of
Managerial Economics.
• Meaning
• It deals with the application of economic theory for achieving the
desired results.
• The integration of economic theory with business practice for the
purpose of facilitating decision making and forward planning by
management.
• Any tools and techniques of economics that are useful for decision
making in business
• Business decision making
• Business economics is the economics involved in business decision making . It is integration of
economic principles with business practise
• To arrive at right decision efforts should be made to establish objectives(decision should be made to arrive at
what to produce and to analyse whether that decision is right)

• Specify the decision problem.( what is the problem and how it canbe sorted out- marketing decision in the
current scenario)

• Identify alternatives (the next step is identify and list complete set of alternative act

• Evaluate the alternatives (though judgement and common sense are the primary requirement for evaluating the
alternatives, techniques which are statistical are developed for evaluating alternatives.

• Select the best alternative\ implement the decision

• Communication and implementation ( decision by managers are carried by subordinates. So decision have to
be communicated properly and this has to be completed)

• Monitor the performance( it provides a basis for making future decisions or revising the past decisions.
•
• Managerial economics consists of the use of economic modes of thought to
analyze business situations.
• Spencer defines managerial economics as the integration of economic
theory with business practice for the purpose of facilitating decision making
and forward planning by management.
• The prime function of management executive in a business organization is
decision making and forward planning. Decision making means the
process of selecting one action from two or more alternatives. forward
planning means establishing plans for the future.
• Economics is a body of knowledge or study that discusses how a society
tries to solve human problems of unltd wants and scare resources.
Economic theory Business Mgnt-
Decision Problems

Managerial
Economics

Optimal solutions
to business
problems
• Scope of economics
• Concerned with firms behaviour on optimal allocation of resources,
provides tools to help in identifying the best courses among the
alternatives , allocation of resources arises due to the scarcity of
resources thus the 4 questions have to be addressed
• What to produce?
• How to produce?
• How much to produce?
• Whom to produce?
• Has to perform numerous duties
• Role and responsibility of a business economist\
• Demand estimation and forecasting
• Preparation of sales forecasts
• To determine the nature and extent of competition
• Analyse the issues and problems of the concerned industry
• Assit in business planning
• Advise on pricing investment, and budget polices
• Follow and tune with the current economic and political changes of a particular country.
• The business economist has to acquire full knowledge about the behavior of the economy as a
whole and the impact of macro economic policies adopted by the govt from time to time
• Knowledge of BOP exchange rates import and export policies of the govt are also essential for a
business economist.
• The first question arises owing to the scarcity of resources have to be
channelized in the right direction so that resources are not wasted
• The combination of resources and the quantity of each resource to
be used to produce a given level of output depending on the resource
available technique of production can be labour or capital intensive
• The quantity to be produced so that there is no wastage and scarcity
of the said raw material for the future period.
• Distribution of goods among the various categories of peoples
• Nature
• Managerial economics is particularly the study of allocation of resources
available to a business firm or organisation. It is concerned with the art of
economising.
• Concerned with the art of making rational choices to yield maxi returns out
of the mini resources and efforts
• Managerial economics pertains to the overlapping area of economics along
with the tools of decision sciences such as mathematical economics,
statistics, econometrics as applied to business management problems
• Micro in nature
• Takes decision at the firm level
• It involves application of economic theory especially micro economics
analysis to practical problems
• In business decision making the real situation tend to be quite different

• There are multiple goals in running a business

• Lack of certainty due to dynamic changes

• The pervasiveness of uncertainty

• Logic of choice – it teaches the art of rational decision making. Thus

economics is of significance in modern business as decision mkg is the
core of business
•
• Basic process in decision making
• Defining the problem at hand-Important stage in business activity a poor problem
does not yield useful result.
• List viable alternatives- once the problem is defined then next action is to make a list
of viable alternatives that can be considered in the decision.
• Identify the expected future events-list the future events that may occur. Eg
prediction of future demand would high demand, low demand, no demand.
• Alternate course of action-the entrepreneur selects each course of alternative action
for every decision taken.he would prefer to go with the one which give better
results.
• Application of the right model
• The decision makers finally apply the suitable model which helps to make the
decision.
Time perspective-economists use concepts of functional time periods i.e long
and short run. Time is an important factor is the business decision making
Discounting principle- a present gain is valued more than a future gain.
V= A/(1 + i)
A= annuity if returns expected in a year
i= current rate of interest.
Present worth =100 , rate of interest 8% then present worth for next year
would be
V=100/1+8%= rs 92.59
• Decision making situations
• Decision under certainity- information in certain situations are complex which helps in taking
decision faster. Here the decision maker is certain about the course of action which his decision
would lead. Starting new product line
• Decision making under risk-this arises when the problem is unknown but on the basis of the
objective or empirical evidence it is possible to assign probabilities to various states of nature. Eg
business ventures
• Decision making under uncertainity-when the state of nature is unknown and no
information is available about the probability of occurrence- eg sales during a recession period
• Decision making under partial information
• It is condition lying between certainity and uncertainity.since partial information is obtained in all
probability the entrepreneur will predict the necessary result based on the obtained information.
• Decision making under conflict: this condition would occur when decision has to be taken while
dealing with a rational opponent. The decision maker has to choose a strategy which takes into
account the action or counter action of his opponent. Situation of telecom service providers.
• Micro and macro economics and its significance

Micro

Macro
d d
Business
decisions
• Basic factors in business decision making:
• Marginalism, Equi-marginalism, and cost principle, Risks and uncertainties, Time value of
money.
• Opportunity cost
• The cost involved in any decisions consist of the sacrifice of alternatives required by that
decision. The opp cost of the funds employed in ones own business is the amount of
interest income which could be earned had been employed in other ventures.
• Example the cost of using a machine alternatively
• Incremental principle-
• Rate of change in revenue versus cost is understood thr incremental principle.
• Revenue = P x qty sold
• Chairs = tc 400 price = 400+150 = 550
• 10 chairs = 5500(tr)
• Profit =TR-TC , 5500-4000 =1500

• revenue –cost of production

• Profits = IR >IC , IR<IC = LOSS
• Functions
• Refer to the numerical relationship which may change on it own
independently.
• Eg Y = f(x)
• Y is a function of x
• Y = 3 +2x means when y increases x also increases
• Demand = f(P)
• Q =f(L,K)

• Graphs
• Are pictorial representation of concepts , also called as visual aids which
enable to trace the relationship between economic variables
• Opportunity cost
• The cost involved in any decisions consist of the sacrifice of alternatives required by that
decision. The opp cost of the funds employed in ones own business is the amount of
interest income which could be earned had been employed in other ventures.
• Example the cost of using a machine alternatively.

• time
• Time perspective-economists use concepts of functional time periods i.e long and short
run. Time is an important factor is the business decision making
• Discounting principle- a present gain is valued more than a future gain.
• V= A/(1 + i)
• A= annuity if returns expected in a year
• i= current rate of interest.
• Present worth =100 , rate of interest 8% then present worth for next year would be
• V=100/1+8%= rs 92.59
• Equi marginal principle
• Time value of money
• Short run and long run period
• PVF= 1/(1+R)n
• Pvf =present value factor
• N- time period
• R =rate of discount
• Supply = s =f(P)
• Eg- 1 soft ware industry
• Decision making
• Creating packages –industry , educational institution, hospitals, freelance soft
ware
• Inputs
• Labour, capital, trained personnel, computers, printers and misc things, plant
etc
• Pricing – should it vary???
• Should not vary???
• Equilibrium is defined as a state of balance or a stable situation
where opposing forces cancel each other out and where no changes
are occurring. An example of equilibrium is in economics when
supply and demand are equal.
• Equilibrium may be divided in to partial and General
• Analysis that treat a sector as a single entity with no relationship
with the other
• General equilibrium relates to analysis of the economy as a whole
• It refers to all consumers, firms, factors of production , all markets
which are simultaneously in equilibrium.
• Scope of Managerial Economics
• Managerial economics is concerned with solving problems pertaining
to business affairs/ it refers to policies of planning and development of
business.
• It covers certain broad areas
• Like consumption analysis
• Production and cost
• Pricing decisions policies and practices
• Profit management
• Capital management
• Decision making
• Case study-2
• Zenith automobiles projected a increasing demand fr their cars in the
Country by 20 percent per annum. Currently all their 10 plants are
fully in operation to maximum capacity. The firm intends to expand
its output with an objective of earning more profits. The
management has two options to chose for expanding the output.
• 1Strategy 1- cost two new additional plants
• 2.Strategy 2- a rival firm prestige automobiles is in a financial trouble
and wishes to sell out its two plants in the vicinity of the zenith. Buy
this and modify.
• Equi marginal principle
• The principle states that an input should be allocated in such a way that the
value added by the last unit of an input is the same in all its uses.
• Ex
• Suppose a firm has got 50 workers to employ on 3 a activities say
production of bottled milk, butter and cheese. The firm must allocate these
workers in such a way that the duty of producing bottled milk, adds to
output worth rs 20 then the marginal worker employed on butter and
cheese production must also earn neither more nor less than rs 20 for the
milk plants. Otherwise the firm will not be making the best use of the
employed labout.
• The principle states that an input should be allocated in such a way that the
value added by the last unit of an input should be allocated in such a way
that the value added by the last unit of the input is the same in all its uses.
• Ex
• Suppose a firm has got 50 workers to employ on 3 a activities say
production of bottled milk, butter and cheese. The firm must allocate these
workers in such a way that the duty of producing bottled milk, adds to
output worth rs 20 then the marginal worker employed on butter and
chesse production must also earn neither more nor less than rs 20 for the
milk plants. Otherwise the firm will not be making the best use of the
employed labout.
 • Variables
• Used symbolically to classify data
• A variable is a quantity which varies from one individual observation
to the other.
• Discrete variable – one which has values in integral no only an d
which cannot be measure
• 1,2,3, etc
• A continuous variable is one which can assume any value-age, wages ,
income
• Exogeneous and endogeneous variable
• exo variable s are those which are taken from outside the systems
• Eg-production influenced by advertisement, govt policy
• Endo variables are those which emerge from within the system
• Eg- production depends on investment, seeds
• Technology.
• PROFITS
• Residual income after payments are made
• A financial gain or benefit that is realized when the amount of rev
gained from business activity exceeds the expenses,
• Total profits = Revenue –cost of production
• Profits are the results of risk bearing
• It is seed money for further investment
• Result of uncertainty bearing
• Classification of profit
• Gross profit is the surplus which accrues to the firm when it
subtracts its total expenditure from receipts.
• Following are included gross profit
• 1.remuneration for the factors of production contributed by the
entrepreneur
• 2.depreciation and maintenance charges
• 3. insurance charges
• 4.monopoly profit
• 5.Chance profit
• Net profit = gross profit – opportunity cost

• Accounting and economic profit

• Implicit and explicit cost
• Ex- own land, own capital
• Accounting cost is the cost where explicit cost is only added
• Economic cost is both explicit and implicit cost is added which is not
reflected in cash out lays
• Profits to be fixed

• Distribution –

• How to market the product

• Word of mouth
• Presentation to needed clientele
• Ad in selected websites
• Case II

• Branding of a Product

• Pros and Cons of advertising

• Decisions on Marketing
• Definition: Walker’s Theory of Profit, also called as a Rent
Theory of profit was propounded by F.A. Walker, who believed
that profit is regarded as a rent of differential ability that an
entrepreneur may possess over the others.
• the walker’s theory of profit is based on the assumption that
a state of perfect competition prevails, wherein all the firms are
presumed to attain the same managerial ability. Each firm would
draw wages for management ability, which in the Walker’s view do
not form a part of the pure profit. The wages of management are
regarded as ordinary wages. Thus, under the perfect completion
scenario, there will be no pure profit and each firm will earn the
management wages, known as normal profit
demerits

• The walker’s theory of profit is mainly criticized due to its

inability to explain the nature of profit.
• It provides only the measure of profits and not its real
nature, which is of utmost importance.
• The assumption that profits arise due to the differential
ability of an entrepreneur does not always stand true. The
rise in the profits could also be due to the entrepreneur’s
monopoly in the marke
Definition: The Innovation Theory of Profit was proposed by Joseph. A.
Schumpeter, who believed that an entrepreneur can earn economic
profits by introducing successful innovations.

According to Schumpeter, innovation refers to any new policy that an

entrepreneur undertakes to reduce the overall cost of
production or increase the demand for his products.

Thus, innovation can be classified into two categories; The first

category includes all those activities which reduce the overall cost of
production such as the introduction of a new method or technique of
production, the introduction of new machinery, innovative methods of
organizing the industry, etc.

• The second category of innovation includes all such activities which

increase the demand for a product. Such as the introduction of a new
commodity or new quality goods, the emergence or opening of a new
market, finding new sources of raw material, a new variety or a design of
the product, etc.
An entrepreneur can earn larger profits for a longer duration if the law allows
him to patent his innovation.

Such as a design of a product is patented to discourage others to imitate it.

Over the time, the supply of factors remaining the same, the factor prices
tend to rise as a result of which the cost of production also increases. On the
other hand, with the firms adopting innovations the supply of good s and
services increases and their prices fall. Thus, on one hand the output per unit
cost increases while on the other hand the per unit revenue decreases.

• There is a point of time when the difference between the costs and receipts
gets disappear. Thus, the profit in excess of the normal profit disappears. This
innovation process continues and also the profits continue to appear or
disappear.
• Profit as a Reward:
• Clark viewed profit not just as the difference between price and cost, but as a reward for
entrepreneurs who can successfully adapt to and capitalize on dynamic changes in the
economy.
• Dynamic Changes:
• The theory highlights the importance of dynamic changes, such as:
• Population Growth: Increased population can lead to greater demand for goods and
services, potentially boosting profits for businesses that can meet this demand.
• Technological Advancements: New technologies can create new products and processes,
offering opportunities for innovation and profit generation.
• Shifting Tastes and Preferences: Changes in consumer tastes and preferences can lead to
demand for new products or modifications to existing ones, creating opportunities for
entrepreneurial ventures.
• Capital Accumulation: Increased capital investment can lead to greater productivity and
potentially higher profits for businesses that can effectively utilize the increased capital.
• Static vs. Dynamic Economy:
• Clark contrasted a static economy, where there is no change, with a
dynamic economy, where there is constant change and growth. In a static
economy, there would be no room for profit as there are no dynamic
changes for entrepreneurs to capitalize on.
• Entrepreneurs as Profit Makers:
• The theory emphasizes the role of entrepreneurs in recognizing and
responding to dynamic changes, ultimately leading to profit generation.
• Pure Profit vs. Normal Profit:
• The theory suggests that pure profit, which is the reward for dynamic
entrepreneurship, may disappear in the long run as other businesses
emulate the successful entrepreneur's methods. However, normal profit,
which is the minimum return needed to keep the business in operation,
would still be present.
• Entrepreneurs as Profit Makers:
• The theory emphasizes the role of entrepreneurs in recognizing and
responding to dynamic changes, ultimately leading to profit
generation.
• Pure Profit vs. Normal Profit:
• The theory suggests that pure profit, which is the reward for dynamic
entrepreneurship, may disappear in the long run as other businesses
emulate the successful entrepreneur's methods. However, normal
profit, which is the minimum return needed to keep the business in
operation, would still be present.
•Pure Profit vs. Normal Profit:
The theory suggests that pure profit, which is the reward for dynamic
entrepreneurship, may disappear in the long run as other businesses emulate the
successful entrepreneur's methods. However, normal profit, which is the minimum
return needed to keep the business in operation, would still be present.
In simpler terms:
Imagine a restaurant owner who successfully adapts to changing
consumer tastes by introducing new dishes or modifying existing
ones. They might be able to increase their profits due to these dynamic
changes in the market. This is an example of how a dynamic theory of
profit might apply in practice.
Criticisms of the Dynamic Theory:
•Ignoring Risk and Uncertainty:
Some critics argue that the theory does not adequately account for the risks and
uncertainties involved in entrepreneurship.
•Overemphasis on Dynamic Changes:
Others argue that the theory overemphasizes the role of dynamic changes and
neglects other factors that can influence profit, such as market structure and
competition.
• Uncertainity
• Exist when outcomes of managerial decisions cannot be predicted
with accuracy
• Possibilities and probabilities are know.
• Experience, insight and prudence allow investment managers to
device strategies for minimizing the chance of failure
• Risk and uncertainities
• Economic risk is the chance of a possible loss. Action are taken in a
decision environment not sure of the out comes
• Insurable risk
• Non insurable risk
• Firms and theories of firms
• Firms are economic entities which buy or employ factors of production and organize them
to create goods and services for sale. A group of firms which produce similar products
become the industry
• Objectives of the firm
• Profits
• Sales maximization
• increase in market share
• building a business reputation
• job satisfaction
• financial stability and liquidity
• maintainence of good labour relations
The Nature of the Firm
• Every firm must deal with the government
• Pays taxes to the government
• Must obey government laws and regulations
• Receive valuable services from the government
• Public capital
• Legal systems
• Financial systems

46
Fig. 1 The Firm and Its Environment

Owners

Initial Financing Profit After Taxes

Input Costs Taxes

Input The Firm
Government
Suppliers (Management)
Inputs Government Services
Government Regulations
Output Revenue

Customers

47
• Theories of the firm
• staff maximization- according to this theory when the managers
control the business instead of satisfying the profitability of owners
and shareholders they may seek to satisfy their own utility by having
more than necessary larger staff to be employed in the organization.
• When the firm possess a degree of monopoly power the manager
may trade off some profits for an expansion in the size of staff.
• Fig
•
•
• Dp discretionary profit
• U = indifference curve
• To find the equilibrium, manager’s indifference map and discretionary
profit curve is brought together. The point of tangency of profit-staff
curve with the highest possible managerial indifference curve at point e
shows the equilibrium of the firm. Since ICs have a negative slope, the
equilibrium point will be at the falling part of profit curve. Thus according
to Williamson, there is a greater preference for staff expenditure by the
managers. The staff expenditure here will be greater than that of a profit
maximiser. This model implies higher output, lower price and lower level
of profit than the profit maximization model
• Sales maximization
• Refers to maximization of sales and sales revenue. This is because
increase in sales enables the firm to capture more market and earn
business reputation.
•
• Managers salary and remuneration are tied to sales and not profits
• Larger sales revenue
• Increases sales enables firms to capture more market and earn business
reputation
• Fig
Y axis profit and x axis staff size
• 3.Growth maximization
• Marris' theory of growth maximization focuses on how firms,
particularly those with managerial discretion (where managers are
separate from owners), strive to balance growth objectives with the
need to satisfy both owner and managerial interests.
• It suggests that firms pursue a balanced growth rate, where the
growth of demand for their products matches the growth of capital
supply. This balanced growth is achieved by maximizing both the
growth rate of demand for the firm's products (gD) and the growth
rate of the firm's capital supply
• Managerial Constraints:
• The size and capabilities of the managerial team limit the firm's ability
to grow. Adding new managers can increase the managerial pool, but
experience and coordination can be constraints.
• Financial Constraints:
• The firm's financial resources and access to capital markets also
restrict growth. Factors like the cost of capital, liquidity, and the need
to maintain a certain level of profitability for shareholders influence
the firm's ability to grow.
International framework of
managerial economics
• the international framework of managerial economics provides a
comprehensive approach for managers to navigate the complexities of
the global business landscape and make informed decisions that drive
profitability and sustainable growth in a globalized world.
• The international framework of managerial economics involves applying
economic principles to business decisions within a global context.
• It synthesizes economic theory, decision science, and business
administration to help firms optimize profitability and efficiency in the
face of global constraints and opportunities. This framework recognizes
the interconnectedness of global markets and the impact of international
trade, finance, and competition on managerial decision-making.
• Global Economic Environment:
• Understanding macroeconomic factors like exchange rates, interest
rates, inflation, and economic growth in different countries is crucial
for international business decisions.
• International Trade:
• Analyzing trade policies, tariffs, and non-tariff barriers, as well as
understanding comparative advantage and competitive strategies in a
globalized market.
• Foreign Direct Investment (FDI):
• Evaluating the opportunities and risks associated with investing in foreign
markets, considering factors like political stability, regulatory environment,
and cultural differences.
• International Finance:
• Managing currency risk, financing international operations, and
understanding international capital markets.
• Global Marketing:
• Adapting marketing strategies to different cultural contexts, understanding
consumer behavior in various markets, and managing global brands.
• Global Production and Supply Chain:
• Optimizing production processes and supply chains across multiple
countries, considering factors like labor costs, transportation costs,
and logistical challenges.
• International Business Ethics and Corporate Social Responsibility:
• Addressing ethical dilemmas in international business, considering the
social and environmental impact of business operations, and adhering
to international norms and standards.