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Basics of Magerial Economics


       Learning Objectives

 To analyze the concept of managerial
 To know how ME help managers
 To understand the concept of
 To be acquainted with real life cases of
  managerial decision making
What is Managerial Economics?
 Managerial Economics =
 Management + Economics.
 Management deals with principles helping
  in decision making under uncertainty and
  improves efficiency
 Economics provides propositions for
  optimum allocation of scarce resources for
  achieving goals
     Definition of Managerial
 Managerial Economics consists of use of
 economic modes of thought to analyse
 business situations…
 Mc Nair & Miriam

 ME is defined as integration of eco theory
 with business practice for purpose of
 facilitating decision making and forward
 planning by the management… Spencer &
How does ME help managers?

  Economics:                               Business
  Theory and                               Management -
  Methodology                              Decision problems
                Managerial Economics
                Application of Economics
                to solving business

                 Optimal solution to
                 business problems
            Real Life examples

 Euro Disney

 Multinational product and pricing

 Building a bridge (funding a public project)

 An R & D decision (uncertainty and decision)
    10 Economic Principles for
1. Managers make decisions
2. Decisions are between alternatives
3. Alternatives have costs and benefits
4. Decision goal is to add value to the firm
5. Value is measured by profits or expected profits
6. Revenue depends on demand for the product
7. Maximum profit entails minimum cost
8. Strategy must be consistent with market
9. Growth requires rational investment decisions
10. Legal and ethical behavior leads to success
 Management is creation and maintenance of an
  internal environment in an enterprise where
  individuals, working together in groups, can
  perform efficiently and effectively towards the
  attainment of group goals. „Koontz and O‟Donell‟
 Management is coordination, an activity or an
  ongoing process, a purposive process, an art of
  getting things done by other people
  Subject matter of Economics
 Deals with wealth

 Scarce means i.e. limited resources
 Unlimited wants
 Alternative uses of scarce means

 Scarcity & Efficiency are twin themes of
 A rational consumer will use scarce resources in
  most efficient manner
             About Economics
 Economics is a science which studies human
    behavior as a relationship between ends and
    scarce means which have alternative uses

   Economics – science or art
   Positive or normative
   Economic vz noneconomic resources
   Land, labour, capital , organisation
       Branches of Economics
 Microeconomics          Macroeconomics

 Study of individual     Studies economy as
  units as firm or         a whole. It is
  household. How
  individuals make         aggregate in
  choices.                 character and takes
 Price theory             the entire economy
                           as a unit of study.
 Provides main source
  of decision making      Eg. GDP of India,
 Eg. Vodafone sales       population etc.
  Questions before Economists
 What to produce        Type of Economies
 How to produce
 For whom to produce    Capitalist or free
                          market economy
                         Socialist Economy
                         Mixed Economy
                                        A production possibility curve


Units of food (millions)

                           5       Units of food Units of clothing
                                     (millions)     (millions)
                                         8m               0.0
                                         7m               2.2m
                           3             6m               4.0m
                                         5m               5.0m
                                         4m               5.6m
                                         3m               6.0m
                                         2m               6.4m
                           1             1m               6.7m
                                         0                7.0m
                               0    1         2       3          4      5        6   7   8
                                                  Units of clothing (millions)
         Managerial Economics
 The application of economic theory and the
  tools of decision science to examine how an
  organization can achieve its aims or objectives
  most efficiently.
 Example:Economic theory says Q= f(P, Y, PC,
  PS); by collecting data on above variables, we
  can estimate the empirical (econometric)
  relationship. This estimated function can be
  used for managerial decision making,
  forecasting etc.
    Relation of ME with other
 Economics and ME
 Mathematics and ME
 Statistics and ME
 Operation Research and ME
 Management theory and ME
 Accounting and ME
 Computers and ME
 The Changing Environment of
    Managerial Economics
 Globalization of Economic Activity
     Goods and Services
     Capital
     Technology
     Skilled Labor
 Technological Change
   Telecommunications Advances
   The Internet and the World Wide Web
    Managerial Economics vz

 Is it the same?
     Managerial Economics &
        Decision making
The prime function is decision making &
 forward planning

1.Demand Forecasting
2.Production planning and cost revenue
3. Study of economic environment
4. Pricing in different market structures
5. Investment decisions
    Steps of decision making
 Define the problem
 Determine the objective
 Identify and evaluate the alternatives
 Select the best alternatives
 Implement the decision
 Monitor performance & sensivity analysis
        The Rationale of firm
 What is a firm?

 Why does it exist?

 What are its functions
               Theory of the Firm
 Firm combines and organizes resources for the
  purpose of producing goods and/or services for
 Internalizes transactions, reducing transactions
 Resource owners use the income generated
  from the sale of their services/resources, to
  purchase goods and services produced by
  firms. Circular flow of economic activity is thus
 Primary goal is to maximize the wealth or value
  of the firm.
           Objective of firm
 The goal is to maximise present or
  discounted value of all future profits
PV (π)= π1+ π2 + ……..+ πn
        1+r (1+r)2         (1+r)n
Present value of future profits is the value of
  firm =
   Constraints on theory of firm
 Limited availability of inputs
 Lack of skilled labour
 Legal constraints

Constraint optimisation is task of manager
  Alternative Objectives of firm
 Sales revenue maximisation
 Managerial Utilty (Corporate power &
  managerial discretion)
 Growth models
 Satisfying behavior
 Corporate social responsibility
          Alternative Theories of the firm
 Sales maximization(William Baumol)
   Adequate rate of profit to satisfy share holders;
    assuming this, maximise sales, even by sacrificing
    some profits.
 Management utility maximization ( Williamson)
    Principle-agent problem: managers try to
     maximise their benefits like salaries, fringe
     benefits, stock options, staff size, lavish offices,
     etc. This can be resolved by linking managers‟
     rewards to firm‟s performance compared to similar
     firms in the industry.
 Satisficing behavior( not maximising) with
  reference sales, profits, growth, mkt.. Share etc.
         Opportunity Cost
Opportunity cost of a decision is the sacrifice
  of alternatives required by that decision.

Returns from second best alternative.

1.All decisions involving choice must have
    opportunity cost calculation
2. Opportunity cost may be real or monetary,
    explicit or implicit.

What will be opportunity cost of the funds
  employed in one‟s own business?
   Concept of Economic Profits
 Profits occur due to risk taking ability,
  managerial ability, monopoly, innovation, friction

 Economic profit = Total Revenue – Total cost
Cost = Explicit costs + Implicit costs

Explicit cost = direct out of pocket expenditure
Implicit cost = costs of factors owned by firm and
  used in its own production
           Function of Profit
 Profit is a signal that guides the allocation
  of society‟s resources.
 High profits in an industry are a signal that
  buyers want more of what the industry
 Low (or negative) profits in an industry are
  a signal that buyers want less of what the
  industry produces.
Tools of Managerial Economics
 Incremental cost
 Opportunity Cost
 Time Perspective
 Discounting principle
 Equi- marginal principle
     Incremental principle
Incremental concept involves estimating the impact
  of decision alternatives.

 The two basic components of incremental
Incremental cost        Incremental Revenue

“ A decision is obviously a profitable one if –
 it increases revenue more than costs
 it decreases some costs to a greater extent than
   it increases others
 it increases some revenues more than it
   decreases others
 it reduces cost more than revenues”
      Time Perspective
 Short Run vz Long Run perspective

 Short Run – only variable factors can
  be changed
 Long Run – All factors of production
  can be changed
          Discounting principle
 A rupee tomorrow is worth less than a rupee today.

 One has to discount costs and revenues at future date
  and make it comparable to present value

Suppose one has a choice between a gift of Rs.100/-
  today or next year. he will chose Rs.100/- today.
 i. the future is uncertain and there may be uncertainty
  in getting Rs. 100/-
 ii. Also, today‟s Rs.100/- can be invested so as to earn
  interest say as 8% so that one year after Rs.100/- will
  become Rs 108/-.

 PV = Rn /(1+i)n
       Equimarginal Principle
 This principle deals with the allocation of
  an available resource among the
  alternative activities.
 an input should be so allocated that the
  value added by the last unit is the same in
  all cases
 MU1/MC1=MU2/MC2=….= MUn/MCn
               Business Ethics
 Identifies   types  of  behavior    that
  businesses and their employees should
  not engage in.
 Source of guidance that goes beyond
  enforceable laws.
 Unethical operations may not sustainable
  in long-term

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