Managerial Economics

Unit - 1

By - Anand Kumar

Unit - 1General Foundation of Managerial Economics – Economic approach, Circular flow of activity, Nature of the firm, Forms of organizations, Objectives of firms – demand analysis and estimation – Individual, market and firm demand, Determinants of demand, Elasticity measures and business decision making, Demand estimation and forecasting – Theory of the firm – Production functions in the short and long run, Cost concepts. Short run and long run costs.

Managerial decision areas• assessment of investible funds• selecting business area• choice of product• determining optimum output• determining price of product• determining input-combination and

technology• sales promotion

Managerial EconomicsManagerial Economics is a science which deals with the application of economics theory in managerial practice. It is the study of allocation of resources available to a firm among its activities. To be very precise, Managerial Economics is ‘Economics applied in decision-making’. It fills the gap between economic theory and managerial practice.

Managerial Economics - Definition“Managerial Economics is the integration of economic theory with business practice for the purpose of facilitating decision-making and forward planning by management.”

- Spencer & Siegelman“The purpose of Managerial Economics is to show how economic analysis can be used in formulating business policies.”

-Joel Dean

Managerial Economics Economic Theories,

Concepts, Methodology and Tools

Business managementDecision Problems

Managerial EconomicsApplication of Economicsin analyzing and solving

Business problems

Optimum solutions tobusiness problems

MICRO ECONOMICSMicro-economics is a branch of economics that studies the behavior of how the individual modern household and firms make decisions to allocate limited resources. Typically, it applies to markets where goods or services are being bought and sold. Micro-economics examines how these decisions and behaviors affect the supply and demand for goods and services, which determines prices, and how prices in turn, determine the quantity supplied and quantity demanded of goods and services.

MACRO ECONOMICSMacroeconomics is a branch of economics dealing with the performance, structure, behavior, and decision-making of the entire economy. This includes a national, regional, or global economy. Macroeconomics study aggregated indicators such as GDP, unemployment rates, and price indices to understand how the whole economy functions. Macroeconomics develop models that explain the relationship between such factors as national income, output, consumption, unemployment, inflation, savings, investment, international trade and international finance.

Characteristics of Managerial Economics• It involves an application of Economic theory –

especially, micro economic analysis to practical problem solving in real business life. It is essentially applied micro economics.

• It is a science as well as art facilitating better managerial discipline. It explores and enhances economic mindfulness and awareness of business problems and managerial decisions.

• It is concerned with firm’s behaviour in optimum allocation of resources. It provides tools to help in identifying the best course among the alternatives and competing activities in any productive sector whether private or public.

Scope of Managerial Economics

1. Demand Analysis and Forecasting2. Cost Analysis3. Production and Supply Analysis4. Pricing Decisions, Policies and Practices5. Profit Management, and 6. Capital Management

1. Demand Analysis & ForecastingA business firm is an economic organism which transforms productive resources into goods that are to be sold in a market. A major part of managerial decision-making depends on accurate estimates of demand. Before production schedules can be prepared and resources employed, a forecast of future sales is essential. This forecast can also serve as a guide to management for maintaining or strengthening market position and enlarging profits.

2. Cost AnalysisA study of economic costs, combined with the data drawn from the firm’s accounting records, can yield significant cost estimates that are useful for management decisions. The factors causing variations in costs must be recognized and allowed for if management is to arrive at cost estimates which are significant for planning purposes. An element of cost uncertainty exists because all the factors determining costs are not always known or controllable.

3. Production & Supply AnalysisProduction analysis is narrower in scope than cost analysis. Production analysis frequently proceeds in physical terms while cost analysis proceeds in monetary terms. Production analysis mainly deals which different production functions and their managerial uses.Supply analysis deals with various aspects of supply of a commodity. Certain important aspects of supply analysis are: Supply schedule, curves and function, Law of supply and its limitations, Elasticity of supply and Factors influencing supply.

4. Pricing Decisions, Policies and Practices

Pricing is a very important area of Managerial Economics. In fact, price is the genesis of the revenue of a firm and as such the success of a business firm largely depends on the correctness of the price decisions taken by it. The important aspects dealt with under this area are: Price Determination in various Market Forms, Pricing Methods, Differential Pricing, Product-line Pricing and Price Forecasting.

5. Profit ManagementBusiness firms are generally organised for the purpose of making profits and, in the long run, profits provide the chief measure of success. In this connection, an important point worth considering is the element of uncertainty existing about profits because of variations in costs and revenues which, in turn, are caused by factors both internal and external to the firm. If knowledge about the future were perfect, profit analysis would have been a very easy task.

6. Capital ManagementOf the various types and classes of business problems, the most complex and troublesome for the business manager are likely to be those relating to the firm’s capital investments. Relatively large sums are involved, and the problems are so complex that their disposal not only requires considerable time and labour but is a matter for top-level decision. Briefly, capital management implies planning and control of capital expenditure.

What is Decision-making?

Decision-making is the process of selecting a particular course of action from among the various alternatives. Every business manager has to work on uncertainties and the future cannot be precisely predicted by anyone. If everything could be predicted accurately, then decision-making would become a very simple process.

What is Decision-making?

Alternative course of Action

available

Selection of a particular Action

Execution of Action Result of Action

Action AAction BAction C

Decision Making

ChosenAction

Full Realisation of objective

Partial realisation of

objective

Non-realisation of

objective

Basic Economic Tools in Managerial Economics

1. Opportunity cost principle2. Incremental principle3. Principle of time perspective4. Discounting principle, and 5. Equi-marginal principle

1. Opportunity Cost Principle The opportunity cost of the funds employed in one’s own business is the interest that could be earned on those funds had they been employed in other ventures. The opportunity cost of the time an entrepreneur devotes to his own business is the salary he could earn by seeking employment. The opportunity cost of using a machine to produce one product is the earnings forgone which would have been possible from other products.

2. Incremental PrincipleIncremental concept is closely related to the marginal costs and marginal revenues, for of economic theory. In actual business situations, it often becomes difficult to apply the concept of marginalism which has to be replaced by incrementalism, for in real world business, one is concerned with not ‘unit change’ but ‘chunk change’. For instance, in a construction project, the labour which a contractor may change is not by one but by tens.

3. Principle of Time PerspectiveThe economic concepts of the long run and the short run have become part of everyday language. Managerial economists are also concerned with the short-run and long-run effects of decisions on revenues as well as costs. The really important problem in decision-making is to maintain the right balance between the long-run and the short-run considerations.

4. Discounting PrincipleOne of the fundamental ideas in economics is that a rupee tomorrow is worth less than a rupee today. This seems similar to saying that a bird in hand is worth two in the bush. A simple example would make this point clear.

5. Equi-marginal PrincipleThis principle deals with the allocation of the available resources among the alternative activities. It should be clear that if the value of the marginal product is higher in one activity than another, an optimum allocation has not been attained. It would, therefore, be profitable to shift labour from low marginal value activity to high marginal value activity, thus increasing the total value of all products taken together.

Circular Flow of Economic ActivitiesEconomic resources

Purchasing goods & services

Income payment of wages, rent, dividend & interestsGoods & Services

Imports Foreign Countries Exports

Taxes Government

Expenditure

Savings Banks Investments

Household Firm

Basic Economic activitiesProduction: The use of economic resources in the creation of goods and services for the satisfaction of human wants.Consumption: The using up of goods and services by consumer purchasing or in the production of other goods.Employment: The use of economic resources in production; engagement in activity.Income Generation: The production of maximum amount an individuals.

Circular Flow of Production

Economic Resources

Producing Units

Goods and Services

Households

Circular Flow of Income

Income flow of wagesInterests & rents

House holds

Purchase of Goods and Services

Producing Units

NATURE OF THE FIRMSince modern firms can only emerge when an entrepreneur of some sort begins to hire people, Coase's analysis proceeds by considering the conditions under which it makes sense for an entrepreneur to seek hired help instead of contracting out for some particular task.The traditional economic theory of the time suggested that, because the market is "efficient" (that is, those who are best at providing each good or service most cheaply are already doing so), it should always be cheaper to contract out than to hire.

Forms of Organisation

1. Sole proprietorship / Single ownership2. Partnership3. Joint Stock Companies4. Cooperative organisation5. State and central Government owned

1. Sole proprietorship A sole proprietorship is a business with one owner who operates the business on his or her own or employ employees. It is the simplest and the most numerous form of business organization in the United States, however it is dangerous as the sole proprietor has total and unlimited liability. Self-contractor is one example of a sole proprietorship.In this type, the single ownership where an individual exercises and enjoys these rights in his own interest. It does well for those enterprises which require little capital and lend themselves readily to control by one person.

2. PartnershipA single owner becomes inadequate as the size of the business enterprise grows. He may not be in a position to do away with all the duties and responsibilities of the grown business. At this stage, the individual owner may wish to associate with him more persons who have either capital to invest, or possess special skill and knowledge to make the existing business still more profitable. Such a combination of individual traders is called Partnership.Partnership may be defined as the relation between persons who have agreed to share the profits of a business carried on by all or any of them acting for all. Individuals with common purposes join as partners and they put together their property ability, skill, knowledge, etc., for the purpose of making profits

3. CORPORATIONIt is a form of private ownership which contains features of large partnership as well as some features of the corporation. A corporation is a limited liability entity doing business owned by multiple shareholders and is overseen by a board of directors elected by the shareholders. It is distinct from its owners and can borrow money, enter into contracts, pay taxes and be sued. The shareholders gain from the profit through dividend or appreciation of the stocks but are not responsible for the company’s debts.

4. Public Limited CompanyA public enterprise is one that is (1) Owned by the state, (2) Managed by the state or (3) Owned and managed by the state. Public enterprises are controlled and operated by the Government either solely or in association with private enterprises. It is controlled and operated by the Government to produce and supply goods and services required by the society. Limited companies which can sell share on the stock exchange are Public Limited companies. These companies usually write PLC after their names.

5. Private Limited CompaniesThese are closely held businesses usually by family, friends and relatives. Private companies may issue stock and have shareholders. However, their shares do not trade on public exchanges and are not issued through an initial public offering. Shareholders may not be able to sell their shares without the agreement of the other shareholders.

Objectives of Firm

1. Maximization of the sales revenue2. Maximization of firm’s growth rate3. Maximization of Managers utility function4. Making satisfactory rate of Profit5. Long run Survival of the firm6. Entry-prevention and risk-avoidance

Conflict in McDonald and Pizza HutThe rapid growth of franchising during the last two decades can be explained largely by the mutual benefits the franchising partners receive. The franchiser increases sales via an ever-expanding network of franchisees. The parent collects a fixed percentage of the revenue that each franchisee earns (as high as 15 to 20 per cent, depending on the terms of the contract). The individual franchisee benefits from the acquired know-how of the parent (the franchiser), its advertising and promotional support and from the ability to sell a well-established product or service. Nonetheless, economic conflicts frequently arise between parent and individual franchisees. Disputes can occur even in the loftiest of franchising realms: the fast food industry. The case in point

Conflict in McDonald and Pizza Hutis the turmoil in the early 1990s between one of the franchisee outlets of the McDonald and the Mac itself in the USA. The franchisee outlet was controlled by Chart House. The key issue centred on the operating autonomy of the franchisee.The conflict between parent and individual franchisee were numerous. First, the parent insisted on periodic remodelling of the premise, which the franchisee resisted. Secondly, the franchisee favoured raising prices on best selling items which the parent opposed – it wanted to expand promotional discounts. Third, the parent sought longer store hours and multiple express lines to cut down on lunchtime congestion. Many franchisees resisted both the moves.

Conflict in McDonald and Pizza HutYet another known name in the fast food industry, Pizza Hut faced a similar problem in the late 1990s in Thailand. The Bangkok branch of the US food franchisee broke away from Thailand’s Pizza Plc., as the later said that after working together for 20 years, it would no longer work on the terms of the US franchiser. The US franchiser wanted certain changes in the operations of the chain in the same line of Mac franchiser, which the franchisee objected to. As a result, the franchiser decided to rebrand 116 new pizza parlours across the country.How would one explain these conflicts? What is their economic source? What ca the parent and the franchisee do to promote cooperation?

Conflict in McDonald and Pizza HutAbove all, if franchising is a profitable activity, why are there so many conflicts?

(McDonald levies a franchisee fee of $ 12,500, a royalty of 3 per cent, a marketing fee of 3 per cent.)

Consumer’s desire for a particular product depends on

ability to buy willingness to buy time period

DemandDemand is the quantity of a good or service that customers are willing and able to purchase during a specified period under a given set of economic conditions. Conditions to be considered include the price of the good in question, prices and availability of related goods, expectations of price changes, consumer incomes, consumer tastes and preferences, advertising expenditures, and so on. The amount of the product that consumers are prepared to purchase, its demand, depends on all these factors.

Demand Schedule

Price

1 $320,000 1000 2 $300,000 2000

3 $280,000 3000 4 $260,000 4000 5 $240,000 5000 6 $220,000 6000 7 $200,000 7000 8 $180,000 8000

Quantity Demanded Per

Month

Demand

Law of Demand

as the quantity demanded rises, the price falls as the price rises, the quantity demanded falls as income rises, the demand for the product rises as supply rises, the demand rises

– there is an inverse relationship between price and quantity demanded.

ElasticityElasticity is a central concept in the theory of supply and demand. In this context, elasticity refers to how supply and demand respond to various factors, including price as well as other stochastic principles. One way to define elasticity is the percentage change in one variable divided by the percentage change in another variable (known as arc elasticity, which calculates the elasticity over a range of values, in contrast with point elasticity, which uses differential calculus to determine the elasticity at a specific point). It is a measure of relative changes.

Concept of Elasticity• Price Elasticity of Demand• Income Elasticity of Demand• Cross Elasticity of Demand

1. Price Elasticity of DemandPrice elasticity of demand is the change in quantity of a commodity demanded to the change in its price. The degree of change in the demand of different commodities due to change in the price of the commodities may vary. In certain cases, the changes in demand may be at higher rates.

2. Income Elasticity of DemandIncome elasticity of demand is the degree of responsiveness of demand to the change in income.

3. Cross Elasticity of DemandThe responsiveness of demand to change in prices of related goods is called cross elasticity of demand (related goods may be substitutes or complementary goods). In other words, it is the responsiveness of demand for commodity X to the change in the price of commodity Y.

Elasticity Demand elastic inelastic unitary

1. Elastic Demand

An elastic demand is one in which the change in quantity demanded due to a change in price is large.

2. Inelastic Demand

An inelastic demand is one in which the change in quantity demanded due to a change in price is small.

3. Unitary elasticityIf the elasticity coefficient is equal to one, demand is unitarily elastic as shown in below figure. For example, a 10% quantity change divided by 10 % price change is one. This means that a one percent change in quantity occurs for every one percent change in price.

Determinants of Demand• Changes of Income• Changes of Taste or Preferences• Changes of Prices of Related Goods• Changes of Price Expectations• Changes of Size of Population

Look at the relationship between the quantity demanded and each of the determinants in turn –

separately – price quantity relationship is the demand curve….

Factors Affecting Elasticity Of Demand1. Availability of Substitutes2. Postponement of Consumption3. Proportion of Expenditure4. Nature of the Commodity5. Different Uses of the Commodity6. The Time Period7. Change in Income8. Habits9. Distribution of Income10. Price Level

DEMAND FORECASTINGDemand forecasting is the activity of estimating the quantity of a product or service that consumers will purchase. Demand forecasting involves techniques including both informal methods, such as educated guesses, and quantitative methods, such as the use of historical sales data or current data from test markets. Demand forecasting may be used in making pricing decisions, in assessing future capacity requirements, or in making decisions on whether to enter a new market.

Necessity for forecasting demandOften forecasting demand is confused with forecasting sales. But, failing to forecast demand ignores two important phenomena. There is a lot of debate in demand-planning literature about how to measure and represent historical demand, since the historical demand forms the basis of forecasting. The main question is whether we should use the history of outbound shipments or customer orders or a combination of the two as proxy for the demand.

Demand Forecasting Methods

FORECASTING METHODS

Survey Method Statistical Method

Opinion Survey

Consumers'Interview

Trendprojection

Brometricmethod

Correlation& Regression

Complete enumeration

Sample survey

End-use method

Concept of SupplySupply is defined as the quantity of a product that a producer is willing and able to supply onto the market at a given price in a given time period.

Note: Throughout this study companion, the terms firm, business, producer and seller have the same meaning.

Supply is the amount of a good that producers are willing and able to offer for sale at various price.

Concept of Supply

The law of SupplyThe law of supply All else equal, the quantity supplied is positively related to price. Prices quantity supplied Prices quantity supplied

Determinants of Supply

• Market price• Input prices• Technology (new production methods)• Expectations • Number of producers

Equilibrium of Supply and DemandA situation in which the supply of an item is exactly equal to

its demand. Since there is neither surplus nor shortage in the market, price tends to remain stable in this situation.

Equilibrium of Supply and Demand

Quantity

Price

$2.00

0 1 2 3 4 5 6 7 8 9 10 11 12 13

Equilibriumquantity

Equilibrium price Equilibrium

Supply

Demand

A situation in which the supply of an item is exactly equal to its demand. Since there is neither surplus nor shortage in the

market, price tends to remain stable in this situation.

THEORY OF FIRMThe theory of the firm consists of a number of economic theories that describe the nature of the firm, company, or corporation, including its existence, behaviour, structure, and relationship to the market. In simplified terms, the theory of the firm aims to answer these questions:

1. Existence2. Boundaries3. Organization4. Heterogeneity of firm actions / performances

ProductionProduction refers to the transformation of inputs or resources into outputs or goods and services. Production process is a process in which economic resources or inputs (composed of natural resources like labour, land and capital equipment) are combined by entrepreneurs to create economic goods and services (outputs or products).

Production

Theory of ProductionProduction theory generally deals with quantitative relationships, that is, technical and technological relationships between inputs, especially labour and capital, and between inputs and outputs.An input is a good or service that goes into the production process. As economists refer to it, an input is simply anything which a firm buys for use in its production process. An output, on the other hand, is any good or service that comes out of a production process.

In the manager’s effort to minimise production costs, thefundamental questions faces are:(a) How can production be optimized or costs minimised?(b) What will be the behaviour of output as inputs increase?(c) How does technology help in reducing production costs?(d) How can the least-cost combination of inputs be achieved?(e) Given the technology, what happens to the rate of return when more plants are added to the firm?

Short Run Production FunctionThe short run is defined in economics as a period of time where at least one factor of production is assumed to be in fixed supply i.e. it cannot be changed. We normally assume that the quantity of capital inputs (e.g. plant and machinery) is fixed and that production can be altered by suppliers through changing the demand for variable inputs such as labour, components, raw materials and energy inputs. Often the amount of land available for production is also fixed. The time periods used in textbook economics are somewhat arbitrary because they differ from industry to industry. The short run for the electricity generation industry or the telecommunications sector varies from that appropriate for newspaper and magazine publishing and small-scale production of foodstuffs and beverages.

Long Run Production

In the long-run, both capital (K) and labour (L) is included in the production function, so that the long-run production function can be written as:A production function is based on the following assumptions:(i) perfect divisibility of both inputs and output;(ii) there are only two factors of production – capital (K) and labour (L);(iii) limited substitution of one factor for the other;(iv) a given technology.

COST CONCEPTThe term cost simply means cost of production. It is the expenses incurred in the production of goods. It is the sum of all money-expenses incurred by a firm in order to produce a commodity. Thus it includes all expenses from the time the raw material are bought till the finished products reach the wholesaler. A managerial economist must have a proper understanding of the different cost concept which are essential for clear business thinking. The cost concept which are relevant to business operation and decision can be grouped on the basis of their propose under two overlapping categories:1. Concept used for accounting purpose2. Concept used in economics analysis of the business

THEORY OF COSTBusiness decisions are generally taken based on the monetary values of inputs and outputs. Note that the quantity of inputs multiplied by their respective unit prices will give the monetary value or the cost of production. Production cost is an important factor in all business decisions, especially those decisions concerning:(a) the location of the weak points in production management;(b) cost minimisation(c) finding the optimal level of output;(d) determination of price and dealers’ margin; and,(e) estimation of the costs of business operation.

Various Types of Costs1. Opportunity Cost vs Outlay Cost2. Past Cost vs Future Cost3. Traceable vs Common Cost4. Out-of-Pocket vs Book-Cost5. Incremental Cost vs Sunk Cost6. Escapable vs Unavoidable Cost7. Shut Down and Abandonment Costs8. Urgent and Postponable Costs9. Controllable and Non-Controllable costs10. Replacement vs Historical Cost11. Private and Social Cost12. Short-run and Long-run Costs13. Fixed cost and Variable Cost

1. Opportunity Cost vs Outlay CostOutlay costs are those costs which involve financial expenditure at some time and hence are recorded in the books of account. Opportunity costs are those costs of “displaced alternatives”. They represent only sacrificed alternatives and hence are not recorded in any financial account. The economic principle behind cost in the modern sense is not the pain or strain involved, nor the money cost involved in producing a thing.

2. Past Cost vs Future CostPast costs, as the name itself implies, are those costs which have been actually incurred in the past and find entry in the books of accounts. Those costs are incurred by the firm at the time of purchase of various items of plant equipment, etc. From the decision-making point of view, future cost is more important. Future costs are those costs which are likely to be incurred in future periods or to be very precise, the costs that are contemplated to be incurred in future periods. Since future is uncertain, these costs are only estimations and they are not accurate figures.

3. Traceable vs Common CostsWhen the cost can be easily identified with an unit of operation, it is called traceable cost or direct can. For example, when the total cost of production per unit has to be arrived at, it has to be broken into cost of raw materials, cost of labour, etc.Non-traceable costs are called common costs which are not traceable to any one unit of operation. They cannot be attributed to a product, a department or a process.

4. Out-of-Pocket vs Book-CostsOut-of-pocket cost denotes immediate current payment. Hence it is called cash cost. For example, the cost of raw material or the wages to labour require immediate payment. On the other hand, book-cost is one which need not be immediately made. For instance, depreciation does not require immediate cash payment and it is not taken into the current expenditure account.

5. Fixed Cost and Variable CostFixed and variable costs are not two distinct categories; rather they are the two ends of a continuum. In the long-run all costs become variable and hence this distinction prevails mainly for a short period. It is valid only for a particular set of circumstances. However, this distinction is useful in evaluating the effect of short-run changes in volume, upon costs and profits.

6. Incremental Cost vs Sunk CostIncremental cost refers to the additional cost incurred due to a change in the level or nature of activity. A change in the activity connotes addition of a product, change in distribution channel, expansion of market, etc. Incremental cost are also known as differential costs. Incremental cost measures the difference between old and new total costs.Sunk costs are the costs which remain unaltered even after a change in the level or nature of business activity. These are known as specific costs. The best of the sunk cost is depreciation. Incremental cost are very useful in business decision, but sunk costs appear to be irrelevant to managerial decisions, as they do not change with the changing business activity.

7. Urgent and Postponable CostsAs the name itself implies, urgent costs are those costs which are incurred to keep the continuance of operations of the firm. It is the money spent on materials and labour. Postponable costs can be post-poned temporarily. For example, the cost on maintenance of building can be postponded. Painting and white washing can be postponed.

COST AND OUTPUT RELATIONSHIPNow you will also come to know about cost and output relationship. Cost and revenue are the two major factors that a profit maximizing firm needs to monitor continuously. It is the level of cost relative to revenue that determines the firm’s overall profitability. In order to maximize profits, a firm tries to increase its revenue and lower its cost. While the market factors determine the level of revenue to a great extent, the cost can be brought down either by producing the optimum level of output using the least cost combination of inputs, or increasing factor productivities, or by improving the organizational efficiency. The firm’s output level is determined by its cost. The producer has to pay for factors of production for their services.