Unit 4th me

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Economic tools in Managerial Economic tools in Managerial Economics Economics Business Decision& Economic Analysis Opportunity Cost Principle *Incremental Principle *Principle of time –perspective *Discounting Principle *Equi – marginal Principle

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Transcript of Unit 4th me

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Economic tools in Managerial EconomicsEconomic tools in Managerial Economics

Business Decision& Economic Analysis Opportunity Cost Principle

*Incremental Principle*Principle of time –perspective

*Discounting Principle *Equi – marginal Principle

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Business Decisions and Economic AnalysisBusiness Decisions and Economic Analysis• Process of decision – making comprises 04 main phases……

– 1. Determining & defining the objective– 2. Collection and analysis of info regarding eco, social, political and foreseeing the necessity and occasion for decision.– 3. Inventing, developing and analyzing possible course of action– 4.Selecting a particular alternative from available alternative.

Personal intelligence, experience ,intuition of the business Personal intelligence, experience ,intuition of the business maker need to be supplemented with quantitative analysis maker need to be supplemented with quantitative analysis of business data on market conditions and business of business data on market conditions and business environment. It is in this area of decision – making that environment. It is in this area of decision – making that economic theories and tools of economic analysis economic theories and tools of economic analysis contribute a great deal. Economic theories state the contribute a great deal. Economic theories state the functional relationship between two or more economic functional relationship between two or more economic variables, under certain given condition.variables, under certain given condition.

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Basic Economic tools in Managerial Basic Economic tools in Managerial EconomicsEconomics

• The basic principles may be identified as:

• Opportunity cost Principle

• Incremental Principle

• Principle of Time Perspective

• Discounting Principle

• Equi – marginal Principle

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Opportunity Cost Principle…………………Opportunity Cost Principle…………………

• For decision – making, the OC principle may be stated as under : The cost involved in any decision consists of the sacrifices of alternative required by that decision. most valuable forgone alternative (or highest-valued option forgone), i.e. the second best alternative

• Opportunity cost need not be assessed in monetary terms, but rather can be assessed in terms of anything which is of value to the person . For example, a person who chooses to watch, television program cannot watch any other at the same time. at the time the person chooses to watch a program, they cannot watch something else, the opportunity to view it is lost.

• Like If a machine can produce either x or y , the OC of producing a given

quantity of x is therefore the quantity of y which it would have produced. If that machine can produce 10 units of x OR 20 units of y, the OC of 1x is

• ……………………2y.

• If there are no sacrifices , there is no OC.

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• Opportunity cost is a key concept because it implies the choice between desirable, yet mutually exclusive results.

• It has been described as expressing "the basic relationship between scarcity and choice.". The notion of opportunity cost plays a crucial part in ensuring that scarce resources are used efficiently.

• Note: Thus, opportunity costs are not restricted to monetary or financial costs: the real cost of output forgone, lost time, pleasure or any other benefit that provides utility should also be considered.

• By studying the Production Possibility Frontier (PPF) one can understand the concept of trade-off or opportunity cost, which says that one has to give up something in order to get something.

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Incremental Principle……………………Incremental Principle……………………• IA involves estimating the impact of decision

alternative on cost and revenues , emphasizing the changes in total cost and total revenue resulting from changes in alternatives like changes in prices, changes in products, changes in procedure, investment or what so ever may be at stake in the decision.

• Two basic components of incremental reasoning areTwo basic components of incremental reasoning are

• Incremental Cost; as change in total cost resulting from a particular decision.

• Incremental revenue; as change in total revenue resulting from a particular decision.

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The Incremental principle may be stated as……

• “ A decision is obviously a profitable one , if– i) it increase revenue more than cost.– ii) it decreases some costs to a greater extent than it increases others.– iii) it increase some revenues more than it decreases others.– iv) it reduces costs more than revenues.

• Incremental reasoning does not mean that the firm should accept all orders at prices which cover merely their incremental costs. The acceptance of order depends upon the existence of idle capacity and labor that would go unutilized in the absence of more profitable opportunities.

• Progressive corporations do make formal use of incremental analysis.

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Principle of Time Perspective……………………..• Managerial Economist are concerned with the short –run and long –range

effects of decision on revenues as well as costs.

• May be stated as under : a decision should take into account both the short run and long run effects on revenues and costs and maintain the right balance between the long run and short – run perspectives.

• Some times if the mgt. commits itself with too much of business at lower prices or with small contribution, it may not have sufficient capacity to take up business with higher contribution when the opportunity arises therefore. Or / may other customer demand a similar low price.

• The really important problem in decision making is to maintain the right balance between the long run and short – run considerations. A decision may be made on the basis of short –run considerations, but may as time elapses have long – run future which make it more or less profitable than it at first appeared.

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For Example…………………..For Example…………………..

• Like: Suppose there is a firm with temporary idle capacity. An order for 5,000 units comes to mgt. attention. The customer is willing to pay Rs. 4.00 / unit or Rs. 20,000 for the whole lot but no more. The short-run incremental cost( ignoring the fixed cost) is only Rs. 3.00, therefore, the contribution to overhead and profit is Rs. 1.00 / unit.( Rs. 5,000 for the lot).

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Discounting Principle……………………• “ a bird in hand is worth ,two in the bush”

• A rupee in hand today is worth more than a rupee received tomorrow i.e. …..time value of money i.e….value of money depreciates with time.

• It is necessary to discount future rupee to make it equivalent to current day rupee.

• The principle involved “ if a decision affects costs and if a decision affects costs and revenues at future dates, it is necessary to discount revenues at future dates, it is necessary to discount those costs and revenues to present values before a those costs and revenues to present values before a valid comparison of alternative is possible”. valid comparison of alternative is possible”.

• Another way Another way of saying is that Rs 100 one year hence is of saying is that Rs 100 one year hence is

not equal to Rs.100 of today but less than that. not equal to Rs.100 of today but less than that.

• But then But then how much money today is equal to Rs 100 one how much money today is equal to Rs 100 one year hence?year hence?

• i.ei.e. V= Rs.100 / (1+ i) . V= Rs.100 / (1+ i) ⁿn; ; Where V = Present Value & i = Where V = Present Value & i = interest rateinterest rate

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Discounting Principle……………………

• The 2000$ payment one year from now has a present value of (10% =

interest rate) =……

• The 1000$ payment two year from now has a present value of (10% = interest rate) = …..

• The 4000$ payment Five year from now has a present value of (10% = interest rate)= ……

• Thus, the present value of the income stream is given by summing the terms = ……………

• The discount rate, that rate at which future values are decreased in order to make them equivalent to today’s value.

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Equi-marginal principle…………

NumberMarginal Utility of

ShirtsMarginal Utility of

Hamburgers

First 11 8Second 9 7Third 7 6

Fourth 4 5Fifth 1 4

•The table contains columns showing the marginal utility of shirts and the marginal utility of hamburgers.

•Shirts and hamburgers cost the same. Suppose that each costs $1.00 and the person has $5.00 to spend.

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Equi-marginal principle……………………….• Maximization occurs when the return on the last

dollar spent is the same in all areas. • In terms of a formula, a person wants(Marginal Benefit of A)/(Price of A) = (Marginal Benefit of B)/(Price

of B).

• I, as a consumer, am most satisfied with my market basket of consumption goods. (desired one )

• This leads to the equimarginal principle that I should arrange my consumption so that every single good is bringing me the same marginal utility per dollar of expenditure.

• In such a situation, I am attaining maximum satisfaction or utility from my purchases. This is clear concept of equimarginal principle.

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The Equimarginal Principle, Continued

The Equimarginal Principle, Continued

NumberMarginal Utility

of ShirtsMUs

Price of ShirtsMarginal Utility of Hamburgers

MUhPrice of

Hamburgers

First 11 5 1/2 8 8

Second 9 4 1/2 7 7

Third 7 3 1/2 6 6

Fourth 4 2 5 5

Fifth 1 1/2 4 4

The power of this idea can be shown if we change the original problem. Suppose that the person still has $5.00 to spend, but the price of shirts doubles from $1.00 to $2.00. The old solution of three shirts and two hamburgers will no longer be affordable. To solve this new problem, two new columns must be added to our table: the marginal utility of shirts per dollar and the marginal utility of hamburgers per dollar. The table below adds them in columns MUs/(Price of Shirts) (the marginal utility of shirts divided by the price of shirts) and MUh/Price of Hamburgers).

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• Principle deals with the allocation of the available resources among the alternative activities.

• When the same product or service is being produced in two or more units of production, in order to get the maximum total output, resources should be allocated among the units of production in such a way that the marginal productivity of each resource is the same in each unit of production.

• "efficient allocation of resources." In the example, we

have a tiny economy, consisting of one farmer and two plots of land. When the marginal productivities on the two plots are equal, this tiny economy has an "efficient allocation of resources." Of course, real economies are more complex, but the principles governing the efficient allocation of resources are the same.

• In In economics, the marginal product is the extra output produced by , the marginal product is the extra output produced by

one more unit of an input (for instance, the difference in output one more unit of an input (for instance, the difference in output when a firm's labour is increased from five to six units). Assuming when a firm's labour is increased from five to six units). Assuming that no other inputs to production change, the marginal product of that no other inputs to production change, the marginal product of a given input (X) can be expressed as:a given input (X) can be expressed as:Y = ΔY/ΔX = (the change Y = ΔY/ΔX = (the change of Y)/(the change of X). of Y)/(the change of X).

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• This rule has a name: it is the Equimarginal Principle. The idea is to make two things equal "at the margin" -- in this case, to make the marginal productivity of labor equal on the two fields. In this example, for instance, we are allocating resources between two fields that produce the same output.

• It should be clear that if the value of the if the value of the marginal product is higher in one activity than marginal product is higher in one activity than another , an optimum allocation has not been another , an optimum allocation has not been attained. The optimum will be reached when the attained. The optimum will be reached when the value of the marginal product is equal in all the value of the marginal product is equal in all the activities.activities.

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