Managerial Economics

Definitions of Economics
• According to Adam Smith (1723-1790),
hailed as the Father of Economics, saw
economics as “….an enquiry into the
nature and causes of the wealth of
nations”.
• According to Alfred Marshall (1842-1924)
“the study of mankind in the everyday
business of life”.
• According to Lionel Robbins (1898-1984)
“the science which studies human
behaviour as a relationship between
ends and scarce means which have
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alternative uses”.
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• Basic Assumptions
• Ceteris Paribus (Latin Phrase)
“All other things being equal”. The term is
most often used in isolating description of a
particular event from other potential
environmental variables.
Ex: Demand and price
• Rationality
Consumers and Producers measure and
compare the costs and benefits of a decision
before going ahead. Ex: whether to train the
existing workers or recruit new workers for
the newly opened unit of the firm
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Types of Economic Analysis

• Micro and Macro
• Micro economics looks at the smaller picture of the
economy and is the study of the behaviour of small
economic units;
• Macro economics is that branch of economic analysis
that deals with the study of aggregates;
• Positive and normative
• Positive economics speaks about ‘what it is’
• Normative economics speaks about ‘what ought to be’
• Ex: The distribution of income in India is unequal
The distribution of income in India should be
equal
• Short run and long run
• Partial and general equilibrium

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Managerial Economics & Theory

• Managerial economics applies
microeconomic theory to business
problems
• How to use economic analysis to make
decisions to achieve firm’s goal of
profit maximization
• Microeconomics
• Study of behavior of individual
economic agents
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Economic Cost of Resources

• Opportunity cost of using any
resource is:
• What firm owners must give up to use
the resource
• Market-supplied resources
• Owned by others & hired, rented, or
leased
• Owner-supplied resources
• Owned & used by the firm
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Total Economic Cost

• Total Economic Cost
• Sum of opportunity costs of both
market-supplied resources & owner-
supplied resources
• Explicit Costs
• Monetary payments to owners of
market-supplied resources
• Implicit Costs
• Nonmonetary opportunity costs of
using owner-supplied resources
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Economic Cost of Using
Resources (Figure 1.1)
E
xplic
itC
os
ts
o f
M
ar
ket
-SuppliedRes
o ur
c e
s
Th
e mone
taryp a
ymentsto
res
our
c eo wn
er
s

+
Im
plic
itC
os
ts
o f
Owne
r-Su p
plie
d Reso
u rc
es
Th
ere
tur
ns fo
rgone b
ynottak
in
g
th
eowners
’resourc
estom a
rke
t

T
ot
alE
con
omicCo
st
= T
he
b
to
o
ta
th
lo
k
p
in
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o
r
o
tu
n
fr
es
ity
o
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o
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s
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s
of

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Types of Implicit Costs

• Opportunity cost of cash provided
by owners
• Equity capital
• Opportunity cost of using land or
capital owned by the firm
• Opportunity cost of owner’s time
spent managing or working for the
firm
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Economic Profit versus
Accounting Profit
• Economic profit = Total revenue – Total economic cost
= Total revenue – Explicit costs – Implicit costs

• Accounting profit = Total revenue – Explicit costs

• Accounting profit does not subtract

implicit costs from total revenue
• Firm owners must cover all costs of all
resources used by the firm
• Objective is to maximize economic profit

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Maximizing the Value of a Firm

• Value of a firm
• Price for which it can be sold
• Equal to net present value of expected
future profit
• Risk premium
• Accounts for risk of not knowing
future profits
• The larger the rise, the higher the
risk premium, & the lower the firm’s
value
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Maximizing the Value of a Firm

• Maximize firm’s value by maximizing
profit in each time period
• Cost & revenue conditions must be
independent across time periods

• Value of a firm =
1 2 T T
t
+ + ... + =
(1 + r ) (1 + r ) 2
(1 + r )
T
t =1 (1 + r ) t

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Corporate Control Mechanisms

• Require managers to hold
stipulated amount of firm’s equity
• Increase percentage of outsiders
serving on board of directors
• Finance corporate investments
with debt instead of equity

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Price-Takers vs. Price-Setters

• Price-taking firm
• Cannot set price of its product
• Price is determined strictly by market
forces of demand & supply
• Price-setting firm
• Can set price of its product
• Has a degree of market power, which
is ability to raise price without losing
all sales
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What is a Market?

• A market is any arrangement

through which buyers & sellers
exchange goods & services
• Markets reduce transaction costs
• Costs of making a transaction other
than the price of the good or service

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Market Structures

• Market characteristics that determine

the economic environment in which
a firm operates
• Number & size of firms in market
• Degree of product differentiation
• Likelihood of new firms entering market

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Perfect Competition

• Large number of relatively small

firms
• Undifferentiated product
• No barriers to entry

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Monopoly

• Single firm
• Produces product with no close
substitutes
• Protected by a barrier to entry

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Monopolistic Competition

• Large number of relatively small

firms
• Differentiated products
• No barriers to entry

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Oligopoly

• Few firms produce all or most of

market output
• Profits are interdependent
• Actions by any one firm will affect
sales & profits of the other firms

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Globalization of Markets

• Economic integration of markets

located in nations around the world
• Provides opportunity to sell more
goods & services to foreign buyers
• Presents threat of increased
competition from foreign producers

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1.Incremental Reasoning
The two basic concepts in the incremental analysis
are : incremental cost and incremental revenue.
• Incremental cost may be defined as the
change in total cost as a result of change in the
level of output, investment, etc
•Incremental Revenue is change in total
revenue resulting from change in level of output ,
price etc.
Use of Incremental Reasoning
While taking a decision, a manager always
determines the worthwhile ness of a decision on
the basis of criterion that the incremental revenue
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should
The exceed
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 Managerial Economics
Illustration:

The firm gets an order The addition to cost due

which can get it an to new order is the
additional revenue of following:
Rs. 2000. The normal
cost of production of Labour Rs.400
this order is:
Materials 800
Labour Rs.600 Overheads 200
Materials 800 Full cost Rs.1400
Overheads 720 • Firm would earn a net
Selling & 280 profit of Rs 2,000 – Rs.
administrati 1400 = Rs. 600 while at
on expenses first it appeared that the
Full cost Rs.2400 firm would make a loss of
Rs.400 by accepting the
order. 22
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A course of action should be

pursued up to the point
where its incremental
benefits equal its incremental
costs.

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Discounting Principle
•The concept of discounting future is based on the
fundamental fact that a rupee now is worth more than a rupee
earned a year after.
•Unless these returns are discounted to find their present
worth, it is not possible to judge whether or not it is worth
undertaking the investment today.

Illustrations

Suppose a sum of Rs.100 is due after 1 year. Let the rate of

interest be 10% . We can determine the sum to be invested
now so as to produce the return (R) of Rs.100 at the end of 1
year. The present value of the discounted value of Rs. 100
will then be,

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R 100
V1 = = = Rs.90.90
(1 + i ) 1.10
The same reasoning can be used to find the present value of longer
periods. A present va lue of Rs.100 due two years later would be,
Rs.100 Rs.100 Rs.100
V2 = = = = 82.64
(1 + i ) (1.10)
2 2
1.21
We can thus write the present worth of a stream of income spread over n
years (i.e R 1 , R 2 ...R n )as
R1 R2 R3 Rn
, , ..........
..,
((1 + i) ) (1 + i) 2 (1 + i )3 (1 + i )n
The sum of present va lues for n years would thus be
n
R1 R2 R3 Rn Rk
V=
((1 + i) )
+
(1
The McGraw-Hill Series + i ) 2
+
(1 + i )3
+ ..........
..,
(1 + i )n
= 
k =1 (1 + i )
25k
 Managerial Economics
The Equi-Marginal
Principle
•The law of equi-marginal utility states that a utility
maximizing consumer distributes his consumption expenditure
between various goods and services he/she consumes in such
a way that the marginal utility derived from each unit of
expenditure on various goods and service is the same.
•This principle suggests that available resources (inputs)
should be so allocated between the alternative options that
the marginal productivity (MP) from the various activities are
equalized.
For eg. Suppose a firm has a total capital of Rs. 100 million
which it has the option of spending on three projects, A,B, and
C. Each of these projects requires a unit expenditure of Rs.
10 million.

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The Equi-Marginal
Principle
Marginal Productivity (MP) Schedule of Projects A, B, and C

Units of Marginal Productivity (MP)

Expenditure
(Rs.10 million)

Project A Project B Project C

1st 50 40 35
2nd 45 30 30
3rd 35 20 20
4th 20 10 15
5th 10 0 12
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The Equi-Marginal
Principle

The equi marginal principle suggests that a profit (gain) maximizing

firms allocates its resources in a proportion such that
MPA = MPB = MPC = ... = MP N

The equi - marginal principle can be applied only where

(i) firms have limited investible resources
(ii) resources have alternativ e uses and
(iii) the investment in various alternativ e uses is subject to diminishin g
marginal productivi ty or return.

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• Class Room Exercise

• Take a case example of a product
• Prepare the cost analysis
• Study the demand and supply
situation
• Analyse the market condition and
fix the price

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