Nature and scope of managerial economics

Managerial economics is concerned with those aspects of

economics and its tools of analysis which are used in decision
making process.
Decision making is a process of selecting a particular course of
action from among various alternatives.
Managerial economics is also called sometimes business
economics.
Business economics is the integration of economic theory with
business practice for purpose of decision-making and forward
planning by management.
Thus managerial economics is the process of application of
principles techniques concepts of economics to solve managerial
problems of business and industrial enterprises.
Managerial economics lies on interface between economics
and business management and serves as a bridge between the
two disciplines.
It takes the concepts of business, accounting, money, costs,
revenues, profit etc. and modifies these to make these fit for
decision-making.
For eg: The accountant has historical data with him while
managerial economist needs forecasts of demand, costs
market share, and profits.
Therefore a managerial economist draws his data from
accountants, engineers and uses it to advise the management
of the firm.
Characteristics of managerial economics
Micro economics
Normative economics
Pragmatic
Uses theory of firm
Takes help of macro economics
Aims at helping the management.
 Nature of managerial economics

Flow chart of decision making process within firm

Product Output
demand decision
estimate

output

Input supply
information Productio
Input nprocess
decisio decision
Production n
technology
information
 Nature of managerial economics
Micro economic in character
Normative science
Prescriptive rather descriptive
Pragmatic
A scientific art
 Scope of managerial economics
Theory of demand.
Theory of production.
Theory of exchange or price theory.
Theory of profit.
Theory of capital and investment.
Environmental issues.
 Conculsion about nature of business
economics
Managerial economics is an application of economic
theory particularly of micro economic theory to
practical problem solving.
Managerial economics can be used to make better
management decisions.
Managerial economics is concerned with decision-
making about optimal allocation of scarce resources to
competing activities.
Managerial economics can be applied to government
agencies as well as business firms with equal ease.
Importance of managerial economics
Reconciling traditional theoretical concepts to
actual business behavior.
Estimating economic relationships.
Predicting relevant economic quantities.
Understanding significant external forces.

External Internal
factors factors
 Managerial economics an
interdisciplinary science
 Managerial economics is the applied economics used for
decision-making. It bridges gap between economic theory and
decision making.
 Managerial economics is intimately related to accounting.
 Managerial economics is related to operational research. The
researches have applied mathematical techniques applied to
practical problems.
 Managerial economics uses statistics and mathematics for
solving decision-making process.
 Basic concepts in economics
Concept of scarcity
The starting point of any economic analysis is the
existence of human wants. Human wants are
unlimited means to satisfy them are limited.
Any economic problem consist of making decisions
regarding the ends to be pursued and the goods to be
used for achievement of such ends.
For ex: any business firm resources available to firm
are limited and the managers of the firm need to
optimally utilize them.
In view of scarcity of resources and multiplicity of
needs the economic problem lies in making best use
of possible resources so as to get maximum
satisfaction. Hence economic problem consist of
making decisions regarding the ends to be persued
and the goods to be used for achievement of such
ends.
 Concept of opportunity cost
Opportunity cost is the benefit foregone from the
alternative that is not selected.
According to Benham, “The opportunity cost of
anything is the next best alternative which could be
produced instead by the same factors or by equivalent
group of factors, costing the same amount of money.”
Opportunity cost means the cost of foregone
opportunities.
Opportunity cost of a product or service means the
revenue earned by the product or service if put to
alternative use.
 Examples
The opportunity cost of the funds tied up in ones own
business is the interest that could be earned on those funds in
other ventures.
The opportunity cost of the effort one puts into his own
business is the salary he could have earn in other occupations.
The opportunity cost of using a machine to produce one
product is the sacrifice of earnings that would be possible
from other products.
The opportunity cost of using a machine that is useless for
any other purpose is nil since its use requires no sacrifice of
other opportunities.
 Principle of incremental cost
Incremental cost is the differential cost that must be
incurred if a decision is taken and that need not be incurred
if the same is not executed.
Incremental cost may be defined as the change in total
cost due to a specific decision.
Similarly incremental revenue is change in the revenue
caused by particular decision.
When incremental revenue exceeds incremental cost
decision is profitable.
This concept helps in arriving a better decision comparing
between incremental cost and incremental revenue.
 Principle of marginalism
The concept of marginalism finds its origin in
scarcity of resources .Scarce resources have to be
allocated very carefully. For deciding whether an
additional labour has to be employed or not one has
to know additional output expected therefrom. This
gives rise marginal revenue and marginal cost
concepts. As long as MR>MC the firm generates
profit. It will stop employing more labourers at the
point where MC=MR. If production is carried beyond
this point the firm is going to face loss.
 Principle of equi-marginalism
The equi-marginal principle is a widely used concept in
economics and is significant in determining optimal
condition in resource allocation. The equi-marginal
principle states that an input should be allocated in such a
way that the value added by last unit of input is the same
in all its uses. Symbolically, it can be stated as follows:
VMPLA=VMPLB=VMPLC where
VMPL: Value of marginal product of labour.
A,B,C,=Three activities
Note: Equi-marginal principle can operate under ideal
conditions.
 TIME PERSPECTIVE
Economist have divided time periods in four periods
(i) Market period, (ii) Short period, (iii) Long period, (Iv)
Secular period.
Market period is characterised by fixed supply of
output. Output cannot be increased in response to
demand.
 Supply can be increased by increasing variable factors
in short run but fixed factors cannot be changed.
In long-run all factors can be altered to suit the
demand and hence all factors are variable.
Economist have established short run cost and prices are higher
than long-run prices and cost.
The argument is that in short term in the short run average
prices may not cover average cost but in long they must be equal.
The decisions of a business firm should be taken only after
considering the short-run and long-run effects of decisions on
cost and revenues.
Ex: A company takes into account only the short-run and raises
its price exorbitantly to increase its profit in the short run but it
can lead to fall in sales in the long run leading to loses. Thus a
proper balance should be maintained between short-run time
perspective and long-run perspective.
 Discounting principle
The concept of discounting principle is based on the simple
principle on simple principle that a rupee today is worth more
than rupee tomorrow. This is because future is uncertain.
Hence whenever the present value of a business has to be
known the future values has to be discounted. This present
value is known as discounted value.
For example: if a person has Rs 100 today as against Rs 100
next year he will prefer Rs 100 today as against tomorrow. This
is because future is uncertain. Secondly @ 10% per year the
person can earn Rs 110 at the end of year. Had he opted for Rs
100 next year he would have suffered a loss of Rs 10. The
present value of Rs 100 one year hence would be less than Rs
100 today.
Businesses need to bother about discounting. This is because most of
the business relate to outflow and inflow of money and resources that
takes place at different points of time. Most of the outflow currently
occur in the current period, whereas inflows occur only in future, therefore in
order to take right decision it is necessary to “discount” future inflows to
their present value level. The simple formula for discounting is :
PVF= 1/(1+r )n
Where PVF=Present value of fund, n=period and r=rate of discount
Let us summarise the underlying logic as follows:
Re 1 now is worth Rs (1+r) in one year’s, time if rate of interest is r.
Re 1 in one years time is worth Rs1/(1+r) or Re 0.91 now if rate of interest
r is 10%
Re 1 in two year’s time is worth Rs 1/(1+r)2 or if the rate of interest r is
 Risk and uncertainity
In common practice the two terms “Risk” and “Uncertainty” are used synonyms.
A very thin line of demarcation can be drawn between these two terms.
Business decisions involve calculation of cost and revenue. It is not easy to
predict the future with accuracy.
Future involves change. Changes may be known or unknown. The result of
known changes may be definite or indefinite. The definite result related with
known changes is known as certainty. The indefinite nature of outcome or result
related with known changes involves risk. Such risks can be estimated and insured.
On other hand if changes are unknown their outcome is indefinite and risk element
is incalculable and immeasurable it is called uncertainty. For example changes in
prices demand and supply are non-insurable risks involve uncertainty. On other
hand theft, loss by fire, death by accident are insurable. Such risks do not involve
profit. It is only non-insurable risk which have element of uncertainty and lead to
emergence of profits. This is the difference between risk and uncertainty.
 Time value of money
Most financial decisions such as the purchase of assets or
procurement of funds, affect the firms cash flows in different
periods.
For example:- if a fixed asset is purchased it will require immediate
cash outlay and will generate cash inflows during many future
periods. If the firm borrows money from the bank it receives cash
now and commits obligation to pay cash for interest and repay
principal in future periods. The firms may raise funds by using equity
shares.
 Future sum= Principal + Interest, which i=interest rate per period,
n=number of period before pay off, f=future value(compound
value) p=present amount.(is invested at i rate of interest for one
year then the future value f, principal plus interest) at the end of
one year will be.
Outstanding amount at the beginning of second
year F1 =P(1+i) the compound sum at end of second
year F2 =P(1+i)2 , F3 =(1+i)3 . The term (1+i)n is the
compound value factor (CVF) of lump sum of Re 1 and
it always has a greater value than 1 for positive i,
indicating that CVF increases as i and n increase. The
compound value can be computed for any lump sum
amount at i rate of interest for n number of years
using the equation.
FUTURE VALUE OF LUMP SUM
Rs 1000 Rate of interest=5% . How it shall grow after
3 years?
F1 = 1000+1000*5% =1000+50.00=1050.
F2 = 1050+1050*5% =1000+52.50=1,102.50
F3 =1,102.50+1,102.50*5%= 1,102.50+55.10=1,157.60

We can see that the CVF for a lump sum of one
rupee at 5% for one year is 1.05 for two years 1.1025
and three years 1,1576 .
 Future value of bank deposit
If you deposited Rs 55,650 in a bank which was paying a
15% rate of interest on ten year time deposit, how much
would the deposit at the end of ten year?
First find compound value factor at 15% for 10 years
which we get CVF of Re 1 as 4046. multiplying 4046 by Rs
225,159.90 as compound value
Fv=55650*CVF
=55,650*4,046=225,159.90
We can obtain the same answer by using a scientific
calculator:
f10 = 55,650*1.1510 = 55,650*4,046=225,159.00.
 Quantitative techniques in
managerial economics
Variables :-
Variable is used symbolically for the quantity or
numerical characteristic of data. A variable is a
quantity which varies from one individual
observation to another. In economics variables
refer to the quantitative aspect of economic
entities. For example economic entities such as
price, demand, rent are treated as variables in
economic analysis.
Variables are of two types
Discrete variable and continuous variables:-
Discrete variable is one which have values in
integral numbers. It cannot be measured but can be
counted only. For example number of children in
family can be 1,2,3, but can never be 1.2, 2.3 etc.

Continuous variables is one which can assume any

value even fractions. Variables such as age, wage,
income, savings are continuous variables
 Functions
Economic variables are interrelated and interdependent.
When relationship is established between two more
variables it is said they are functionally related. Functions
refer to the numerical relationship or dependence of one
variable on other variable.
Of the two functionally related variables, one is the
independent variable and another is dependent variable.
Independent variable which may change on its own
independently. Dependent variable is one which is
changing in relation to the change in the assigned
independent variable in given function.
Let the dependent variable be represented by Y and
independent variable by X and they are functionally related
then the value of Y uniquely changes to a given change in
the value of X. In mathematical terms it may be stated as:
Y=f(X)
where f stands for “a function of”. This means that
Y is function of X. That is to say, Y is related to X.
In economics we come across many such functional
relationships. For instance
Demand function: Dx=f(px) denotes that demand for X is
function of price of X.
 Linear function
The general form of a linear function is:
Y=a+bx where a and b are constant.
To illustrate graphical presentation let us take a specific
linear function:-
Y=3+2x
We may have the schedule thus:

values of x values of y

0 3
1 5
2 7
3 9
In a linear function Y=a+bx if a=0 the graphical curve
will pass through the origin for any other positive
value it will be intercept the Y axis.


Y=3+2x
9

1 2 3
 Non linear function
A function which when plotted graphically does not
produce straight line is called non-linear function. The
quadratic function, for instance is non-linear function.
Its general form is
 y=ax2+bx+c
Where x and y are variables and a, b and c are
constants. If we specify the quadratic equation as:
 y=x2-6x+10 we may have the schedule.

X Y

1 5
2 2
3 1
4 2
5 5
 CONCEPT OF SLOPE
The concept of slope is very important. Slope is the
property of plotted points on the curve or graph of a
function. In geometry the slope is defined as the ratio
of the length of the vertical side to the length of the
horizontal side of triangle. Thus
 Slope= Vertical length
 Horizontal length.
The slope refers to steepness of the line or curve.
 Graphs
“A picture says thousand words”. Daigrams are
powerful tool used in extensively used in economics
to represent a multitude of concepts. A daigram may
be drawn to scale by plotting the values on graph.
The graph of a function F can be defined to be the
set of all points where X belongs to domain of F. If
we plot the dependent variable X on horizontal axis
and independent variable Y on vertical axis then each
pair of values of X and Y can be plotted on a graph.
Graphs may be linear and non-linear.
 Concept of derivative.
The concept of derivate bears a close relation with
concept of margin. Marginal value of dependent
variable is the change in the variable associated with
unit change in a independent variable. Let us explain
with the help of following function:
 Y=f(X)
Y is a dependent variable and X is an independent
variable. Let is use the symbol of Δ to denote change.
Then ΔX would represent a change in the value of Y.
following the concept marginality the marginal value
of Y can be expressed as:
 Marginal Y=ΔY/ΔX
The derivative defines the slope at a point in economics
slope is very important slope is the property of plotted points
on the curve or graph of a function .The slope of curve stands
for the rate of change of one variable in relation to a unit
change in the associated variables
Derivative of a function is denoted by dy/dx i.e derivative of
y with respect to x,where y=f(x)
To optimize we simply take the derivative,set the equation
equal to zero and solve for x

Differential calculus is an important tool in managerial

economics