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LESSON 1
NATURE & SCOPE OF MANAGERIAL ECONOMICS
The terms Managerial Economics and Business Economics are often
used interchangeably. However, the terms Managerial Economics
has become more popular and seems to displace Business
Economics.
DECISION-MAKING AND FORWARD PLANNING
The chief function of a management executive in a business firm is
decision-making and forward planning. Decision-making refers to
the process of selecting one action from two or more alternative
courses of action. Forward planning on the other hand is arranging
plans for the future. In the functioning of a firm the question of
choice arises because the available resources such as capital, land,
labour and management, are limited and can be employed in
alternative uses. The decision-making function thus involves making
choices or decisions that will provide the most efficient means of
attaining an organisational objectives, for example profit
maximization. Once a decision is made about the particular goal to
be achieved, plans for the future regarding production, pricing,
capital, raw materials and labour are prepared. Forward planning
thus goes hand in hand with decision-making. The conditions in
which firms work and take decisions, is characterised with
uncertainty. And this uncertainty not only makes the function of
decision-making and forward planning complicated but also adds a
different dimension to it. If the knowledge of the future were
perfect, plans could be formulated without error and hence without
any need for subsequent revision. In the real world, however, the
business manager rarely has complete information about the future
sales, costs, profits, capital conditions. etc. Hence, decisions are
made and plans are formulated on the basis of past data, current
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information and the estimates about future that are predicted as
accurately as possible. While the plans are implemented over time,
more facts come into the knowledge of the businessman. In
accordance with these facts the plans may have to be revised, anda different course of action needs to be adopted. Managers are thus
engaged n a continuous process of decision-making through an
uncertain future and the overall problem that they deal with is
adjusting to uncertainty.
To execute the function of decision-making in an uncertain
frame-work, economic theory can be applied with considerable
advantage. Economic theory deals with a number of concepts and
principles relating to profit, demand, cost, pricing, production,
competition, business cycles and national income, which are aided
by allied disciplines like accounting. Statistics and Mathematics also
can be used to solve or at least throw some light upon the problems
of business management. The way economic analysis can be used
towards solving business problems constitutes the subject matter of
Managerial Economics.
DEFINITION
According to McNair the Merriam, Managerial Economics consists of
the use of economic modes of thought to analyse business
situations.
Spencer and Siegelman have defined Managerial Economics
as the integration of economic theory with business practice for the
purpose of facilitating decision-making and forward planning by
management.
The above definitions suggest that Managerial economics is
the discipline, which deals with the application of economic theory
to business management. Managerial Economics thus lies on the
margin between economics and business management and serves
as the bridge between the two disciplines. The following Figure 1.1
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shows the relationship between economics, business management
and managerial economics.
APPLICATION OF ECONOMICS TO BUSINESS MANAGEMENT
The application of economics to business management or the
integration of economic theory with business practice, as Spencer
and Siegelman have put it, has the following aspects :
Reconciling traditional theoretical concepts ofeconomics in relation to the actual business behavior
and conditions: In economic theory, the technique of
analysis is that of model building. This involves making some
assumptions and, drawing conclusions on the basis of the
assumptions about the behavior of the firms. The
assumptions, however, make the theory of the firm unrealistic
since it fails to provide a satisfactory explanation of what thefirms actually do. Hence, there is need to reconcile the
theoretical principles based on simplified assumptions with
actual business practice and develop appropriate extensions
and reformulation of economic theory. For example, it is
usually assumed that firms aim at maximising profits. Based
on this, the theory of the firm suggests how much the firm
will produce and at what price it would sell. In practice,however, firms do not always aim at maximum profits (as they
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may think of diversifying or introducing new product etc.) To
that extent, the theory of the firm fails to provide a
satisfactory explanation of the firms actual behavior.
Moreover, in actual business language, certain terms likeprofits and costs have accounting concepts as distinguished
from economic concepts. In managerial economics, an
attempt is made to merge the accounting concepts with the
economics, an attempt is made to merge the accounting
concepts with the economic concepts. This helps in a more
effective use of financial data related to profits and costs to
suit the needs of decision-making and forward planning.
Estimating economic relationships: This involves the
measurement of various types of elasticities of demand such
as price elasticity, income elasticity, cross-elasticity,
promotional elasticity and cost-output relationships. The
estimates of these economic relationships are to be used for
the purpose of forecasting.
Predicting relevant economic quantities: Economic
quantities such as profit, demand, production, costs, pricing
and capital are predicated in numerical terms together with
their probabilities. As the business manager has to work in an
environment of uncertainty, the future needs to be foreseen
so that in the light of the predicted estimates, decision-making
and forward planning may be possible.
Using economic quantities in decision-making and
forward planning: This involves formulating business
policies for establishing future business plans. This nature of
economic forecasting indicates the degree of probability of
various possible outcomes, i.e., losses or gains that will occur
as a result of following each one of the available strategies.
Thus, a quantified picture gets set up, that indicates the
number of courses open, their possible outcomes and the
quantified probability of each outcome. Keeping this picture in
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view, the business manager is able to decide about which
strategy should be chosen.
Understanding significant external forces: Applying
economic theory to business management also involvesunderstanding the important external forces that constitute
the business environment and with which a business must
adjust. Business cycles, fluctuations in national income and
government policies pertaining to taxation, foreign trade,
labour relations, antimonopoly measures, industrial licensing
and price controls are typical examples. The business
manager has to appraise the relevance and impact of theseexternal forces in relation to the particular business unit and
its business policies.
CHARACTERISTICS OF MANAGERIAL ECONOMICS
There are certain chief characteristics of managerial economics,
which can help to understand the nature of the subject matter and
help in a clear understanding of the following terms:
Managerial economics is micro-economic in character. This is
because the unit of study is a firm and its problems.
Managerial economics does not deal with the entire economy
as a unit of study.
Managerial economics largely uses that body of economic
concepts and principles, which is known as Theory of the Firm
or Economics of the Firm. In addition, it also seeks to apply
profit theory, which forms part of distribution theories in
economics.
Managerial economics is concrete and realistic. I avoids
difficult abstract issues of economic theory. But it alsoinvolves complications ignored in economic theory in order to
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face the overall situation in which decisions are made.
Economic theory ignores the variety of backgrounds and
training found in individual firms. Conversely, managerial
economics is concerned more with the particular environmentthat influences decision-making.
Managerial economics belongs to normative economics rather
than positive economics. Normative economy is the branch of
economics in which judgments about the desirability of
various policies are made. Positive economics describes how
the economy behaves and predicts how it might change. In
other words, managerial economics is prescriptive rather thandescriptive. It remains confined to descriptive hypothesis.
Managerial economics also simplifies the relations among
different variables without judging what is desirable or
undesirable. For instance, the law of demand states that as
price increases, demand goes down or vice-versa but this
statement does not imply if the result is desirable or not.
Managerial economics, however, is concerned with whatdecisions ought to be made and hence involves value
judgments. This further has two aspects: first, it tells what
aims and objectives a firm should pursue; and secondly, how
best to achieve these aims in particular situations. Managerial
economics, therefore, has been described as normative
microeconomics of the firm.
Macroeconomics is also useful to managerial economics sinceit provides an intelligent understanding of the business
environment. This understanding enables a business
executive to adjust with the external forces that are beyond
the managements control but which play a crucial role in the
well being of the firm. The important forces are: business
cycles, national income accounting, and economic policies of
the government like those relating to taxation foreign trade,
anti-monopoly measures and labour relations.
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DIFFFFERENCE BETWEEN MANAGERIAL ECONOMICS AND
ECONOMICS
The difference between managerial economics and economics canbe understood with the help of the following points:
Managerial economics involves application of economic
principles to the problems of a business firm whereas;
economics deals with the study of these principles only.
Economics ignores the application of economic principles to
the problems of a business firm.
Managerial economics is micro-economic in character,however, Economics is both macro-economic and micro-
economic.
Managerial economics, though micro in character, deals only
with a firm and has nothing to do with an individuals
economic problems. But microeconomics as a branch of
economics deals with both economics of the individual as well
as economics of a firm. Under microeconomics, the distribution theories, viz., wages,
interest and profit, are also dealt with. Managerial economics
on the contrary is mainly concerned with profit theory and
does not consider other distribution theories. Thus, the scope
of economics is wider than that of managerial economics.
Economic theory assumes economic relationships and builds
economic models. Managerial economics adopts, modifies andreformulates the economic models to suit the specific
conditions and serves the specific problem solving process.
Thus, economics gives the simplified model, whereas
managerial economics modifies and enlarges it.
Economics involves the study of certain assumptions like in
the law of proportion where it is assumed that The variable
input as applied, unit by unit is homogeneous or identical inamount and quality. Managerial economics on the other
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hand, introduces certain feedbacks. These feedbacks are in
the form of objectives of the firm, multi-product nature of
manufacture, behavioral constraints, environmental aspects,
legal constraints, constraints on resource availability, etc.Thus managerial economics, attempts to solve the
complexities in real life, which are assumed in economics. this
is done with the help of mathematics, statistics, econometrics,
accounting, operations research, etc.
OTHER TERMS FOR MANAGERIAL ECONOMICS
Certain other expressions like economic analysis for business
decisions and economics of business management have also been
used instead of managerial economics but they are not so popular.
Sometimes expressions like Economics of the Enterprise, Theory
of the Firm or Economics of the Firm have also been used for
managerial economics. It is, however, not appropriate t use theses
terms because managerial economics, though primarily related to
the economics of the firm, differs from it in the following respects:
First, Economics of the Firm deals with the theory of the firm,
which is a body of economic principles relating to the firm
alone. Managerial economics on the other hand deals with
the, application of the same principles to business.
Secondly, the term Economics of the firm is too simple in its
assumptions whereas managerial economics has to reckon
with actual business behaviour, which is much more complex.
SCOPE OF MANAGERIAL ECONOMICS
As regards the scope of managerial economics, there is no general
uniform pattern. However, the following aspects may be said to be
inclusive under managerial economics:
Demand analysis and forecasting.
Cost and production analysis. Pricing decisions, policies and practices.
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Profit management.
Capital management.
These aspects may also be defined as the Subject-Matter of
Managerial Economics. In recent years, there is a trend towardsintegrations of managerial economics and operations research.
Hence, techniques such as linear programming, inventory models
and theory of games have also been regarded as a part of
managerial economics.
Demand Analysis and Forecasting
A business firm is an economic Organisation, which transformsproductive resources into goods that are to be sold in a market. A
major part of managerial decision-making depends on accurate
estimates of demand. This is because before production schedules
can be prepared and resources are employed, a forecast of future
sales is essential. This forecast can also guide the management in
maintaining or strengthening the market position and enlarging
profits. The demand analysis helps to identify the various factorsinfluencing demand for a firms product and thus provides
guidelines to manipulate demand. Demand analysis and forecasting,
thus, is essential for business planning and occupies a strategic
place in managerial economics. It comprises of discovering the
forces determining sales and their measurement. The chief topics
covered in this are:
Demand determinants Demand distinctions
Demand forecasting.
Cost and Production Analysis
A study of economic costs, combined with the data drawn from the
firms accounting records, can yield significant cost estimates.
These estimates are useful for management decisions. The factors
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causing variations in costs must be recognised and thereby should
be used for taking management decisions. This facilitates the
management to arrive at cost estimates, which are significant for
planning purposes. An element of cost uncertainty exists in thisbecause all the factors determining costs are not always known or
controllable. Therefore, it is essential to discover economic costs
and measure them for effective profit planning, cost control and
sound pricing practices. Production analysis is narrower in scope
than cost analysis. The chief topics covered under cost and
production analysis are:
Cost concepts and classifications
Cost-output relationships
Economics of scale
Production functions
Cost control.
Pricing Decisions, Policies and Practices
Pricing is a very important area of managerial economics. In fact
price is the origin of the revenue of a firm. As such the success of a
usiness firm largely depends on the accuracy of price decisions of
that firm. The important aspects dealt under area, are as follows:
Price determination in various market forms
Pricing methods
Differential pricing product-line pricing and price forecasting.
Profit Management
Business firms are generally organised with the purpose of making
profits. 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. This uncertainty
occurs because of variations in costs and revenues. These are
caused by factors such as internal and external. If knowledge about
the future were perfect, profit analysis would have been a very easy
task. However, in a world of uncertainty, expectations are not
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always realised. Thus profit planning and measurement make up the
difficult area of managerial economics. The important aspects
covered under this area are:
Nature and measurement of profit. Profit policies and techniques of profit planning.
Capital Management
Among the various types and classes of business problems, the
most complex and troublesome for the business manager are those
relating to the firms capital investments. Capital management
implies planning and control and capital expenditure. In this
procedure, relatively large sums are involved and the problems areso complex that their disposal not only requires considerable time
and labour but also top-level decisions. The main elements dealt
with cost management are:
Cost of capital
Rate of return and selection of projects.
The various aspects outlined above represent the major
uncertainties, which a business firm has to consider viz., demand
uncertainty, cost uncertainty, price uncertainty, profit uncertainty
and capital uncertainty. We can, therefore, conclude that
managerial economics is mainly concerned with applying economic
principles and concepts to adjust with the various uncertainties
faced by a business firm.
MANAGERIAL ECONOMICS AND OTHER SUBJECTS
Yet another useful method of explaining the nature and scope ofmanagerial economics is to examine its relationship with other
subjects. The following discussion helps to understand relationship
between managerial economics and economics, statistics,
mathematics, accounting and operations research.
Managerial Economics and Economics
Managerial economics is defined as a subdivision of economics thatdeals with decision-making. It may be viewed as a special branch of
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economics bridging the gulf between pure economic theory and
managerial practice. Economics has two main divisions-
microeconomics and Macroeconomics. Microeconomics has been
defined as that branch where the unit of study is an individual or afirm. It is also called price theory (or Marshallian economics) and
is the main source of concepts and analytical tools for managerial
economics. To illustrate, various micro-economic concepts such as
elasticity of demand, marginal cost, the short and the long runs,
various market forms, etc., are all of great significance to
managerial economics.
Macroeconomics, on the other hand, is aggregative in
character and has the entire economy as a unit of study. The chief
contribution of macroeconomics to managerial economics is in the
area of forecasting. The modern theory of income and employment
has direct implications for forecasting general business conditions.
As the prospects of an individual firm often depend greatly on
general business conditions, individual firm forecasts rely on general
business forecasts.
A survey in the U.K. has shown that business economists have
found the following economic concepts quite useful and of frequent
application:
Price elasticity of demand
Income elasticity of demand
Opportunity cost
Multiplier Propensity to consume
Marginal revenue product
Speculative motive
Production function
Liquidity preference
Business economists have also found the following main areas
of economics as useful in their work. Demand theory
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Theory of firms price, output and investment decisions
Business financing
Public finance and fiscal policy
Money and banking
National income and social accounting
Theory of international trade
Economies of developing countries.
Thus, it is obvious that Managerial Economics is very closely
related to Economics.
Managerial Economics and Statistics
Statistics is important to managerial economics in several ways.
Managerial economics calls for the organising quantitative data and
deriving a useful measure of appropriate functional relationships
involved in decision-making. For instance, in order to base its pricing
decisions on demand and cost considerations, a firm should have
statistically derived or calculated demand and cost functions.
Managerial economics also employs statistical methods for
experimental testing of economic generalisations. The
generalisations can be accepted in practice only when they are
checked against the data from the world of reality and are found
valid. Managers do not have exact information about the variables
affecting decisions and have to deal with the uncertainty of future
events. The theory of probability, upon which statistics is based,
provides logic for dealing with such uncertainties.
Managerial Economics and Mathematics
Mathematics is yet another important subject closely related to
managerial economics. This is because managerial economics is
mathematical in character, as it involves estimating various
economic relationships, predicting relevant economic quantities and
using them in decision-making and forward planning. Knowledge of
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geometry, trigonometry ad algebra is not only essential but also
certain mathematical tools and concepts such as logarithms and
exponential, vectors, determinants, matrix, algebra, calculus,
differential as well as integral, are the most commonly used devices.Further, operations research, which is closely related to managerial
economics, is mathematical in character. It provides and analyses
data ad develops models, benefiting from the experiences of
experts drawn from different disciplines, viz., psychology, sociology,
statistics and engineering.
MANAGERIAL ECONOMICS AND ACCOUNTING
Managerial economics is also closely related to accounting, which is
concerned with recording the financial operations of a business firm.
In fact, a managerial economist depends chiefly on the accounting
information as an important source of data required for his decision-
making purpose. for instance, the profit and loss statement of a firm
shows how well the firm has done and whether the information it
contains can be used by managerial economist to throw significant
light on the future course of action that is whether the firm should
improve its productivity or close down. Therefore, accounting data
require careful interpretation, reconstruction and adjustments
before they can be used safely and effectively. It is in this context
that the link between management accounting and managerial
economics deserves special mention. The main task of management
accounting is to provide the sort of data, which managers need if
they are to apply the ideas of managerial economics to solve
business problems correctly. The accounting data should be
provided in such a form that they fit easily into the concepts and
analysis of managerial economics.
Managerial Economics and Operations Research
Operations research is a subject field that emerged during the
Second World War and the years thereafter. A good deal of
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interdisciplinary research was done in the USA. as well as other
western countries to solve the complex operational problems of
planning and resource allocation in defence and basic industries.
Several experts like mathematicians, statisticians, engineers andothers teamed up together and developed models and analytical
tools leading to the emergence of this specialised subject. Much of
the development of techniques and concepts, such as linear
programming, inventory models, game theory, etc., emerged from
the working of the operation researchers. Several problems of
managerial economics are solved by the operation research
techniques. These highlight the significant relationship between
managerial economics and operations research. The problems
solved by operation research are as follows:
Allocation problems: An allocation problem confronts with
the issue that men, machines and other resources are scarce,
related to the number sand size of the jobs that need to be
completed. The examples are production programming and
transportation problems.
Competitive problems: competitive problems deal with
situations where managerial decision-making is to be made in
the face of competitive action. That is, one of the factors to be
considered is: What will competitors do if certain steps are
taken? Price reduction, for example, will not lead to increased
market share if rivals follow suit.
Waiting line problems :Waiting line problems arise when a
firm wants to know how many machines it should install in
order to ensure that the amount of work-in-progress waiting
to be machined is neither too small nor too large. Such
situations arise when for example, a post office, or a bank
wants to know how many cash desks or counter clerks it
should employ in order to balance the business lost through
long guesses against the cost of installing more equipment or
hiring more labour.
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Inventory problems: Inventory problems deal with the
principal question: What is the optimum level of stocks of
raw-materials, components or finished goods for the firm to
hold?The above discussion explains that the managerial economics is
closely related to certain subjects such as economics, statistics,
mathematics and accounting. A trained managerial economist
combines concepts and methods from all these subjects by bringing
them together to solve business problems. In particular, operations
research and management accounting are getting very close to
managerial economics.
USES OF MANAGERIAL ECONOMICS
Managerial economics achieves several objectives. The principal
objectives are as follows:
It presents those aspects of traditional economics, which are
relevant for business decision-making in real life. For this
purpose, it picks from economic theory those concepts,principles and techniques of analysis, which are concerned
with the decision-making process. These are adapted or
modified in such a way that it enables the manager to take
better decisions. Thus, managerial economics attains the
objective of building a suitable tool kit from traditional
economics.
Managerial economics also incorporates useful ideas fromother disciplines such as psychology, sociology, etc. If they are
found relevant for decision-making. In fact, managerial
economics takes the aid of other academic disciplines that are
concerned with the business decisions of a manager in view of
the various explicit and implicit constraints subject to which
resource allocation is to be optimised.
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It helps in reaching a variety of business decisions even in a
complicated environment. Certain examples of such decisions
are those decisions concerned with:
o
The products and services to be producedo The inputs and production techniques to be used
o The quantity of output to be produced and the selling
prices to be subscribed
o The best sizes and locations of new plants
o Time of replacing the equipment
o Allocation of the available capital
Managerial economics helps a manager to become a more
competent model builder. Thus, he can pick out the essential
relationships, which characterise a situation and leave out the
other unwanted details and minor relationships.
At the level of the firm, functional specialists or functional
departments exist, e.g., finance, marketing, personnel,
production etc. For these various functional areas, managerial
economics serves as an integrating agent by co-ordinating the
different areas. It then applies the decisions of each
department or specialist, those implications, which are
pertaining to other functional areas. Thus managerial
economics enables business decision-making to operate not
with an inflexible and rigid but with an integrated perspective.
This integration is important because the functional
departments or specialists often enjoy considerable autonomyand achieve conflicting goals.Managerial economics keeps in
mind the interaction between the firm and society and
accomplishes the key role of business as an agent in attaining
social economic welfare. There is a growing awareness that
besides its obligations to shareholders, business enterprise
has certain social obligations as well. Managerial economics
focuses on these social obligations while taking businessdecisions. By doing so, it serves as an instrument of furthering
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the economic welfare of the society through socially oriented
business decisions.
Thus, it is evident that the applicability and usefulness of
managerial economics is obtained by performing the followingactivates:
Borrowing and adopting the tool-kit from economic theory.
Incorporating relevant ideas from other disciplines to achieve
better business decisions.
Serving as a catalytic agent in the course of decision-making
by different functional departments/specialists at the firms
level. Accomplishing a social purpose by adjusting business
decisions to social obligations.
ECONOMIC THEORY AND MANAGERIAL ECONOMICS
Economic theory offers a variety of concepts and analytical tools
that can assist the manager in the decision-making practices.
Problem solving in business has, however, found that there exists awide disparity between the economic theory of a firm and actual
observed practice, thus necessitating the use of many skills and be
quite useful to examine two aspects in this regard:
The basic tools of managerial economics which it has
borrowed from economics, and
The nature and extent of gap between the economic theory of
the firm and the managerial theory of the firm.Basic Economic Tools in Managerial Economics
The most significant contribution of economics to managerial
economics lies in certain principles, which are basic to the entire
range of managerial economics. The basic principles may be
identified as follows:
1. Opportunity Cost Principle
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The opportunity cost of a decision means the sacrifice of
alternatives required by that decision. This can be best understood
with the help of a few illustrations, which are as follows:
The opportunity cost of the funds employed in ones ownbusiness is equal to the interest that could be earned on those
funds if they were employed in other ventures.
The opportunity cost of the time as an entrepreneur devotes
to his own business is equal to the salary he could earn by
seeking employment.
The opportunity cost of using a machine to produce one
product is equal to the earnings forgone which would havebeen possible from other products.
The opportunity cost of using a machine that is useless for any
other purpose is zero since its use requires no sacrifice of
other opportunities.
If a machine can produce either X or Y, the opportunity cost of
producing a given quantity of X is equal to the quantity of Y,
which it would have produced. If that machine can produce 10units of X or 20 units of Y, the opportunity cost of 1 X is equal
to 2 Y.
If no information is provided about quantities produced,
except about their prices then the opportunity cost can be
computed in terms of the ratio of their respective prices, say
Px/Py.
The opportunity cost of holding Rs. 500 as cash in hand for
one year is equal to the 10% rate of interest, which would
have been earned had the money been kept as fixed deposit
in a bank. Thus, it is clear that opportunity costs require the
ascertaining of sacrifices. If a decision involves no sacrifice, its
opportunity cost is nil.
For decision-making, opportunity costs are the only relevant
costs. The opportunity cost principle may be stated as under:
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The cost involved in any decision consists of the sacrifices of
alternatives required by that decision. If there are no sacrifices,
there is no cost.
Thus in macro sense, the opportunity cost of more guns in aneconomy is less butter. That is the expenditure to national fund for
buying armour has cost the nation of losing an opportunity of buying
more butter. Similarly, a continued diversion of funds towards
defence spending, amounts to a heavy tax on alternative spending
required for growth and development.
2. Incremental Principle
The incremental concept is closely related to the marginal costs and
marginal revenues of economic theory. Incremental concept
involves two important activities which are as follows:
Estimating the impact of decision alternatives on costs and
revenues.
Emphasising the changes in total cost and total cost and total
revenue resulting from changes in prices, products,
procedures, investments or whatever may be at stake in thedecision.
The two basic components of incremental reasoning are as
follows:
Incremental cost: Incremental cost may be defined as the
change in total cost resulting from a particular decision.
Incremental revenue: Incremental revenue means the change
in total revenue resulting from a particular decision.The incremental principle may be stated as under:
A decision is obviously a profitable one if:
o It increases revenue more than costs
o It decreases some costs to a greater extent than it
increases other costs
o It increases some revenues more than it decreases
other revenueso It reduces costs more that revenues.
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Some businessmen hold the view that to make an overall
profit, they must make a profit on every job. Consequently, they
refuse orders that do not cover full cost (labour, materials and
overhead) plus a provision for profit. Incremental reasoningindicates that this rule may be inconsistent with profit maximisation
in the short run. A refusal to accept business below full cost may
mean rejection of a possibility of adding more to revenue than cost.
The relevant cost is not the full cost but rather the incremental cost.
A simple problem will illustrate this point.
IIIustration
Suppose a new order is estimated to bring in additional revenue of
Rs. 5,000. The costs are estimated as under:
Labour Rs. 1,500Material Rs. 2,000Overhead (Allocated at 120% of labour cost) Rs. 1,800Selling administrative expenses(Allocated at 20% of labour and material
cost)
Rs. 700
Total Cost Rs. 6,000
The order at first appears to be unprofitable. However,
suppose, if there is idle capacity, which can be, utilised to execute
this order then the order can be accepted. If the order adds only Rs.
500 of overhead (that is, the added use of heat, power and light, the
added wear and tear on machinery, the added costs of supervision,
and so on), Rs. 1,000 by way of labour cost because some of the idle
workers already on the payroll will be deployed without added pay
and no extra selling and administrative cost then the incremental
cost of accepting the order will be as follows.
Labour Rs. 1,500Material Rs. 2,000Overhead Rs. 500Total Incremental Cost Rs. 3,500
While it appeared in the first instance that the order will result
in a loss of Rs. 1,000, it now appears that it will lead to an addition
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of Rs. 1,500 (Rs. 5,000- Rs. 3,500) to profit. Incremental reasoning
does not mean that the firm should accept all orders at prices,
which cover merely their incremental costs. The acceptance of the
Rs. 5,000 order depends upon the existence of idle capacity andlabour that would go unutilised in the absence of more profitable
opportunities. Earleys study of excellently managed large firms
suggests that progressive corporations do make formal use of
incremental analysis. It is, however, impossible to generalise on the
use of incremental principle, since the observed behaviour is
variable.
3. Principle of Time Perspective
The 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 on costs. The actual 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 in the course of time offer long-run
repercussions, which make it more or less profitable than it
appeared at first. An illustration will make this point clear.
IIIustration
Suppose there is a firm with temporary idle capacity. An order for
5,000 units comes to managements attention. The customer is
willing to pay Rs. 4.00 per unit or Rs. 20,000 for the whole lot but
not more. The short-run incremental cost (ignoring the fixed cost) is
only Rs. 3.00. Therefore, the contribution to overhead and profit is
Re. 1.00 per unit (Rs. 5,000 for the lot. However, the long-run
repercussions of the order ought to be taken into account are as
follows:
If the management commits itself with too much of business
at lower prices or with a small contribution, it may not have
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sufficient capacity to take up business with higher
contributions when the opportunity arises. The management
may be compelled to consider the question of expansion of
capacity and in such cases; even the so-called fixed costsmay become variable.
If any particular set of customers come to know about this
low price, they may demand a similar low price. Such
customers may complain of being treated unfairly and feel
discriminated. In response, they may opt to patronise
manufacturers with more decent views on pricing. The
reduction or prices under conditions of excess capacity mayadversely affect the image of the company in the minds of its
clientele, which will in turn affect its sales.
It is, therefore, important to give due consideration to the time
perspective. The principle of time perspective 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.
Haynes, Mote and Paul have cited the case of a printing
company. This company pursued the policy of never quoting prices
below full cost though it often experienced idle capacity and the
management was fully aware that the incremental cost was far
below full cost. This was because the management realised that the
long-run repercussions of pricing below full cost would make up for
any short-run gain. The management felt that the reduction in rates
for some customers might have an undesirable effect on customer
goodwill particularly among regular customers not benefiting from
price reductions. It wanted to avoid crating such an image of the
firm that it exploited the market when demand was favorable but
which was willing to negotiate prices downward when demand was
unfavorable.
4. Discounting Principle
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One of the fundamental ideas in economics is that a rupee
tomorrow is worth less than a rupee today. This seems similar to the
saying that a bird in hand is worth two in the bush. A simple
example would make this point clear. Suppose a person is offered achoice to make between a gift of Rs. 100 today or Rs. 100 next year.
Naturally he will choose the Rs. 100 today.
This is true for two reasons. First, the future is uncertain and
there may be uncertainty in getting Rs. 100 if the present
opportunity is not availed of. Secondly, even if he is sure to receive
the gift in future, todays Rs. 100 can be invested so as to earn
interest, say, at 8 percent so that. one year after the Rs. 100 of
today will become Rs. 108 whereas if he does not accept Rs. 100
today, he will get Rs. 100 only in the next year. Naturally, he would
prefer the first alternative because he is likely to gain by Rs. 8 in
future. Another way of saying the same thing is that the value of Rs.
100 after one year is not equal to the value of Rs. 100 of today but
less than that. To find out how much money today is equal to Rs.
100 would earn if one decides to invest the money. Suppose the
rate of interest is 8 percent. Then we shall have to discount Rs. 100
at 8 per cent in order to ascertain how much money today will
become Rs. 100 one year after. The formula is:
V =
Rs. 1001 + i
where,
V = present value
i = rate of interest.
Now, applying the formula, we get
V =
Rs. 1001 + i
=
1001.08
If we multiply Rs. 92.59 by 1.08, we shall get the amount of
money, which will accumulate at 8 per cent after one year.
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92.59 x 1.08 = 99.0072
= 1.00
The same reasoning applies to longer periods. A sum of Rs.
100 two years from now is worth:
V =
Rs. 100
=
Rs. 100
=
Rs. 100(1+i)2 (1.08)2 1.1664
Similarly, we can also check by computing how much the
cumulative interest will be after two years. The principle involved in
the above discussion is called the discounting principle and is stated
as follows: If a decision affects costs and revenues at future dates,
it is necessary to discount those costs and revenues to present
values before a valid comparison of alternatives is possible.
5. Equi-marginal Principle
This principle deals with the allocation of the available resource
among the alternative activities. According to this principle, an input
should be allocated in such a way that the value added by the last
unit is the same in all cases. This generalisation is called the equi-
marginal principle.
Suppose a firm has 100 units of labour at its disposal. The firm
is engaged in four activities, which need labour services, viz., A, B, C
and D. It can enhance any one of these activities by adding more
labour but sacrificing in return the cost of other activities. If the
value of the marginal product is higher in one activity than another,
then it should be assumed that an optimum allocation has not been
attained. Hence it would, 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. For
example, if the values of certain two activities are as follows:
Value of Marginal Product of labour
Activity A = Rs. 20
Activity B = Rs. 30
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In this case it will be profitable to shift labour from A to
activity B thereby expanding activity B and reducing activity A. The
optimum will be reach when the value of the marginal product is
equal in all the four activities or, when in symbolic terms:VMPLA = VMPLB = VMPLC = VMPLD
Where the subscripts indicate labour in respective activities.
Certain aspects of the equi-marginal principle need
clarifications, which are as follows:
First, the values of marginal products are net of incremental
costs. In activity B, we may add one unit of labour with an
increase in physical output of 100 units. Each unit is worth 50paise so that the 100 units will sell for Rs. 50. But the
increased output consumes raw materials, fuel and other
inputs so that variable costs in activity B (not counting the
labour cost) are higher. Let us say that the incremental costs
are Rs. 30 leaving a net addition of Rs. 20. The value of the
marginal product relevant for our purpose is thus Rs. 20.
Secondly, if the revenues resulting from the addition of labour
are to occur in future, these revenues should be discounted
before comparisons in the alternative activities are possible.
Activity A may produce revenue immediately but activities B,
C and D may take 2, 3 and 5 years respectively. Here the
discounting of these revenues will make them equivalent.
Thirdly, the measurement of value of the marginal product
may have to be corrected if the expansion of an activityrequires an alternative reduction in the prices of the output. If
activity B represents the production of radios and it is not
possible to sell more radios without a reduction in price, it is
necessary to make adjustment for the fall in price.
Fourthly, the equi-marginal principle may break under
sociological pressures. For instance, du to inertia, activities
are continued simply because they exist. Similarly, due totheir empire building ambitions, managers may keep on
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expanding activities to fulfil their desire for power.
Department, which are already over-budgeted often, use
some of their excess resources to build up propaganda
machines (public relations offices) to win additional support.Governmental agencies are more prone to bureaucratic self-
perpetuation and inertia.
Gaps between Theory of the Firm and managerial Economics
The theory of the firm is a body of theory, which contains certain
assumptions, theorems and conclusions. These theorems deal with
the way in which businessmen make decisions about pricing, and
production under prescribed market conditions. It is concerned with
the study of the optimisation process.
For optimality to exist profit must be maximised and this can
occur only when marginal cost equals marginal revenue. Thus, the
optimum position of the firm is that which maximises net revenue.
Managerial economics, on the other hand, aims at developing a
managerial theory of the firm and for the purpose it takes the help
of economic theory of the firm. However, there are certain
difficulties in using economic theory as an aid to the study of
decision-making at the level of the firm. This is because for the
purposes of business decision-making it fails to provide sufficient
analytical tools that are useful to managers. Some of the reasons
are as follows:
Underlying all economic theory is the assumption that the
decision-maker is omniscient and rational or simply that he is
an economic man. Thus being omniscient means that he
knows the alternatives that are available to him as well as the
outcome of any action he chooses. The model of economic
man however as an omniscient person who is confronted
with a compete set of known or probabilistic outcomes is a
distorted representation of reality. The typical business
decision-maker usually has limited information at his disposal,
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limited computing ability and a limited number of feasible
alternatives involving varying degrees of risk. Further, the net
revenue function, which he is expected to maximise, and the
marginal cost and marginal revenue functions, which he isexpected to equate, require excessive knowledge of
information, which is not known and cannot be obtained even
by the most careful analysis. Hence, it is absurd to expect a
manager to maximise and equalise certain critical functional
relationships, which he does not know and cannot find out.
In micro-economic theory, the most profitable output is where
marginal cost (MC) and marginal revenue (MR) are equal. InFigure 1.2, the most profitable output will be at ON where
MR=MC. This is the point at which the slope of the profit
function or marginal profit is zero. This is highlighted in Figure
1.3 where the most profitable output will be again at ON. In
economic theory, the decision-maker has to identify this
unique output level, which maximises profit.
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In real world, however, a complexity often arises, viz., certain
resource limitations exist. As a result, it is not possible to attain the
maximum output level (ON). In practical terms the maximum output
possible as a result of resource limitations is, say, OM. Now the
problem before the decision-maker is to find out whether the
output, which maximises profit, is OM or some other level of output
to the left of OM. It is obvious that economic theory is of no help for
ON level of output because it is not relevant in view of the resource
limitations. A managerial economist here has to take the aid of
linear programming, which enables the manager to optimise or
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search for the best values within the limits set by inequality
conditions.
Another central assumption in the economic theory of the
firm is that the entrepreneur strives to maximise hisresidual share, or profit. Several criticisms of this
assumption have been made:
o The theory is ambiguous, as it doesnt clarify.
Whether it is short or long run profit that is to be
maximised. For example, in the short run, profits
could be maximised by firing all research and
development personnel and thereby eliminatingconsiderable immediate expenses. This decision
would, however, have a substantial impact on long-
run profitability.
o Certain questions create some confusion around the
concept of profit maximisation. Should the firm seek
to maximise the amount of profit or the rate of profit?
What is the rate of profit? Is it profit in relation tototal capital or profit in relation to shareholders
equity?
o There is no allowance for the existence of psychic
income (Income other than monetary, power,
prestige, or fame), which the entrepreneur might
obtain from the firm, quite apart from his monetary
income.
o The theory does not recognise that under modern
conditions, owners and managers are separate and
distinct groups of people and the latter may not be
motivated to maximise profits.
o Under imperfect competition, maximisation is an
ambiguous goal, because actions that are optimal for
one will depend on the actions of the other firms.
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o The entrepreneur may not care to receive maximum
profits but may simply want to earn satisfactory
profits. This last point is particularly relevant from
the behavioural science standpoint because itintroduces a concept of satiation. The notion of
satiation plays no role in classical economic theory.
To explain business behaviour in terms of this theory,
it is necessary to assume that the firms goals are not
concerned with maximising profit, but with attaining
a certain level or rate of profit, holding a certain
share of the market or a certain level of sales. Firms
would try to satisfy rather than maximise. But
according to Simon the satisfying model damages all
the conclusions that can be derived concerning
resource allocation under perfect competition. It
focuses on the fact that the classical theory of the
firm is empirically incorrect as a description of the
decision-making process. Based on this notion of
satiation, it appears that one of the main strengths of
classical economic theory has been seriously
weakened.
Most corporate undertakings involve the investment of
funds, which are expect to produce revenues over a
number of years. The profit maximisation criterion provides
no basis for comparing alternatives that can promise
varying flows of revenue and expenditure over time.
The practical application of profit maximisation concept
also has another limitation. It provides no explicit way of
considering the risk associated with alternative decisions.
Two projects generating similar expected revenues in the
future and requiring similar outlays might differ vastly as
regarding the degree of uncertainty with which the benefits
to be generated. The greater the uncertainty associated
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with the benefits, the greater the risk associated with the
project.
Baumol on the other hand is of the view that firms do not
devote all their energies to maximising profit. Rather acompany will seek to maximise its sales revenue as long as
a satisfactory level of profit is maintained. Thus Baumol has
substituted Total sales revenue for profits. Also, two
decision criteria or objectives have been advanced viz., a
satisfactory level of profit and the highest sales possible. In
other words, the firm is no longer viewed as working
towards one objective alone. Instead, it is portrayed asaiming at balancing two competing and non-consistent
goals. Baumols model is based on the view that managers
salaries, their status and other rewards often appear as
closely related to the companies size in which they work
and is measured by sales revenue rather than their
profitability. As such, managers may be more concerned to
increased size than profits. And the firms objective thus
becomes sales maximisation rather than profits
maximisation.
Empirical studies of pricing behaviour also give results that
differ from those of the economic theory of firm as can be
seen from the following examples:
o Several studies of the pricing practices of business
firms have indicated that managers tend to set
prices by applying some sort of a standard mark-up
on costs. They do not attempt to estimate marginal
costs, marginal revenues or demand elasticities,
even if these could be accurately measured.
o For many firms, prices are more often set to attain,
a particular target return on investment, say, 10 per
cent, than to maximise short or long-run profits.
o There is some evidence that firms experiencing
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declining market shares in their industry strive
more vigorously to increase their sales than do
competing firms, which are experiencing steady or
increasing market shares. An alternative model to profit maximisation is the concept
of
wealth maximisation, which assumes that firms seek to
maximise the present value of expected net revenues over
all periods within the forecasted future.
As pointed out by Haynes and Henry, a study of the
behaviour of actual firms shows that their decisions are notcompletely determined by the market. These firms have
some freedom to develop decisions, strategies or rules,
which become part of the decision-making system within
the firm. This gap in economic theory has led to what has
come to be known as Behavioural Theory of the Firm. This
theory, however, does not replace the former but rather
powerfully supplements it. The behavioural theoryrepresents the firm as an adoptive institution. It learns
from experience and has a memory. Organisational
behaviour, is embodies into decision rules and standard
operating procedures. These may be altered over long run
as the firm reacts to feedback from experience. However,
in the short run, decisions of the organisation are
dominated by its rules of thumb and standard methods.
CONCLUSION
The various gaps between the economic theory of the firm and the
actual decision-making process at the firm level are many in
number. They do, however, stress that economic theory seriously
needs major fixing up and substantial changes are in progress for
creating better and different models. Thus the classical economic
concepts like those of rational man is undergoing important
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changes; the notion of satisfying is pushing aside the aim of
maximisation and newer lines and patterns of thoughts are being
developed for finding improved applications to managerial decision-
making. A strong emphasis is laid on quantitative model building,experimentation and empirical investigation and newer techniques
and concepts, such as linear programming, game theory, statistical
decision-making, etc., are being applied to revolutionise the
approaches to problem solving in business and economics.
MANAGERIAL ECONOMIST: ROLE AND RESPONSIBILITIES
A managerial economist can play a very important role by assisting
the management in using the increasingly specialised skills and
sophisticated techniques, required to solve the difficult problems of
successful decision-making and forward planning. In business
concerns, the importance of the managerial economist is therefore
recognised a lot today. In advanced countries like the USA, large
companies employ one or more economists. In our country too, big
industrial houses have understood the need for managerial
economists. Such business firms like the Tatas, DCM and Hindustan
Lever employ economists. A managerial economist can contribute to
decision-making in business in specific terms. In this connection,
two important questions need be considered:
1. What role does he play in business, that is, what particular
management problems lend themselves to solution through
economic analysis?
2. How can the managerial economist best serve management,
that is, what are the responsibilities of a successful
managerial economist?
Role of a Managerial Economist
One of the principal objectives of any management in its decision-
making process is to determine the key factors, which will influence
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the business over the period ahead. In general, these factors can be
divided into two categories:
External
InternalThe external factors lie outside the control of management
because they are external to the firm and are said to constitute
business environment. The internal factors lie within the scope and
operations of a firm and hence within the control of management,
and they are known as business operations. To illustrate, a business
firm is free to take decisions about what to invest, where to invest,
how much labour to employ and what to pay for it, how to price itsproducts, and so on. But all these decisions are taken within the
framework of a particular business environment, and the firms
degree of freedom depends on such factors as the governments
economic policy, the actions of its competitors and the like.
Environmental Studies of a Business Firm
An analysis and forecast of external factors constituting generalbusiness conditions, for example, prices, national income and
output, volume of trade, etc., are of great significance since they
affect every business firm. Certain important relevant factors to be
considered in this connection are as follows:
The outlook for the national economy, the most important
local, regional or worldwide economic trends, the nature of
phase of the business cycle that lies immediately ahead. Population shifts and the resultant ups and downs in regional
purchasing power.
The demand prospects in new as well as established markets.
Impact of changes in social behaviour and fashions, i.e.,
whether they will tend to expand or limit the sales of a
companys products, or possibly make the products obsolete?
The areas in which the market and customer opportunities arelikely to expand or contract most rapidly.
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Whether overseas markets expand or contract and the affect
of new foreign government legislations on the operation of the
overseas plants?
Whether the availability and cost of credit tend to increase ordecrease buying, and whether money or credit conditions
ahead are likely to easy or tight?
The prices of raw materials and finished products.
Whether the competition will increase or decrease.
The main components of the five-year plan, the areas where
outlays have been increased and the segments, which have
suffered a cut in their outlays.
The outlook to governments economic policies and
regulations and changes in defence expenditure, tax rates
tariffs and import restrictions.
Whether the Reserve Banks decisions will stimulate or
depress industrial production and consumer spending and
how will these decisions affect the companys cost, credit,
sales and profits.
Reasonably accurate data regarding these factors can enable the
management to chalk out the scope and direction of their own
business plans effectively. It will also help them to determine the
timing of their specific actions. And it is these factors, which present
some of the areas where a managerial economist can make
effective contribution. The managerial economist has not only to
study the economic trends at the micro-level but also must interpret
their relevance to the particular industry or firm where he works. He
has to digest the ever-growing economic literature and advise top
management by means of short, business-like practical notes. In
mixed economy like that of India, the managerial economist
pragmatically interprets the intentions of controls and evaluates
their impact. He acts as a bridge between the government and the
industry, translating the governments intentions and transmitting
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the reactions of the industry. In fact, the government policies
emerge out of the performance of industry, the expectations of the
people and political expediency.
Business Operations
A managerial economist can also be helpful to the management in
making decisions relating to the internal operations of a firm in
respect of such problems as price, rate of operations, investment,
expansion or contraction. Certain relevant questions in this
context would be as follows:
What will be a reasonable sales and profit budget for the
next year?
What will be the most appropriate production schedules
and inventory policies for the next six months?
What changes in wage and price policies should be made
now?
How much cash will be available next month and how
should it be invested?
Specific Functions
The managerial economists can play a further role, which can cover
the following specific functions as revealed by a survey pertaining to
Brittain conducted by K.J.W. Alexander and Alexander G. Kemp:
Sales forecasting.
Industrial market research.
Economic analysis of competing companies.
Pricing problems of industry.
Capital projects.
Production programmes.
Security / Investment analysis and forecasts.
Advice on trade and public relations.
Advice on primary commodities.
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Advice on foreign exchange.
Economic analysis of agriculture.
Analysis of underdeveloped economics.
Environmental forecasting.
The managerial economist has to gather economic data, analyse
all relevant information about the business environment and
prepare position papers on issues facing the firm and the industry.
In the case of industries prone to rapid theological advances, the
manager may have to make continuous assessment of tl1e impact
of changing technology. The manager' may need to evaluate the
capital budget in the light of short and long-range financial, profit
and market potentialities. Very often, he also needs to prepare
speeches for the corporate executives. It is thus clear that in
practice, managerial economists perform many and various
functions. However, of all these, the marketing functions, i.e., sales
force listing an industrial market research, are the most important.
For this purpose, the managers may collect statistical records of
the sales performance of their own business and those rehiring to
their rivals, carry out analysis of these records and report on trends
in demand, their market shares, and the relative efficiency of their
retail outlets. Thus, while carrying out heir functions, the managers
may have to undertake detailed statistical analysis. There are, of
course, differences in the relative importance of the various
functions performed from firm to firm and in the degree of
sophistication of the methods used in performing these functions.
But there is no doubt that the job of a managerial economist
requires alertness and the ability to work uriderpressure.
Economic Intelligence
Besides these functions involving sophisticated analysis, managerial
economist may also provide general intelligence service. Thus the
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economist may supply the management with economic information
of general interest such as competitors
prices and products, tax rates, tariff rates, etc.
Participating in Public Debates
Many well-known business economists participate in public debates.
The government and society alike are seeking their advice and
views. Their practical experience in business and industry adds
prestige to their views. Their public recognition enhances their
protg in the .firm itself.
Indian Context
In the Indian context, a managerial economist is expected to
perform the following functions:
Macro-forecasting for
demand and supply.
Production planning at macro and micro levels.
Capacity planning and product-mix determination.
Economics of various production lines.
Economic feasibility of new production lines / processes and
projects.
Assistance in preparation of overall development plans.
Preparation of periodical economic reports bearing on various
matters such as the company's product-lines, future growth
opportunities, market pricing situation, general business,. and
various national/international factors affecting industry and
business.
Preparing briefs; speeches, articles and papers for top
management for various chambers, Committees, Seminars,
Conferences, etc
Keeping management informed of various national and
International Developments on economic/industrial matters.
With the adoption of the new economic policy, the macro-
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economic environment is changing fast and these changes have
tremendous implications for business. The managerial economists
have to playa much more significant role. They ha'1e to constantly
measure the possibilities of translating the rapidly changingeconomic scenario into workable business opportunities. As India
marches towards globalisation, the managerial economists will have
to interpret the global economic events and find out how the firm
can avail itself of the various export opportunities or of establishing
plants abroad either wholly owned or in association with local
partners.
Responsibilities of a Managerial Economist
Besides considering the opportunities that lie before a managerial
economist it is necessary to take into account the services that are
expected by the management. For this, it is necessary for a
managerial economist to thoroughly recognise the responsibilities
and obligations. A managerial economist can serve the mana-
gement best by recognising that the main objective of the
business, is to make a profit on its invested capital. Academictraining and the critical comments from people outside the
business may lead a managerial economist to adopt an apologetic
or defensive attitude towards profits. There should be a strong
personal conviction on part of the managerial economist that
profits are essential and it is necessary to help enhance the ability
of the firm to make profits. Otherwise it is difficult to succeed in
serving management.Most management decisions necessarily concern the future,
which is rather uncertain. It is, therefore, absolutely essential that a
managerial economist recognises his responsibility to make
successful forecast. By making the best possible forecasts and
through constant efforts to improve, a managerial' ng, the risks
involved in uncertainties. This enables the management to follow a
more orderly course of business planning. At times, it is requiredfor the managerial economist to reassure the management that an
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important trend will continue. In other cases, it is necessary to
point out the probabilities of a turning point in some activity of
importance to management. In any case, managerial economist
must be willing to make fairly positive statements about impendingeconomic developments. These can be based upon the best
possible information and analysis. The management's confidence in
a managerial economist increases more quickly and thoroughly
with
a record of successful forecasts, well documented in advance
and modestly evaluated when the actual results become
available.
A few consequences to the above proposition need also be
emphasised here.
First, a managerial economist has a major responsibility to alert
managelI1ent at the earliest possible moment in' case there is
an err6r' in his forecast. This will assist the mallagement in
making appropriate adjustment in policies and programmes
and strengthen his oWn position as a member of themanagement team by keeplrighis fingers on the economic
pulse of the
business.
Secondly, a managerial economist must establish and maintain
many contacts with individuals and data sources: which would
not be immediately available to the other members of the
management. Extensive familiarity with reference sources andmaterial is essential. It is still more important that the known
individuals who are specialists in particular fields have a
bearing on tpe managerial economist's work. For this purpose,
it is required that managerial economist joins professional
associations and tak~ active part in them. In fact, one of the
best means of determining the quality of a managerial
economist is to evaluate his ability to obtain informationquickly by personal contacts rather than by lengthy research
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from either readily available or obscure reference sources.
Within any business, there' may be a wealth of knowledge and
experience but the managerial economist would be really
useful ifit is possible pn his part to supplement the existingknow-how with additional information and in the quickest
possible manner.
Again, if a managerial economist is to be really helpful to the
management in successful decision-making and forward planning, it
is necessary'" to able to earn full status on the business team.
Readiness to take up special assignments, be that in study teams,
committees or special projects is another important requirement.This is because it is necessary for the managerial economist to win
continuing support for himself and his professional ideas. Clarity of
expression and attempting to minimise the use of technical
terminology while communJcating his ideas to management
executives is also an essential role so as to win approval.
To conclude, a managerial economist has a very important role
to play by helping management in successful decision-making andforward planning. But to discharge his role successfully, it is
necessary to recognise the 'relevant responsibilities and obligations.
To some business executives, however, a managerial economist is
still a luxury or perhaps even a necessary evil. It is not surprising,
therefore, to find that while tneir status is improving and their
impor;ance is gradually rising, managerial economists in certain
firms still 'feel quite insecure. Nevertheless, there is a definite andgrowing realisation that they can contribute significantly to the
profitable growth of firms and effective solution oftMir problems,
and this' promises them a positive future.
REVIEW QUESTIONS
1. What is managerial economics? How does it differ from
traditional economics?
2. Discuss the nature and scopeofmanagerial economics.
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3. Show the significance of economic analysis in business
decisions.
4. Managerial Economics is perspective rather than descriptive in
character? Examine this statement.5. Assess the contribution and limitations of economic analysis to
business decision-making.
6. Briefly explain the five principles, which are basic to the entire
gamut of managerial economics.
7. Explain the role of marginal analysis in determining optimal
solution if managerial economics. How does it compare with
break-even analysis?8.Discuss some of the important economic concepts and
techniques that help busirless management.
9. Explain the various functions of a managerial economist. How
can he best serve the management?
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LESSON 2
DEMAND ANALYSIS
Demand is one of the crucial requirements for the existence of
any business firm. Firms are interested in their profit and sales,
both of which depend partially upon the demand for the product.
The decisions, which management makes with respect to
production, advertising, cost allocation, pricing, inventory
holdings, etc. call for an analysis of demand. While how much a
firm can produce depends upon its capacity and demand for its
products. If there is no demand for a product, its production is
unworthy. If demand falls short of production, one way to
balance the two is to create new demand through more and
better advertisements. The more the future demand for a
product, the more inventories the firm would hold. The larger
the demand for a firm's product, the higher is the price it can
charge.
Demand analysis seeks to identify and measure the forces
that determine sales. Once this is done the alternative ways of
manipulating or managing demand can easily be inferred.
Although, demand for a finri's product reflects what the
consumers buy, this can be influenced through manipulating the
factors on which consumers base their demands. Demand
analysis attempts to estiinate the demand for a product in
future, which further helps to plan production based on the
estimated demand.
MEANING OF DEMAND
Demand for a good implies the desire of an individual to acquire
the product. It also includes willingness and ability of ail individual
to pay for the product. For example, a miser's desire for and his
ability to pay for a car is not demand, for he does not have the
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necessary will to pay for the car. Similarly, a poor person's desire
for and his willingness to pay for a car is not demand because he
lacks the necessary purchasing power. One can also imagine an
individual, who possesses both the will and the purchasing powerto pay for a good. But this purchasing power is not the demand for
that good, this is because he does not have the desire to buy that
product. Therefore, demand is successful when there are all the
three factors: desire, willingness and ability. It should also be
noted that demand for any goods or services has no meaning
unless it is stated with reference to time, price, competing
product, consumer's incomes, tastes and preferences. This is
because demand varies with fluctuations in these factors. For
example, the demand for an Ambassador car in India is 40,000 is
meaningless unless it is stated that this was the demand in 1976
when an Ambassador car's price was around thirty thousand
rupees. The price of the competing cars prices were around the
same, a Bajaj scooter's price was around five thousand rupees and
petrol price was around three and a half rupees per litre. In 1977,
the demand for Ambassador cars could be different if any of the
above factors happened to be different. Furthermore, it should be
noted that a product is defined with reference to its particular
quality. If its quality changes it can be deemed as another
product. Thus, the demand for any product is the desire,
wi1lihigness and ability to buy the product with reference to a
partkular time and given values of variables on which it depends.
TYPES OF DEMAND
The demand for various kinds of goods is generally classified on
the basis of kinds of consumers, suppliers of goods, nature of
goods, duration of consumption goods, interdependence of
demand, period of demand and nature of use of goods
(intermediate or final), The major classifications of demand are asfollows:
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Individual and market demand
Demand for firm's prodtictand industry's products
Autonomous and derived demand
Demand for durable and non-durable goods
Short-term and long-term demand
Individual and Market Demand
The quantity of a product, which an individual is willing to buy at
a particular price during a specific time period, given his money
income, his taste, and prices of other commodities (particularly
substitutes and complements), is called 'individual's demand for aproduct'. The total quantity, which all comsumers are willing to
buy at a given price per time unit, given their money income,
taste, and prices of other commodities is known as 'market
demand for the good'. In other words, the market demand for a
good is the sum of the individual demands of all the c6-nsumers
of a product, over a time period at given prices.
Demand for Firm's Product and Industry's Products
The quantity of a firm's yield, that can be disposed of at a given
price over a period refers to the demand for firm's product. The
aggregate demand for the product of all firms of an industry is
known as the market-demand or demand for industry's product.
This distinction between the two kinds of demand is not of much
use in a highly competitive market since it merely signifies the
distinction between a sum and its parts. However, where market
structure is oligopolistic, a distinction between the demand for
firm's product and industry's product is useful from managerial
point of view. The product of each firm is so differentiated from the
products of the rival firms that consumers treat each product
different from the other. This gives firms an opportunity to plan the
price of a product, advertise it in order to capture a larger market
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share thereby to enhance profits. For instance, market of cars,
radios, TV sets, refrigerators, scooters, toilet soaps and toothpaste,
all belong to this category of markets.
In case of monopoly and perfect competition, the distinctionbetween demand for a firm's product and industry's product is not
of much use from managerial point of view. In case of monopoly,
industry is one-firmindustiy andthe demand for firm's product is
the same as that of the industry. In case of perfect competition,
products of all firms .of the industry are homogeneous and price
for each firm is determined by industry. Firms have little
opportunity to plan the prices permissible under local conditionsand advertisement by a firm becomes effective for the whole
industry. Therefore, conceptual distinction between demand for
film's product and industry's product is not much use in business
decisions making.
Autonomous and Derived Demand
An Autonomous demand for a product is one that arises
independently of the demand for any other good whereas a derived
demand is one, which is derived from demand of some other good.
To look more closely at the distinction between the two kinds of
demand, consider the demand for commodities, which arise directly
from the biological or physical needs of the human beings, such as
demand for food, clothes and shelter. The demand for these goods
is autonomous demand. Autotnomous demand also arises as a'
result of demonstration effect, rise in income, and increase in
population and advertisement of new produCts. On the other hand,
the demand for a good that arises because of the demand for some
other good is called derived demand. For instance, demand for
land, fertiliser and agricultural tools and implements are derived
demand, since the demand of goods, depends on the demand of
food. Similarly, demand for steel, bricks, cement etc., is a derived
demand because it is derived from the demand for houses and
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other kind of buildings. [n general, the demand for, producer goods
or industrial inputs is a derived one. Besides, demand for
complementary goods (which complement the use of other goods)
or for supplementary goods (which supplement or provideadditional utility from the use of other goods) is a derived demand.
For instance petrol is a complementary goods for automobiles and
a chair is a complement to a table. Consider some examples of
supplement goods. Butter is supplement to bread, mattress is
supplement to cot and sugar is supplement to tea. Therefore,
demand for petrol, chair, and sugar would be considered as derived
demand. The conceptual distinction between autonomous demand
and derived demand would be useful according to the point of view
of a bllsinessman to the extent the former can serve as an indicator
of the latter.
Demand for Durable and Non-durable Goods
Demand is often classified under demand for durable and non-
durable goods. Durable goods are those goods whose total utility is
not exhausted in single or short-run use. Such goods can be used
continuously over a period of time. Durable goods may be consumer
goods as well as producer goods. Durable consumer goods include
clothes, shoes, house furniture, refrige