Managerial Economics Chap II

8/7/2019 Managerial Economics Chap II

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Fundamental concepts used in

Business Decisions


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Opportunity Cost and decision making

Related to alternative uses of scare resources

Concepts of opportunity cost:

a) Scarce resourcesb) Alternative resources


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Eg; Suppose a firm has Rs.100 million at its

disposal and three risk free alternative uses

like, and

Alternative 1 expand the size of the firm earns Rs.20 mn

Alternative 2 set up new production unit earns Rs.18 mn

Alternative 3 buy shares in another firm earns Rs.16 mn

Alternative 2 is the second best alternative. Thus the opportunitycost of availing an opportunity is the foregone income

expected from the second best opportunity cost of using the

resources.


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Opportunity cost assumes a great significance

where economic gain is neither insignificant

nor very large and requires a careful

evaluation of the two options.

Economic Gain = Actual Earnings

Opportunity cost


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Opportunity cost concept can be applied to allresources in business decisions when at least twoalternatives are involved.

If a firm decides to fire the labour officer, the lossof an efficient labour officer is the opportunitycost of buying peace with the labour union.

Incase the firm decides to retain the labourofficer, cost of prolonged litigation, possiblelabour strike and consequent reduction in outputcost are the opportunity costs of retaining thelabour officer.


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The Decision Rule

Suppose a profit maximizing firm is faced witha problem how much to produce so that

profit is maximum.

Basic principle is MR=MC Profit is maximized at a level of output where

cost of producing one additional unit equals

the revenue from the sale of that unit ofoutput.


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Limitations ofMarginal principle

Can be applied only when the management

has TC and TR data for each and every unit of

output.

When MC is used in cost analysis, reduces the

value ofMC to the change in variable cost

only. Therefore, the marginal analysis can be

applied to a situation in which only variable

cost changes.


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Incremental Principle and Decision Rule

It is applied in business decisions which involve bulkproduction and large increase in total cost and totalrevenue.

Such increase in TC and TR is called incremental cost

and incremental revenue related to incrementaloutput.

Incremental costs include both FC and VC.

Three major incremental costs are:

a) Present explicit costb) Opportunity cost

c) Future cost


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Three major incremental costs

Present explicit cost : FC and VC

Opportunity cost: expected income foregone

from the best use of the resources involved inpresent decision

Future cost : Depreciation and advertisement

costs if the product does not sell well as

expected.


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Contribution Analysis

Contribution = IR IC

It is applied to analyse the contribution made by thebusiness decision to overhead costs and revenue to

work out the net result of that business decision. It is used in whether or not to

a) Accept the project

b) Introduce a new product

c) Accept a fresh orderd) To add an additional plant

e) Make or buy decision


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Contribution Analysis and the relevant costs

The relevant costs are

i) Present explicit costs:

a) Explicit variable costs Direct labour, directmaterial cost and direct variable overheads

b) Fixed costs New additional equipment and

personnel.ii) Opportunity Cost:

iii) Future Incremental Costs:


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Contribution Analysis and the

irrelevant costs

Committed costs: payment of old debts,

interest, salaries and wages of mangers and

workers,

Sunk Costs: Purchase of assets and non-

recoverable advance payments.


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Equi- Marginal Principle

It is based on the law of Equi-marginal utility.

This law states that a utility maximising consumer

distributes his consumption expenditure between

various goods and services he/she consumes in

such a way that the marginal utility derived from

each unit of expenditure on various goods and

services is the same. This pattern of consumptionexpenditure maximises a consumers total utility.


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The Equi-marginal

principle This principle states that a a rational

decision maker would allocate the

resources in such a way that it provideequal marginal benefit per unit of cost.

MU1/MC1=MU2/MC2=MUn/MCn


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Law of Equi-marginal utility and Business Decision

Business managers have over a period of timeapplied this law to allocate resources betweenalternative uses with a view to maximise profit incase a firm carries out more than one businessactivity.

The principle suggests that available resources(inputs) should be so allocated between the

alternate options that the marginal productivitygains (MP) from various activities are equalised.

MPA = MPB = MPCMPN


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Deals with allocation of resources among alternativeactivities

According to this principle an input should be employed indifferent activities in such proportion that the value added

by last unit is the same in all activities or marginal productsfrom various activities are equalized.

MPA=MPB=MPC=MPN

Equi - Marginal Principle


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Time Perspective in Business Decision

Short term perspective cracker industry

Long term perspective investment,

expansion, introduction of a new product,

advertisement etc. However the business decision of taking the

short term for the establishment of

Management Institute and long termperspective of buying manufacturing

explosives is dangerous for cracker industry.


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The discounting

principle The time value of money refers to the

fact that a rupee received in the future is

not worth a rupee today. PV = A

(1+I)n


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Discounting Principle

A rupee now is worth more than a rupee earned a yearafter

To take decision regarding investment which will yieldreturn over a period of time it is necessary to find itspresent worth by using discounting principle

This principle helps to bring value of future rupees to

present rupees PV=1/1+i i=8%

PV=100/1.08=92.59

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Managerial Economics Chap II

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