Introduction to

Managerial
Economics
 Concept of Managerial Economics

 Prof. Ragnar Frisch coined this term for

the first time in 1933.

 It studies individual units like individual

households, pricing of a product, wages of

worker and so on.

Managerial Economics
Those activities of mankind are studied which are concerned with
earnings and spending of money.

For the successful handling of these activities certain laws and rules are
formulated which are known as various theories of economics.

Use of these rules & tools provided for analysing business conditions and
applying them for arriving at various economic decision is known as
managerial economics.
Defining Managerial Economics
―Managerial Economics is economics applied in

decision making. It is a special branch of economics

bridging the gap between abstract theory and

managerial practice.‖ – Haynes, Mote and Paul.

―Business Economics consists of the use of economic

modes of thought to analyse business situations.‖ –

McNair and Meriam

 Other Definitions of Managerial Economics

According to McGutgan and Moyer: ―Managerial economics is the application of economic

theory and methodology to decision-making problems faced by both public and private

institutions‖.

According to E.F. Brigham and J. L. Pappar, Managerial Economics is ―the application of

economic theory and methodology to business administration practice.‖

D.C. Hague describes Managerial Economics as ―a fundamental

academic subject which seeks to understand and analyse the problems

of business decision making.

 After the study of various definitions it can be concluded that:

Managerial Economics is that branch of knowledge in which theories of economic

analysis are used for solving business management problems and determination of
business policies.

Managerial Economics serves as a bridge between Economics and Business

Management.
Importance of
Economics in
Management
 Learning Objectives

Helpful in
Decision
making Helps
Helps in
Helps to
organizing control costs

Makes
Helpful in
planning
coordination
easier

Helpful in Importance
of Helpful in
formulating
Demand
managerial managerial Forecasting
policies
economics
 Importance of Application of Economics in Business Management

1) Helpful in Organizing: Business

managers can learn through the study
of Business Economics what to
produce, how to produce, for whom to
produce and when to produce. This
helps them to organize well.

2) Helpful in Planning: Managers with

the use of business economics can
plan to mobilize and use resources
effectively.

3) Helpful in Decision making: Business

manager can decide on the basis of
their knowledge of Business Economics
number of relevant things such as
what kind of production should be
undertaken, what should be the
technique etc. so as to get the
maximum profit.
 Importance of Application of Economics in Business Management

4) Helpful in co ordination: Business

economics helps to establish co
ordination between traditional
theoretical concepts of economics and
actual business practices.
5) Helpful in Formulating Business Policies:
Business Economics helps in deciding its
policies for the real objectives and
certain business situation of the firm.
6) Helpful in Cost Control: Business
Economics helps in cutting the cost of
production and other costs involved in
business.
 Importance of Application of Economics in Business Management

7) Helpful in Demand Forecasting: Business

economics provides the use of economic
concepts for estimating economic relations
among various variables for managerial
decisions.
8) Minimizing Uncertainties: Business
economics helps to reduce uncertainties
existing within and outside the organization
9) Helpful in Understanding External
Environment: Business Economics helps the
business managers in understanding the
external environment in which the firm has
to function and shows him the way to co-
ordinate his business with it.
Significance of
Economics in
Decision
Making
 ROLE OF MANAGERIAL ECONOMICS IN MANAGERIAL DECISION MAKING

Managerial economics uses economic concepts and decision science techniques to solve

managerial problems.

Management Decision Problems

Economic Concepts Decision Sciences

Managerial Economics

Optimal Solutions to Managerial Decision

Problems
 How does managerial economics helps in decision making?

Following are the steps helps to managers while taking decisions..

1.Establish objectives.

2.Define the problem.

3.Identify factors that affect the problem.

4.Specify alternative solutions.

5.Collect data and other information's.

6.Evaluate and screen alternatives.

7.Implement best alternative and monitor result.

 Examples of Managerial Decisions

• How to use economic theory to set prices that

maximize profits.

• How to use economic theory to choose the cost-

minimizing production technique for a given scale of

output.

• How to use economic theory to select the ―optimal‖

location for a new restaurant, grocery store, etc.

• How to use economic theory to forecast near-term

demand for goods and services.

 Nature of
Managerial
Economics
Nature of Managerial Economics

Art and
Science
Micro
Pragmatic
economics

Nature of
Manageme
Managerial
Uses macro
nt oriented Economics economics

Prescriptive
Multi-
/Normative
disciplinary
discipline
 Nature of Managerial Economics
 Art and Science: Managerial economics requires a lot
of logical thinking and creative skills for decision making
or problem-solving. It is also considered to be a stream of
science by some economist claiming that it involves the
application of different economic principles, techniques
and methods, to solve business problems.
 Micro Economics: In managerial economics,
managers generally deal with the problems related to a
particular organization instead of the whole economy.
Therefore it is considered to be a part of
microeconomics.
 Uses Macro Economics: A business functions in an
external environment, i.e. it serves the market, which is a
part of the economy as a whole.
 Nature of Managerial Economics
 Multi-disciplinary: It uses many tools and principles
belonging to various disciplines such as accounting,
finance, statistics, mathematics, production, operation
research, human resource, marketing, etc.
 Prescriptive / Normative Discipline: It aims at goal
achievement and deals with practical situations or
problems by implementing corrective measures.
 Management Oriented: It acts as a tool in the hands of
managers to deal with business-related problems and
uncertainties appropriately. It also provides for goal
establishment, policy formulation and effective decision
making.
 Pragmatic: It is a practical and logical approach
towards the day to day business problems
 Scope of
Managerial
Economics
 Scope of Managerial economics
1) Demand Analysis and Forecasting: Demand analysis and
forecasting of demand facilitates the decision making and
forward planning. If demand forecasting of a firm is correct,
the firm earns more profit and if they are wrong it suffers
losses.

2) Production Planning and Management: Every firm is engaged

in certain production, hence it has to plan and manage the
production. Firm has to make profitable decisions keeping its
factors of production and the product in view.

3) Cost Analysis: One of the important responsibilities of business

managers is to analyze and control costs in order to maximize
the profit. It can be done only by the proper investigation
and research about the respective costs.

4) Pricing Policies and Practices: Deciding the price is one of the

important subject of business economics. The success of a
firm depends upon decisions regarding prices.
 Scope of Managerial economics

5) Profit Management: Managerial economics

helps in analysis of profit measurement and
control.

6) Capital Management: Capital

management in business economics
includes cost of capital, profitability of the
capital and the selection of suitable
project or projects out of various projects.

7) Decision Theory under Uncertainty:

Uncertainties are many fold such as
uncertainty of demand, uncertainty of cost,
uncertainty of capital etc. Many statistical
methods are developed for taking decision
under condition of such uncertainties.
Relationship of
Economics with
other
Disciplines
 Managerial Economics Relationship with other disciplines

Many new subjects have evolved in recent years due to the interaction among basic
disciplines. managerial economics can be taken as the best example of such a
phenomenon among social sciences. Hence it is necessary to trace its roots and relationship
with other disciplines.
 1. Relationship with economics:

The relationship between managerial economics and economics theory may be viewed form the

point of view of the two approaches

• Micro Economics and Macro Economics.

o Microeconomics is the study of the economic behavior of individuals, firms and other such
micro organizations.

o Uses concepts such as marginal cost, marginal revenue, elasticity of demand as well as price
theory and theories of market structure to name only a few.

o Macro Economics deals with the analysis of national income, the level of employment,
general price level, consumption and investment in the economy and even matters related
to international trade, Money, public finance, etc.
 2. Management theory and accounting:
• Managerial economics has been influenced by the
developments in management theory and accounting
techniques. Accounting refers to the recording of
pecuniary transactions of the firm in certain books
• A proper knowledge of accounting techniques is very
essential for the success of the firm because profit
maximization is the major objective of the firm.
• Managerial Economics requires a proper knowledge of
cost and revenue information and their classification.
• A student of managerial economics should be familiar
with the generation, interpretation and use of
accounting data. The focus of accounting within the
firm is fast changing from the concepts of store keeping
to that if managerial decision making, this has resulted
in a new specialized area of study called ―Managerial
Accounting‖.
 3. Managerial Economics and mathematics:

• The use of mathematics is significant for managerial

economics in view of its profit maximization goal long
with optional use of resources.

• The major problem of the firm is how to minimize cost,

hoe to maximize profit or how to optimize sales.

• Mathematical concepts and techniques are

widely used in economic logic to solve these problems

• Mathematical symbols are more convenient to handle

and understand various concepts like incremental cost,
elasticity of demand etc., Geometry, Algebra and
calculus are the major branches of mathematics which
are of use in managerial economics.
 4. Managerial Economics and Statistics:
• Managerial Economics needs the tools of statistics
in more than one way.

• Statistical methods provide and sure base for

decision- making.

• Managerial Economics also make use of

correlation and multiple regressions in related
variables like price and demand to estimate the
extent of dependence of one variable on the
other.

• The theory of probability is very useful in problems

involving uncertainty.
 5. Managerial Economics and Operations Research:

Operation research provides a scientific model of

the system and it helps managerial economists in

the field of product development, material

management, and inventory control, quality control,

marketing and demand analysis. The varied tools of

operations Research are helpful to managerial

economists in decision- making.

 Basic
Assumptions in
Economics
 Topic Heading

The following points highlight the four main categories of assumptions in

economic theories. The categories are:

1. Psychological or Behavioural Assumptions

2. Institutional Assumptions

3. Structural Assumptions

4. Ceteris Paribus Assumptions.

 1. Psychological or Behavioral Assumptions:

These assumptions are about the individual human behavior. They refer to rational behavior of
individuals as consumers and producers.

A rational consumer aims at the maximization of his satisfaction from a given money income and
its expenditure on goods and services.

 A rational producer aims at maximizing his profits.

 According to Baumol and Blinder, rational behavior ―is defined in economics as characterizing
those decisions that are most effective in helping the decision- maker achieve his own objectives,
whatever they may be. The objectives themselves (unless they are self-contradictory) are never
considered rational or irrational‖.
 2. Institutional Assumptions:

• These assumptions in economic theory relate to social, political and economic institutions.

• All economic theories have been developed on the assumption of a capitalist economy in which
the means of production and distribution are privately owned and used for personal gain.

• It assumes stable government and certain socio-economic institutions which include private
property, self-interest, economic liberalism or laissez-faire, competition and the price system.

• The institutional assumptions are the basis of micro-economic theories.

 3. Structural Assumptions:

• These assumptions relate to the nature, physical structure or topography of the economy and

the state of technology.

• These assumptions relate to a static economy where there is movement but no change.

•The structural assumptions are used in production functions of various types and in growth

theories.

• But in the long run, labour, capital and other resources and technology are assumed to

change in certain theories.

 4. Ceteris Paribus Assumption:

• Another important assumption made in economics is the ceteris paribus or other things being

equal assumption.

• In order to consider the impact of one factor at a time the other factors are held constant.

• The ―other things‖ are such assumptions as no change in income, tastes, habits, prices of related

goods etc.
Fundamental Concepts
of Managerial
Economics
 1. The Incremental Concept

 Incremental concept involves estimating the impact of decision alternatives on costs and
revenues, emphasizing the changes in total cost and total revenue resulting from changes in prices,
products, procedures, investments or whatever else may be at stake in the decisions.
 The two basic components of incremental reasoning are:
Incremental cost
Incremental revenue.
 Incremental cost may be defined as the change in total cost resulting from a particular decision.
Incremental revenue is the change in total revenue resulting from a particular decision.
The incremental principle may be stated as follows: A decision is a profitable one if—
 it increases revenue more than cost
 it decreases some costs to a greater extent than it increases others
 it increases some revenues more than it decreases others and it reduces cost more than
revenues.
 Topic Review
For Example:
Suppose a firm gets an order that brings additional revenue of Rs 3,000. The cost of production
from this order is:
Rs.
Labour 800
Materials 1,300
Overheads 1,000
Selling and administration expenses 700
Full cost 3,800
At a glance, the order appears to be unprofitable. But suppose the firm has some idle capacity
that can be utilised to produce output for new order. There may be more efficient use of
existing labour and no additional selling and administration expenses to be incurred. Then the
incremental cost to accept the order will be:
Rs.
Labour 600
Materials 1,000
Overheads 800
Total incremental cost 2,400
Incremental reasoning shows that the firm would earn a net profit of Rs 600 (Rs 3,000 – 2,400),
though initially it appeared to result in a loss of Rs 800. The order should be accepted
 2. The Concept of Time Perspective
According to the principle of time perspective, a manger/decision maker should give due
emphasis, both to short-term and long-term impact of his decisions, giving apt significance to
the different time periods before reaching any decision.
 Short-run refers to a time period in which some factors are fixed while others are variable.
The production can be increased by increasing the quantity of variable factors.
 While long-run is a time period in which all factors of production can become variable. Entry
and exit of seller firms can take place easily.
 3. The Concept of Discounting Principle

Discounting principle explains about the comparison of money value in present

and future time.

Example:

If person is given option to take 100/- as a gift for today.

or

If person is given option to take 100/- as a gift after one month.

Normally a person chooses first offer only. Why because ―today rupee is having

more worth than tomorrows rupee‖

 4. The Concept of Equimarginal Principle

The principle states that an input should be allocated so that value added by the last unit is the
same in all cases. This generalization is popularly called the equi-marginal.

Let us assume a case in which the firm has 100 unit of labour at its disposal. And the firm is involved
in five activities viz., А, В, C, D and E. The firm can increase any one of these activities by employing
more labour but only at the cost i.e., sacrifice of other activities.

An optimum allocation cannot be achieved if the value of the marginal product is greater in one
activity than in another.
 4. The Concept of Equimarginal Principle

 For a consumer, this concept implies that money may be allocated over various commodities

such that marginal utility derived from the use of each commodity is the same. Similarly, for a

producer this concept implies that resources be allocated in such a manner that the marginal

product of the inputs is the same in all uses.

 5. Risk and Uncertainty

 Managerial decisions are actions of today which bear fruits in future which is unforeseen.
 Future is uncertain and involves risk.
 The uncertainty is due to unpredictable changes in the business cycle, structure of the
economy and government policies.
 This means that the management must assume the risk of making decisions for their institution in
uncertain and unknown economic conditions in the future.
What is Firm?
 Concept of Firm

 A firm is an entity that draws various types of

factors of production in different amounts from the

economy, and converts them into desirable

output(s), through a process with the help of suitable

technology.
 Understanding concept of firms

 The performances of firms get analyzed in the framework of an economic model.

 Business decisions include many vital decisions like whether a firm should
undertake research and development program, should a company launch a new
product, etc.

 The economic model of a firm is called the theory of the firm.

 Factors of Production

Economists have identified five factors of Production:

1) Land

2) Labor

3) Capital

4) Enterprise

5) Organization
Theory of Firms
 Forms of Ownership

 Businesses may be organized in various forms, depending on their

size, nature and need for resources.

Three broad categories of business organizations are:

Private sector (wholly owned by people, individually, or as a group),

Public sector (owned, managed and controlled by government) and

Joint sector (owned and managed jointly by individuals and government)

 Forms of Ownership
Forms of Ownership

Private Sector Joint Sector Public Sector

Individual Collective

Proprietorship Company Corporation Department

Partnership Company Cooperative

 Private Sector

Ownership is in the hands of individuals, whether independently, or as a small group, or in a

large number, without any investment from the government

Types of business organizations under private sector:

•Sole Proprietorship

•Partnership

•Joint Stock Company

•Cooperative
 Public sector

Government is the investor and the owner of a business

Established in India as per the First

Industrial Policy enunciated in 1948 and restated in 1956

Three broad categories of State Enterprises in India:

i.Public Sector Units (e.g. SAIL, BHEL, ONGC and IOC)

ii. Corporations and Boards (e.g. Coir Board, Railway Board

and Food Corporation of India)

iii. Departments (e.g. Telephoneand Telegraph, Education, and Health)

Objectives of the Firm
 Objectives of the firm

• The basic objectives of the firm:

Provides the framework for all the functions, strategies and managerial decisions

Determines the short and long term perspective of the firm

 Profit Maximization Theory

Objective of business is generation of the largest amount of profit

Profit = Total Revenue-Total Cost

Traditionally efficiency of a firm measured in terms of its profit generating capacity

Criticism

Confusion on measure of profit

Confusion on period of time

Validity questioned in competitive markets

 Baumol’s Theory of Sales Revenue Maximization

• In competitive markets firms aim at maximizing revenue through maximization of sales

• Sales volumes determine market leadership in competition

• Dichotomy of managers’ goals and owners’ goals

• Manager’s salary and other benefits linked with sales volumes, rather than profits

• Managers attach their personal prestige to the company’s revenue or sales.

• They attempt to maximize the firm’s total revenue instead of profits

 Marris’ Hypothesis of Maximization of Growth Rate

 Two Sets of goals:

• Owners (Share holders) aims at profits and market shares
• Managers aim at better salary, job security and growth

Both achieved by maximizing balanced growth of the firm (G),

dependent on:
Growth rate of demand for the firm’s products (GD) and
Growth rate of capital supply to the firm (GC)

Constraints in the objective of maximization of balanced growth:

Managerial Constraint
Financial Constraint
 Williamson’s Model of Managerial Utility Function

• Managers apply their discretionary power to maximize their own utility function

– Constraint of maintaining minimum profit to satisfy shareholders

• Utility function of managers (Um) depends on:

– managers’ salary (measurable)

– Job security

– Power

– Status

– Professional satisfaction

– Power to influence firm’s objectives

 Behavioural Theories

Simon’s Satisficing Model

Firms have to incur costs in acquiring information

in the present

Objective of maximizing either profit, or sales,

or growth act as constraints to rational decision making
―Bounded rationality"
Satisfactory level of profit, sales and growth
Model by Cyert and March
Stakeholdershave different and oft conflicting goals

‘Satisficing behaviour’ aiming at satisfying all stakeholders.

Aspiration level on basis of past experience, past performance of the firm, performance of
other similar firms, and future expectations