Basic tools in Managerial Economics

Economic theory offers a variety of concepts and analytical tools which can be of considerable assistance to the managers in his decision making practice. These tools are helpful for managers in solving their business related problems. These tools are taken as guide in making decision.

Following are the basic economic tools for decision making:

1.    Opportunity cost

2.    Incremental principle

3.    Principle of the time perspective

4.    Discounting principle

5.    Equi-marginal principle

1) Opportunity cost principle:

By the opportunity cost of a decision is meant the sacrifice of alternatives required by that decision.

For e.g.

a) The opportunity cost of the funds employed in one’s own business is the interest that could be earned on those funds if they have been employed in other ventures.

b) The opportunity cost of using a machine to produce one product is the earnings forgone which would have been possible from other products.

c) The opportunity cost of holding Rs. 1000as cash in hand for one year is the 10% rate of interest, which would have been earned had the money been kept as fixed deposit in bank.

Its clear now that opportunity cost requires ascertainment of sacrifices. If a decision involves no sacrifices, its opportunity cost is nil. For decision making opportunity costs are the only relevant costs.

2) Incremental principle:

It is related to the marginal cost and marginal revenues, for economic theory. Incremental concept involves estimating the impact of decision alternatives on costs and revenue, emphasizing the changes in total cost and total revenue resulting from changes in prices, products, procedures, investments or whatever may be at stake in the decisions.

The two basic components of incremental reasoning are

1.    Incremental cost

2.    Incremental Revenue

The incremental principle may be stated as under:

“A decision is obviously a profitable one if –

·         it increases revenue more than costs

·         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”

3) Principle of Time Perspective

Managerial economists are also concerned with the short run and the long run effects of decisions on revenues as well as costs. The very important problem in decision making is to maintain the right balance between the long run and short run considerations.

For example;

Suppose there is a firm with a temporary idle capacity. An order for 5000 units comes to management’s attention. The customer is willing to pay Rs 4/- unit or Rs.20000/- for the whole lot but not more. The short run incremental cost(ignoring the fixed cost) is only Rs.3/-. There fore the contribution to overhead and profit is Rs.1/- per unit (Rs.5000/- for the lot)

Analysis:

From the above example the following long run repercussion of the order is to be taken into account:

1) If the management commits itself with too much of business at lower price or with a small contribution it will not have sufficient capacity to take up business with higher contribution.

2) If the other 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 against.

In the above example it is therefore important to give due consideration to the time perspectives. “a decision should take into account both the short run and long run effects on revenues and costs and maintain the right balance between long run and short run perspective”.

4) Discounting Principle:

One of the fundamental ideas in Economics is that a rupee tomorrow is worth less than a rupee today. Suppose a person is offered a choice to make between a gift of Rs.100/- today or Rs.100/- next year. Naturally he will chose Rs.100/- today. This is true for two reasons-

i) The future is uncertain and there may be uncertainty in getting Rs. 100/- if the present opportunity is not availed of

ii) Even if he is sure to receive the gift in future, today’s Rs.100/- can be invested so as to earn interest say as 8% so that one year after Rs.100/- will become 108

5) Equi – marginal Principle:

This principle deals with the allocation of an available resource among the alternative activities. According to this principle, an input should be so allocated that the value added by the last unit is the same in all cases. This generalization is called the equi-marginal principle.

Suppose, a firm has 100 units of labor at its disposal. The firm is engaged in four activities which need labors services, viz, A,B,C and D. it can enhance any one of these activities by adding more labor but only at the cost of other activities.

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Business decision making

Managerial Economics : Definition, Nature, Scope

Business decision making

Business decision making is essentially a process of selecting the best out of alternative opportunities open to the firm. The steps below put managers analytical ability to test and determine the appropriateness and validity of decisions in the modern business world. Following are the various steps in decision making process:

1.    Establish objectives

2.    Specify the decision problem

3.    Identify the alternatives

4.    Evaluate alternatives

5.    Select the best alternatives

6.    Implement the decision

7.    Monitor the performance

Modern business conditions are changing so fast and becoming so competitive and complex that personal business sense, intuition and experience alone are not sufficient to make appropriate business decisions. It is in this area of decision making that economic theories and tools of economic analysis contribute a great deal.

Managerial Economics : Definition, Nature, Scope

Managerial economics is a discipline which deals with the application of economic theory to business management. It deals with the use of economic concepts and principles of business decision making. Formerly it was known as “Business Economics” but the term has now been discarded in favour of Managerial Economics.

Managerial Economics may be defined as the study of economic theories, logic and methodology which are generally applied to seek solution to the practical problems of business. Managerial Economics is thus constituted of that part of economic knowledge or economic theories which is used as a tool of analysing business problems for rational business decisions. Managerial Economics is often called as Business Economics or Economic for Firms.

Definition of 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

“Business Economics (Managerial Economics) is the integration of economic theory with business practice for the purpose of facilitating decision making and forward planning by management.” - Spencerand Seegelman.

“Managerial economics is concerned with application of economic concepts and economic analysis to the problems of formulating rational managerial decision.” – Mansfield

Nature of Managerial Economics:

• The primary function of management executive in a business organisation is decision making and forward planning.
• Decision making and forward planning go hand in hand with each other. Decision making means the process of selecting one action from two or more alternative courses of action. Forward planning means establishing plans for the future to carry out the decision so taken.
• The problem of choice arises because resources at the disposal of a business unit (land, labour, capital, and managerial capacity) are limited and the firm has to make the most profitable use of these resources.
• The decision making function is that of the business executive, he takes the decision which will ensure the most efficient means of attaining a desired objective, say profit maximisation. After taking the decision about the particular output, pricing, capital, raw-materials and power etc., are prepared. Forward planning and decision-making thus go on at the same time.
•  A business manager’s task is made difficult by the uncertainty which surrounds business decision-making. Nobody can predict the future course of business conditions. He prepares the best possible plans for the future depending on past experience and future outlook and yet he has to go on revising his plans in the light of new experience to minimise the failure. Managers are thus engaged in a continuous process of decision-making through an uncertain future and the overall problem confronting them is one of adjusting to uncertainty.
•  In fulfilling the function of decision-making in an uncertainty framework, economic theory can be, pressed into service with considerable advantage as it deals with a number of concepts and principles which can be used to solve or at least throw some light upon the problems of business management. E.g are profit, demand, cost, pricing, production, competition, business cycles, national income etc. The way economic analysis can be used towards solving business problems, constitutes the subject-matter of Managerial Economics.
• Thus in brief we can say that Managerial Economics is both a science and an art.

Scope of Managerial Economics:

The scope of managerial economics is not yet clearly laid out because it is a developing       science. Even then the following fields may be said to generally fall under Managerial Economics:

    1.  Demand Analysis and Forecasting

    2.  Cost and Production Analysis

    3.  Pricing Decisions, Policies and Practices

    4.  Profit Management

    5.  Capital Management

These divisions of business economics constitute its subject matter.

Recently, managerial economists have started making increased use of Operation Research methods like Linear programming, inventory models, Games theory, queuing up theory etc., have also come to be regarded as part of Managerial Economics.

   1.Demand Analysis and Forecasting: A business firm is an economic organisation which is engaged in transforming productive resources into goods that are to be sold in the market. A major part of managerial decision making depends on accurate estimates of demand. A forecast of future sales serves as a guide to management for preparing production schedules and employing resources. It will help management to maintain or strengthen its market position and profit base. Demand analysis also identifies a number of other factors influencing the demand for a product. Demand analysis and forecasting occupies a strategic place in Managerial Economics.

  2.Cost and production analysis: A firm’s profitability depends much on its cost of production. A wise manager would prepare cost estimates of a range of output, identify the factors causing are cause variations in cost estimates and choose the cost-minimising output level, taking also into consideration the degree of  uncertainty in production and cost calculations. Production processes are under the charge of engineers but the business manager is supposed to carry out the production function analysis in order to avoid wastages of materials and time. Sound pricing practices depend much on cost control. The main topics discussed under cost and production analysis are: Cost concepts, cost-output relationships, Economics and Diseconomies of scale and cost control.

  3.Pricing decisions, policies and practices: Pricing is a very important area of Managerial Economics. In fact, price is the genesis of the revenue of a firm ad as such the success of a business firm largely depends on the correctness of the price decisions taken by it. The important aspects dealt with this area are: Price determination in various market forms, pricing methods, differential pricing, product-line pricing and price forecasting.

    4.Profit management: Business firms are generally organized for earning profit and in the long period, it is profit which provides the chief measure of success of a firm. Economics tells us that profits are the reward for uncertainty bearing and risk taking. A successful business manager is one who can form more or less correct estimates of costs and revenues likely to accrue to the firm at different levels of output. The more successful a manager is in reducing uncertainty, the higher are the profits earned by him. In fact, profit-planning and profit measurement constitute the most challenging area of Managerial Economics.

   5.Capital management: The problems relating to firm’s capital investments are perhaps the most complex and troublesome. Capital management implies planning and control of capital expenditure because it involves a large sum and moreover the problems in disposing the capital assets off are so complex that they require considerable time and labour. The main topics dealt with under capital management are cost of capital, rate of return and selection of projects.

Conclusion: The various aspects outlined above represent the major uncertainties which a business firm has to reckon with, viz., demand uncertainty, cost uncertainty, price uncertainty, profit uncertainty, and capital uncertainty. We can, therefore, conclude that the subject-matter of Managerial Economics consists of applying economic principles and concepts towards adjusting with various uncertainties faced by a business firm.

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Basic tools in Managerial EconomicsBusiness decision making