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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