MANAGERIAL ECONOMICS FOR MM FT SEMESTER 1 2013-15

UNIT 1 - INTRODUCTION TO ECONOMICS AND MANAGERIAL ECONOMICS

a.
b.
c.
d.

NATURE
SCOPE
CHARACTERISTICS AND SIGNIFICANCE OF MANAGERIAL ECONOMICS
RELATIONSHIP OF MANAGERIAL ECONOMICS WITH ECONOMICS, OPERATION
RESEARCH, DECISION MAKING, STATISTICS, ACCOUNTING ETC.

NATURE Application of economic theory and tools of analysis of decision science to examine how an
organization can achieve its objectives most efficiently- Salvatore
Spencer and Siegelman: Integration of economic theory with business practice for the
purpose of facilitating decision making and forward planning by management
Evan Douglas: Application of economic principles and methodologies to the decision-making
process within the firm or organizationunder conditions of uncertainty
Decision Making Process
5 Stages of Decision making Process:
1. Define the problem
2. Determine the objective
3. Identify possible solutions
4. Select the best possible solution
5. Implement the decision
Importance of Quantitative Tools
Analysis of variables is a key procedure in economic analysis.
Economic research and policy-making require up-to-date data and extensive analysis.
Use of Mathematical tools
Use of Statistical Techniques
Time Series: For Demand forecasting
Regression: Two or multiple variables used to study interrelationships, estimation and
prediction
Measures of central tendency and variation

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Role of Economics
What is the role of Economics in Business?
Costs, prices, output, compensation, strategic behavior, importantly, ethics
The Big Picture- Whose job?

The BIG Picture

Revenue earned

Income spent
Goods demand

Product
Market

Goods supplied

Households

Firms

Inputs supplied
Income earned

Inputs demand
Factor
Market

Factor costs

Economic theory forms the basis for different management areas such as accounts, finance,
marketing, systems and operations.
A manager has to deal with problems pertaining to the individual firm as well as domestic and
global environment.
Microeconomics: Deals with individual unit

Macroeconomics: Deals with aggregates

Microeconomics:
Theory of demand and supply- consumer behavior, demand theory, demand forecasting and
factors affecting individual and market supply- Helps in choice of commodities for production
Theory of Production: Production function and laws of returns to scale etc- gives an idea about
I/O relations, input requirement size of firm, technology choice of output. Helps producer to plan
production, cost and budget.
Market Analysis: helps understand degrees of competition, pricing-output decisions, price
discrimination, monopoly power, and advertising

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Profit Analysis: Provides logical analysis of break-even point, emergence of profits, profitmaximizing output, dealing with risk and uncertainty
Theory of capital: Along with quantitative techniques enables investors to calculate cost of
capital, efficiency of capital, efficient allocation of capital, and choice of projects as per riskreturn analysis
Behavior of macroeconomic indicators: GDP, GNP, GDCF, GDS, HDI etc.
Business Cycles Inflation- Employment
Fiscal Policy
Monetary Policy
Foreign Trade: Imports and exports, Exchange rate, trade policies and capital flows
Macro economics: How variables and policies impact business?
Role of Economics in Business:
Economics is a tool, means to an end
To help Efficient allocation and achieve business objectives
Optimizing behavior- Maximize goals, minimize costs under constraint
Logic, tools and techniques of economics to analyze business problems, evaluate business
options and opportunities with a view to arriving at an appropriate business decision.

3 main contributions of economic theory to business economics, according to Baumol:

o Analytical models: To recognize the structure of managerial problems, eliminate
minor details, and concentrate on main issue
o Ascertaining relevant variables and specifying the data - Even if the models are not
directly applicable, they enhance capabilities of business analyst
o Economic theories offer conceptual clarity to avoid conceptual pitfalls
Provides consistency to business analysis
Role of Managerial Economist:
A. To decide
What to produce?
Where?
How?
How much?
Allocation of resources?
For whom to produce?
At what price to sell?
B. Plan and control business operations Cost minimization
Profit maximization
Managing competition
Economic intelligence
Market research
C. Uncertainty & Risk management
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Forecast change in environment and policies- domestic and international

To manage change in global scenario
Everything comes at a price- quality is not free

Growing Challenges to the Managerial Economist:

Globalization - People-goods-services- communication- Finance- Ideas

o Global corporations
o Research & production facilities across countries
o Global markets
o Global Finance
o Employment Diversity
o Global work culture
o Resource base: Crossing boundaries
o Global management practices
o Outsourcing
o Increased competition
o Increased Opportunity
o Tastes converging internationally?
o Customizing to local tastes
o Not merely exporters, but need to be insiders in major markets

Computerization and Technology

o Easier model-building and simulation
o Quick and complicated data analysis
o Rapid spread of information
o Internet changing both buyers and sellers
o Videoconferencing- saving cost and time
o Paperless administration
o Speed of dispatch, lower inventories, less waste

Dismantling of Traditional Hierarchies

o Information today can be transmitted directly from top management to workers
o Middle managers are today increasingly being used to shelter top management from
day-to-day activities

Changing Basis for Value Creation

o Peter Drucker: World is moving from economy of goods to an economy of
knowledge
o Creation of value increasingly based on knowledge and communications and not natural
resources and physical labour

Bridging the gap between theory and Practice :

o Real world is complex, chaotic, interdependent as against simplifying economic
assumptions
o Not tailor-made solutions but a framework of logical thinking

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The Global business Leader has to Imbibe and inculcate essential qualities such as
o Global outlook
o Managing diversities
o Flexibility with efficiency
o Long-term goals with steps and migration path
o Speed and stamina for transformation

Essentially, 3 sets of skills:

o Human- understand, work with and motivate with other people as individuals as well as
groups
o Technical- Ability to use tools, techniques and processes that are specific to the field
o Conceptual-Ability to analyze complex situations and respond effectively to challenges

SCOPE OF MANAGERIAL ECONOMICS

Demand analysis and forecasting

Cost analysis
Production and supply analysis
Pricing decisions, policies and practices
Profit management, and Capital management

CHARACTERISTICS AND SIGNIFICANCE OF MANAGERIAL ECONOMICS

Managerial economics is micro-economic in character

Uses broadly theory of the firm concepts
Also seeks to apply profit theory which forms part of distribution theories
Is pragmatic as it avoids difficult abstract issues of economic theory.
But involves dealing with real life complications of business world
Belongs to normative economics rather than positive economics. It is prescriptive rather
than descriptive. It involves judgment as to what is good/bad for business. Managerial
economics deals with which decision needs to be made on the basis of its merits and
demerits. Economic theory does not go into judging decisions. Managerial economics tells
what the aims and objectives of a firm should be. Then it tells how best these can be
achieved
Managerial economics is therefore described as normative micro-economics of the firm
Macro-economics is also useful to managerial economics as it provides an intelligent
understanding of the environment in which the business must operate.

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RELATIONSHIP OF MANAGERIAL ECONOMICS WITH ECONOMICS, OPERATION

RESEARCH, DECISION MAKING, STATISTICS, ACCOUNTING ETC.

STRATEGIC
MANAGEMENT

ACCOUNTANCY

MARKETING

FINANCE

INFORMATION
SYSTEMS

ORGANIZATION
BEHAVIOUR

OPERATIONS RESEARCH

HUMAN RELATIONS

ECONOMETRICS
ECONOMICS

PSYCHOLOGY

SOCIOLOGY
RATE OF RETURN (HIGH)
TIME SPAN (LOW)
-

RATE OF RETURN (LOW)

TIME SPAN (HIGH)

MANAGEMENT = ECONOMICS + PSYCHOLOGY (BROADER LEVEL OF UNDERSTANDING AS IS

PERCEIVED BY MOST INDIVIDUALS. THE BEDROCK IS FORMED FROM S O C I O L O G Y)

P.S CHANDIRAMANI @ I.M.S , D.A.V.V, INDORE

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UNIT 2 - FUNDAMENTAL CONCEPTS

a.
b.
c.
d.
e.
f.
g.
h.

INCREMENTAL REASONING
MARGINAL ANALYSIS
EQUIMARGINAL UTILITY
TIME PERSPECTIVE
CONSUMER SURPLUS
OPPORTUNITY COST
TIME VALUE OF MONEY
THEORIES OF FIRM
MANAGERIAL THEORIES BAUMOL AND WILLIAMSON
BEHAVIORAL THEORIES SIMON, CYRET AND MARCH

INCREMENTAL REASONING A Guide to Economic Reasoning - Economic reasoning is making decisions by comparing costs
and benefits.
Incremental reasoning is used in accepting or rejecting a business proposition or option.
Whenever a manager takes a decision he asks the question Is it worthwhile? - The implicit
criterion is that incremental benefit should exceed its incremental costs. Decision or action is
worthwhile already if the decision maker or the firm can expect to be better off than before.
Original reasoning forces the manager to examine the changes in total revenues and total costs
resulting for changes in production, sales, price and related decisions. Wrong decisions may
follow if the focus is on the concept of average than on marginal analysis.
2 basics components of I.R are

Incremental Cost

Incremental Revenue

MARGINAL ANALYSIS
o

Marginal Costs and Marginal Benefits

o The relevant costs and benefits are the expected incremental, or additional,
costs incurred and the expected incremental benefits of a decision.
o Economist use the term marginal when referring to additional or incremental.
o Marginal cost the additional cost to you over and above the costs you have
already incurred.

This means not counting sunk costs costs that have already been
incurred and cannot be recovered.
o Marginal benefit the additional benefit above and beyond what youve
already accrued.
o According to the economics decision rule:

If the relevant benefits of doing something exceed the relevant costs, do
it.

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Rs. Invested
(Rs0000)

A (Profit)
(Rs000)

If the relevant costs of doing something exceed the relevant benefits,

dont do it.
B (Profit)
(Rs000
(Rs000)

selection

17

24

12

30

16

35

20

39

24

A/B

42

28

44

32

45

36

10

45

40

Utility Approach to Consumer Behavior

Need for cardinal measure of utility

analysis
ysis is useful for explaining behavior
Total and Marginal utility
law of diminishing Marginal Utility
Equimarginal rule and utility maximization

Nature of Total Utility -

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When more and more units of a good are consumed in a specific time period, the utility
derived tends to increase at a decreasing rate
Eventually, some maximum utility is derived and additional units cause total utility to
diminish. As an example, think of eating free hot cakes.
It is possible for total utility to initially increase at an increasing rate.

Marginal Utility
Marginal utility [MU] is the change in total utility associated with a 1 unit change in
consumption.
As total utility increases at a decreasing rate, MU declines.
As total utility declines, MU is negative
When TU is a maximum, MU is 0 [This is sometimes called the Satiation point or the point
of absolute diminishing utility.

Marginal Utility [MU] is the change in total utility [TU]

caused by a one unit change in quantity [Q] ;
MU = TU
Q
The first unit consumed increases TU by 30.
MU
The 2cd unit increases TU by 25.
30
25
20

Utility
Q

1
2
3
4
5
6
7
8

TU

MU

30

30

55

25

75

20

90

15

100
105

10

..

10

105

0
-5

The first unit consumed, Q

120 increases TU by 30, TU.

max TU

80
60

40
20

20

..

10
1

Fall 97

. . ...

Q/ut

For the first unit:

30
TU
=
Q
1
TU
= 30,
Q

MU =
The slope of TU is

[Using calculus, MU is the change in TU

as change in quantity approaches 0.]

between the 2cd and 3rd

units TU = 20 or the
slope of TU is 20.

The MU is the slope of TU or the

TU rate of change in TU associated
with a one unit change in quantity.

TU

MU
30

Remember that the MU is associated with the

midpoint between the units as each additional
unit is added.

TU
100

.. .
MU

1Q2

100

..

Q/ut

MU is the slope of the TU.

..
3

. .MU
..
5

The second unit changes TU [ TU] by

25, The slope of TU between the 1 and
second unit is 25.

Where MU = 0, TU is a maximum.
Q/ut

Principles of Microeconomics

P.S CHANDIRAMANI @ I.M.S , D.A.V.V, INDORE

Slide -- 9

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Consumer Preferences
Both MU and TU are determined by the preferences or utility function of the individual
and the quantity consumed.
Utility cannot be measured directly but individual choices reveal information about the
individuals preferences
Surrogate variables [age, gender, ethnic background, religion, etc.] may be correlated with
preferences.
There is a tendency for TU to increase at a decreasing rate [MU declines] as more of a good
is consumed in a given time period: i.e. diminishing marginal utility
Diminishing Marginal Utility
Initially, it may be possible for TU to increase at an increasing rate. In which case MU will
increase [MU is the slope of TU which is increasing].
Eventually, as more and more of a good are consumed in a given time period, TU continues
to increase but at a decreasing rate; MU decreases.
This is called the point of diminishing marginal utility.
Law of Diminishing MU
Notes about the Law of Diminishing MU
o Time period must be specified for law.
o Law tells us that eventually the marginal utility curve will be downward sloping.
o Law tells us that eventually the total utility curve will become flatter.
o Slope of the total utility curve is equal to marginal utility
Shape of MU

Eventually downward sloping

Law of diminishing marginal utility
Positive always

Rational behavior
Consumer only purchases a good if they get some positive utility from it.
Consumer Choices
If there were no costs associated with choices, the individual will consume a good until MU
= 0 [this maximizes TU or the total benefits, TB]
Typically, individuals are constrained by a budget [or income] and the prices they pay for the
goods they consume.
Net benefits are maximized where MB = MC; as long as the MU or MB of the next unit of
good purchased exceeds the Price or MC, it will increase net benefits

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Society and Individual

The individual will purchase more of a good so long as their perceived or anticipated MB
exceeds the price they must pay for the good: Buy so long as MB > P, optimum where, P =
MB
From a social perspective that good should only be produced and sold if the price is greater
than or equal to the MC: Sell so long as P > MC, optimum where P = MC
Social optimum when MB = P = MC

LAW OF EQUI-MARGINAL UTILITY

o
o
o
o
o

The Law of Equi-marginal utility is the further elaboration of the Law of diminishing
marginal utility.
It is also known as the Law of Substitution and the Law of maximization of satisfaction.
The households maximizing the utility will so allocate the expenditure between
commodities that the utility of the last penny spent on each item is equal.
Formula for Consumers equilibrium
MU(A)/P(A) = MU(B)/P(B) = .= MU(N)/P(N)
Assumptions:

Utilities are independent

Marginal utility of money remains constant.

Utility is cardinal.

Consumer is rational.
Limitations..

Utility is immeasurable.

Indivisible goods

Prices and tastes are changing.

Time Factor.

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CONSUMER SURPLUS CONSUMER SURPLUS

Notice that someone is willing and able to pay $6.80 for the
first unit. If the market price [established by S and D]
were $3, the buyer would purchase at $3 even though they
were willing to pay
PX
$6.80 for the first unit.
7
They receive utility
6.80
that they did not have
6
to pay for [6.80-3.00].
5
This is called consumer
4
surplus.
At market equilibrium,
Consumer surplus will be
the area above the market
price and below the demand
function.
Fall 97

consumer
surplus

3
2
1
1

Principles of Microeconomics

QX/ut

Slide -- 31

OPPORTUNITY COSTo
o
o

The Opportunity cost of the chosen activity is the value of the next-best alternative to
the activity you have chosen.
Opportunity cost is the basis of cost/benefit economic reasoning.
In economic reasoning, opportunity cost must be less than the benefit of what you have
chosen.

TIME VALUE OF MONEY Present value (PV) of an amount (FV) to be received at the end of n periods when the perperiod interest rate is i:

FV
PV =
(1 + i ) n

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THEORIES OF FIRM
o

Sales Maximization Model William Baumol

According to the sales-maximization model introduced by William Baumol and
others, managers of modern corporations seek to maximize sales after an
adequate rate of profit has been earned to satisfy stockholders.

Baumol argued that a larger firm may feel more secure, may be able to get
better deals in the purchase of inputs and lower rates in borrowing money, and
may have a better image with consumers, employees, and suppliers.

Indeed, some early empirical studies found a strong correlation between
executives salaries and sales, but not between salaries and profits. More recent
studies, however, found the opposite.
Williamsons Model of Managerial Discretion

The managerial theory of firm developed by Oliver E. Williamson states that
managers apply discretion in making and implementing policies to maximize
their own utility rather than trying for the maximization of profit which
ultimately maximizes the utility of owner shareholders. This is known as the
management utility maximization.

It postulates that with the advent of the modern corporation and the resulting
separation of management from ownership, managers are more interested in
maximizing their utility, measured in terms their compensation (salaries, fringe
benefits, stock options, etc.), the size of their staff, the extent of control over
the corporation, lavish offices, etc., than in maximizing corporate profits.

This is referred to as the principal-agent problem. That is, the agent (manager)
may be more interested in maximizing his or her benefits than maximizing the
principals (the owners) interest.
Theory of Satisfying - Simon

The advocates of satisficing theory say that firms goal should be satisficing
rather than optimizing. Satisfying means acceptance of less than the best. They
argue that the behavior of real-world managers is not always consistent with
the profit-maximization goal.

Because of the great complexity of running the large modern corporation a
task often complicated by uncertainty and a lack of adequate data managers
are not able to maximize profits but can only strive for some satisfactory goal in
terms of sales, profits, growth, market share, and so on.

Simon called this satisficing behavior. That is, the large corporation is a
satisficing, rather than a maximizing organization.
Cyert and Marchs Behavioral Theory

Cyert and March opined that a large-scale corporate type of firm exists these
days. Hence, entrepreneur cannot alone be a decision maker. The decisionmaking involves a complex group or organization. It consists of various
individuals whose interest may conflict with each other.

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The group is called organizational coalition and includes managers,

stockholders, workers, consumers and so on. All of these individuals participate
in setting the goals of an organization.
Unlike conventional theory of single goal, behavioral theory states that an
organization has multiple goals. The real world firm generally possesses the
following five goals:
Production Goal: According to this goal, production should not
fluctuate too much nor fall below an acceptable level. Because this
ensures stable employment, maintenance of adequate cost
performance and growth, the workers and those in production
department have this goal.
Inventory Goal: This goal originates mainly from the inventory
department, or from the sales and production departments. The sales
department needs enough stock of output for the customers, while the
production department requires adequate stocks of raw materials and
other items necessary for a uniform flow of the output.
Sales Goal: The sales goal is simply an aspiration with respect to the
level of sales. Particularly, this goal arises from salesmen, since their
success depends on their ability to maintain or expand the sales.
Market-share Goal: This goal is an alternative to the sales goal and
arises from the sales department. This department decides on the
advertising campaigns, the market research programmes, and so on.
Profit Goal: This goal is set by the top management in order to satisfy
the demands of shareholders and the expectations of bankers; and also
to generate funds with which they can achieve their own goals and
projects, or satisfy the other goals of the firm.
While making decisions, firms are guided by these five goals. The conflict among
different goals may come up. For example, sales goal may require a lower price
whereas the profit goal a higher price. Sales and production goal may require
high inventories whereas profit goal may require low inventories. Such conflicts
among coalition members are resolved within the firm as a result of persuasion
and accommodation of each others viewpoint.
The firm in the behavioral theories seeks to satisfice overall performance, rather
than maximize profits, sales or other magnitudes. The firm is a satisficing
organization rather than a maximizing entrepreneur. The top management,
accountable for the coordination of the activities of the various members of the
firm, want:
to attain a satisfactory level of production,
to attain a satisfactory share of the market,
to earn a satisfactory level of profit
to divert a satisfactory percentage of their total receipts to research
and development or to advertising,

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to acquire a satisfactory public image, and so on.

But, it is not clear in the behavioral theories what is a satisfactory and what an
unsatisfactory attainment is.
Means for the Resolution of Conflicts:
The top management uses different methods to resolve the conflicts
within the firm. The means for the resolution of conflicts are:
o delegation of authority,
o budget determination,
o monetary payments like wages, salary and dividend,
o side payment given to the scientist of research department in
addition to regular salary,
o slack payments it is defined as payments to the various groups
of the coalition above than the payments required for efficient
working of the firm.
o fulfilling demand according priority,
o decentralization of decision-making.

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