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Chap-1 MANAGERIAL ECONOMICS

Paul, J., Kaushal, L., & Sebastian, V. J.
(2012).
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CHAPTER

Nature and Scope of

Managerial Economics

t Nature of Managerial Economics

Definition
Relationship to Business Administration
Managerial Economics-A decision making process
t Scope of Managerial Economics
t The Theory of the Firm
Reasons for existence of firms and their function
Objective and Value of the firm
Constrains on the Operations of the Firm
Limitations of the theory of Firm
t Nature and Function of Profits
Business versus Economic Profit
Theories of Profit
Function of Profit
t Basics of Demand and Supply
Demand
Supply
t International Framework of Managerial Economics
t Global Concepts for managers

2 Managerial Economics

Nature of Managerial Economics

Economics is usually divided into two parts, Macroeconomics and Microeconomics.
Macroeconomics is the study of the whole of the economic system. Through the
help of macroeconomic theories analysis of the total output, total employment, the
unemployment rate, the consumer index and the exports and imports. Although, in
the newspaper and the television its the macroeconomic issues which are discussed
the most, the microeconomic factors of the economy are also important.
Managerial Economics should be thought of as applied microeconomics. It
helps the manager of the firm recognize the different economic factors at play and
their affect on the firm and the consequences on the managerial behavior. It also
helps in linking different economic concepts together for building a better tool for
the managers decision making.
Managerial economics applies economic tools and techniques to business and
administrative decision making to achieve business goal by effectively using the
given business resources. Though we study economics in theory it would be of
no use if the art of practical application doesnt exist. Therefore, the subject of
managerial economics helps us bridge the gap between the theory and its practical
application in economies. Managerial economics lays down rules that help in taking
effective managerial decisions and also assist managers to identify how economic
forces affect organizations and what could be the economic consequences of
managerial behavior. It is an essential managerial talent to understand the principles
that govern the economic behavior of firms and individuals which finally result in
better managerial decisions, higher profits, and an increase in the value of the firm.
Managerial economics has a number of applications; it can be used both for
profit and non-profit sectors. For instance, in a limited staff, equipments, resources
if a hospital wants to provide the best facilities and care to its patients it can readily
make use of the concepts of managerial economics. Thus, we can see that managerial
economics helps in meeting with the organizational goals effectively and efficiently.
Managerial economics relates traditional economics with the decision sciences to
develop vital tools for managerial decision making and helps in identifying ways to
efficiently achieve goals. For instance, suppose a small business of mineral water
want to rapidly grow and reach a size that permits efficient use of national media
advertising. In this case Managerial economics can help in achieving this short-run
objective swiftly and effectively by identifying pricing and production strategies.
The tools and concepts offered in this chapter will help in the decision making
process of the firms managers and will also increase the effectiveness of the decision
making by expanding and sharpening the analytical framework used by mangers to
make decisions.

 Nature and Scope of Managerial Economics 3

Managerial Economics-A Decision Making Process

Managerial Economics serves as a link between traditional economics and the
decision making sciences for the purpose of business decision making. It directly
deals with real people and real business situations. It facilitates the decision making
process by applying economic principles and methodologies and helps in attaining
desired economic goals which could be related to minimization of cost, maximization
of revenue or profit and many more.
Managerial economics rely on traditional economics and decision sciences to
analyze any business problem and study the impact of alternative courses of action on
the optimum utilization of resources. It deals with the application of knowledge and
understanding of economic principles, concepts, tools and techniques to facilitate
a decision making process in the presence of uncertainty. It also bridges the gap
between pure analytical problem dealt in economic theory and the real business
problem faced in day to day business situations. It provides tools and techniques
to make the manager competent enough to take effective decision in real business
situations. Well said by Milton H. Spensor and Louis Seigelman that Managerial
Economics is the integration of economic theory with the business practice for the
purpose of facilitating decision making and forward planning in management.
Decision
problem

Traditional
economics

Managerial
economics

Decision science
(tools and techniques
of analysis)

Optimal solution
to business
problem

Role of managerial Economics in Decision making

Scope of Managerial economics

Managerial Economics provides strategic planning tool that helps in analyzing the
problem and formulating rational managerial decisions. Decision making is a crucial
aspect in any business problem. It is an evolutionary science which correlates the
understanding and application of economic knowledge with the emerging business

4 Managerial Economics
problems in the economy. The basic business problems that arise in any decision
making or forward planning process involves operational and environmental
issues.
Resource Allocation- Managerial economics is first and foremost, like traditional
economic theory is concerned with the problem of optimum allocation of resources.
The problem of determining optimum level of output that maximizes profit is taken
care by the marginal analysis. On should ensure the most effective use of scare
resources to get the optimal results. Linear programming technique is the most
effective tool in decision making used to solve optimization problems.
Demand Estimation- It is very important for the firm to accurately estimate the
market demand and to cater to the respective demand at the right time with right
quantity. The basic understanding of demand is crucial for demand forecasting or
demand estimation. Demand analysis helps to identify the factors responsible for
influencing the market demand. There are many factors that contribute in influencing
the market demand, namely, income of an individual, price of the commodity and
price of the related goods and many more. It has increasing becoming easy to forecast
the demand with the help of many computer softwares like SPSS , SAS etc.
Managing Inventory and handling Queuing problem -Managing inventory
requires the correct estimation about the holding of the inventory stocks of raw
material and also of the finished goods over time. These decisions are based upon
the demand analysis by considering the demand and supply conditions. For instance,
suppose a firm expects a rise in the future demand for its product, it has to plan
accordingly whether it need to hire more labors or need to install more machinery, to
cope with the increased demand. Such problems are termed as queuing problems.
Cost Analysis Cost analysis is a very crucial in decision making. Pricing policy
along with the cost analysis forms the base of profit planning. It also deals with the
concept of cost benefit analysis.
Pricing and Competitive strategy- Pricing plays a very crucial role when you are
not the only supplier of a good in the market. The pricing strategy depends on the
type of market structure, may be oligopolistic, monopolistic or monopoly market.
Price theory explains how the prices are determined in these different markets.
Competitive strategy anticipates price determination by taking into consideration
other players strategies regarding pricing, advertising and marketing.
Profit Analysis Economist defines profit as the reward for uncertainty bearing and
risk taking abilities. The manger is successful if it can reduce uncertainty and earn
higher profits. Profit estimating and measuring is the most challenging aspect of
managerial economics. Profit earning is the main yardstick to measure the success
of a firm in the long run.

 Nature and Scope of Managerial Economics 5

The Theory of the Firm

A firms basic objective is to produce and distribute goods and services. The firm
also earns profit by achieving these objectives. The concept of firm plays a very
crucial role in the theory and practice of managerial economics.

Reasons for Existence of Firms and their Functions

In a free market economy, the organization and the interface of the producers i.e.
the firms and the consumers is accomplished through a price system. Within the
firms the transactions and the organization is generally taken care by managers. The
reason why firms exist is because the total cost of producing any rate of output is
lower than if the firm did not exist. The reasons behind this are that, firstly, there is
a cost of obtaining information on price. Secondly, the entrepreneurs skill is also a
very crucial factor. It can also act as a constraining factor for the firm.

Objective and Value of the Firm

A managements decision can only be evaluated against the objective that its
attempting to achieve. It was assumed that a firms main objective is to maximize
profit. Also, it is assumed that the decisions taken by the managers are for the same.
But the issue arises when the period of the decision is taken into account i.e. whether
the decision is for next 5 years or 15 years? Usually the managers reduce the current
year profits in order to make future gains.
As both the current year and the future year is important, it is assumed that
the goal is to maximize the present or discounted value of all future profits. Thus,
formally the goal of the firm is to
Maximize: PV () =

p1
+
t =1 (1 + r )t
n

p2
+ +
t =1 (1 + r )t
n

pn

t =1 (1 +

r )n

Where , is profit in time period t, and r is an appropriate discount rate used to

reduce future profits for n time periods to their present value. Now, the objective
function can be written as
Maximize: PV () =

pt

t =1 (1 +

r )t

The present value of all the future profits also can be interpreted as the value of
the firm that is what a willing buyer would pay for the business.
The above equation will work only if the different departments would work
together to reduce cost and increase efficiency. For instance, the marketing,
production and other departments could provide timely services and information to
bring down the cost and increase the sales.

6 Managerial Economics

Constrains on the Operations of the Firm

There are many factors which affect the working of a firm and many of them also
acts as the constraints, due to their limited availability and other reasons.

Limited availability of inputs

Amount of investments
Contractual agreements
Level of output
Legal restrictions
Governmental rules
Apart from these above stated factors there are many other technological and
financial issues too. But these only help in preparing the firms better for the future.
The level of managerial decision making is refined even more if these constraints
are well taken care off.

Limitations of the Theory of Firm

There are many questions related to the decision making power and the accuracy
of the decisions of the managers. But its very difficult to say whether optimizing
is their main centre of focus or not. Also what are the factors which are important
in retaining the managers in the firm? Would generous compensation be of more
use than the promise of growth? The answers for these questions are impossible to
give.
Research has shown that its due to the competition that the managers are forced
to seek value maximization in their operating decisions. Stockholders are, of course,
interested in value maximization as it affects their rates of return on the common
stock investment.
Finally, it is also unwise to seek technical solution of a problem when its cost
exceeds the benefit by and large.

Smiths theory of the Invisible Hand

Adam Smith, the father of modern economics understood the importance of how a
decentralized market economy would work with little or no outside regulation. He
saw that if the firms seek to maximize their own importance i.e. if they follow their
self-interest, the individual participants in this economy would achieve socially
desirable results. In his book An Inquiry into the Nature and Causes of the Wealth
of nation in 1776, he wrote
It is not from the benevolence of the butcher, the brewer, or the baker that we expect
our dinner, but from their regard to their own self interest. We address ourselves,

 Nature and Scope of Managerial Economics 7

not to their humanity but to their self love; never talk to them of our own necessities,
but of their own advantage.
According to Smith there is an invisible hand at work that guides the private
decisions in socially beneficial ways. This is the coordinating mechanism in the
economy, the price system.
Every individual endeavors to employ his capital so that its produce may be of
greatest value. He generally neither intends to promote the public interest, nor
knows how much he is promoting it. He intends only his own security, only his own
gain. And he is in this led by an invisible hand to promote an end which was no part
of his intention. By pursuing his own interest he frequently promotes that of society
more effectually than when he really intends to promote it.
Thus we see that even in 1776, Adam Smith could clearly see the advantages that
an economic system based on the self interest of the individual and the firm could
bring forth

Nature and Function of Profits

In order to understand the concept of profit maximization, the concept of profit
should be clear. Profit can be defined as revenue minus the cost. It is the amount
used to fund the equity capital after the payment of all other resources used by the
firm.

Business versus Economic Profit

Economists define profit as the excess of revenue over cost. In this a normal rate
of return is included on equity capital plus an opportunity cost for the effort of the
owner for doing the business. The minimum return necessary to retain and attract
investment is the risk adjusted normal rate of return on capital. If define the business
profit its minus the non cash cost of capital and the owner provided inputs. This is
called the economic profit.
Business profit and economic profit is used in a free enterprise economy. While a
normal profit is a simple cost for capital.

Theories of Profit
Disequilibrium Profit Theories
Markets are sometimes in disequilibrium because of unanticipated changes in demand
or cost conditions. The unanticipated shocks produce positive or negative economic

8 Managerial Economics
profits for some firms. Profits are sometimes above or below normal because of
factors that prevent instantaneous adjustment to new market conditions.
Monopoly profit theory is an extension of the frictional profit theory explained
above. Monopoly profits exist when firms are sheltered from competition by high
barriers to entry. Economies of scale, high capital requirements, patents, or import
protection, among other factors, enable some firms to build monopoly positions that
allow above-normal profits for extended periods.

Compensatory Profit Theory

Innovation profit theory, describes the above normal profits that arise due to the
successful invention or modernization. As in the case of frictional or disequilibrium
profits, innovation profits are susceptible to the onslaught of competition from new
and established competitors.
Compensatory profit theory describes above normal rates of return that reward
firms. This could be due to the extraordinary success in meeting with either
customer needs or maintaining high efficiency level. Superior firms provide goods
and services that are better, faster or cheaper than the competition.

Function of Profit
Each of the preceding theory describes economic profit in one way or the other.
Economic profits play a valuable role in any market based economy. The firm
should increase its output is shown by the above normal profits earned by it.
Economic profits are very crucial because they help in allocating scarce economical
resources.

Basics of Demand and Supply

A firm produces either what the consumer demands or what it thinks the consumer
requires. Thus, consumer satisfaction helps in the production of new and innovative
products.

Demand
Demand is when under a certain economic condition the customer is ready to
purchase certain goods or services from a firm. The conditions could include the
price of the good in question, its availability, consumers income, consumers tastes,
and its preference and so on. Form the managerial point of view an aggregate of the
consumer demand is taken which is also called the market demand.
Sometimes goods and services are in demand because they are important
inputs in the manufacturing or distribution of some other products. Their demand

 Nature and Scope of Managerial Economics 9

is derived from the demand for the products they are used to provide. This is also
called derived demand.
The market demand function the demand curve etc. would be explained and
dealt with in detail in the coming chapters.

Supply
The supply of a product or a service depends on the market. The amount of a good
or service supplied will rise when the marginal benefit to producers, is greater than
the marginal cost of production. The amount of any good or service supplied will
fall when the marginal benefits isles than the marginal cost of production.
The managerial decision making requires a firm understanding of both the
market as well as the individual supply conditions.

Management and Economics

There is no formula that guarantees success. It is not possible to train an individual
to be a successful manager but it is definitely possible to provide approaches and
knowledge that could help individuals in thinking about business issues and making
effective business decisions. The requisite to make a wise decision is to identify
what is important and to determine the best possible strategy to deal the situation.

Role of Managerial Economist

The Managerial Economist must ensure that the main objective is to make reasonable
profit any business it deals in. The main objective might not be profit maximization
at times but certainly to continue in any business the firm has to ensure profit
earning. Majority of the responsibilities of an Economist emerge from this basic
obligation. Economists analyze the markets, firms, individual human behavior and
helps in decision making.
Managerial Economist is responsible to assist management is making decisions
about the uncertain future. The knowledge about future is imperfect and thus there
is risk associated to all the decisions one make about future activities. Economist
helps the management in reducing the element to risk to a certain extent by
scientific forecasting of economic environment. Successful forecasting is a key to
any successful business. Economist should revise their forecast from time to time
by updating all the new developments taking place in the environment.
It is very important for the Managerial economist to do proper social networking
and maintain contacts with the important peoples who are specialist in different
fields. The data required for forecasting should be easily made available to him so
that the forecasts are timely revised. The biggest challenge for the economist is to
obtain latest information quickly by establishing contacts with the sources of such
information. Managerial Economist should be well verse with the latest information
about the behavior of the economy and the impact of various macroeconomic

10 Managerial Economics
policies like monetary and fiscal that has an impact on any business activity. Thus
it is important to know all the current happening at both national and international
levels. They should also be able to keep pace with the ever changing technology
because all the business decisions are taken within the framework of technological
developments.
The managerial economists actively participate in the decision making and
forward planning process. Thus the economist should have the ability to express
himself clearly so that the non- economist stature person is able to interpret his
findings and is able to get the message across. Management is interested in the
practical solutions to the current problems, they are not interested to know the theory
and do the interpretation themselves, and thus the role of a managerial economist
comes into picture that helps them to translate economic concepts into day to day
business solutions.
It is well said that there is a very minute difference between the manager and the
managerial economist. Manager is a decision maker whereas managerial economist
is an advisor to the manager. A Managerial economist may certainly move ahead
to the decision making position in due course of time by attaining more expertise
required by the managerial decision making role.

International Framework of Managerial

Economics
Managerial economics like other theories have seen a world of change. All the
economic activities including the goods and services, skilled labor, capital and
technology have seen the impact of globalization. For instance, there is abundance
in skilled labor; the wages of the skilled labor have seen a rise too. The same case is
seen in goods and services, capital and technology. Technology has seen a sudden
change in telecommunications, internet and World Wide Web. Internet has changed
the market and its scope drastically. It has eliminated the geographical boundaries
and the goods and services are easily provided to one and all. Thus, increases the
elasticity of demand.
Telecommunications and internet has influence the commerce potential and
firms use them strategically to increase their growth by leaps and bounds. It also
adds to the firms competitive advantage. But due to the globalization, the firms
have become more sensitive to the demand and supply change around the world
than before.

Case StudyThe Microsoft Saga

In 1992, Bill Gates had surpassed in amassing a fortune which went past those of
Donald Trump, Ross Perot and many others. He was listed as Americas wealthiest

 Nature and Scope of Managerial Economics 11

person by Forbes magazine. He was barely 36 years of age and had a fortune of
$630 crores. Americas richest nerd has now surpassed some $4,000 crores and its
a phenomenal growth that his organization has shown. Now the question arises as
to how has he made it possible in a free enterprise system?
Bill Gates is college dropout and after he learnt what he could about personal
computers and its usage in Harvard he decided to built an operating system himself.
His operating system, MS-DOS or the Microsoft Disk Operating System was such
a creation that IBM agreed to use it in its line of personal computers. Later on it was
replaced by Windows and since then we have had Vista and many other updated
versions of the operating system from the Microsoft.
The firm had made its presence felt in the business community. In 1997, the firm
recorded a profit of more than $200 crores. It ranked third after IBM and Hewlett
- Packard. Microsoft also started producing some world class applications for the
PC and many such products. He has also ventured into many other works related
to the same field, for instance that of purchasing the electronic reproduction rights
to various art and photographic works across thousands of museums and libraries
around the world. This is a part of his interactive home entertainment systems
plan.
With extreme diligence, innovation and the ability to take timely and calculated
risks, Gates have demonstrated how much the market has the potential to reward.
Thus, he has shown the true essence of the free market economic system, where if
you deliver what the consumer needs and demands then you are suitably and richly
rewarded for your efficiency and innovativeness.

Review Questions

1. Should the firms be primarily viewed as economic entities?

2. Explain the role of profit in a free market economic system?
3. A firms profit has been at approximately Rs. 15 crores per year in each of
the last 5 years. The company has 25 lakhs shares of outstanding stock, and
the market price has been about Rs.500 per share. The top management has
been receiving only salary during this period. Develop a plan combining stock
option, bonus and other things to provide them with better incentives.

Economic Concepts for Global Managers

Absolute Advantage
The principle of absolute advantage refers to the ability of an individual, firm, or
country to produce more of a good or service than its competitors, by utilizing
the same amount of resources. The concept of absolute advantage is attributed to
Adam Smith for his 1776 publication An Inquiry into the Nature and Causes of

12 Managerial Economics
the Wealth of Nations in which he countered mercantilist ideas. Smith argued
that it was impossible for all nations to become rich simultaneously by following
mercantilism because the export of one nation is another nations import and insisted
that all nations would gain simultaneously if they practice free trade and specialize
amongst them in accordance with their absolute advantage.
For instance, let us consider the case of 3 countries. We assume that the labor
and material costs used in the production process of a video game are equivalent
across the three countries.
Country

Video games per day

No.of workers

India

150

100

Thailand

170

100

Bangladesh

100

100

India can produce 150 video games per day with 100 workers.
Thailand can produce 170 video games per day with 100 workers.
Bangladesh can produce 100 video games per day with 100 workers.
Keeping in mind that the labor and material costs are constant across the three
countries, Thailand has the absolute advantage over both Countries India and
Bangladesh because it can produce the 170 video games per day at the same cost
as other countries. India has an absolute advantage over Bangladesh because it
can produce 150 video games (more than 100) per day with the same number of
workers. Bangladesh does not have absolute advantage over any country because
it cant produce more video games than either India or Thailand given the same
input.

Comparative Advantage
The law of comparative advantage refers to the ability of an individual, a firm or
a country to produce a particular good or service at a lower opportunity cost than
another party. It can be distinguished from absolute advantage which relates to the
ability of a party to produce a particular good at a lower absolute cost than another.
Comparative advantage concept explains the benefits from mutual trade between
two parties although both parties can produce all goods with fewer resources than
the other. The net benefits of mutual trade amongst the parties concerned are termed
gains from trade. It is the main concept of the pure theory of international trade.
Let us consider an example. Assume that each country has constant opportunity
costs of production between the two products and both economies have full
employment at all times. All the factors of production are mobile within the countries
between video games and Music system industry industries, but are immobile
between the countries.

 Nature and Scope of Managerial Economics 13

Country

Video Games

Music Systems

India

200

200

Thailand

600

300

Thailand has an absolute advantage over India in the production of food video
games and music systems Thus there seems to be no need for trade amongst the
two countries. Thialnd is more efficient in producing both the goods. But lets have
a look from the opportunity cost aspect. The opportunity costs shows otherwise.
Indias opportunity cost of producing one video game is one music systems and
vice versa. Thailands opportunity cost of one music system is two video games
and vice versa. Thailand has a comparative advantage in video games production,
because of its lower opportunity cost of production compared to India. India has
a comparative advantage over Thailand in the production of music systems, the
opportunity cost of which is higher in Thailand with respect to video games than in
India.

Exchange Rate
International trade among different countries is difficult because of the existence of
different currencies used by different countries. International trade is only possible
if we can know how much to pay in the terms of other countrys currency. Foreign
Exchange rate refers to the amount of one currency that must be paid to attain
other countrys currency .It is the rate that specifies how much one currency is
worth in terms of other countrys currency or It is the value of a foreign nations
currency in terms of the home nations currency. Exchange rate are governed by the
host countrys exchange rate system. With the floating exchange rate, the value of
countrys currency is governed by the market demand and supply forces. Whereas
in the case of fixed exchange rates, the government of the host country tries to
change interest rates or buy and sell foreign currencies to maintain a fixed value
against the US dollar, the Euro or the basket of currencies. This is termed as pegging
the value of the currency to another.
For example an exchange rate of 50 Rs (Indian currency) to the United States
dollar (USD, $) means that Rs 50 is worth the same as USD 1. The foreign exchange
market is one of the biggest markets in the world.
The spot exchange rate refers to the current exchange rate whereas the forward
exchange rate refers to an exchange rate that is quoted and traded today but will be
delivered and executed on a specific future date.
The market regulated exchange rate fluctuates with the change in the values
of the two corresponding currencies. If the demand for certain currencies say
for instance, USD increases, supply remaining constant, the value of USD will
appreciate. On the contrary, if the supply of USD increases, demand remaining

14 Managerial Economics
constant, the value of USD will depreciate. The demand for certain currency could
be attributable to either for transaction purpose, known as transaction demand for
money or speculative purpose known as speculative demand for money.

Balance of payments
A balance of payments (BOP) is viewed as an accounting record of all monetary
transactions involving payments or receipts of foreign currency exchange between
a country and the rest of the world. These transactions in the BOP include payments
for the countrys exports and imports of goods, services, and financial capital and
financial transfers. It is a summary of international transactions for a specific
period, usually a year, and is prepared in a domestic currency of the country
concerned. Sources of funds for a country, such as exports or the receipts of loans
and investments, are recorded as positive or surplus items. Uses of funds, for the
purpose of imports or investments in foreign countries, are recorded as a negative
or deficit item
BOP comprises of current account and the capital account.
Current account records the net earnings of the country if the account is in
surplus or shows the net spending if the account is in deficit. It is the sum of the
balance of trade (net earnings on exports payments for imports), factor income
(earnings on foreign investments payments made to foreign investors) and cash
transfers.
The capital account records the net change in ownership of foreign assets. It
includes the reserve account (the international operations of a countrys central
bank), along with loans and investments between the country and the rest of
world.
Thus BOP is represented as:
BOP = Current Account Capital account + Balancing Item.
The balancing item is an amount that accounts for any statistical errors and
ensures that the sum of current and capital accounts is zero. When all components
of the BOP sheet are included it must sum to zero as there cannot be any overall
surplus or deficit but certainly imbalances are possible on individual elements of the
BOP, such as the current account or capital account.

Opportunity Cost
The concept of an opportunity cost was first developed by John Stuart Mill.
It is one of the prime concepts in Economics. We all know that our appetite for
goods and services are insatiable thus it is important to determine how to allocate
limited resources. It expresses the basic relationship between scarcity and choice.
Opportunity cost concept ensures the optimum and efficient utilization of resources.

 Nature and Scope of Managerial Economics 15

It is the cost of an alternative that must be forgone in order to pursue a certain

action
For instance, you are sitting in the cafeteria and are wondering whether to order
French Fries and Nuggets or a Pizza. You have a limited budget, say $10. Now you
have to make a choice and use our resources, $100 effectively. Suppose you ordered
one plate French fries with Nuggets that means the opportunity cost of your order
is one Pizza that you have sacrificed in order to enjoy the benefits of the alternative
choice.
Quite often, the increase in production of a good or service requires some cost
or sacrifice to be incurred. These costs are known as opportunity costs. In 1990,
the demand for Harley Davidson motorbikes in Japan was very strong, controlled
almost sixty percent of the big bike market, and the company operated at 100 percent
production capacity. The management was forced to decide the best possible way
of allocating their limited production capacity to satisfy the market demand. The
management decided to produce different models of the bike for sale in US and
other countries and this lead to significant opportunity cost by simply not utilizing
their entire production capacity to produce most expensive and profitable models
for export in Japan. If Harley Davidson would have not had a foresighted approach
and just concentrated on the short term gains, it would have risked alienating the
domestic demand of devoted bikers in Japan. Opportunity cost is thus the cost of
choice, when output, time and money are limited.

Time Perspective Principle

The time perspective principle is very crucial when it comes to decision making
by a manager. The manager has to decide upon time frame, may be short run or
long run while considering execution or implementation of any policy or plan. The
factors of production are not all variable in the short run. There is a possibility that
few factors could be increased or decreased only in the long run. Labor for instance,
is considered as variable factor in the short run whereas capital is assumed to be
fixed in the short run. Short run is considered as a current period whereas long run
is considered as a future period. Short run time periods is very important to notice
the producers response to price changes by using the varying quantities of variable
input. If the business is profitable and the producer can generate more revenue they
will opt for maximum utilization of variable resources to produce maximum output.
Per the consumers perspective, the short run is a period in which they respond to
price changes with the prevalent tastes and preferences.
Long run is a time period in which new sellers may enter a market or a seller
already existing may leave. In the long run all the factors of production are variable
that and could be changed, for instance capital and labor both can be altered per
the requirement. Per the consumers perspective, long run provides enough time to
respond to price changes by actually changing their tastes and preferences or their
alternative goods and services.

16 Managerial Economics

Marginal and Incremental Concept

A manager is responsible to use the factors of production efficiently and effectively
because as we know recourses are scarce. Marginal analysis deals with analyzing
the impact of a unit change in any one variable on the other variables. For instance,
suppose HLL plans to increase the price of its product, Surf Excel and this decision
to increase the price depends on the resulting change in the marginal revenue and
the marginal cost. Because in the market there are many more substitutes available
so the price rise is a very crucial decision and if it results in the additional revenue
generation then definitely it is a very appropriate managerial decision. Marginal
represents a small change whereas incremental deals with big changes or structural
changes for instance, changes in revenue and cost due to the change in the policy
matter. Suppose an MNC in Gurgaon is facing a problem in hiring good professionals
from Delhi and Noida region due to the commuting problem. To overcome this
problem it plans to run its own cabs so that commuting is no longer a problem and
the company could recruit best resources from nay place in NCR. This cost will be
incremental in nature and will generate incremental revenue because of the efficient
and professional staffs are now available to handle the various projects.
Thus, a resultant change in the output because of a change in process, product or
investment is regarded as an incremental change. Incremental reasoning is based on
the fact that only the incremental cost other than the full cost should be considered to
evaluate the profitability of a decision. As per the incremental principle any decision
taken is profitable when it increases the 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 costs more than revenues.

Equi -Marginal Principle

The equi-marginal principle states that a rational decision maker would allocate
his /her scare resources among alternative uses in such a way that marginal utility
per dollar is same for all alternatives. A rational consumer considers what he gets
(marginal utility) for what he pays, or MU per dollar,
MUx
or
Px
If a dollar gives higher additional utility from consuming a unit of Y than
another unit of X at the same price per unit, then will reduce consumption of units
of X and increase consuming units of Y. When the consumer increases consumption
of Y it leads to lower marginal utility for the next unit. Whereas by decreasing the
consumption of X implies higher marginal utility per unit, because the principle of
diminishing marginal utility comes into play. Hence the consumer tends to move to
equi-marginal point where MUx/Px = MUy/Py and the additional utility per dollar
is same for X and Y.

 Nature and Scope of Managerial Economics 17

Family Model of Economics and Management

The relationship between the subjects Economics and Management can be
presented as a family model. See Table 1.
Table 1.1 Family Model of Economics and Management
Mother

Father

Child

Economics

Manager

Management

Financial economics

Accountant

Finance

Micro economics

Salesman

Marketing

International economics

MNC

International Business

Labour economics

Employer

HR Management

Monetary economics

Bank

Bank Management

Industrial economics

Engineer

Industrial Management

Transport economics

Distributor

Supply Chain Management

International economics

Exporter

Foreign Trade

Source Dr Justin Paul , Indian Management, AIMA-Business Standard Journal, Vol.44,

Issue 3, March 2005, pp 70-72

Summary
Economics not only helps us to better understand the human behavior and the activities
of the firm but it also provides valuable insights and tools to businessmen.
Managerial economics is the science of directing scarce resources to manage
cost effectively.
Managerial Economics provides strategic planning tool that helps in analyzing
the problem and formulating rational managerial decisions.
Management is about making choices. Economics is the study of decision
making thus it helps the manager in taking the correct decision.
A firm produces either what the consumer demands or what it thinks the
consumer requires. Thus, consumer satisfaction helps in the production of new and
innovative products.
Economist defines profit as the reward for uncertainty bearing and risk taking
abilities. The manger is successful if it can reduce uncertainty and earn higher
profits

Review Questions

1. Discuss the nature and scope of managerial Economics.

2. Explain the different roles of managerial economist.
3. Explain the concept of :
(i) Opportunity cost
(ii) Equi- marginal utility
(iii) Time Perspective principle
4. Comment on the International Framework of Managerial Economics
5. Should the firms be primarily viewed as economic entities?
6. Explain the role of profit in a free market economic system?
7. A firms profit has been at approximately Rs. 15 crores per year in each of the
last 5 years. The company has 25 lakhs shares of outstanding stock, and the
market price has been about Rs.500 per share. The top management has been
receiving only salary during this period. Develop a plan combining stock option,
bonus and other things to provide them with better incentives.

References
Managerial Economics by Atmananad, Excel Books.
Managerial economics by DM Mithani, Himalys Publishing House
Managerial economics by Ivan Png and Dale Lehman, Blackwell Publishing
The Nature of the Firm, by R.H. Coase, Economica, November 1937.