Managerial Economics

MANAGERIAL ECONOMICS
Management is
Coordination of various resources
An activity or ongoing process
A process with a purpose or goal
An art of getting things done by others
Economics
Studies the behaviour of human beings organisations in situations
involving choice
Problem of choice arises due to
1. Human wants are unlimited but of varying degrees of
importance
2. Economic resources are limited and have alternative uses


A close relationship between management and economics has led
to the development of managerial economics

Managerial economics
application of principles and methods of economics to analyse
problems faced by management of business or other types of
organisations and to help find solutions that advance the best
interest of such organisation
(Davis and S. Chang)
Management decision problems
|
-------------------------------------------------
| |
Economic theory decision sciences
Micro economics mathematical economics
Macroeconomics econometrics
Used by
Managerial economics
|
Optimal solution to managerial decision problems

Process of decision making

Establish objectives
Define the problem
Identify possible solutions
Select the best possible solution( considering input constraints
consider legal and other constraints)
Implement the decisions

SCOPE OF MANAGERIAL ECONOMICS
++++++++++++++++++++++++++++++++
Managerial economics is concerned with
1. Micro economics
2. Macroeconomics
MICROECONOMICS is the study of particular firms ,particular
households, individual prices ,wages, income,individual
industries, particular commodities
MACROECONOMICS deals not with individual quantities as such
but with aggregates of these ,not with individual incomes but
with national income, not with individual prices but with price
level, not with individual outputs but with national output
Application of micro economics

Micro economics deals with internal issues(all those problems
which are within the business and fall within the purview and
control of management
What to produce
How to produce
Where to locate the production unit
How to promote sales
What technology to be adopted
Which category of customer to cater to
How to decide on new investments
Application of macro economics

Macro economics deals with external issues
Type of economic system in the country
General trends in national income ,employment,prices savings
& investment
Political environment state attitude towards private business
Social factors-value system of society, customs and habits
governments economic policies- industrial,monetary fiscal,
price,foreign
Trends in labour supply
ECONOMIC CONCEPTS RELEVANT TO
BUSINESS
ECONOMIC CONCEPTS RELEVANT TO BUSINESS
+++++++++++++++++++++++++++++++++++++++
1.THE OPPORTUNITY COST PRINCIPLE:
The opportunity cost of anything is the next best alternative that
could be produced instead,by the same factors and costing the
same amount of money

*All decisions which involve choice must involve opportunity cost
calculations
* The opportunity cost may be either real or monetary,non
quantifiable or quantifiable

The concept of opportunity cost can be explainrd by using a
PRODUCTION POSSIBILITY CURVE
The PPC joins the different combination of goods which an
economy can produce,given its state of technology and total
resources.

PPC demonstrates that
There is a limit to what one can achieve,given the available
resources
* Every choice made has an accompanying opportunity cost.
* in most cases thePPC is concave to the origin.This is due to
the increasing opportunity costs

2. INCREMENTAL CONCEPT
the two basic concepts in incremental analysis are
1. Incremental cost:
Change in total cost as a result of change in output
2. Incremental revenue
Change in total revenue resulting from a change in level of output

A manager always determines the worth of a decision on the basis
of the criterion IR> IC
3.CONCEPT OF PROFIT
Accounting concept of profit is
Profit= Total Revenue-Explicit costs
Economic profits is
Profit=Total revenue-(explicit+implicit costs)

4.OPTIMISATION CONCEPT
Optimisation is the act of choosing the best alternative out of the
available ones
Optimisation problems have three elements
1.Decision variables: variables whose optimal values have to be
determined

2. The objective function: (mathematical relationship between
choice variables and some variables whose values are to be
maximised or minimised
3. Feasible set: (available set of alternatives)
5.THE DISCOUNTING PRINCIPLE(TIME VALUE OF MONEY)
If a decision affects both costs and revenues at a future date,it is
essential to discount these costs and revenues to make them
comparable to some present value before a valid comparison of
alternatives is made
6.CONCEPT OF DEMAND
The decisions which management takes with respect to
production,advertising ,pricing etc call for an analysis of
demand


7.CONCEPT OF SUPPLY
Supply is the willingness and ability of producers to make a specific
quantity of output available to consumers at a particular price
over a given period of time
8 PRODUCTION
The essence of production is the creation of utilities.the term
production in economics is not confined to bringing about
physical transformation in the matter .It also covers rendering
of services
9. DISTRIBUTION
Distribution is concerned with sharing of national inciome among
the different factors of production

10.TIME PERIOD
Short run:
Operating period of the business in which at least one factor of
production is fixed
Long run
A period in which all factors of production is variable
11MARGIN AND AVERAGE
Margin refers to small (incremental ) increases or decreases
The concept of average refers to an arithmetic mean
12.ELASTICITY
The concept of elasticity measures the responsiveness of one
variable to a change in another variable

13.CONSUMPTION FUNCTION
The most important determinant of consumption is income.This
relationship between consumption and income is termed as
consumption function or the propensity to consume
C= f(Y)
C is consumption, f is function ,Y is income
The law consists of 3 propositions
1.When aggregate income increases , consumption expenditure
also increases but by a somewhat smaller amount
2 . When income increases, the increment of income will be
divided in a certain proportion between consumption and
saving
3.As income increases both consumption spending and saving will
go up
The income consumption relationship can be specified by the
equation
C = a + b.Y (a > 0, 0<b<1)
Where a is autonomous consumption and b.Y is induced
consumption
Autonomous consumption is determined independently of income
Induced consumption is consumption is consumption induced by
income
Assumptions of the law
Habits of people regarding spending do not change
*The conditions are normal in the economic system
The existence of a capitalistic economy

DEMAND ANALYSIS & BUSINESS FORECASTING
DEMAND ANALYSIS
++++++++++++++++
Demand for a commodity refers to the quantity of the commodity
which an individual household is willing to purchase per unit of
time at a particular place
Demand implies
Desire to acquire it
* willingness to pay for it
* ability to pay for it
Demand function is a comprehensive formulation which
specifies the factors that influence the demand for the product
(price of product, price of substitutes,price of compliments
,income of consumer.taste or preference of user etc
Demand curve considers only price demand relation,other factors
remaining the same.
The inverse relationship between the price of the commodity and
quantity demanded per time period is referred to as the
LAW OF DEMAND.
Marshalls cardinal utility approach to the law of demand
=====================================
Utility is a capacity to satisfy human wants.The price which a
consumer is willing to pay for a commodity is a measure of its
utility.
1. According to Law of diminishing marginal utility when a person
consumes more units of a good his total utility increases while
the extra utility derived from consuming successive units of the
good diminishes

2. Law of equi marginal utility says that the consumer would
maximise his utility if he allocates his expenditure on various
goods he consumes such that the utility of the last rupee spent
on each good is equal
Thus at equilibrium
Mux = Muy MUn
-------- ---- ---------
Px PY PN
Based on these two laws Marshal draws a logical conclusion that
the quantity purchased varies inversely with price.
The inverse relationship between price and demand can be
explained in terms of PRICE EFFECT, INCOME EFFECT AND
SUBSTITUTION EFFECT
Factors affecting level of demand (other than price)
=======================================
Population: market demand for a commodity increases with
population
As income increases demand for good quality products
(normal goods ) increaseswhile the demand for poor quality
products (inferior goods) would decrease
Prices of related commodities: demand for a good directly
varies with the price of its substitutes.demand for a good
varies inversely with the price of its complementary good
Consumers expectations: an expectation of increase in future
prices of essential goods will induce the household to
purchase more.if consumers expect a higher income in future
they will increase present consumption
Consumers tastes and preferences

Movement along and off the demand curve:
====================================

Movement of the quantity demanded along the demand
curve is a result of change in price
If other factors change and as a result demand changes it is
referred to as increase or decrease in demand i.e. movement
of quantity demanded off the demand curve. it is depicted by
a shift in demand curve

A demand function can be stated as
Dx =f ( Px)
The above demand function in a linear form can be expressed as
Dx =a -bPx
Where Dxis quantity of commodity X demanded,
A is a constant parameter ,which shows the initial demand
irrespective of the price of commodity X, and
B is a constant parameter which shows the functional
relationshipbetween the price of commodity X and the
demand for it( the negative sign of b shows inverse
relationship between demand and price
Exceptions to the law of demand
==========================
Giffen goods
Conspicuous necessities (upper sector goods)
Conspicuous consumption (snob value)
Emergencies
Change in fashion
Types of demand
==============
Consumer goods and producer goods
Perishable and durable goods
Autonomous and derived demand
Short run and long run demand

Consumers surplus
==============
A consumers surplus is the excess of the price which a person
would be willing to pay rather than go without the good, over
that which he actually does pay
Assumptions
==========================
Utility is measured in cardinal numbers
Marginal utility of money remains constant
Utility derived from a commodity does not depend on consumption
of other commodities
Consumer;s,taste income etc remains constant.


2. ORDINAL UTILITY APPROACH
===========================
This approach assumes that utility cannot be measured but can be
compared. every individual has a scale of preferences.
An INDIFFERENCE CURVE is a logical construction of alternative
choices taking into account consumers given scale of
preferences.


The BUDGET LINE or the PRICE LINE represents different
combinations of two goods X and Y which the consumer can
buy by spending all his income

A consumer reaches equilibrium at a point where his budget line is
tangent to an indifference curve from his indifference map. It is
the optimal choice under the given constraints
MRSxy = Px
-----
Py
Where MRSxy is the marginal rate of substitution of X for Y
Px is price of X Py is price of Y


1. The ICC ( Income consumption curve ) represents the income effect

1. The substitution effect is always measured through a movement of
the consumers equilibrium point along the same indifference curve.

2. Price effect is a composite of income effect and substitution effect.

Income effect occurs due to increase or decrease in real income resulting
from a decrease (increase ) in the price of a commodity. substitution
effect occurs due to the consumers inherent tendency to substitute
cheaper goods for relatively expensive ones

CONCEPT OF SUPPLY
====================
* Supply is the willingness and ability of producers to make a
specific quantity of output available to consumers at a
particular price over a given period of time.
* The LAW OF SUPPLY describes the behaviour of sellers or
producers. It states that other things remaining the same ,there
is a direct relationship between the quantity supplied of a
commodity and its price
* Like the law of demand the law of supply is also a statement
about the aggregate behaviour of sellers of a commodity
* Supply curve is a graphical representation of supply schedule.
supply curve slopes upwards from left to right

FACTORS AFFECTING LEVEL OF SUPPLY (other than price)
=========================================
Technology: Improvement in technology will enable the
producer to supply more at the same price
Input prices: if a producer is able to obtain inputs at lower
prices he will be able to supply more at the same price
Government taxes and subsidies: the expected reaction of
suppliers to an increased excise rate is to reduce the supply at
the given price.
Prices of related goods: it the price of related goods increase
the producers may transfer resources to these products
Expectations about the future: if suppliers expect a higher price
for a commodity, they would reduce its supply
MOVEMENT ALONG AND OFF THE SUPPLY CURVE
=========================================

When all underlying other factors are held constant , the
changes in the quantity supplied can be obtained from the
movement along a supply curve
When the underlying other factors change , the whole supply
curve tends to shift upward or downward
An increase in supply is denoted by a downward and rightward
shift of the supply curve
A decrease in supply is denoted by an upward and leftward
shift of the supply curve
PRODUCERS SURPLUS
===============================

The supply curve shows the minimum price that the producers
must receive to cover the rising marginal costs and supply each
quantity of the commodity
producers surplus is defined as the excess money receipts of a
producer over his minimum supply price
If the price of the product rises the total producers surplus
would be more. if the price of the product falls the total
producers surplus become less.
INTERACTION OF DEMAND AND SUPPLY
===============================
Price is determined in a free market by the interplay of supply
and demand.
When quantity demanded is greater than quantity supplied,
prices tend to rise: when quantity supplied is greater than
quantity demanded, prices tend to fall.
When quantity supplied equals quantity demanded ,prices have
no tendency to change.this point represents a state of rest or
equilibrium.
The price and quantity at equilibrium are known as equilibrium
price and equliibrium quantity
The intersection of supply and demand curve indicates the
equilibrium point

SHIFTS IN DEMAND AND SUPPLY CURVES
==============================
A change in either the demand or supply conditions will lead to
a shift in either the demand curve or supply curve or both
resulting in the establishment of a new equilibrium quantity
and price.

Altering underlying conditions of demand
and supply
SHIFT
Supply, left
Supply, right
Demand,left
Demand , right

PRICE
Increase
Decrease
Decrease
Increase

QUANTITY
Decrease
Increase
Decrease
Increase

INTERACTION OF DEMAND AND SUPPLY
===============================
When both the demand and supply increase (or decrease), the
equilibrium quantity would invariably increase (or decrease).
The equilibrium price may increase , decrease or remain the
same, depending on the relative shifts in the two curves

On the other hand when demand decreases (or increases), and
supply increases ( or decreases)the equilibrium price would
invariably decrease ( or increase ).the equilibrium quantity may
increase, decrease or remain the same depending on the
extent of the shift in the two curves

EXCEPTIONAL DEMAND CURVES
===============================
There are some exceptions to the law of downward sloping
demand , which are sometimes referred to as exceptional
demand curves
The regression can be at the upper end of the curve ( e.g goods
of ostentation jewellery, antiques ,paintings )
The regression can be at the lower end of the curve ( e.g
inferior goods ,giffen goods)
EXCEPTIONAL SUPPLY CURVE
========================
One exception to the law of upward sloping supply is the case of
the backward sling supply curve for labour
DEMAND ELASTICITIES
==========================

ELASTICITY measures the degree of responsiveness of the dependent
variable with respect to the independent variable. elasticity is
defined as the ratio of the percentage changes in the two variable
The elasticity of Y with regard to X can be measured as
Y * X
------ -----
Y X
That is, Percentage change in Y(dependent variable)
----------------------------------------
Percentage change in X ( independent variable)
DEMAND ELASTICITIES
==========================

Elasticity of demand Ed = percentage change in quantity
demanded
--------------------------------------.
Percentage change in price
We use percentages rather than absolute amounts in measuring
consumer responsiveness. This is because if we use absolute
changes our impression of buyer responsiveness will be
arbitrarily affected by the choice of units
TYPES OF DEMAND ELASTICITIES
==========================
1.Price elasticity of demand:
Is the measure of degree of responsiveness of the quantity
demanded of a good to a change in its price, other things
remaining the same.
Methods of measuring price elasticity:
1. Point elasticity method (geometric method)
Ep =%change in qty demanded
---------------------------------- where
%change in price
% change in qty demanded= New qty -Old qty *100
--------------------------
Old qty


And % change in price =new price - old price *100
-----------------------------
Old price
* the price elasticity of a straight line demand curve varies from
infinity at the price axis to zero at the quantity axis.
Elasticity at a point on the demand curve is measured by using
the formula:
Ep =lower segment of the demand curve
----------------------------------------------
Upper segment of the demand curve

Different degrees of elasticity:
----------------------------------
1. Perfectly inelastic demand: the demand for a commodity is
not responsive to any change in price.
2. Perfectly elastic demand: purchasers are prepared to buy all
that is available in the market at a particular price
3. Unit elasticity of demand: percentage change in quantity
demanded equals percentage change in price
4. Relatively inelastic demand: percentage change in quantity
demanded is less than percentage change in price
5. Relatively elastic demand : percentage change in quantity
demanded is greater than percentage change in price

2. Arc elasticity method:
The point elasticity as illustrated by geometric method is of use
only if there is a slight or small change in price. but if there is
considerable change in prices it is required to take average
value over some range of the demand function. This is called
arc elasticity of demand
Ep = Q * P1 + P2
----- ------------
P Q1 + Q2
Where p1 and Q1 are original price and qty
P2 and Q2 are final price and qty

3. Total outlay method
Total outlay (expenditure ) of a household = p * q
Where p is the price and q is the quantity of a commodity
If as a result of fall in price,
1. the total outlay decreases, then e < 1
2. The total outlay increases e > 1
3. Total outlay remains the same e = 1

Factors influencing price elasticity
=====================
1. Nature of commodity: demand is more elastic for comforts and
luxuries it is inelastic for necessities
2. The number and closeness of substitutes: the more and better
the substitutes the greater is the price elasticity of demand
3. Number of uses of the commodity: the greater the number of
uses the greater is its price elasticity
4. Time period: the greater the time period , the greater is the
price elasticity of demand
5. Proportion of income spent on the commodity: the greater the
proportion of income spent on a commodity, the larger is the
price elasticity
2. Income elasticity of demand:
Is a numerical measure of the degree to which quantity demanded
responds to a change in income , other determinants of
demand being kept constant.
Ei = % change in quantity demanded
---------------------------------------
% change in income
The value of income elasticity of demand for inferior goods
is NEGATIVE
The value of income elasticity of demand for necessities is
POSITIVE& less than (+1)
The value of income elasticity of demand for comforts and
luxuries is POSITIVE more than (+1)


3.Cross elasticity of demand:
Is numerical measure of the degree to which quantity demanded of
a good responds to changes in the prices of other commodities
, the other determinants of demand being kept constant.

Ec = % change in quantity demanded of good X
--------------------------------------------------------
% change in price of good Y

If X and Y are complements Ec will be NEGATIVE
If X and Y are substitutes Ec will be POSITIVE

ELASTICITY OF SUPPLY
===================
* Elasticity of supply measures the responsiveness of market
supply to changes in price of the product
* Es = % change in qty supplied
---------------------------------
% change in price
* Types of elasticities of supply:
=======================
1. Relatively inelastic supply: quantity supplied changes by a
smaller percentage than price
2. Relatively elastic supply: quantity supplied changes by a larger
percentage than price

3 . Unit supply elasticity: quantity supplied changes by the same
percentage as price
4. Perfectly inelastic supply: quantity supplied remains the same,
whatever the price
5. Perfectly elastic supply : suppliers will produce an unlimited
quantity at the existing price.
Factors influencing elasticity of supply
============================
1 . Time factor : the longer the time period, the more elastic the
supply
2 Ability to store the product: products that can be stored for
longer periods have more elastic supply
3 Cost of production: with the increase in output if the cost of
production rises substantially ,the firm may not increase supply
with the rise in price.( less elastic)
EQUILIBRIUM PRICE UNDER DIFFERENT TIME PERIODS
1. Market period:
Very short period in which supply is limited to stock
Supply is perfectly inelastic
Equilibrium price is determined by demand forces only
2.Short period:
Period in which supply can be changed to a limited extent by
changing the variable factors of production
The supply curve is relatively inelastic
The equilibrium price is determined by demand and supply
3.long period:
Supply can be fully adjusted by changing all factors
Supply curve is more elastic
DEMAND FORECASTING
==================
DEMAND FORECASTING means an estimation of sales in future or
knowing the future trends of sales or consumer behaviour in
terms of disposal of their incomes for the product or service in
question in future.
The AIM of demand forecasting is to reduce the risk that the
firm faces in its operational decision making and in planning for
its long term growth
Demand forecasts are important for :
1. Production plannning
2. Resource planning
3. Sales policy
4. Price policy
5. Inventory planning
METHODS OF DEMAND FORECASTING
============================
The methods of demand forecasting can be broadly classified into
SURVEY METHODS and STATISTICAL METHODS

(A) SURVEY METHODS:
1.Experts opinion: conducting an opinion poll of experts and
knowledgeable people in the field ( consultants, academicians,
agents etc)
2. Delphi method : arriving at a consensus by questioning a group
of experts repeatedly
3. Consumer survey methods : can be of three types
a. Complete enumeration method: almost all potential users of the
product are asked about their future plans of purchasing the
product


b. Sample survey method : a sample of consuming units is selected
from the relevant population and data is collected on their
probable demand for the product
c. End use method: when product is used for more than one use
this method is useful
4. Market experiments: market experiments are conducted to
generate demand forecasts
a. Test marketing : innovation ( in design, content,quality etc) is
tested on an experimental basis
b. laboratory experiments : under ideal conditions created
specifically to test some relevant hypotheses about consumer
behaviour, selected individuals are experimented upon

(B) STATISTICAL METHODS
1. Trend method : two methods are used for trend projection
based on time series data
a. Graphical method: time series data on the variable (e.g. sales )
under forecast are used to fit a trend line graphically
b. Least squares method: trend models are basically regression
models with demand as a dependent variable and time as
independent variable.

2. Smoothing method: sometimes time series analysis does not
reveal a significant trend(upward or downward. In such cases
smoothing method becomes useful
3.Barometric methods: use economic indicators as barometer to
forecast trends in business activity.
Economic indicators used in barometric methods are classified into
three categories
a. Leading indicators: generally precede the event and hence are
very useful in making reasonably accurate forecast
b. Coincidental indicators: personal income , industrial
production etc
c. Lagging indicators: variables which fall behind other related
variables e.g. outstanding loans, lending rates for loans etc
4. Regression method: demand function for a product is estimated.
In the demand function , quantity to be forecast is a dependent
variable and variables that determine demand are independent
variables

PRODUCTION ANALYSIS
PRODUCTION ANALYSIS relates physical output to physical units
of factors of production and studies the least cost combination
of factor inputs, factor productivities and returns to scale.
Concept of production : production is more than just a physical
transformation of resources into output. It includes all activities
directly and indirectly related to production.
Production function: the technical relationship between
quantities of input and the quantities of output is known as the
production function.
Q=f (X1, X2, ---------Xn) where Q is output, X1---Xn is input
The relative importance of a factor of production varies from
one product to another
PRODUCTION ANALYSIS
Short run Production function ( one variable input case)
A formal functional relationship between inputs and output can be
used to relate one input with the output, the other inputs
remaining constant at a given level.
X =f (Ko, L) : capital is held constant
X = f (K, Lo ) : labour is held constant
A PRODUCTION SCHEDULE lists the different quantities of output
that will be produced by different quantities of physical inputs
TOTAL PRODUCT refers to the total output produced by the use of
variable factor inputs
MARGINAL PRODUCT is the change in total product resulting from
the use in the production process of one more or one less unit
of the variable factor
Marginal product equation can be found out by using
differentiation (derivative of production function)
PRODUCTION ANALYSIS

The behaviour of marginal product curve is governed by THE
LAW OF DIMINISHING MARGINAL RETURNS
as successive units of variable factor are applied to a given
amount of fixed factor the marginal product will eventually
decline and will become zero if more units of variable factor are
employed whereafter the marginal product will be negative and
even total product will fall
AVERAGE PRODUCT is the output per unit of the variable factor

The three stages of production
Diminishing returns to a factor can be graphically understood with
the help of total and marginal product curves
PRODUCTION ANALYSIS

STAGE 1: total product increases at an increasing rate. Marginal
product increases and reaches its maximum. Average product
increases ( but slower than marginal product)
STAGE 2 : TP increases at a diminishing rate and becomes
maximum. MP starts diminishing and becomes equal to zero.
AP starts diminishing
STAGE 3: TP reaches its maximum, becomes constant and then
starts declining . Mp keeps on declining and becomes negative.
AP continues to diminish but must always be greater than zero

Stage 2 is the only relevant range for a rational firm in a
competitive situation

PRODUCTION ANALYSIS
Long run Production function
* The technical possibilities of producing an output level by various
combinations of two factors can be graphically represented in
terms of an isoquant.
* An isoquant is the locus of all the combinations of two factors of
production that yield the same level of output
Different points on the isoquant show different combinations of
two factors (e.g labour and capital) and hence different
techniques of producing the output with the existing
technology.
A technique of production is geometrically represented by a
RADIUS VECTOR(straight line passing through the origin)

PRODUCTION ANALYSIS
TYPES OF ISOQUANTS

1. Linear isoquant: assumes perfect substitutability of factors of
production
2. Input output isoquant (right angled isoquant) : assumes zero
substitutability of factors of production
3. Kinked isoquant: assumes limited substitutability of factors of
production .substitutability of factors only at kinks
4. Smooth convex isoquant : an isoquant with infinite efficient
techniques would imply a smooth convex curve to the origin.
This firm assumes continuous substitutability of factors of
production over a certain range beyond which factors cannot
substitute each other

PRODUCTION ANALYSIS
Characteristics of isoquants:
====================
An isoproduct curve slopes downward to the right: it is
possible to substitute capital for labour
It is convex to the origin : the producer is willing to sacrifice
fewer and fewer units of one factor ( labour) for additional
units of other factor ( capital)
Isoquants do not intersect: if they did it would be a logical
contradiction
Higher isoquants denote higher level of output
PRODUCTION ANALYSIS
Marginal rate of technical substitution
==============================
The substitutability of one factor for another is given by the slope
of the isoquant and is known as the marginal rate of technical
substitution
The slope of the isoquant shows how many extra units of
(capital) must be employed to replace one unit of labour, if
output is to be maintained or viceversa
MRTS (L K) = K
L

* According to the principle of diminishing MRTS , the value of the
MRTS diminishes as one moves along an isoquant down
towards right

PRODUCTION ANALYSIS
ISOQUANT MAP shows all the possible combinations of factor inputs
(labour and capital) that can produce different levels of output
ISOCOST LINE represents various combinations of inputs that may be
purchased for a given amount of expenditure
Given the monetary resources ,if the factor prices change the
slope of the isocost line will change

A rational producer is expected to
1. maximise output for a given unit of cost or
2. minimise cost subject to a given level of output
The optimal combination of inputs is given at the tangency point
of an isoquant and an isocost line
At this point the slope of the isoquant(i.e.MRTS) and the slope of
the isocost line ( i.e. relative factor prices ) are the same

PRODUCTION ANALYSIS
Expansion path
===========
The expansion path is the locus of the points of tangency between
the isoquants and isocost lines
It shows how the firm given the factor prices, will change the
amount of two factors when it increases the scale of production
A firm expands by moving from one tangency or efficient
production point to another .
Returns to scale
==========
In the long run output can be increased by increasing the scale of
operations (increasing all factors by the same proportion)
Returns to scale can be expressed as a movement along the scale line
or expansion path
PRODUCTION ANALYSIS
Returns to scale are classified as:

1. Increasing returns to scale: output increase more than
proportionate to increase in inputs. (QE) > 1
2. Constant returns to scale: output increase proportionate to input
increase (QE) = 1
3. Decreasing returns to scale: output increase less than
proportionate to increase in inputs. (QE) <1
Returns to scale can be measured in terms of coefficient of output
elasticity (QE)
QE =percentage change in output
----------------------------------
Percentage change in input

PRODUCTION ANALYSIS
Returns to scale occur due to economies of scale.
Economies of scale imply the benefits derived by a producer by
expanding its scale of production.

1.INTERNAL ECONOMIES: accrues to a firm because of its own
efforts
Arise due to (1)indivisibilities and(2) specialisation
Different kinds of Internal economies:
1. Technical economies
2. Marketing economies
3. Managerial economies
4. Financial economies
5. Risk bearing economies

PRODUCTION ANALYSIS
2. EXTERNAL ECONOMIES : are those which a firm reaps as a result of
growth of industry as a whole
Arises due to (1) localisation and (2) availability of specialised services
Different kinds of external economies are:
1. Cheap materials and equipments
2. Growth of technical knowhow
3. Development of skilled labour
4. Growth of subsidiary and anciliary industries
5. Development of transportation and marketing facilities
6. Development of information services

* Increase in scale beyond the optimum level results in
DISECONOMIES OF SCALE

PRODUCTION ANALYSIS
Important internal diseconomies:
1. Managerial diseconomies
2. Labour diseconomies
3. Financial diseconomies
4. Exhaustible natural resources

Some external diseconomies:
1. Increase in price of factors that are in short supply
2. Environmental problems : pollution etc

ECONOMIES OF SCOPE refers to the reduction of a firms unit cost by
producing two or more goods or services jointly rather than
separately

COST ANALYSIS
COST ANALYSIS
==============
The basic objective of cost analysis is to explore its relevance to
decision making. costs play a very important role in managerial
decisions involving a selection between alternative courses of
action
COST CONCEPTS
+++++++++++
1. INCREMENTAL COSTS: change in overall costs that results from a
particular decision being made
2. SUNK COST : costs of those highly specialised resources/inputs
which are such that after they are employed in a particular
enterprise they cannot be put to any alternative use.

COST ANALYSIS
.
3 HISTORICAL COST : the original price paid for the plant, equipment
or material
4. REPLACEMENT COST: cost that the firm would have to incur if it
wants to replace the same plant,equipment or material
5. EXPLICIT COSTS : those expenses which are actually paid by the
firm
6. IMPLICIT COSTS: the earnings of those employed resources which
belong to the owner himself
7. DIRECT COSTS : costs which can be directly attributed to the
production of a unit of a given product
8. INDIRECT COSTS: costs which cannot be separated and clearly
attributed to individual units of production

COST ANALYSIS
.
9. FIXED AND VARIABLE COST: fixed costs are those which are incurred
in hiring the fixed factors of production whose amount cannot be
altered in the short run.
Variable costs are those costs which are incurred on the employment
of variable factors whose amount cannot be altered in the short
run
10.PRIVATE AND SOCIAL COSTS: private costs are the micro level
economic costs that relate to the functioning of a firm as a
production unit.
Macro level economic costs generated by the decisions of the firm
but are paid by the society and not the firm.
COST ANALYSIS
.SHORT PERIOD COSTS
==================
short period is the time period over which some factors of
production are fixed and others are variable.
In the short run costs incurred by the firm are bifurcated into fixed
costs and variable costs

TOTAL FIXED COSTS (TFC) are those associated with all fixed
factors at any given level of output
TOTAL VARIABLE COSTS (TVC) are those associated with all
variable factors of production at any given level of output
TOTAL COSTS (TC) are the costs associated with all factors of
production at any given level of output
TC = TFC + TVC

COST ANALYSIS

AVERAGE FIXED COST (AFC) is the fixed cost associated with
producing one unit of output
AVERAGE VARIABLE COST (AVC) is the variable cost associated
with producing one unit of output
AVERAGE TOTAL COST (ATC) is the cost per unit of output . It is
also known as AVERAGE COST (AC)
ATC = AFC + AVC
The behaviour of average total cost curve will depend on the
behaviour of the average variable cost curve and the average fixed
cost curve
MARGINAL COST (MC) is the cost associated with producing one
more unit of output

COST ANALYSIS
PROPERTIES OF COST CURVES
AFC declines continuously as output increases,while AVC, ATC and
MC first fall and then rise as output increases
AVC first declines, reaches minimum and rises thereafter.when
AVC attains minimum MC equals AVC
ATC first declines reaches a minimum and rises thereafter .when
ATC attains its minimum MC equals ATC
MC first declines, reaches minimum and rises thereafter
MC lies below both AVC and ATC when they are declining; it lies
above them when they are rising
The optimum rate of output is produced at that point where the
minimum point of ATC curve is intersected by the rising MC curve
The cost curves are the mirror image of the shape of the
corresponding productivity curves
COST ANALYSIS
LONG PERIOD COSTS
================
The long run cost of production is the least possible cost of
production of any given level of output when all inputs are
variable including the size of the plant
The LTC curve gives the total costs for various levels of output
when all factors are variable
The relationship between LAC and LMC follows that of the LTC
curve

At the point of inflection on LTC curve LMC takes the minimum
value
At the point of kink of LTC curve ,LAC assumes minimum value
COST ANALYSIS
The LONG RUN AVERAGE COST CURVE is derived from short run
cost curves
* The LAC is also U shaped but is flatter than SAC

* U shape of SAC is because of law of variable proportions

* U shape of SAC depends upon returns to scale .A firm enjoys
increasing returns to scale when the LAC is falling , constant
returns to scale at the minimum level of LAC and decreasing
returns to scale when the LAC is rising.

Given the technology a firm trying to minimise its average cost
over time must choose a plant size which gives minimum LAC,
where SAC = SMC = LAC = LMC. This is the OPTIMUM FIRM

COST ANALYSIS
FORMS OF COST FUNCTIONS
=======================
The cost output relationship is expressed by the cost function
TC = f (Q)
Where TC is total cost ,Q is output
The cost function can be expressed in three forms
1. Cubic cost function :According to this function , as output
increases, the total cost first increases at a decreasing rate and
then it increases at an increasing rate
2. Quadratic cost function: total cost increases at an increasing rate
from the outset of production
3. Linear cost function: total cost increases at a constant rate

REVENUE ANALYSIS
REVENUE ANALYSIS
==================
The nature of revenue and revenue curves will depend no the
nature of the demand for the product and its price
TOTAL REVENUE : The income from the sale of a given quantity of
output
TR= P * Q where P is price and Q is quantity
AVERAGE REVENUE is the price or revenue per unit of output
AR = TR
-------
Q
Average revenue from the sellers point of view is the price from the
buyers point of view

REVENUE ANALYSIS
MARGINAL REVENUE is the revenue obtained by selling an
additional unit of a commodity

AR AND MR UNDER PERFECT COMPETITION
-------------------------------------------------
A perfectly competitive market is one where the following
conditions exist
1. Large number of buyers and sellers
2. Homogeneous product
3. Free entry and exit of firms
4. Buyers and sellers have perfect knowledge about market
conditions
5. Perfect mobility of factors of production

REVENUE ANALYSIS
The individual seller has a perfectly elastic demand curve
Since price charged will be same for all the units sold the price of
the additional unit MR will be same as the price of all the units
sold . The AR and MR curves become identical
Since the firm sells output at a constant price its total revenue will
increase at a constant rate. Revenue curve is linear and slopes
upward
AR and MR under MONOPOLY
------------------------------------
For a monopoly to exist the following conditions are essential
1. Single producer or seller
2. No rivals or direct competitors of the firm
3. No entry
4. Monopolist is a price maker
REVENUE ANALYSIS

There is only one firm in the industry and so there is no difference
between the demand curve for the industry and the firm.
Demand curve is downward sloping
Total revenue increases initially, reaches a maximum level and
then falls with the increase in output sold
MR is positive until total revenue reaches maximum and it
becomes negative when total revenue starts falling. MR is zero
when TR is maximum
Both AR and MR are downward sloping but the rate of fall in MR
is greater than that of AR
MR curve bisects the horizontal distance between the AR curve
and the y axis

BREAK EVEN ANALYSIS
BREAK-EVEN ANALYSIS
==================
Break- even analysis also known as cost volume-profit analysis is
a form of short run cost analysis based on the economists
analysis of variable and fixed costs in relationship to the sales
price of the product

BREAK-EVEN POINT is that volume of sales where the firm breaks
even ,that is, TOTAL COSTS equal TOTAL REVENUE

The break-even sales level can be determined
1. Graphically (break-even chart)
2. algebraically

BREAK EVEN ANALYSIS
*Break-even analysis is useful in three important areas
1. Analysing the items of cost for, both fixed and variable for cost
reduction and control and improved profitability
2. Forecasting the results of business activity
3. Examining the effect of alternative business decisions

ASSUMPTIONS OF BREAK-EVEN ANALYSIS
All costs are perfectly variable or absolutely fixed
Volume of production and volume of sales are equal
All revenue is perfectly variable with the physical volume of
production
A stable product mix is assumed
PROFIT ANALYSIS
PROFIT ANALYSIS
++++++++++++
Profit is a reward for entrepreneurs who organise their business
activities
Profit is a residual income and not contractual income as in the
case of other factors
There are much greater fluctuations in profits than in the rewards
of other factors
Profits may be negative whereas rent, wages and interest must
always be positive
Measurement of profit:
PROFIT = TOTAL REVENUE TOTAL COST
The accountant considers only explicit costs, but the economist
considers both explicit and implicit costs

PROFIT ANALYSIS
PROFIT MAXIMISATION
Profit maximisation is the principal objective of a firm
NORMAL PROFIT: is that portion of profit which is absolutely
necessary for business to remain in operation.the entrepreneur
gets normal profit when AR = AC or TR=TC
SUPERNORMAL PROFIT: is any return above the normal profit. A
firm gets supernormal profits when AR > AC or TR > TC
THEORIES OF PROFIT
==================
1. Risk and uncertainty theory of profit
Risk bearing is the special function of the entrepreneur and it leads to
the emergence of profit :- Prof Hawley
Risks are an inherent in any business and they are of two types
,insurable risks and non insurable risks:- Prof F . H. Knight

PROFIT ANALYSIS
2. Dynamic theory of profit
Profits belong to dynamic economy. In a static economy pure profits
would be eliminated as fast as they could be created:- Prof Clark

3. Innovations theory of profit
Profits are the results of innovations introduced by entrepreneurs.
Innovational profits have a tendency to appear , disappear and
reappear as a result of emergence of new and more clever
innovation:- Prof J A Schumpeter

4. Profit is a reward for organising other factors of production.an
entrepreneur combines the factors of production to produce
output

MARKET ANALYSIS
PERFECT COMPETITION
Equilibrium of the firm in the short run:
* A firm is said to be in equilibrium when it has no incentive to
produce a unit more or a unit less.
* The rational firm aiming at maximisation of profit produces output
upto the POINT OF EQUILIBRIUM which is achieved when
1 MC = MR and
2. MC is increasing at the point of equilibrium
In the short run , a firm which is in equilibrium may earn normal
profit, supernormal profit or may even incur loss
If a firm is incurring losses it will continue to produce if at least the
total variable costs are recovered. If the price is so low that the
firm cannot recover its total variable cost ,it would prefer to close
down (SHUT DOWN POINT)

MARKET ANALYSIS
PERFECT COMPETITION
=================
Equilibrium of the industry in the short run:

All firms have similar cost curves. In the short run, firms will be in
equilibrium earning normal profits, supernormal profits or losses
For an industry to be in equilibrium there would have to be no
incentive for the number of firms in the industry to change i.e
entry or exit of firms
In the short period, the industry will not be in equilibrium
MARKET ANALYSIS

Equilibrium of the firm & industry in the long run:
--------------------------------------------------
In the long run
Each firm gets only normal profits
Each firm is producing at an optimum scale and using its plant to
the optimum point
The condition for the long run equilibrium of the firm is
LMC =LAC = P
In the long run all the firms are earning only normal profit and
therefore the industry is in equilibrium with normal prodit
MC = MR =AC = AR(price)
MARKET ANALYSIS
MONOPOLY
==========
Short run equilibrium:
In the short run monopolist maximises his short run profits or
minimises his short run losses if
1. MC = MR
2. MC cuts the MR from below
In the short run monopolist can expand or contract output by
varying the amount of variable factors but working with a given
existing plant
In the short run monopolist may earn excess profit . Being a price
maker he may charge a price based on demand that gives him
excess profit

MARKET ANALYSIS
Having a monopoly does not guarantee profits. Profits depends
upon whether there are customers who will pay prices high
enough to exceed production costs
Monopoly firm may suffer losses on account of non recovery of
fixed costs
If the price falls below AVC the monopolist would shut down even
in the short run

Long run equilibrium:
----------------------------
*The long run equilibrium output is produced at a point where LMC
cuts MR from below.
In the long run monopolist has time to expand his plant or
intensively utilise his existing plant which will maximise his profit.

MARKET ANALYSIS

The size of his plant and the degree of utilization of any given
plant size depends entirely on MARKET DEMAND
Since even in the long run , the monopolists demand curve
remains sloping downward,it cannot be tangent to average cost
curve at minimum AC. It implies that the firm will produce less
than its optimum output level in the long run
* Monopoly firm can get supernormal profits even in the long run

Price discrimination under monopoly
============================
* A seller indulges in price discrimination when he sells the same
product at different prices to different buyers

MARKET ANALYSIS
Equilibrium under PRICE DISCRIMINATION
==========================
Case 1:
A monopolist firm sells a single product in two different markets
with different elasticities of demand
It is assumed that production takes place at same point
Resale among the customers is not possible
Monopolist will produce that amount of output where MC = CMR
(combined marginal revenue)
He will divide the whole output between the two markets such
that MR of one market =MR of the other market
Case 2:
* The firm has a monopoly in the domestic market but faces perfect
competition in the world market
MARKET ANALYSIS
Monopolist produces that output where MC = CMR
The producer is said to be DUMPING in the world market since he
is charging less price in the world market than in the home market
MONOPOLISTIC COMPETITION
===========================
It is a market situation where the forces of monopoly and
competition interplay in determining the price
(e.g soaps & detergents ,ice cream parlours, fast food restaurants)
The consumers preference of particular product confer monopoly
element on the products
Producers compete with one another in two ways
1.price competition
2. non price competition (PRODUCT DIFFERENTIATION ,SELLING
COSTS)
MARKET ANALYSIS
Features of monopolistic competition
1.Large number of independent sellers
2. Free entry and exit of firms
3. Existence of large number of imperfect substitutes (product
differentiation
4. Large number of buyers
Short run equilibrium:
===============
In the short run , a monopolistic competitive firm attains
equilibrium where its MC = MR and MC is rising at the
equilibrium point
The firm may get abnormal profit or suffer losses. Normal profit
situation is not likely in the short run

MARKET ANALYSIS
Long run equilibrium
================
In the long run the entry of new firms and the consequent
changes in the demand curve will wipe out the supernormal
profits
The final equilibrium will be such that all firms in the group will
attain equilibrium by equating MC = MR and the group as a whole
attain s equilibrium when each firm gets only normal profits with
AC = AR
The equilibrium output is less than optimum i.e minimum point of
U shaped AC curve

MARKET ANALYSIS
OLIGOPOLY
================
Oligopoly refers to a market situation in which a few firms produce
goods which are either close substitutes or homogeneous
products
Features of oligopoly:
1. Large number of buyers
2. Sellers are few in number
3. Interdependence in price output policy
4. Indeterminate demand curve
5. Products are fairly good substitutes of each other
6. Entry of firms is possible but made difficult by the strategy of
existing players
MARKET ANALYSIS
Equilibrium in oligopoly:
THE KINKED DEMAND CURVE MODEL OF OLIGOPOLY
An oligopolistic firm is guided in its decisions by the imagined
demand curve which is based on its expected reaction of its rivals
For upward changes in price ,a firms demand is expected to be
highly elastic
For downward changes in the price the firms demand curve is
expected to be less elastic
Because of differences in elasticity( and slope ) the demand curve
of the firm has a corner or KINK at the current price
Due to the kink in demand curve, the MR curve is discontinuous at
the level of output corresponding to the kink
Total profit is maximised at the point of kink
The price remains rigid or sticky at the existing level

MARKET ANALYSIS
COLLUSIVE OLIGOPOLY MODELS
=====================
Two types of collusion
1. cartels:
firms jointly fix a price and output policy through agreement
The industry demand and industry MR are used to determine
profit maximising output and price
The industry output is divided among the members of the cartel
through negotiations
1. Price leadership :
Price is determined by the price leader
one firm sets the price and others follow it
It is more successful in industries where product differentiation is low

CAPITAL BUDGETING

Capital budgeting refers to the process of planning capital projects
, raising funds and efficiently allocating resources to those capital
projects
Types of capital projects:
1. replacement
2. Cost reduction
3. Output expansion of traditional products and markets
4. Expansion into new products or markets
5. Government regulation
Importance of capital budgeting:
-------------------------------------
1. Irreversibility of capital investment decisions
2. Substantial outlay

CAPITAL BUDGETING
3. Long gestation period
4. Capital budgeting decisions are subject to uncertainty
5. Impact on future costs
PROCESS OF CAPITAL BUDGETING
The capital budgeting is an application of the marginal revenue
and marginal cost principle
Firms should undertake capital expenditure projects as long as the
marginal returns from the projects exceed their marginal costs
The stages in capital budgeting process are
1. generation of capital investment projects
2. estimation of cashflows
3. Evaluation of investment projects
4. Ex-post evaluation of projects

CAPITAL BUDGETING
METHODS OF EVALUATION OF INVESTMENTS
==================================
1. PAYBACK PERIOD METHOD
This method calculates the time period required to return the
original investment
The shorter the payback period , the more desirable the project
Payback period = original investment
------------------------------------
Annual net cash inflow
2. AVERAGE RATE OF RETURN ON INVESTMENT(ARR)
It is the ratio of average annual net income from the project to the
original investment in percentage terms
Where net income is difference between the net cash inflows
generated by the project and cash outflows from initial
investment

CAPITAL BUDGETING
*The higher the ARR , the better the project

3.NET PRESENT VALUE METHOD
This method is based on the economic reasoning of discounting
future cash flows to make them comparable
The NET PRESENT VALUE of a project is the sum of the present
value of all the cash flows associated with the project
The discount rate employed for evaluating the present value of
the expected future cash flows should reflect the risk of the
project
* If NPV is positive, ACCEPT the project
If NPV is negative REJECT the project

CAPITAL BUDGETING
4. PROFITABILITY INDEX METHOD (BENEFIT COST RATIO)
* This is a variant of the NPV method.
* Profitability index = present value of cash inflows
----------------------------------------
Original cash outlay
* If PI is > 1 ,accept the project
If PI is < 1 reject the project
Among the projects , the project with higher PI will be selected
5. INTERNAL RATE OF RETURN METHED (IRR)
The IRR is the rate of discount which equates the present value of
the income stream over the life of the project with the present
value of the net cash investment
If IRR is > the opportunity rate of interest the project is accepted
If IRR is < opportunity rate of interest, the project is rejected

CAPITAL BUDGETING
CAPITAL RATIONING

Capital rationing refers to the selection of the investment
proposals in a situation of constraint on availability of capital
funds , to maximise the wealth by maximising the NPV of its
projects selected for implementation

Capital rationing may arise due to
1. managements ability to manage the projects
2. Limited internal funds
3. Capital expenditure budget

MACRO ECONOMICS
INPUT OUTPUT ANALYSIS
===================
The technique of input output analysis was developed by W.W.
Leontief in the context of American economy in 1941.
Input output analysis takes into account the INTERDEPENDENCE
of production plans and activities of the many industries which
constitute an economy
The analysis deals almost exclusively with production
An input output table shows the purchases by a particular sector
from all the other sectors and sales by the sector to the other
sectors
From the input output table , input coefficients can be calculated
MACRO ECONOMICS
Assumptions
1.Each industry produces one homogeneous good
2. Inputs employed in fixed proportions
3. Factor & commodity prices are given
4. No external economies or diseconomies of production
5. Firms enjoy constant returns to scale
USES
1. Gives a total picture of the market for any group of commodities
2. Companies can forecast the input requirements needed to meet a
forecasted change in demand for their product
3. Helps to determine what effect changes in demand will have on
different industries

Managerial Economics

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Managerial Economics

Uploaded by

Copyright:

Available Formats

MANAGERIAL ECONOMICS

You might also like