Managerial Economics

Unit - 1
By - Anand Kumar
Unit - 1
General Foundation of Managerial Economics
Economic approach, Circular flow of activity,
Nature of the firm, Forms of organizations,
Objectives of firms demand analysis and
estimation Individual, market and firm
demand, Determinants of demand, Elasticity
measures and business decision making,
Demand estimation and forecasting Theory
of the firm Production functions in the short
and long run, Cost concepts. Short run and
long run costs.
Managerial decision areas
assessment of investible funds
selecting business area
choice of product
determining optimum output
determining price of product
determining input-combination and
technology
sales promotion
Managerial Economics
Managerial Economics is a science which deals
with the application of economics theory in
managerial practice. It is the study of allocation
of resources available to a firm among its
activities. To be very precise, Managerial
Economics is Economics applied in decision-
making. It fills the gap between economic
theory and managerial practice.
Managerial Economics - Definition
Managerial Economics is the integration of
economic theory with business practice for the
purpose of facilitating decision-making and
forward planning by management.
- Spencer & Siegelman
The purpose of Managerial Economics is to
show how economic analysis can be used in
formulating business policies.
-Joel Dean
Managerial Economics

Economic Theories,
Concepts, Methodology
and Tools
Business management
Decision Problems
Managerial Economics
Application of Economics
in analyzing and solving
Business problems
Optimum solutions to
business problems
MICRO ECONOMICS
Micro-economics is a branch of economics that
studies the behavior of how the individual
modern household and firms make decisions to
allocate limited resources. Typically, it applies
to markets where goods or services are being
bought and sold. Micro-economics examines
how these decisions and behaviors affect the
supply and demand for goods and services,
which determines prices, and how prices in turn,
determine the quantity supplied and quantity
demanded of goods and services.
MACRO ECONOMICS
Macroeconomics is a branch of economics dealing
with the performance, structure, behavior, and
decision-making of the entire economy. This
includes a national, regional, or global economy.
Macroeconomics study aggregated indicators such
as GDP, unemployment rates, and price indices to
understand how the whole economy functions.
Macroeconomics develop models that explain the
relationship between such factors as national
income, output, consumption, unemployment,
inflation, savings, investment, international trade
and international finance.

Characteristics of Managerial Economics
It involves an application of Economic theory
especially, micro economic analysis to practical
problem solving in real business life. It is
essentially applied micro economics.
It is a science as well as art facilitating better
managerial discipline. It explores and enhances
economic mindfulness and awareness of business
problems and managerial decisions.
It is concerned with firms behaviour in optimum
allocation of resources. It provides tools to help in
identifying the best course among the alternatives
and competing activities in any productive sector
whether private or public.
Scope of Managerial Economics
1. Demand Analysis and Forecasting
2. Cost Analysis
3. Production and Supply Analysis
4. Pricing Decisions, Policies and Practices
5. Profit Management, and
6. Capital Management
1. Demand Analysis & Forecasting
A business firm is an economic organism which
transforms productive resources into goods
that are to be sold in a market. A major part of
managerial decision-making depends on
accurate estimates of demand. Before
production schedules can be prepared and
resources employed, a forecast of future sales is
essential. This forecast can also serve as a guide
to management for maintaining or
strengthening market position and enlarging
profits.
2. Cost Analysis
A study of economic costs, combined with the
data drawn from the firms accounting records,
can yield significant cost estimates that are
useful for management decisions. The factors
causing variations in costs must be recognized
and allowed for if management is to arrive at
cost estimates which are significant for planning
purposes. An element of cost uncertainty exists
because all the factors determining costs are
not always known or controllable.
3. Production & Supply Analysis
Production analysis is narrower in scope than cost
analysis. Production analysis frequently proceeds in
physical terms while cost analysis proceeds in
monetary terms. Production analysis mainly deals
which different production functions and their
managerial uses.
Supply analysis deals with various aspects of supply
of a commodity. Certain important aspects of
supply analysis are: Supply schedule, curves and
function, Law of supply and its limitations, Elasticity
of supply and Factors influencing supply.
4. Pricing Decisions, Policies and Practices
Pricing is a very important area of Managerial
Economics. In fact, price is the genesis of the
revenue of a firm and as such the success of a
business firm largely depends on the
correctness of the price decisions taken by it.
The important aspects dealt with under this
area are: Price Determination in various Market
Forms, Pricing Methods, Differential Pricing,
Product-line Pricing and Price Forecasting.
5. Profit Management
Business firms are generally organised for the
purpose of making profits and, in the long run,
profits provide the chief measure of success. In
this connection, an important point worth
considering is the element of uncertainty
existing about profits because of variations in
costs and revenues which, in turn, are caused
by factors both internal and external to the firm.
If knowledge about the future were perfect,
profit analysis would have been a very easy task.
6. Capital Management
Of the various types and classes of business
problems, the most complex and troublesome
for the business manager are likely to be those
relating to the firms capital investments.
Relatively large sums are involved, and the
problems are so complex that their disposal not
only requires considerable time and labour but
is a matter for top-level decision. Briefly,
capital management implies planning and
control of capital expenditure.
What is Decision-making?
Decision-making is the process of selecting a
particular course of action from among the
various alternatives. Every business manager
has to work on uncertainties and the future
cannot be precisely predicted by anyone. If
everything could be predicted accurately, then
decision-making would become a very simple
process.
What is Decision-making?

Alternative
course of Action
available
Selection of a
particular Action
Execution of
Action
Result of Action
Action A
Action B
Action C
Decision
Making
Chosen
Action
Full Realisation
of objective
Partial
realisation of
objective
Non-
realisation of
objective
Basic Economic Tools in Managerial Economics
1. Opportunity cost principle
2. Incremental principle
3. Principle of time perspective
4. Discounting principle, and
5. Equi-marginal principle
1. Opportunity Cost Principle
The opportunity cost of the funds employed
in ones own business is the interest that could
be earned on those funds had they been
employed in other ventures.
The opportunity cost of the time an
entrepreneur devotes to his own business is the
salary he could earn by seeking employment.
The opportunity cost of using a machine to
produce one product is the earnings forgone
which would have been possible from other
products.
2. Incremental Principle
Incremental concept is closely related to the
marginal costs and marginal revenues, for of
economic theory. In actual business situations,
it often becomes difficult to apply the concept
of marginalism which has to be replaced by
incrementalism, for in real world business, one
is concerned with not unit change but chunk
change. For instance, in a construction project,
the labour which a contractor may change is
not by one but by tens.
3. Principle of Time Perspective
The economic concepts of the long run and the
short run have become part of everyday
language. Managerial economists are also
concerned with the short-run and long-run
effects of decisions on revenues as well as costs.
The really important problem in decision-
making is to maintain the right balance
between the long-run and the short-run
considerations.
4. Discounting Principle
One of the fundamental ideas in economics is
that a rupee tomorrow is worth less than a
rupee today. This seems similar to saying that a
bird in hand is worth two in the bush. A simple
example would make this point clear.
5. Equi-marginal Principle
This principle deals with the allocation of the
available resources among the alternative
activities. It should be clear that if the value of
the marginal product is higher in one activity
than another, an optimum allocation has not
been attained. It would, therefore, be
profitable to shift labour from low marginal
value activity to high marginal value activity,
thus increasing the total value of all products
taken together.
Circular Flow of Economic Activities
Economic resources
Purchasing goods & services
Income payment of wages, rent,
dividend & interests
Goods & Services
Imports
Foreign Countries
Exports
Taxes
Governmen
t
Expenditure
Savings Banks Investments
Household Firm
Basic Economic activities
Production: The use of economic resources in
the creation of goods and services for the
satisfaction of human wants.
Consumption: The using up of goods and
services by consumer purchasing or in the
production of other goods.
Employment: The use of economic resources in
production; engagement in activity.
Income Generation: The production of
maximum amount an individuals.
Circular Flow of Production
Economic Resources
Producing Units
Goods and Services
Households
Circular Flow of Income
Income flow of wages
Interests & rents
House holds
Purchase of
Goods and Services
Producing Units
NATURE OF THE FIRM
Since modern firms can only emerge when an
entrepreneur of some sort begins to hire people,
Coase's analysis proceeds by considering the
conditions under which it makes sense for an
entrepreneur to seek hired help instead of
contracting out for some particular task.
The traditional economic theory of the time
suggested that, because the market is "efficient"
(that is, those who are best at providing each good
or service most cheaply are already doing so), it
should always be cheaper to contract out than to
hire.
Forms of Organisation
1. Sole proprietorship / Single ownership
2. Partnership
3. Joint Stock Companies
4. Cooperative organisation
5. State and central Government owned
1. Sole proprietorship
A sole proprietorship is a business with one owner
who operates the business on his or her own or
employ employees. It is the simplest and the most
numerous form of business organization in the
United States, however it is dangerous as the sole
proprietor has total and unlimited liability. Self-
contractor is one example of a sole proprietorship.
In this type, the single ownership where an
individual exercises and enjoys these rights in his
own interest. It does well for those enterprises
which require little capital and lend themselves
readily to control by one person.
2. Partnership
A single owner becomes inadequate as the size of the
business enterprise grows. He may not be in a position
to do away with all the duties and responsibilities of the
grown business. At this stage, the individual owner
may wish to associate with him more persons who have
either capital to invest, or possess special skill and
knowledge to make the existing business still more
profitable. Such a combination of individual traders is
called Partnership.
Partnership may be defined as the relation between
persons who have agreed to share the profits of a
business carried on by all or any of them acting for all.
Individuals with common purposes join as partners and
they put together their property ability, skill, knowledge,
etc., for the purpose of making profits
3. CORPORATION
It is a form of private ownership which contains
features of large partnership as well as some features
of the corporation. A corporation is a limited liability
entity doing business owned by multiple shareholders
and is overseen by a board of directors elected by the
shareholders. It is distinct from its owners and can
borrow money, enter into contracts, pay taxes and be
sued. The shareholders gain from the profit through
dividend or appreciation of the stocks but are not
responsible for the companys debts.
4. Public Limited Company
A public enterprise is one that is (1) Owned by the
state, (2) Managed by the state or (3) Owned and
managed by the state.
Public enterprises are controlled and operated by the
Government either solely or in association with
private enterprises. It is controlled and operated by
the Government to produce and supply goods and
services required by the society. Limited companies
which can sell share on the stock exchange are Public
Limited companies. These companies usually write
PLC after their names.
5. Private Limited Companies
These are closely held businesses usually by family,
friends and relatives. Private companies may issue
stock and have shareholders. However, their shares
do not trade on public exchanges and are not issued
through an initial public offering. Shareholders may
not be able to sell their shares without the agreement
of the other shareholders.
Objectives of Firm
1. Maximization of the sales revenue
2. Maximization of firms growth rate
3. Maximization of Managers utility function
4. Making satisfactory rate of Profit
5. Long run Survival of the firm
6. Entry-prevention and risk-avoidance
Conflict in McDonald and Pizza Hut
The rapid growth of franchising during the last two decades
can be explained largely by the mutual benefits the
franchising partners receive. The franchiser increases sales
via an ever-expanding network of franchisees. The parent
collects a fixed percentage of the revenue that each
franchisee earns (as high as 15 to 20 per cent, depending on
the terms of the contract). The individual franchisee
benefits from the acquired know-how of the parent (the
franchiser), its advertising and promotional support and
from the ability to sell a well-established product or service.
Nonetheless, economic conflicts frequently arise between
parent and individual franchisees. Disputes can occur even
in the loftiest of franchising realms: the fast food industry.
The case in point
Conflict in McDonald and Pizza Hut
is the turmoil in the early 1990s between one of the
franchisee outlets of the McDonald and the Mac itself in
the USA. The franchisee outlet was controlled by Chart
House. The key issue centred on the operating autonomy
of the franchisee.
The conflict between parent and individual franchisee were
numerous. First, the parent insisted on periodic remodelling
of the premise, which the franchisee resisted. Secondly, the
franchisee favoured raising prices on best selling items which
the parent opposed it wanted to expand promotional
discounts. Third, the parent sought longer store hours and
multiple express lines to cut down on lunchtime congestion.
Many franchisees resisted both the moves.
Conflict in McDonald and Pizza Hut
Yet another known name in the fast food industry, Pizza
Hut faced a similar problem in the late 1990s in Thailand.
The Bangkok branch of the US food franchisee broke away
from Thailands Pizza Plc., as the later said that after
working together for 20 years, it would no longer work on
the terms of the US franchiser. The US franchiser wanted
certain changes in the operations of the chain in the same
line of Mac franchiser, which the franchisee objected to.
As a result, the franchiser decided to rebrand 116 new
pizza parlours across the country.
How would one explain these conflicts? What is their
economic source? What ca the parent and the franchisee do
to promote cooperation?
Conflict in McDonald and Pizza Hut
Above all, if franchising is a profitable activity, why are there
so many conflicts?

(McDonald levies a franchisee fee of $ 12,500, a royalty of 3
per cent, a marketing fee of 3 per cent.)
Consumers desire for a particular product
depends on
ability to buy
willingness to buy
time period
Demand
Demand is the quantity of a good or service that customers
are willing and able to purchase during a specified period
under a given set of economic conditions. Conditions to be
considered include the price of the good in question, prices
and availability of related goods, expectations of price
changes, consumer incomes, consumer tastes and
preferences, advertising expenditures, and so on. The
amount of the product that consumers are prepared to
purchase, its demand, depends on all these factors.
Demand Schedule
Price
1 $320,000 1000
2 $300,000 2000
3 $280,000 3000
4 $260,000 4000
5 $240,000 5000
6 $220,000 6000
7 $200,000 7000
8 $180,000 8000
Quantity
Demanded Per
Month
Demand
Law of Demand
as the quantity demanded rises, the price falls
as the price rises, the quantity demanded falls
as income rises, the demand for the product rises
as supply rises, the demand rises
there is an inverse relationship between price and
quantity demanded.
Elasticity
Elasticity is a central concept in the theory of supply and
demand. In this context, elasticity refers to how supply and
demand respond to various factors, including price as well as
other stochastic principles. One way to define elasticity is the
percentage change in one variable divided by the percentage
change in another variable (known as arc elasticity, which
calculates the elasticity over a range of values, in contrast
with point elasticity, which uses differential calculus to
determine the elasticity at a specific point). It is a measure of
relative changes.
Concept of Elasticity
Price Elasticity of Demand
Income Elasticity of Demand
Cross Elasticity of Demand
1. Price Elasticity of Demand
Price elasticity of demand is the change in quantity of a
commodity demanded to the change in its price. The degree
of change in the demand of different commodities due to
change in the price of the commodities may vary. In certain
cases, the changes in demand may be at higher rates.
2. Income Elasticity of Demand
Income elasticity of demand is the degree of responsiveness
of demand to the change in income.






3. Cross Elasticity of Demand
The responsiveness of demand to change in prices of related
goods is called cross elasticity of demand (related goods may
be substitutes or complementary goods). In other words, it is
the responsiveness of demand for commodity X to the change
in the price of commodity Y.
Elasticity Demand
elastic
inelastic
unitary
1. Elastic Demand
An elastic demand is one in which the change in quantity
demanded due to a change in price is large.
2. Inelastic Demand
An inelastic demand is one in which the change in quantity
demanded due to a change in price is small.
3. Unitary elasticity
If the elasticity coefficient is equal to one, demand is unitarily
elastic as shown in below figure. For example, a 10% quantity
change divided by 10 % price change is one. This means that a
one percent change in quantity occurs for every one percent
change in price.
Determinants of Demand
Changes of Income
Changes of Taste or Preferences
Changes of Prices of Related Goods
Changes of Price Expectations
Changes of Size of Population


Look at the relationship between the quantity
demanded and each of the determinants in turn
separately price quantity relationship is the demand
curve.
Factors Affecting Elasticity Of Demand
1. Availability of Substitutes
2. Postponement of Consumption
3. Proportion of Expenditure
4. Nature of the Commodity
5. Different Uses of the Commodity
6. The Time Period
7. Change in Income
8. Habits
9. Distribution of Income
10. Price Level
DEMAND FORECASTING
Demand forecasting is the activity of estimating the quantity
of a product or service that consumers will purchase.
Demand forecasting involves techniques including both
informal methods, such as educated guesses, and
quantitative methods, such as the use of historical sales data
or current data from test markets. Demand forecasting may
be used in making pricing decisions, in assessing future
capacity requirements, or in making decisions on whether to
enter a new market.
Necessity for forecasting demand
Often forecasting demand is confused with forecasting sales.
But, failing to forecast demand ignores two important
phenomena. There is a lot of debate in demand-planning
literature about how to measure and represent historical
demand, since the historical demand forms the basis of
forecasting. The main question is whether we should use the
history of outbound shipments or customer orders or a
combination of the two as proxy for the demand.
Demand Forecasting Methods
FORECASTING METHODS
Survey Method Statistical Method
Opinion
Survey
Consumers'
Interview
Trend
projection
Brometric
method
Correlation
& Regression
Complete
enumeration
Sample
survey
End-use
method
Concept of Supply
Supply is defined as the quantity of a product that a producer
is willing and able to supply onto the market at a given price
in a given time period.

Note: Throughout this study companion, the terms firm,
business, producer and seller have the same meaning.

Supply is the amount of a good that producers are willing and
able to offer for sale at various price.
Concept of Supply
The law of Supply
The law of supply
All else equal, the quantity supplied is positively
related to price.
Prices quantity supplied
Prices quantity supplied

Determinants of Supply
Market price
Input prices
Technology (new production methods)
Expectations
Number of producers
Equilibrium of Supply and Demand
A situation in which the supply of an item is exactly equal to
its demand. Since there is neither surplus nor shortage in the
market, price tends to remain stable in this situation.
Equilibrium of Supply and Demand
Quantity
Price
$2.00
0 1 2 3 4 5 6 7 8 9 10 11 12 13
Equilibrium
quantity
Equilibrium price
Equilibrium
Supply
Demand
A situation in which the supply of an item is exactly equal to
its demand. Since there is neither surplus nor shortage in the
market, price tends to remain stable in this situation.
THEORY OF FIRM
The theory of the firm consists of a number of economic
theories that describe the nature of the firm, company, or
corporation, including its existence, behaviour, structure, and
relationship to the market. In simplified terms, the theory of
the firm aims to answer these questions:
1. Existence
2. Boundaries
3. Organization
4. Heterogeneity of firm actions / performances
Production
Production refers to the transformation of inputs or
resources into outputs or goods and services. Production
process is a process in which economic resources or inputs
(composed of natural resources like labour, land and capital
equipment) are combined by entrepreneurs to create
economic goods and services (outputs or products).
Production
Theory of Production
Production theory generally deals with quantitative
relationships, that is, technical and technological
relationships between inputs, especially labour and capital,
and between inputs and outputs.
An input is a good or service that goes into the production
process. As economists refer to it, an input is simply anything
which a firm buys for use in its production process. An output,
on the other hand, is any good or service that comes out of a
production process.

In the managers effort to minimise production costs, the
fundamental questions faces are:
(a) How can production be optimized or costs minimised?
(b) What will be the behaviour of output as inputs increase?
(c) How does technology help in reducing production costs?
(d) How can the least-cost combination of inputs be achieved?
(e) Given the technology, what happens to the rate of return
when more plants are added to the firm?
Short Run Production Function
The short run is defined in economics as a period of time
where at least one factor of production is assumed to be in
fixed supply i.e. it cannot be changed. We normally assume
that the quantity of capital inputs (e.g. plant and machinery)
is fixed and that production can be altered by suppliers
through changing the demand for variable inputs such as
labour, components, raw materials and energy inputs. Often
the amount of land available for production is also fixed.
The time periods used in textbook economics are somewhat
arbitrary because they differ from industry to industry. The
short run for the electricity generation industry or the
telecommunications sector varies from that appropriate for
newspaper and magazine publishing and small-scale
production of foodstuffs and beverages.
Long Run Production
In the long-run, both capital (K) and labour (L) is included in
the production function, so that the long-run production
function can be written as:
A production function is based on the following assumptions:
(i) perfect divisibility of both inputs and output;
(ii) there are only two factors of production capital (K) and
labour (L);
(iii) limited substitution of one factor for the other;
(iv) a given technology.
COST CONCEPT
The term cost simply means cost of production. It is the
expenses incurred in the production of goods. It is the
sum of all money-expenses incurred by a firm in order to
produce a commodity. Thus it includes all expenses from
the time the raw material are bought till the finished
products reach the wholesaler.
A managerial economist must have a proper
understanding of the different cost concept which are
essential for clear business thinking. The cost concept
which are relevant to business operation and decision
can be grouped on the basis of their propose under two
overlapping categories:
1. Concept used for accounting purpose
2. Concept used in economics analysis of the business
THEORY OF COST
Business decisions are generally taken based on the
monetary values of inputs and outputs. Note that the
quantity of inputs multiplied by their respective unit
prices will give the monetary value or the cost of
production. Production cost is an important factor in all
business decisions, especially those decisions
concerning:
(a) the location of the weak points in production
management;
(b) cost minimisation
(c) finding the optimal level of output;
(d) determination of price and dealers margin; and,
(e) estimation of the costs of business operation.
Various Types of Costs
1. Opportunity Cost vs Outlay Cost
2. Past Cost vs Future Cost
3. Traceable vs Common Cost
4. Out-of-Pocket vs Book-Cost
5. Incremental Cost vs Sunk Cost
6. Escapable vs Unavoidable Cost
7. Shut Down and Abandonment Costs
8. Urgent and Postponable Costs
9. Controllable and Non-Controllable costs
10. Replacement vs Historical Cost
11. Private and Social Cost
12. Short-run and Long-run Costs
13. Fixed cost and Variable Cost

1. Opportunity Cost vs Outlay Cost
Outlay costs are those costs which involve financial
expenditure at some time and hence are recorded in the
books of account. Opportunity costs are those costs of
displaced alternatives. They represent only sacrificed
alternatives and hence are not recorded in any financial
account. The economic principle behind cost in the
modern sense is not the pain or strain involved, nor the
money cost involved in producing a thing.
2. Past Cost vs Future Cost
Past costs, as the name itself implies, are those costs
which have been actually incurred in the past and find
entry in the books of accounts. Those costs are incurred
by the firm at the time of purchase of various items of
plant equipment, etc.
From the decision-making point of view, future cost is more
important. Future costs are those costs which are likely to be
incurred in future periods or to be very precise, the costs that
are contemplated to be incurred in future periods. Since
future is uncertain, these costs are only estimations and they
are not accurate figures.
3. Traceable vs Common Costs
When the cost can be easily identified with an unit of
operation, it is called traceable cost or direct can. For
example, when the total cost of production per unit has
to be arrived at, it has to be broken into cost of raw
materials, cost of labour, etc.
Non-traceable costs are called common costs which are not
traceable to any one unit of operation. They cannot be
attributed to a product, a department or a process.
4. Out-of-Pocket vs Book-Costs
Out-of-pocket cost denotes immediate current payment.
Hence it is called cash cost. For example, the cost of
raw material or the wages to labour require immediate
payment. On the other hand, book-cost is one which
need not be immediately made. For instance,
depreciation does not require immediate cash payment
and it is not taken into the current expenditure account.
5. Fixed Cost and Variable Cost
Fixed and variable costs are not two distinct categories;
rather they are the two ends of a continuum. In the long-
run all costs become variable and hence this distinction
prevails mainly for a short period. It is valid only for a
particular set of circumstances. However, this distinction
is useful in evaluating the effect of short-run changes in
volume, upon costs and profits.

6. Incremental Cost vs Sunk Cost
Incremental cost refers to the additional cost incurred due to
a change in the level or nature of activity. A change in the
activity connotes addition of a product, change in distribution
channel, expansion of market, etc. Incremental cost are also
known as differential costs. Incremental cost measures the
difference between old and new total costs.
Sunk costs are the costs which remain unaltered even after a
change in the level or nature of business activity. These are
known as specific costs. The best of the sunk cost is
depreciation. Incremental cost are very useful in business
decision, but sunk costs appear to be irrelevant to managerial
decisions, as they do not change with the changing business
activity.
7. Urgent and Postponable Costs
As the name itself implies, urgent costs are those costs which
are incurred to keep the continuance of operations of the
firm. It is the money spent on materials and labour.
Postponable costs can be post-poned temporarily. For
example, the cost on maintenance of building can be
postponded. Painting and white washing can be postponed.
COST AND OUTPUT RELATIONSHIP
Now you will also come to know about cost and output
relationship. Cost and revenue are the two major factors
that a profit maximizing firm needs to monitor
continuously. It is the level of cost relative to revenue
that determines the firms overall profitability. In order to
maximize profits, a firm tries to increase its revenue and
lower its cost. While the market factors determine the
level of revenue to a great extent, the cost can be
brought down either by producing the optimum level of
output using the least cost combination of inputs, or
increasing factor productivities, or by improving the
organizational efficiency. The firms output level is
determined by its cost. The producer has to pay for
factors of production for their services.