Business Economics, I UNIT, MBA I SEM, JNTUH

 UNIT I: Introduction to Business Economics

Economics:

Economics is a study of human activity both at individual and national level. The economists of early age treated economics merely as the science of wealth. The reason for this is clear. Every one of us in involved in efforts aimed at earning money and spending this money to satisfy our wants such as food, Clothing, shelter, and others. Such activities of earning and spending money are called“Economic activities”. It was only during the eighteenth century that Adam Smith, the Father of Economics, defined economics as the study of nature and uses of national wealth’.

Dr. Alfred Marshall, one of the greatest economists of the nineteenth century, writes “Economics is a study of man’s actions in the ordinary business of life: it enquires how he gets his income and how he uses it”. Thus, it is one side, a study of wealth; and on the other, and more important side; it is the study of man. As Marshall observed, the chief aim of economics is to promote ‘human welfare’, but not wealth. 

The definition given by AC Pigou endorses the opinion of Marshall. Pigou defines Economics as “the study of economic welfare that can be brought directly and indirectly, into relationship with the measuring rod of money”.

Prof. Lionel Robbins defined Economics as “the science, which studies human behaviour as a relationship between ends and scarce means which have alternative uses”. With this, the focus of economics shifted from ‘wealth’ to human behaviour’.

Lord Keynes defined economics as ‘the study of the administration of scarce means and the determinants of employments and income”.

Microeconomics

The study of an individual consumer or a firm is called microeconomics (also called the Theory of Firm). Micro means ‘one millionth’. Microeconomics deals with behavior and problems of single individual and of micro organization. Managerial economics has its roots in microeconomics and it deals with the micro or individual enterprises. It is concerned with the application of the concepts such as price theory, Law of Demand and theories of market structure and so on.

Macroeconomics

The study of ‘aggregate’ or total level of economics activity in a country is called macroeconomics. It studies the flow of economics resources or factors of production (such as land, labour, capital, organisation and technology) from the resource owner to the business firms and then from the business firms to the households. It deals with total aggregates, for instance, total national income total employment, output and total investment. It studies the interrelations among various aggregates and examines their nature and behaviour, their determination and causes of fluctuations in the. It deals with the price level in general, instead of studying the prices of individual commodities. It is concerned with the level of employment in the economy. It discusses aggregate consumption, aggregate investment, price level, and payment, theories of employment, and so on.

Though macroeconomics provides the necessary framework in term of government policies etc., for the firm to act upon dealing with analysis of business conditions, it has less direct relevance in the study of theory of firm.

Management

Management is the science and art of getting things done through people in formally organized groups. It is necessary that every organisation be well managed to enable it to achieve its desired goals. Management includes a number of functions: Planning, organizing, staffing, directing, and controlling. The manager while directing the efforts of his staff communicates to them the goals, objectives, policies, and procedures; coordinates their efforts; motivates them to sustain their enthusiasm; and leads them to achieve the corporate goals.

Business Economics or Managerial Economics

Introduction

Managerial Economics as a subject gained popularity in USA after the publication of the book “Managerial Economics” by Joel Dean in 1951.

Managerial Economics refers to the firm’s decision making process. It could be also interpreted as “Economics of Management” or “Economics of Management”. Managerial Economics is also called as “Industrial Economics” or “Business Economics”.

As Joel Dean observes managerial economics shows how economic analysis can be used in formulating polices.

Meaning & Definition:

In the words of E. F. Brigham and J. L. Pappas Managerial Economics is “the applications of economics theory and methodology to business administration practice”.

Managerial Economics bridges the gap between traditional economics theory and real business practices in two days. First it provides a number of tools and techniques to enable the manager to become more competent to take decisions in real and practical situations. Secondly it serves as an integrating course to show the interaction between various areas in which the firm operates.

C. I. Savage & T. R. Small therefore believes that managerial economics “is concerned with business efficiency”.

M. H. Spencer and Louis Siegelman explain the “Managerial Economics is the integration of economic theory with business practice for the purpose of facilitating decision making and forward planning by management”.

It is clear, therefore, that managerial economics deals with economic aspects of managerial decisions of with those managerial decisions, which have an economics contest. Managerial economics may therefore, be defined as a body of knowledge, techniques and practices which give substance to those economic concepts which are useful in deciding the business strategy of a unit of management.

Managerial economics is designed to provide a rigorous treatment of those aspects of economic theory and analysis that are most use for managerial decision analysis says J. L. Pappas and E. F. Brigham.

Managerial Economics, therefore, focuses on those tools and techniques, which are useful in decision-making.

Nature of Managerial Economics

Managerial economics is, perhaps, the youngest of all the social sciences. Since it originates from Economics, it has the basis features of economics, such as assuming that other things remaining the same

The features of managerial economics are explained as below:

(a) Close to microeconomics: Managerial economics is concerned with finding the

solutions for different managerial problems of a particular firm. Thus, it is more

close to microeconomics.

(b) Operates against the backdrop of macroeconomics: The macroeconomics

conditions of the economy are also seen as limiting factors for the firm to operate. In other words, the managerial economist has to be aware of the limits set by the

macroeconomics conditions such as government industrial policy, inflation and so

on.

(c) Normative statements: A normative statement usually includes or implies the words ‘ought’ or ‘should’. They reflect people’s moral attitudes and are expressions of what a team of people ought to do. For instance, it deals with statements such as ‘Government of India should open up the economy. Such statement are based on value judgments and express views of what is ‘good’ or ‘bad’, ‘right’ or ‘ wrong’. One problem with normative statements is that they cannot to verify by looking at the facts, because they mostly deal with the future. Disagreements about such statements are usually settled by voting on them.

(d) Prescriptive actions: Prescriptive action is goal oriented. Given a problem and the objectives of the firm, it suggests the course of action from the available alternatives for optimal solution. If does not merely mention the concept, it also explains whether the concept can be applied in a given context on not. For instance, the fact that variable costs are marginal costs can be used to judge the feasibility of an export order.

(e) Applied in nature: ‘Models’ are built to reflect the real life complex business situations and these models are of immense help to managers for decision-making. The different areas where models are extensively used include inventory control, optimization, project management etc. In managerial economics, we also employ case study methods to conceptualize the problem, identify that alternative and determine the best course of action.

(f) Offers scope to evaluate each alternative: Managerial economics provides an opportunity to evaluate each alternative in terms of its costs and revenue. The managerial economist can decide which is the better alternative to maximize the profits for the firm.

(g) Interdisciplinary: The contents, tools and techniques of managerial economics are drawn from different subjects such as economics, management, mathematics, statistics, accountancy, psychology, organizational behavior, sociology and etc.

(h) Assumptions and limitations: Every concept and theory of managerial economics is based on certain assumption and as such their validity is not universal. Where there is change in assumptions, the theory may not hold good at all.

Scope of Business Economics 

However, then the following fields may be considered under business economics:

1. Demand Analysis and Forecasting.

2. Cost and Production Analysis.

3. Pricing Decisions, Policies and Practices.

4. Profit Management.

5. Capital Management.

Let us make in-depth study of these methods:

1. Demand Analysis and Forecasting:

The foremost aspect regarding its scope is in demand analysis and forecasting. A business firm is an economic unit which transforms productive resources into saleable goods. Since all output is meant to be sold, accurate estimates of demand help a firm in minimizing its costs of production and storage.

A firm must decide its total output before preparing its production schedule and deciding on the resources to be employed. Demand forecasts serves as a guide to the management for maintaining its market share in competition with its rivals, thereby securing its profit. Thus, demand analysis facilitates the identification of the various factors affecting the demand for a firm’s product. This, in turn helps the firm in manipulating the demand for its output.

In fact, demand forecasts are the starting point for a firm’s planning and decision-making. This deals with the basic tools of demand analysis i.e.; Demand Determinants, Demand Distinctions and Demand Forecasting etc.

2. Cost and Production Analysis:

A firm’s profitability depends much on its costs of production. A wise manager would prepare cost estimates of a range of output, identify the factors causing variations in costs and choose the cost-minimising output level, taking also into consideration the degree of uncertainty in production and cost calculations. Production processes are under the charge of engineers but the business manager works to carry out the production function analysis in order to avoid wastages of materials and time. Sound pricing policies depend much on cost control.

The main topics discussed under cost and production analysis are:

Cost concepts, cost-output relationships, Economies and Diseconomies of scale and cost control.

3. Pricing Decisions, Policies and Practices:

Another task before a business manager is the pricing of a product. Since a firm’s income and profit depend mainly on the price decision, the pricing policies and all such decisions are to be taken after careful analysis of the nature of the market in which the firm operates. The important topics covered in this field of study are: Market Structure Analysis, Pricing Practices and Price Forecasting.

4. Profit Management:

Each and every business firms are tended for earning profit; it is profit which provides the chief measure of success of a firm in the long period. Economists tell us that profits are the reward for uncertainty bearing and risk taking. A successful business manager is one who can form more or less correct estimates of costs and revenues at different levels of output. The more successful a manager is in reducing uncertainty, the higher are the profits earned by him. It is therefore, profit-planning and profit measurement that constitutes the most challenging area of business economics.

5. Capital Management:

Still another most challenging problem for a modern business manager is of planning capital investment. Investments are made in the plant and machinery and buildings which are very high. Therefore, capital management requires top-level decisions. It means capital management i.e., planning and control of capital expenditure. It deals with Cost of capital, Rate of Return and Selection of projects.

Relationship with other Disciplines 

1. Managerial Economics and Economics:

Managerial Economics is economics applied to decision making. It is a special branch of economics, bridging the gap between pure economic theory and manage­rial practice. Economics has two main branches—micro-economics and macro-economics.

2. Managerial Economics and Theory of Decision Making:

The theory of decision making is relatively a new subject that has a significance for managerial economics. In the process of management such as planning, organising, leading and controlling, decision making is always essential. Decision making is an integral part of today’s business management. A manager faces a number of problems connected with his/her business such as production, inventory, cost, marketing, pricing, investment and personnel.

Economist are interested in the efficient use of scarce resources hence they are naturally interested in business decision problems and they apply economics in management of business problems. Hence managerial economics is economics applied in decision making. 

3. Managerial Economics and Operations Research:

Mathematicians, statisticians, engineers and others join together and developed models and analytical tools which have grown into a specialised subject known as operation research. The basic purpose of the approach is to develop a scientific model of the system which may be utilised for policy making.

The development of techniques and concepts such as Linear Programming, Dynamic Programming, Input-output Analysis, Inventory Theory, Information Theory, Probability Theory, Queuing Theory, Game Theory, Decision Theory and Symbolic Logic.

4. Managerial Economics and Statistics:

Statistics is important to managerial economics. It provides the basis for the empirical testing of theory. It provides the individual firm with measures of appropriate func­tional relationship involved in decision making. Statistics is a very useful science for business execu­tives because a business runs on estimates and probabilities.

Statistics supplies many tools to managerial economics. Suppose forecasting has to be done. For this purpose, trend projections are used. Similarly, multiple regression technique is used. In managerial economics, measures of central tendency like the mean, median, mode, and measures of dispersion, correlation, regression, least square, estimators are widely used. 

Statistical tools are widely used in the solution of managerial problems. For eg. sampling is very useful in data collection. Managerial economics makes use of correlation and multiple regression in business problems involving some kind of cause and effect relationship.

5. Managerial Economics and Accounting:

Managerial economics is closely related to accounting. It is recording the finan­cial operation of a business firm. A business is started with the main aim of earning profit. Capital is invested / employed for purchasing properties such as building, furniture, etc and for meeting the current expenses of the business.

Goods are bought and sold for cash as well as credit. Cash is paid to credit sellers. It is received from credit buyers. Expenses are met and incomes derived. This goes on the daily routine work of the business. The buying of goods, sale of goods, payment of cash, receipt of cash and similar dealings are called business transactions.

The business transactions are varied and multifarious. This has given rise to the necessity of recording business transaction in books. They are writ­ten in a set of books in a systematic manner so as to facilitate proper study of their results.

There are three classes of accounts:

(i) Personal account,

(ii) Property accounts, and

(iii) Nominal accounts.

Man­agement accounting provides the accounting data for taking business decisions. The accounting tech­niques are very essential for the success of the firm because profit maximisation is the major objective of the firm.

6. Managerial Economics and Mathematics:

Mathematics is another important subject closely related to managerial economics. For the derivation and exposition of economic analysis, we require a set of mathematical tools. Mathematics has helped in the development of economic theories and now mathematical economics has become a very important branch of economics.

Mathematical approach to economic theories makes them more precise and logical. For the estimation and prediction of economic factors for decision mak­ing and forward planning, mathematical method is very helpful. The important branches of math­ematics generally used by a managerial economist are geometry, algebra and calculus.

The mathemati­cal concepts used by the managerial economists are the logarithms and exponential, vectors and deter­minants, input-out tables. Operations research which is closely related to managerial economics is mathematical in character.

7. Managerial Economics and Marketing:

Managerial Economics helps marketing in two ways. First, as a basic discipline, providing tools and concepts of analysis and second, as an integrating area, providing its judgement on the optimum sales volume under the given cost function of a firm, market structure, and the objective function to be optimized. How much to sell under given circumstances is answered by an economist and how to sell the desired amount of output is the domain of the marketing manager. Sometimes, selling more than what is desired may harm the interest of the firm. It has, however, the sanction neither of Economics nor of marketing principles as both stresses on the protection of long run interests of the firm.

Economics is of a great help to marketing in the sphere of pricing. Of the three basic aspects of pricing viz. value theory, price theory, and pricing techniques, the first two are the exclusive domain of Economics, while the third one forms part of both Managerial Economics and marketing. In the case of pricing techniques, there are varying practices in different organizations. In many pricing is handled by the accounts staff such as chartered accountants and company secretaries. There are several areas of marketing which are totally or heavily dependent on economic theory. These are:

* Theory of the Firm

* Concepts of goals and goal formulation

* Market structures

* Pricing

8. Managerial Economics and Production Management:

Production is defined as the creation of utility by transforming input into output. It usually refers to manufacturing activity and the term operations are used to denote a wider meaning, encompassing all economic activity which creates economic utility. Operations personnel have four basic responsibilities to fulfill while producing a firm's products or services:

* Supply of quantities,

* Maintenance of time-bound deliveries,

* Fulfillment of quality requirement, and

* Economizing production operations.

For this, the personnel have to deal with a number of inter-related areas including production planning, production control, quality control, methods analysis, materials handling, plant layout, inventory control, work management, and wage incentives. A knowledge of Economics would help operations personnel not only to economize their production operations but also help them

* To monitor and analyse the input market,

* To monitor market maturity, technical maturity, and competitive maturity of products being produced,

* To have better coordination with the R & D department with respect to product and process innovation, and

* To take decisions on production targets.

Managerial Economics and Personnel Management:

A human resource manager has to concern himself with two types of problems: (i) an effective utilization of human resources in terms of costs and productivity and (ii) improvement in the terms and conditions of employment as an adjunct to employee satisfaction. Manpower planning, at the micro level, is another important function of an HRD manager wherein a firm ensures that it has the right number and the right kind of people, at the right places, at the right time, doing work for which they are economically most useful.

Managerial economics can help personnel management by analysing the economic and financial aspects of personnel problems both in relation to the economic welfare of the firm and to the prevailing environment of the economy as a whole. It explains the economic implications of policies and strategies and judges their consistency with respect to organizational objectives as well as internal and external constraints. It can provide a safety range for wage negotiations with trade unions. Business forecasting could provide information for devising employment norms of the sales force

Business Decision Making Process

Decision making is the process of making choices by identifying a decision, gathering information, and assessing alternative resolutions.

Using a step-by-step decision-making process can help you make more deliberate, thoughtful decisions by organizing relevant information and defining alternatives. This approach increases the chances that you will choose the most satisfying alternative possible.

Step 1: Identify the decision

You realize that you need to make a decision. Try to clearly define the nature of the decision you must make. This first step is very important.

Step 2: Gather relevant information

Collect some pertinent information before you make your decision: what information is needed, the best sources of information, and how to get it. This step involves both internal and external “work.” Some information is internal: you’ll seek it through a process of self-assessment. Other information is external: you’ll find it online, in books, from other people, and from other sources.

Step 3: Identify the alternatives

As you collect information, you will probably identify several possible paths of action, or alternatives. You can also use your imagination and additional information to construct new alternatives. In this step, you will list all possible and desirable alternatives.

Step 4: Weigh the evidence

Draw on your information and emotions to imagine what it would be like if you carried out each of the alternatives to the end. Evaluate whether the need identified in Step 1 would be met or resolved through the use of each alternative. As you go through this difficult internal process, you’ll begin to favor certain alternatives: those that seem to have a higher potential for reaching your goal. Finally, place the alternatives in a priority order, based upon your own value system.

Step 5: Choose among alternatives

Once you have weighed all the evidence, you are ready to select the alternative that seems to be best one for you. You may even choose a combination of alternatives. Your choice in Step 5 may very likely be the same or similar to the alternative you placed at the top of your list at the end of Step 4.

Step 6: Take action

You’re now ready to take some positive action by beginning to implement the alternative you chose in Step 5.

Step 7: Review your decision & its consequences

In this final step, consider the results of your decision and evaluate whether or not it has resolved the need you identified in Step 1. If the decision has not met the identified need, you may want to repeat certain steps of the process to make a new decision. For example, you might want to gather more detailed or somewhat different information or explore additional alternatives.

Role of a Managerial Economist

A managerial economist plays a vital role in the decision-making process of an organization. He/she is responsible for assisting the top management of an organization to make efficient business decisions. A managerial economist is also called business economist or economic advisor. He/she makes use of a number of complicated and specialized techniques required in the process of business decision making.

Apart from this, he/she is also accountable for analyzing the internal and external factors that affect the business environment of an organization. 

A. The internal factors are those factors that are under the control of an organization. These factors include:

1. formulation of price policy

2. Expansion or contraction of business

3. Level of efficiency 

4. Determination of wage policy.

B. External factors are those factors that are uncontrollable of an organisation. These factors include:

1. Economic policies of the government

2. Fluctuations in economic conditions

3. Labor laws. 

All these internal and external factors directly or indirectly influence the performance of an organization. Therefore, a managerial economist needs to carefully study and analyze these factors.

Besides this, a managerial economist has various functions in an organization, which are as follows:

a. Forecasting sales of an organization

b. Performing individual market research

c. Performing economic analysis of rival organizations

d. Analyzing the pricing policy of the industry; thereby formulating the pricing policy of the organization

e. Performing investment analysis

f. Assisting the top management in making decisions related to trade and public relations and foreign exchange

g. Performing capital budgeting and production planning

h. Measuring the earning capacity of an organization

i. Keeping the top management informed regarding any changes in the business environment.

6 Basic Principles of Managerial Economics

Managerial Economics is both conceptual and metrical. Before the substantive decision problems which fall within the purview of managerial economics are discussed, it is useful to identify and under­stand some of the basic concepts underlying the subject.

Economic theory provides a number of con­cepts and analytical tools which can be of considerable and immense help to a manager in taking many decisions and business planning. This is not to say that economics has all the solutions. In fact, actual problem solving in business has found that there exists a wide disparity between economic theory of the firm and actual observed practice.

Therefore, it would be useful to examine the basic tools of managerial economics and the nature and extent of gap between the economic theory of the firm and the managerial theory of the firm. The contribution of economics to managerial economics lies in certain principles which are basic to managerial economics. There are six basic principles of managerial economics.

They are:

1. The Incremental Concept

2. The Concept of Time Perspective

3. The Opportunity Cost Concept

4. The Discounting Concept

5. The Equi-marginal Concept

6. Risk and Uncertainty

1. The Incremental Concept:

The incremental concept is probably the most important concept in economics and is certainly the most frequently used in Managerial Economics. Incremental concept is closely related to the mar­ginal cost and marginal revenues of economic theory.

The two major concepts in this analysis are incremental cost and incremental revenue. Incremental cost denotes change in total cost, whereas incremental revenue means change in total revenue resulting from a decision of the firm.

The incremental principle may be stated as follows:

A decision is clearly a profitable one if

(i) It increases revenue more than costs.

(ii) It decreases some cost to a greater extent than it increases others.

(iii) It increases some revenues more than it decreases others.

(iv) It reduces costs more than revenues.

Illustration:

Some businessmen hold the view that to make an overall profit, they must make a profit on every job. The result is that they refuse orders that do not cover full costs plus a provision of profit. This will lead to rejection of an order which prevents short run profit. A simple problem will illustrate this point. Suppose a new order is estimated to bring in an additional revenue of Rs. 10,000. The costs are estimated as under:

Labour Rs. 3,000

Materials Rs. 4,000

Overhead charges Rs. 3,600

Selling and administrative expenses Rs. 1,400

Full Cost Rs.12, 000

The order appears to be unprofitable. For it results in a loss of Rs. 2,000. However, suppose there is idle capacity which can be utilised to execute this order. If order adds only Rs. 1,000 to overhead charges, and Rs. 2000 by way of labour cost because some of the idle workers already on the pay roll will be deployed without added pay and no extra selling and administrative costs, then the actual incremental cost is as follows:

Labour Rs. 2,000

Materials’ Rs. 4,000

Overhead charges Rs. 1,000

Total Incremental Cost Rs. 7,000

Thus there is a profit of Rs. 3,000. The order can be accepted on the basis of incremental reasoning. Incremental reasoning does not mean that the firm should accept all orders at prices which cover merely their incremental costs.

The concept is mainly used by the progressive concerns. Even though it is a widely followed concept, it has certain limitations:

(a) The concept cannot be generalised because observed behaviour of the firm is always vari­able.

(b) The concept can be applied only when there is excess capacity in the concern.

(c) The concept is applicable only during the short period.

2. Concept of Time Perspective:

The time perspective concept states that the decision maker must give due consideration both to the short run and long run effects of his decisions. He must give due emphasis to the various time periods. It was Marshall who introduced time element in economic theory.

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 main problem in decision making is to establish the right balance between long run and short run.

In the short period, the firm can change its output without changing its size. In the long period, the firm can change its output by changing its size. In the short period, the output of the industry is fixed because the firms cannot change their size of operation and they can vary only variable factors. In the long period, the output of the industry is likely to be more because the firms have enough time to increase their sizes and also use both variable and fixed factors.

In the short period, the average cost of a firm may be either more or less than its average revenue. In the long period, the average cost of the firm will be equal to its average revenue. A decision may be made on the basis of short run considerations, but may as time elapses have long run repercussions which make it more or less profitable than it at first appeared.

Illustration:

The firm which ignores the short run and long run considerations will meet with failure can be explained with the help of the following illustration. Suppose, a firm having a temporary idle capacity, received an order for 10,000 units of its product. The customer is willing to pay only Rs. 4.00 per unit or Rs. 40,000 for the whole lot but no more.

The short run incremental cost (ignoring the fixed cost) is only Rs. 3.00. Therefore, the contribution to overhead and profit is Rs. 1.00 per unit (or Rs. 10, 000 for the lot). If the firm executes this order, it will have to face the following repercussion in the long run:

(a) It may not be able to take up business with higher contributions in the long run.

(b) The other customers may also demand a similar low price.

(c) The image of the firm may be spoilt in the business community.

(d) The long run effects of pricing below full cost may be more than offset any short run gain.

Haynes, Mote and Paul refer to the example of a printing company which never quotes prices below full cost due to the following reasons:

(1) The management realized that the long run repercus­sions of pricing below full cost would more than offset any short run gain.

(2) Reduction in rates for some customers will bring undesirable effect on customer goodwill. Therefore, the managerial econo­mist should take into account both the short run and long run effects as revenues and costs, giving appropriate weight to most relevant time periods.

3. The Opportunity Cost Concept:

Both micro and macro economics make abundant use of the fundamental concept of opportunity cost. In everyday life, we apply the notion of opportunity cost even if we are unable to articulate its significance. In Managerial Economics, the opportunity cost concept is useful in decision involving a choice between different alternative courses of action.

Resources are scarce, we cannot produce all the commodities. For the production of one com­modity, we have to forego the production of another commodity. We cannot have everything we want. We are, therefore, forced to make a choice.

Opportunity cost of a decision is the sacrifice of alternatives required by that decision. Sacrifice of alternatives is involved when carrying out a decision requires using a resource that is limited in supply with the firm. Opportunity cost, therefore, represents the benefits or revenue forgone by pursuing one course of action rather than another.

The concept of opportunity cost implies three things:

1. The calculation of opportunity cost involves the measurement of sacrifices.

2. Sacrifices may be monetary or real.

3. The opportunity cost is termed as the cost of sacrificed alternatives.

Opportunity cost is just a notional idea which does not appear in the books of account of the company. If resource has no alternative use, then its opportunity cost is nil.

In managerial decision making, the concept of opportunity cost occupies an important place. The economic significance of opportunity cost is as follows:

1. It helps in determining relative prices of different goods.

2. It helps in determining normal remuneration to a factor of production.

3. It helps in proper allocation of factor resources.

4. Equi-Marginal Concept:

One of the widest known principles of economics is the equi-marginal principle. The principle states that an input should be allocated so that value added by the last unit is the same in all cases. This generalisation is popularly called the equi-marginal.

Let us assume a case in which the firm has 100 unit of labour at its disposal. And the firm is involved in five activities viz., А, В, C, D and E. The firm can increase any one of these activities by employing more labour but only at the cost i.e., sacrifice of other activities.

An optimum allocation cannot be achieved if the value of the marginal product is greater in one activity than in another. It would be, therefore, profitable to shift labour from low marginal value activity to high marginal value activity, thus increasing the total value of all products taken together.

If, for example, the value of the marginal product of labour in activity A is Rs. 50 while that in activity В is Rs. 70 then it is possible and profitable to shift labour from activity A to activity B. The optimum is reached when the values of the marginal product is equal to all activities. This can be expressed symbolically as follows:

VMPLA = VMPLB = VMPLC = VMPLD = VMPLE

Where VMP = Value of Marginal Product.

L = Labour

ABCDE = Activities i.e., the value of the marginal product of labour employed in A is equal to the value of the marginal product of the labour employed in В and so on. The equimarginal principle is an extremely practical notion.

It is behind any rational budgetary procedure. The principle is also applied in investment decisions and allocation of research expenditures. For a consumer, this concept implies that money may be allocated over various commodities such that marginal utility derived from the use of each commodity is the same. Similarly, for a producer this concept implies that resources be allocated in such a manner that the marginal product of the inputs is the same in all uses.

5. Discounting Concept:

This concept is an extension of the concept of time perspective. Since future is unknown and incalculable, there is lot of risk and uncertainty in future. Everyone knows that a rupee today is worth more than a rupee will be two years from now. This appears similar to the saying that “a bird in hand is more worth than two in the bush.” This judgment is made not on account of the uncertainty surround­ing the future or the risk of inflation.

It is simply that in the intervening period a sum of money can earn a return which is ruled out if the same sum is available only at the end of the period. In technical parlance, it is said that the present value of one rupee available at the end of two years is the present value of one rupee available today. The mathematical technique for adjusting for the time value of money and computing present value is called ‘discounting’.

The following example would make this point clear. Suppose, you are offered a choice of Rs. 1,000 today or Rs. 1,000 next year. Naturally, you will select Rs. 1,000 today. That is true because future is uncertain. Let us assume you can earn 10 per cent interest during a year.

You may say that I would be indifferent between Rs. 1,000 today and Rs. 1,100 next year i.e., Rs. 1,100 has the present worth of Rs. 1,000. Therefore, for making a decision in regard to any investment which will yield a return over a period of time, it is advisable to find out its ‘net present worth’. Unless these returns are discounted and the present value of returns calculated, it is not possible to judge whether or not the cost of undertaking the investment today is worth.

The concept of discounting is found most useful in managerial economics in decision problems pertaining to investment planning or capital budgeting.

The formula of computing the present value is given below:

V = A/1+i

where:

V = Present value

A = Amount invested Rs. 100

i = Rate of interest 5 per cent

V = 100/1+.05 = 100/1.05 =Rs. 95.24

Similarly, the present value of Rs. 100 which will be discounted at the end of 2 years: A 2 years V = A/ (1+i) 2

For n years V = A/ (1+i) n

6. Risk and Uncertainty:

Managerial decisions are actions of today which bear fruits in future which is unforeseen. Future is uncertain and involves risk. The uncertainty is due to unpredictable changes in the business cycle, structure of the economy and government policies.

This means that the management must assume the risk of making decisions for their institution in uncertain and unknown economic conditions in the future. Firms may be uncertain about production, market prices, strategies of rivals, etc. Under uncer­tainty, the consequences of an action are not known immediately for certain.

Economic theory generally assumes that the firm has perfect knowledge of its costs and demand relationships and of its environment. Uncertainty is not allowed to affect the decisions. Uncertainty arises because producers simply cannot foresee the dynamic changes in the economy and hence, cost and revenue data of their firms with reasonable accuracy.

Also dynamic changes are external to the firm, they are beyond the control of the firm. The result is that the risks from unexpected changes in a firm’s cost and revenue data cannot be estimated and therefore the risks from such changes cannot be insured. But products must attempt to predict the future cost and revenue data of their firms and determine the output and price policies.

The managerial economists have tried to take account of uncertainty with the help of subjective probability. The probabilistic treatment of uncertainty requires formulation of definite subjective expec­tations about cost, revenue and the environment. The probabilities of future events are influenced by the time horizon, the risk attitude and the rate of change of the environment.