Nature Of Managerial Economics 6k2x5u

NATURE OF MANAGERIAL ECONOMICS The nature of managerial economics is defined by factors such as it. 1.Is essentially microeconomic in nature; Microeconomics is the branch of economics that deals with the individual units of an economy. These individual units may be either a person or a firm or a group of persons or firms. Since managerial economics is concerned with the analysis of and finding optimal solutions to decision-making problems of businesses/firms, it is essentially microeconomic in nature. 2; Is pragmatic .Managerial economics is a practical subject. It goes beyond providing rigid and abstract theoretical frameworks for managers. While at some places it avoids difficult abstract issues of economic theories, at some others, it incorporates complications ignored by economic theory in order to analyze the overall situation in which managerial decision-making takes place. Thus, it is pragmatic. 3 Belongs to normative economics, i.e. besides being descriptive, it is also

prescriptive .Economics can also be classified as positive or normative. Positive economics describes what is, i.e. observed economic phenomenon. Normative economics on the other hand prescribes what ought to be, i.e. it distinguishes the ideal from the actual. Managerial economics is prescriptive, not merely descriptive.

4.Is conceptual in nature Managerial economics is based on a sound framework of economic concepts. Its subject matter is not an arbitrary collection of prescriptions. It aims to analyze business problems on the basis of established concepts. Thus, it is conceptual in nature. 5. Utilizes some theories of macroeconomics When all individual matters are added up and it becomes a matter of analyzing the problems of the economy or the nation as a whole, we call it macroeconomics. An individual economic unit operates in an environment. It affects and is affected by the environment. Most aspects related to this environment are the subject matter of macroeconomics. Managerial economics does not prescribe solutions to business problems in isolation. In order to arrive at logical outcomes, it takes the help of some macroeconomic theories to understand the environment in which the firm operates. 6. Is problem solving in nature. Besides analyzing the managerial problems of business units, managerial economics aims at finding out optimal solutions to the business problems of firms. In order words, it is problem-solving in nature.

MANAGERIAL ECONOMICS AND OTHER DISCIPLINES An important feature of managerial economics is its relationship with other disciplines. Although essentially a branch of economics, the subject draws upon a number of other disciplines for propounding its theories and concepts for managerial decision-making.

1.Economics; The relationship between managerial economics and economics is similar to that of a body and one of its part. The blood running through both is the same. Managerial economics studies the fundamental problem of an economy, i.e. resources are scarce and the uses to which they can be put to are unlimited. As referred to earlier, managerial economics is essentially microeconomic in character. It is economics applied to a firm’s decision-making. Various microeconomic concepts such as demand, production, cost, price and profit analysis are of great significance to managerial economics.

2.Statistics Statistical tools are of immense use in business decision-making. Managerial economics being prescriptive, aims at estimating the future on the basis of proper analysis of the past and existing structures. Estimation of the future course of action is an essential element in managerial decision-making. Statistical techniques and concepts relating to data collection, data analysis, forecasting techniques and the theory of probability provide the framework for all such analysis and prescriptions of managerial economics. Thus, statistics is closely linked to managerial economics.

3.Mathematics Several important methodologies and concept of managerial economics are based on mathematics. The concept of marginal, which is the slope of the total, that is the rate

of change of the total, originates from geometry/differential calculus, while the concept of elasticity uses differential calculus. Similarly, cost-output relationships and pricing decisions are explained on the basis of algebra and geometry. Managerial economics also makes use of logarithms, exponentials, determinants and matrices.

4.Operations Research; Managerial economics depends heavily on the models and tools of operations research or quantitative techniques. Operations research is a subject that consists of a number of models and analytical tools, which are developed on the basis of interdisciplinary research for solving complex problems of planning and allocation of scarce resources, primarily in defence industries. Managerial economics has generalized and developed the models and tools of operations research for the purpose of business decision-making. Linear programming models, inventory models, game theory, etc. are a few tools that have originated in the works of operation researchers.

5.ing; ing is concerned with the recording of the financial operations of a firm. The cost and revenue data that form the basis of all the analyses and computations of managerial economics are quantified through the process of ing. In other words, ing information is one of the principal sources of data required by managerial economists for decision-making. The branch of ing that provides data in a form that can be used by managers to apply the concepts of managerial economics for decision-making is known as managerial ing.

Basic concepts in Business Economics; or The most significant contribution of economics to managerial economics lies in certain principles which are basic to the entire gamut of managerial economics. The basic principles may be identified as: 1.Opportunity cost principle, 2.Incremental principle, 3.Principle of time perspective, 4.Discounting principle, and 5.Equi-marginal principle. They are discussed hereunder as follows: 1.Opportunity Cost principle. By the opportunity cost of a decision is meant the sacrifice of alternatives required by that decision. This can best be understood with the help of a few illustrations: (i)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; (ii)The opportunity cost of the time an entrepreneur devotes to his own business is the salary he could earn by seeking employment; (iii)The opportunity cost of using a machine to produce one produce one product is the earnings forgone which would have been possible from producing other products; The opportunity cost of using a machine that is useless for any other purpose is zero since its use requires no sacrifice of other opportunities. Thus, it should be clear that opportunity costs require ascertainment of sacrifices. If a decision involves no sacrifice, its opportunity cost is nil. For decision-making, opportunity costs are the only relevant costs. The opportunity cost principle may be stated as under; The cost involved in any decision consists of the sacrifices of alternatives required by that decision. If there are no sacrifices, there is no cost

2.Incremental principle Incremental concept is closely related to the marginal costs and marginal revenues, for of economic theory. Incremental concept involves estimating the impact of decision alternatives on costs and revenues, emphasizing the changes in total cost and total revenue

resulting from changes in prices, products, procedures, investments or whatever may be at stake in the decision. The two basic components of incremental reasoning are: incremental cost and incremental revenue. Incremental cost may be defined as the change in total cost resulting from a particular decision. Incremental revenue is the change in total revenue resulting from a particular decision. The incremental principle may be stated as under; “A decision is obviously a profitable one if(i)It increases revenue more than costs; (ii)It decreases some costs to a greater extent than it increases others; (iii)It decreases some revenues more than it decreases others; and (iv)It reduces cost more than revenues.” Some businessmen take 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 cost (labour, materials and overhead) plus a provision for profit. Incremental reasoning indicates that this rule may be inconsistent with profit maximization in the short run. A refusal to accept business below full cost may mean rejection of possibility of adding more to revenue than to cost. The relevant cost is not the full cost but rather the incremental cost. A simple problem will illustrate this point.

Illustration Suppose a new order is estimated to bring in an additional revenue of Rs. 5,000. The cost are estimated as under: labour Rs. 1,500 materials Rs. 2,000 overhead (allocated at 120% of labour cost) Rs. 1,800 Selling and istrative expenses (allocated at 20% of labour and material cost) Rs. 700 Full cost ------------Rs. 6,000 -------------The order appears to be unprofitable. However, suppose, there is idle capacity which can be utilized to execute this order. If the order adds only Rs. 500 of overhead (that is, the added use of heat, power and light, the added wear and tear on machinery, the added cost of supervision, and so on), only Rs. 1,000 by way of labour cost some of the idle workers already on the payroll will be deployed without added pay, and no extra selling and istrative cost, the incremental cost of accepting the order will be as follows: Materials Rs. 2,000 Labour Rs. 1,000 Overhead Rs. 500 Total Incremental Cost ---------------------Rs. 3,500 ----------------------

While it appeared in the first instance that the order will result in a loss of Rs. 1,000, it now appears that it will lead to an addition of Rs. 1,500 (Rs. 5,000-Rs. 3,5000) to profit. Incremental reasoning does not mean that firm should accept all orders at prices which cover merely their incremental costs. The acceptance of the Rs. 5,000 order depends upon the existence of idle capacity and labour that would go unutilized in the absence of more profitable opportunities.

3.Principle of Time Perspective. 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 consideration. 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 Suppose there is a firm with temporary idle capacity. An order for 5,000 units comes to management’s attention. The customer is willing to pay Rs. 4.00 per unit or Rs. 20,000 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 (Rs. 5,000 for the lot). However, the following long-run repercussions of the order ought to be taken into as well.

(1)If the management commits itself with too much of business at lower prices or with a small contribution, it may not have sufficient capacity to take up business with higher contributions when the opportunity arises therefor. The management may be compelled to consider the question of expansion of capacity and in such cases, even the so-called fixed costs may become variable. (2)If other customers come to know about this low price, they may demand a similar low price. Such customers may complain of being treated unfairly and feel discriminated against. They may as such opt to patronise manufacturers with firmer ‘ethical’ views on pricing. The reduction of prices under conditions of excess capacity may adversely affect the image of the company in the minds of ots clientele ultimately affecting its sales. It is, therefor, important to give due consideration to the time perspective. The principle of time perspective may be stated as under: “A decision should take into both the short-run and long-run effects on revenues and costs and maintain the right balance between the long-run and short-run perspectives.”

4.Discounting Principle. One of the fundamental ideas in economics is that a rupee tomorrow is less than a rupee today. Suppose a person in offered a choice to make between a gift of Rs. 100 today or Rs. 100 next year. Naturally he will choose the Rs. 100 today. This is true for two reasons. First, the future is uncertain and there may be uncertainty in getting Rs. 100 if the present opportunity is not availed of . Secondly, even if he is sure to receive the gift in future, today’s Rs. 100 can be invested so as to earn interest, say at 8per cent so that one year after the Rs.100 of today will become Rs. 108 whereas if he does not accept Rs. 100 today, he will get Rs. 100 only one year hence. Another way of saying the same thing is that Rs. 100 one year hence is not equal to Rs. 100 of today but less than that. But then how much money today is equal to Rs. 100 one year hence? To find it out, the relevant rate of interest which one would earn if one decides to invest the money. At the rate of interest is 8 per cent. Then we shall have to discount Rs. 100 at 8 per cent in order to ascertain how much money today will become Rs. 100 one year after. The formula is : V=Rs. 100 1+I where V= present value i= pate of interest Now, applying the formula, we get V= Rs100 1 +I =100 1.08 = Rs. 92. 59 As a cross-check, if we multiply Rs. 92.59 by 1.08, we shall get the money which will accumulate at 8 per cent after one year: 92. 59 * 1.08= 99.9972 =Rs. 100

The same reasoning applies to longer periods. A sum of Rs. 100 two years from now is worth V = Rs.100 = Rs. 100 = Rs. 100 (1 + i) 2 =(1.08) 2 = 1.1664 = Rs. 85.73 Again, we can check by computing how much the cumulative interest will be after two years. The principal involved In the foregoing discussion can be called the discounting principle may be stated as “If a decision affects costs and revenues at future dates, it is necessary to discount those costs and revenues to present values before a valid comparison of alternatives is possible.”

5.Equi-marginal Principle. This principle deals with the allocation of the available resources among the alternatives. According to this principle, an input should be so allocated that the value added by last unit is the same in. all cases. This generalization is called the equi-marginal principle. Suppose a firm has 100 units of labour at its disposal. The firm is engaged in four activities which need labour services, viz.. A, B, C and D. It can enhance any one of these activities by adding more labour but only at the cost of other activities. It should be clear that if the value of the marginal product is higher in one activity than another, an optimum allocation has 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. To take an example, if in activity A, the value of marginal product of labour is Rs. 20 while that in activity B, it is Rs. 30, is profitable to shift labour from activity A to activity B thereby expanding activity b and reducing activity A. The optimum will be reached when the value of the marginal product is equal in all the four activities or, symbolically expressed, when VMPLa = VMPLB = VMPLC = VMPLD Whereby the subscripts indicate labour in respective activities. Certain aspects of the equi-marginal principle need clarification. First, the values of marginal products are net of incremental costs. In activity B we may add one unit of labour with an increase in physical output of 100 units. Each unit is worth 50 paise so that the 100 units will sell for Rs. 50. But the increased output consumes raw materials, fuel and other inputs so that variable costs in activity B (not counting the labour cost) are higher. Let us say that the incremental costs are Rs.30 leaving a net addition of Rs. 20. The value of the marginal product relevant for our purpose is thus Rs. 20. Secondly, if the revenues resulting from the addition of labour are to occur in future, these revenues ought to be discounted before comparisons in the alternative activities are possible. Activity A may produce revenue immediately but activities B, C and D may take 2, 3 and 5 years respectively. Here the discounting of these revenues will render them comparable.

Thirdly, the measurement of the value of the marginal product may have to be corrected if the expansion of an activity requires a reduction in the prices of the output. If activity B represents the production of radios and it is not possible to sell more radios without a reduction in price, it is necessary to make adjustment for the fall in price. Fourthly, the equi-marginal principal may break under sociological pressures. For instance, due to inertia, activities are continued simply because they exist. Again, motivated by empire building, managers may keep on expanding activities to fulfil their ambition for power. Departments which are already over budgeted often use some of their excess resources to build up propaganda machines (public relations offices) to win additional . Governmental agencies are more prone to bureaucratic self-perpetuation and inertia.