BASIC CONCEPTS AND PRINCIPLES:

Definition, Nature and Scope of Economics, Micro Economics and Macro Economics,
Managerial Economics and its relevance in business decisions. Fundamental Principles of
Managerial Economics - Incremental Principle, Marginal Principle, Opportunity Cost
Principle, Discounting Principle, Concept of Time Perspective, Equi-Marginal Principle
Utility Analysis, Cardinal Utility and Ordinal Utility, Case Studies

NATURE OF MANAGERIAL ECONOMICS

Managerial economics adopts the principles of macroeconomics to help managers study a
business's external environment for improved management of an enterprise. This approach to
managerial economics helps managers analyze various external influences that affect everyday
business activities, including a country's economic status, government policies, and market
conditions
1. Art and Science
Management theory requires a lot of critical and logical thinking and analytical skills to make
decisions or solve problems. Many economists also find it a source of research, saying it
includes applying different economic concepts, techniques, and methods to solve business
problems.
2. Microeconomics
Managers typically deal with the problems relevant to a single entity rather than the economy
as a whole. It is, therefore, considered an integral part of microeconomics.
A corporation works in an external world, i.e., serving the consumer, an important part of the
economy. For this purpose, managers must evaluate the various macroeconomic factors, such
as market dynamics, economic changes, government policies, etc., and their effect on the
company.
4. Multidisciplinary
Managerial economics uses many tools and principles that belong to different disciplines, such
as accounting, finance, statistics, mathematics, production, operational research, human
resources, marketing, etc.
5. Prescriptive or Normative Discipline
By introducing corrective steps managerial economics aims at achieving the objective and
solves specific issues or problems.
6. Management Oriented
This serves as an instrument in managers’ hands to deal effectively with business-related
problems and uncertainties. This also allows for setting priorities, formulating policies, and
making successful decisions.
7. Pragmatic
The solution to day-to-day business challenges is realistic and rational.
Different individuals take different views of the principles of managerial economics. Others
may concentrate more on customer service and prioritize efficient production.
SCOPE OF MANAGERIAL ECONOMICS

The scope of managerial economics encompasses aspects of running a successful business

and their contributions to effective decision-making in an organizational setting.

Managerial economics aids companies in the house in an effective decision-making process by

informing the management on using different quantifiable tools such as available time and
money resources and economic concepts to formulate policies for making informed managerial
decisions. Business executives can use concepts of managerial economics to perform
successful production and cost evaluations when approximating the cost of production and to
determine factors that cause disparities in cost approximations.

Managerial economics enables managers to evaluate and decide on production activities a

business correctly can be engaged in and the relevant production costs related to them. This
approach to management guarantees that organizational resources are used efficiently to
minimize the general costs of production.

Managerial economics also covers demand evaluation and estimations issues because it aids
business managers in analyzing demand and anticipating future worries. Accurate estimates
of demand help production managers prepare appropriate production schedules and allocate
available resources as intended. Furthermore, managerial economics shapes an organization's
pricing strategies since pricing is among the critical decisions business managers make. It also
dictates approaches that enable businesses to earn pre-ferred profits and attain envisioned
growth both in the short- and long-term periods.

Managerial economics is an effective management tool because it supplies all pertinent

information to business executives to make informed decisions on product prices. Core
aspects encompassed under this area include pricing approaches and differential pricing
strategies. Also, managerial economics covers profit management in an organizational setting.
It directs business executives on how to manage profits made from conducting business
activities, given profits are the primary measure of the performance and growth of a company.

Another scope of managerial economics entails capital management because making lucrative
capital investment choices make up complex activities managers undertakes. Therefore,
managerial economics help managers plan and manage an organization's capital expenses
through proper evaluations to establish profitable investment opportunities. This approach
guarantees profitability before investing time and resources in a doubtful business venture.
DIFFERENCES BETWEEN MICROECONOMICS AND MACROECONOMICS
Ragnar Frisch has classified economics into two broad categories: Micro & Macro-economics.
Once again the term ‘micro’ and ‘macro’ have been derived from the Greek words Mikros and
Makros, which mean ‘small’ and ‘large’ respectively.

Microeconomics deals with the behaviour of individual economic units and the markets where
they interact. For example, it studies the decision making by a producer (firm) and a consumer,
and the individual markets for each of the products they produce and buys. Thus,
microeconomics talks about the behaviours of buyers and sellers of cars, quantity and price of
cars, and the same for all other goods and services in the economy.
In contrast, macroeconomics is concerned with the behaviour of the economy at large (like
India and each of the other countries) and national aggregates, such as national income,
general price index, total employment and unemployment, wage rate, money supply, interest
rate, national saving and investment, fiscal deficit, exports, imports, balance of trade and
foreign exchange rate, business cycles and growth rate of an economy, etc.

Microeconomics (“micro” meaning small) looks at the smaller picture of the economy and is the
study of the behaviour of small economic units, such as that of an individual consumer, a
seller (or a producer, or a firm), or a product. It focuses on the basic theories of supply and
demand in individual markets (say of cars, food items, mobile phones, etc.), and deals with
how individual businesses decide how much of something to produce and at what price to sell
it, and how individual consumers decide on how much of something to buy. In other words,
microeconomics analyses the market behaviour of individual consumers and firms, in an
attempt to understand their decision-making processes.

Macroeconomics (“macro” meaning large) is that branch of economic analysis that deals with
the study of aggregates. As opposed to microeconomics, in macro analysis we study the
industry as a unit, and not the firm. In macroeconomics, we talk about aggregate demand and
aggregate supply, national income, national capital formation, employment, inflation etc.

Microeconomics deals at the firm’s level and takes into consideration the decision-making
power of individual units, whereas macroeconomics deals with the economy level and takes
into consideration the impact of government policies on the aggregates like national income
and employment.

However, micro and macro economics are not to be taken as substitutes of each other; rather
they complement each other. To quote Paul Samuelson “…if you read one branch of economics
carefully, but ignore the other, you will be half-educated”.
The points given below explain the difference between micro and macro economics in detail:

Basis For Microeconomics Macroeconomics

Comparison

Meaning The branch of economics that The branch of economics that studies the
studies the behavior of an behavior of the whole economy, (both
individual consumer, firm, family is national and international) is known as
known as Microeconomics. Macroeconomics.

Scope & Microeconomics deals with the the focus of macroeconomics is on

Business operational or internal issues of Aggregate economic variables - It deals
Application individual economic units - product, with broad economic issues.
firm, household, industry etc.
Covers various Environment and
Microeconomics stresses on external issues such as national income,
Individual economic variables. national output, general price level, total
consumption, total savings, total
It covers various issues like demand
investment, employment, monetary/
and supply equilibrium, product
fiscal policies, international trade etc.
pricing, factor pricing, production,
consumption, economic welfare, etc.

Concerned with Theory of consumer behaviour, Theory of National Income, Aggregate

Theory of Production, Theory of Consumption, Theory of General Price
Factor Pricing, Theory of Product Level, Economic Growth.
Pricing.

Approach for Microeconomics takes a bottom-up Macroeconomics considers a top-down

Analysis approach. approach.

Importance Helpful in determining the prices of Maintains stability in the general price
a product along with the prices of level.
factors of production (land, labor,
It helps in resolving major economic
capital, entrepreneur etc.) within
issues like inflation, deflation,
the economy.
disinflation, poverty, unemployment, etc.

Limitations It is based on unrealistic It has been analyzed that 'Fallacy of

assumptions, i.e. in Composition' involves, which sometimes
microeconomics it is assumed that doesn't proves true because it is possible
there is a full employment in the that what is true for aggregate may not
society which is not at all possible. be true for individuals too.

Although a distinction has often been made between microeconomics and macroeconomics,
strictly speaking there is only one ‘economics’.
 RELEVANCE OF MANAGERIAL ECONOMICS:

The various theories or principles of microeconomics used to solve the internal problems of the
organization arising in the course of business operations are as follows:

1. Demand Theory: Demand Theory emphasizes the consumer’s behavior toward a

product or service. This considers the customers’ desires, expectations, preferences,
and conditions to enhance the manufacturing process.
2. Decisions on Production and Production Theory: This theory is primarily concerned
with the volume of production, process, capital and labour, costs involved, etc. It aims
to optimize the production analysis to meet customer demand.
3. Market Structure Pricing Theory and Analysis: It focuses on assessing a product’s
price considering the competition, market dynamics, production costs, optimizing sales
volume, etc.
4. Exam and management of profit: the companies are operating for assets; hence, they
aim to maximize profit. It also depends on demand from the market, input costs, level of
competition, etc.
5. Decisions on capital and investment theory: Capital is the most important business
element. This philosophy takes priority over the proper distribution of the resources of
the company and investments in productive programs or initiatives to boost operational
performance.

MANAGERIAL ECONOMICS AND ITS RELEVANCE IN BUSINESS DECISIONS

Managerial decisions in any business area would include:
(i) Assessment and evaluation of investible funds
(ii) Selection of business area
(iii) Choice of product to deal with
(iv) Determination of optimum level of output
(v) Determination of price of product
(vi) Determination of input-combination, mix and technology
(vii) Publicity and sales promotion

 Derive effective solutions with logical thinking.

 Maximize profits and reduce production costs.
 Successfully plan business operations from production to consumption.
 Speculate, forecast, and make suitable investments

Managerial economics helps in effective decision making and a business manager is essentially
involved in the processes of decision making as well as forward planning. In doing so,
managerial economics is of great importance for a business manager.

 It is a branch of economics that is applied to analyze almost all business decisions. It is

meant to undertake risk analysis, production analysis that is useful for production
efficiency. Likewise, it is of great use for capital budgeting processes as well.

 In the most positive form, it seeks to make successful forecasts with the objective of
minimizing the risks involved. It deals with the aspects as how much cash should be
 available and how much of it should be invested in relation to a choice of processes and
projects while making possible the economic feasibility of various production lines.

 As regards the pricing of products being produced by a business entity, it is one of the
most critical decisions for a manager to fix the price of particular products as it is by
means of pricing decisions taken by a manager, the inflow of revenue is determined.
The areas that are to be covered through managerial economics application in this
respect are, price methods, product line pricing and price forecasting etc.

1) Efficient business process:

Internal factors like the organization’s goal, product demand, price, output, resource
availability, etc., affect the smooth functioning of the organization. A comprehensive analysis
of all internal factors helps you make better decisions in improving the internal business
process. Making rational decisions to suit the emerging trends and economic climate is the
need of the hour. You need to schedule and monitor all production activities of the
organization. And ensure effective functioning as per the process standards.
2) Framing policies:
Formulate policies after continuous testing and based on your past experiences. Managerial
economics involves humans; with varied perspectives and approaches. The scope for
universal application of policies is limited, and they are adapted depending on situations.
3) Long-term planning:
Analyze the internal and external factors; influencing the business environment using diverse
economic theories and tools. It’s a continuous process; and focuses on the what, how and who
of the production process.
The future is uncertain; focus on effective long-term planning and devise strategies to utilize
limited resources to maximize profits and reduce production costs.
4) Sourcing raw materials:
With the scarcity of raw materials, make suitable decisions involving suppliers, competitors,
and customers. Including the internal business environment; to efficiently manage resources
to lower costs. It enables you to handle scarce resources and find suitable alternatives.
5) Demand Analysis:
Demand theory helps you decide on the type of product/service. It involves studying consumer
behavior, purchase trends, factors influencing purchase patterns, etc.
Demand analysis is critical in decision-making. Assessing and forecasting future sales helps
strengthen the organization’s position in the market and improve profitability. It also gives you
the insight to handle losses with minimal impact.
6) Profit Analysis:
Profits decide an organization’s success and failure. Earning reasonable profits is crucial for
every business. Organizations take huge risks with capital investments to achieve long-term
profitability. Proper planning, profit analysis, profit distribution, and analyzing the scope for
further investment are challenging aspects of managerial economics.
7) Efficient management of Funds:
Production, cost analysis, and project appraisal strategies help you make decisions concerning
raw materials, production techniques, machinery, recruiting professionals, etc.
Budgeting and controlling the flow of funds are essential for every business. It involves a
considerable amount of time and labor. Cost of capital and return on investment (ROI) is vital
to capital management.
8) Effective market research:
A meticulous analysis of the market trends helps you to fix product prices and make output
decisions. Analyzing domestic and foreign markets is crucial as it helps determine niche
market segments and allows for global expansion. Thereby; reducing production costs and
increasing product life.
9) Measure Efficiency:
You will be involved with utilizing various tools and techniques to measure the efficiency of the
business process. Prepare necessary reports with the statistics and keep the management
updated; with enhancement strategies for improving efficiency.
10) Economic Intelligence:
External factors like government policies, employment opportunities, stages of the product
cycle, exchange rates, emerging economic, market trends, etc., affect the efficient functioning
of the organization.
A complete survey and analysis of these factors help understand their impact on the
organization. Update the management with the relevant data and the latest approaches.
FUNDAMENTAL PRINCIPLES OF MANAGERIAL ECONOMICS

THE OPPORTUNITY COST PRINCIPLE

The problem of choice makes it necessary to sacrifice some of the alternatives against the one
selected. Individuals and firms make such decisions based on expectations of greater benefits
from one alternative over another. In other words, there is an opportunity cost involved in a
choice.
Opportunity cost is the benefit forgone from the next best alternative that is not selected.
Let us give examples to explain this “choice”. You may be working in your hometown and
suppose you have got another job offer in a city away from your hometown. Now if you select
the new offer, you would be foregoing the benefits of staying at home.
The opportunity cost principle argues that a decision to accept an employment for any factor
of production is good (profitable) if the total reward for the factor in that occupation is greater
or at least no less than the factor’s opportunity cost; the opportunity cost being the loss of the
reward in the next best use of that resource.

MARGINAL OR INCREMENTAL PRINCIPLE

The concept of marginality deals with a unit increase in cost or revenue or utility.
According to this concept, Marginal Cost (or Revenue or Utility) is the change in Total Cost (or
Total Revenue or Total Utility) due to a unit change in output.
In other words, Marginal Cost (or Marginal Revenue or Marginal Utility) is the Total Cost (or
Total Revenue or Total Utility) of the last (or nth.) unit (of output). Thus, we may express
Marginal Cost (MC) as:
MCn = TCn – TCn–1 …

Similarly, we can compute Marginal Revenue or Marginal Utility as

Marginal Revenue , MRn = TRn – TRn–1
Marginal Utility, MUn = TUn – TUn–1

Suppose Firm A is producing three units and selling them at a price of Rs. 25 per unit, making
a total profit of Rs. 28. If the customer for its fourth unit of output, is offering Rs. 14 only,
should the firm accept this offer? According to the full cost principle, the offer must be rejected
since the average cost of four units equals Rs. 14.50, which exceeds the offered price.
However, the marginal or incremental principle would argue that the cost of the fourth unit
(MC) equals Rs. 11, which is less than the price offered, thereby his profit would increase, and
so the order must be accepted; profit would increase from Rs. 28 to Rs. 31.
The difference between marginal and incremental concepts

The marginal concept has two salient characteristics;

• One, the marginal concept is applicable to change in revenue, cost or profit, etc. with
respect to change in output only.
• Two, the concept requires that the change in output is infinitesimally small, to be
approximated by one in case of discrete data.
However, there is an inherent problem with the marginal concept and that is, in reality
variables may not be subject to such unit change as explained above. In such cases, it is
always more convenient to use the incremental concept, rather than the marginal concept.

The incremental concept is applied usually when the changes are not necessarily in terms of
a single unit, but in bulk. The incremental concept is applicable with respect to any variable
and for any extent of change.
If a decision to increase revenue also entails an increase in costs, then the incremental
concept would tell whether the decision is right (if the increment in cost is less than
incremental revenue) or wrong.

• The net profit is Rs 7425 when a carpenter sells 100 chairs, and, suppose, it would
have been Rs 7625 if he had sold 101 chairs. Then the marginal profit = [(7625–
7425)/(101–100)] = 200, which is also the average incremental profit.
• Instead, if the profit was Rs 7425 when the carpenter charged a price of Rs 450 per
chair and, suppose, Rs 8000 if he had charged a price of Rs 475, the incremental
profits would equal to Rs 575 [8000 – 7425] and the average incremental profit = Rs 23
[(8000 – 7425)/(475 – 450).
• In the latter case, the concept of marginal profit is not applicable at all. Thus, while the
incremental principle is versatile, the marginal concept is specific to changes in a
particular variable brought about by small changes in output alone.

EQUI-MARGINAL (RATIONALITY) PRINCIPLE

The law of equi-marginal utility states that consumer distributes his expenditure between
different goods in such a way that the marginal utility derived from the last rupee spent on
each good is the same. Symbolically,
MUa/Pa = MUb/Pb = MUc/Pc = …..... = MUn/Pn (Consumer Equilibrium)
Thus, the consumer, while dividing his expenditure between goods considers both their
marginal utilities and prices.
By equating the ratios of marginal utilities to prices of goods, the consumer succeeds in
deriving maximum possible utility from his expenditure. This is the best position which he can
attain. Similarly, a producer seeking maximum profit would use that technique of production
(input-mix) which would ensure.

Where,
MRP1 = marginal revenue product of input 1 (e.g, labour),
MRP2 marginal revenue product of input 2 (e.g., capital),
MC1 = marginal cost of input 1, and so on.
DISCOUNTING AND COMPOUNDING PRINCIPLE

The core of discounting principle is that a rupee in hand today is worth more than a rupee
received tomorrow. In other words, it refers to time value of money, i.e., the fact that the value
of money depreciates with time.
The discounting and compounding principle (DCP) states that when a decision involves money
receipts or payments over a period of time, all the money transactions must be valued at a
common period to be meaningful for decision analysis.
The money has time value for three reasons: earning power, changing prices, and uncertainty.
• Money has earning power, for it can earn at least an interest rate even if it is deposited
in a bank. On this count, a rupee to day is worth more than a rupee at a future date.
• Money has a derived demand, in the sense that it is wanted not for its own sake but for
its purchasing power, which depends inversely on the price level. Thus, during inflation,
a rupee today is worth more than a rupee at a future date.
Similarly, today’s money is certain but a promise to give it tomorrow is uncertain, for the
promise may not be honoured either because the payee has no money or because he is
dishonest
Suppose an investment costs Rs l00 lakhs this year and is expected to yield net returns of Rs
30 lakhs, Rs 40 lakhs and Rs 60 lakhs, in the next three years, respectively. Assume further
that the interest cost of the money is 10 per cent, there is no inflation/deflation and no
uncertainty about these cash flows. Then, whether the investment should be made or not
depends upon whether the following equation yields a positive or negative value:

The solution to this yields an amount of Rs 5.41 lakhs, and so the investment is desirable.
Incidentally, it should be noted here that interest is compounded once a year but any
frequency of compounding can easily be handled through this technique.

TIME PERSPECTIVE PRINCIPLE

• The time perspective principle argues that the decision-maker must give due
consideration both to the short and long-run consequences of, his/her decision, giving
appropriate weights to the various time periods before arriving at a decision.
• The principle can be well explained through recalling the example cited under the
marginal or incremental principle. The order for the fourth unit at Rs. 14 in spite of an
average cost of Rs. 14.50 was worth accepting by the producer on the short-run
consideration for sure. But if that were to disturb the customers (market) in the long-
run, it may have to be rejected. Similarly, we do come across many new products which
are sold below cost or on relatively small margins in the beginning with the hope of
commanding a good market and thereby making profits in the long-run.
• Nirma soap powder and Rin soap cakes perhaps fall in this category. If the managers
did not have time perspective in their mind, they would never have resorted to such
practices (i.e., of selling them at below their corresponding costs in the beginning),
called ‘price penetration’.
UTILITY FUNCTION:
Consumer preferences can be represented as a utility function. A utility function shows an
individual’s perception of the level of utility that would be attained from consuming each
conceivable bundle or combination of goods and services. A simple form of a utility function
for a person who consumes only twogoods, X and Y, might be
U 5 f (X, Y)
where X and Y are, respectively, the amounts of goods X and Y consumed, f means “a function
of” or “depends on,” and U is the amount of utility the person receives from each combination
of X and Y. Thus, utility depends on the quantities consumed of X and Y.

INDIFFERENCE CURVE ANALYSIS

Indifference Curve: Indifference curve can be defined as the locus of all points (representing various combinations of two goods)
that give the same satisfaction to the consumer. Indifference is also called iso-utility curve.

All the combinations (viz. A, B, C & D) yield the same degree of

satisfaction to the consumer. So, he is indifferent among them i.e. all
combinations are equally desirable (it will not matter which one he gets).

Indifference Schedule: Indifference schedule is tabular representation of all the combinations of two goods that give the
consumer the same degree of satisfaction.

Good X Good Y
1 12
2 8
3 5
4 3
5 2

The Indifference schedules can be converted into Indifferent curves by plotting various points (representing combinations of two
goods) on a graph paper.
Indifference Plane or Commodity space: The area between X and Y-axes is known as Indifference Plane or Commodity space.

This plane is full of finite points and each point on the plane
indicates a different combination of Good X and Good Y.

Qty. of
Good Y

Qty. of Good X

Indifference Map: Each Indifference curve represents a certain level of consumer satisfaction. A set of Indifference curves
representing various levels of satisfaction obtainable from different schedules of Indifference is called Indifference Map.

An Indifference Map represents complete description of tastes

& preferences of a consumer.

An Indifference Curve situated farther from origin of the axes

is ranked higher than the one situated near the origin.

Any combination on a higher IC will be preferred to any combination on a lower IC. We can’t indicate how much more
satisfaction a combination on higher IC will give since Indifference curve approach is based on ordinal utility assumption. So, we
can know the qualitative difference in satisfaction only.
Assumption in Indifference Curve Analysis:

1) Rationality of Behavior: The consumer always tries to obtain maximum satisfaction from his expenditure on commodities.
From among different available combinations, he chooses the one that provides him with maximum possible satisfaction.

2) Non-satiety: The consumer always prefers a large amount of a good to amount i.e. he has not yet reached the point of
satiety (saturation) in the consumption of the good.
3) Ordering Ability & Continuity: The consumers are capable of ordering or ranking all the conceivable combinations of
goods according to the satisfaction they yield. It is in technical terms known as “Scale of Preferences”. It is also assumed
that the consumer can make minute comparisons & rank different combinations, how –so-ever small the difference in
satisfaction may be between them.
4) Scale of Preferences is independent of Market Prices: The consumer, in his preferences or indifference is not influenced by
market prices of goods. He is supposed not to regard a higher-priced commodity as superior & lower-priced inferior.

5) Ordinal Utility: The consumer may not be able to indicate the exact amount of satisfaction he derives from commodities or
a combination of them, but he is capable of judging whether the satisfaction obtained from a good or combination of goods
is equal to, lower than or higher than that obtained from another.
6) Weak Ordering: Weak ordering implies that there is a possibility of consumer being indifferent between any two
combinations along-with possibility if preferring one combination of goods to another. The consumer may prefer A to B or
B to A or may be indifferent between them.
7) Transitivity & Consistency of choice:
Transitivity – The consumers’ preference or indifference relations do not contradict his positions between combinations
taken as a whole. For example,
 If the consumer prefers A to B and B to C, then he also prefers A to C.
 If the consumer is indifferent between A & B and also between B & C, he is indifferent between A & C too.
Consistency – means the consumer’s preference or indifference relations don’t change over time i.e. if he prefers A to B in
one period, he will not prefer B to A (or treat them as equal) in another period.
8) Complete Information: It is assumed that the consumer possesses ‘complete information’ about all the relevant aspects of
the economic environment he finds himself in e.g. Prices of Commodities, Availability of goods, satisfaction to be obtained
from them, all these things are very well known to him.
9) Diminishing Marginal Rate of Substitution: It is assumed that the consumer will be willing to (give up) smaller & smaller
units of one good in order to have successive additional units of another, while maintaining the same level of satisfaction.
10)
Combination Qty of Good X Qty of Good Y MRS of Good X for Good Y (Y / X)

A 1 12 -

B 2 8 4

C 3 5 3

D 4 3 2

E 5 2 1