MBA 1st SEM

MANAGERIAL ECONOMICS (103)

UNIT-2

ECONOMICS
Generally we associate economics with finance or financial resources. But it’s not all about
money only. Economics is the study of demand and supply, production and consumption anf
allocation of resources in a way so that one can get maximum efficiency and profit. So,
basically it teaches us the optimal utilization of resources.

Economics is the social science that studies how individuals, businesses, governments, and
societies make choices about allocating resources to satisfy their unlimited wants and
needs.

MANAGERIAL ECONOMICS
Managerial economics is a branch of economics that focuses on applying economic
principles and methods to business decision-making. It involves using economic theory and
tools to analyze and solve business problems, with the goal of maximizing efficiency and
profitability.

The study of managerial economics helps the organizations in the following:

1. Cost-benefit analysis
2. Demand and supply analysis
3. Production and cost theory
4. Market structures (e.g. perfect competition, monopoly, oligopoly)
5. Pricing strategies
6. Investment and capital budgeting
7. Risk analysis and uncertainty
8. Strategic decision-making

THE NATURE/CHARACTERSTICS OF MANAGERIAL ECONOMICS :

1. Normative: It provides guidelines and rules for making optimal decisions. It helps
managers making sound decisions in various situations with the help of certain pre- defined
norms.

2. Pragmatic: It provides the practical solutions to business problems instead of solutions

based on certain theories. Understanding of managerial economics helps us making
practical solutions based on the problem, as every problem/ situation needs to be tacked
differently so we cannot provide same theory to all the problems.
3. Microeconomic: Economics is both macro n micro in nature but ME is micro in nature
which means at small scale. ME focuses on individual firms and markets, rather than the
economy as a whole. But, for this, it uses the macro concept of Economics. E.g. if there is
inflation or any financial or natural disaster at in the nation or the world it will affect the
individual business decisions as well.

4. Prescriptive: It recommends courses of action for managers to achieve specific goals. It is

prescriptive in nature, not descriptive as ME tells us that if demand of the product is less, we
should decrease the price of the product. But, it doesn’t tell us about the result of it.

5. Interdisciplinary: It draws on concepts and methods from economics, finance,

accounting, and management rather than economics only. We consider it as an art as well
as science because like arts it provides us certain principles and like science it is applied in
nature and is based on data and facts.

6. Analytical: It uses quantitative and qualitative methods to analyze data and make
informed decisions, which helps business to grow and expand further.

7. Goal-oriented: It aims to maximize efficiency, profitability, and shareholder value by

using the various economic tools and techniques.

8. Dynamic: It recognizes that business environments are constantly changing and adapts to
new circumstances. So, accordingly we need to change our economic practices and
strategies.

By understanding the nature of managerial economics, managers can make informed

decisions that drive business success.

SCOPE OF MANAGERIAL ECONOMICS: (Means the area where it is used/ relevant)

The scope of managerial economics is broad and encompasses various aspects of business
decision-making, including:

1. Production and Cost Analysis: Production and cost analysis is a fundamental concept in
microeconomics, which helps businesses and organizations understand the relationship
between the quantity of goods produced and the costs associated with production. ME
helps the managers in Examining the relationship between inputs and outputs, and
minimizing costs.

2. Pricing and Output Decisions: Analyzing the production cost and market demand helps
the firm to determine optimal prices and production levels to maximize profits.
3. Investment Decisions: ME helps the firms in evaluating investment opportunities and
selecting projects that maximize returns.

4. Resource Allocation: means allocating scarce resources to achieve business objectives.

Managerial economics plays a crucial role in resource allocation by providing tools and
techniques to help managers make informed decisions by analyzing data, forecasting,
identifying insufficiencies, evaluating alternatives, optimal resource utilization means to put
the resources where they can be max utilized.

5. Risk Analysis and Uncertainty: Managerial economics provides valuable tools and
techniques to help analyze and manage risk and uncertainty in business decision-making by
performing :

1. Sensitivity Analysis: Examines how changes in key variables affect outcomes.

2. Break-Even Analysis: Identifies the point where revenue equals total fixed and variable
costs.
3. Decision Trees: Visualizes possible outcomes and probabilities.
4. Expected Value (EV) Analysis: Calculates the expected outcome based on probabilities.

6. Market Structure and Competition: Analyzing market structures and developing

strategies to compete effectively.

7. Environmental and Social Issues: Managerial economics plays a crucial role in addressing
environmental and social issues by: Considering the economic impact of environmental and
social issues on business decisions, Environmental Impact Assessment: Evaluating the
environmental consequences of business decisions, Resource Allocation: Optimizing
resource usage to minimize waste and pollution, Sustainable Development: Balancing
economic, social, and environmental objectives.

8. Strategic Decision-Making: Managerial economics plays a vital role in strategic decision-

making by providing analytical tools and techniques to:
1. Identify business opportunities and challenges
2. Evaluate strategic options
3. Optimize resource allocation
4. Manage risk and uncertainty
5. Enhance competitive advantage
By applying managerial economics, businesses can optimize their operations, improve
efficiency, and achieve their goals.
DECISION MAKING
Decision-making is the process of selecting a course of action from multiple alternatives to
achieve a specific goal or solve a problem.

Economic decisions refer to practically all the decisions made by individuals, businesses, and
governments that involve the production, consumption, and allocation of resources. It is the
process of choosing how to use resources to get the best possible outcome.

A simple example, of an individual economic decision is the purchase of a gadget at a certain

price.

Process of managerial decision making:

The decision-making process is an ongoing and essential part of running any business or
organisation. Decisions are taken to keep all business activities and organisational functions
running smoothly.

The various steps include:

1. Define the Problem: Identify the issue or opportunity that requires a decision.

2. Gather Data: Collect relevant information about the problem/need, market, and potential
solutions.

3. Analyze Data: Apply economic tools and techniques to interpret the data e.g. Analyze the
relationship between costs, volume, and profit, Visualize and evaluate complex decisions,
Evaluate outcomes under different scenarios.

4. Identify Alternatives: Generate potential solutions or options by using various tools n

techniques like customer base, potential market, availability of resources etc.

5. Evaluate Alternatives: Assess the pros and cons of each option using economic criteria
(e.g., cost-benefit analysis, break-even analysis- it is the point is the point where we are in
no profit, no loss zone).

6. Choose the Optimal Option: Select the best alternative based on economic and business
objectives means the option where we find minimum investment and maximum profit.

7. Implement the Decision: Put the chosen option into action.

8. Monitor and Evaluate: Now monitor the course of action and track the decision's
effectiveness and adjust as needed to get the maximum efficiency and optimum utilization
of resources.

FUNDAMENTAL CONCEPTS OF DECISION MAKING:

INCREMENTALISM PRINCIPLE OF DECISION MAKING:

Incrementalism is an economic theory that involves a series of small changes over a long
period of time that result in a larger change overall. It refers to a gradual, step-by-step
approach to make decisions.
It involves- Small-scale changes, Iterative decision-making, Flexibility and adaptability at
workplace, Emphasis on learning from experience and Avoidance of drastic or revolutionary
changes.

Process of Incrementalism involves:

1. Breaking down complex problems into smaller, manageable parts

2. Focusing on incremental changes rather than radical transformations
3. Building on existing solutions and experiences
4. Gradually improving or modifying existing policies or decisions
5. Emphasizing learning and adaptation over grand, sweeping changes
6. Encouraging experimentation and testing of new ideas
7. Fostering a culture of continuous improvement and refinement

Pros of incrementalism include:

1. Reduced risk
2. Increased flexibility
3. Improved learning and adaptation
4. More manageable and achievable goals

Cons of incrementalism include:

1. Slow progress
2. Inertia and resistance to change
3. Lack of bold vision or innovation
4. Potential for incremental changes to be overshadowed by larger problems

Incrementalism is suitable for situations where Complex problems require gradual solutions,
Stakeholder buy-in ( means the shareholders are committed for the success of the project)
and support are crucial, Risk needs to be minimized and Continuous improvement is valued
over radical change (quick decisions)
MARGINALISM PRINCIPLE OF DECISION MAKING:

Marginalism in decision-making refers to the analysis of the additional costs and benefits of
a decision, focusing on the margin or the next unit of change. It's based on the idea that the
value of a good or service is determined by the additional satisfaction it provides, or its
marginal utility.
For example, we all know water is more important for us than diamonds. We'd rather have
water. But, if given a choice, many of us would prefer getting a diamond as a prize instead of
an extra bucket of water.

It involves:
1. Evaluating the incremental costs and benefits of a decision
2. Considering the effect of a small change on the overall outcome
3. Making decisions based on the margin, rather than the total
4. Focusing on the additional value created by a decision

Key principles of marginalism:

1. Marginal utility: The additional satisfaction gained from one more unit of a good or
service
2. Marginal cost: The additional cost incurred by producing or consuming one more unit
3. Marginal benefit: The additional benefit gained from one more unit
4. Marginal analysis: Comparing marginal costs and benefits to make decisions

Pros of marginalism:
1. Helps make optimal decisions
2. Encourages efficient resource allocation
3. Simplifies complex decisions

Cons of marginalism:
1. Assumes incremental changes
2. Ignores sunk costs (a cost that has already been incurred and cannot be recovered e.g.
market research)
3. May not account for externalities
4. Can lead to overemphasis on short-term gains

Marginalism is suitable for situations where:

1. Small changes have significant effects
2. Resources are scarce
3. Decisions need to be optimized
4. Trade-offs (when you choose one thing, you have to give up something else) need to be
evaluated
 EQUIMARGIONAL PRINCIPLE IN DECISION MAKING:

The equimarginal principle is a microeconomic principle that states that when there are
multiple production alternatives in a system, the marginal costs of each alternative must be
equal at the minimum total production cost.
The equimarginal principle is also known as the law of substitution or the law of maximum
satisfaction. It's a heuristic rule that explains how consumers spend their income on
different goods to maximize satisfaction:

 Consumers will get the most satisfaction when the marginal utility per unit of money is the
same for each commodity.
 Consumers should spend their limited income so that the last rupee spent on each
commodity yields equal marginal utility.
The importance of equimarginal principle:
 Helps businesses allocate resources efficiently
 Helps firms maximize profitability
 Provides a rational strategy to maximize satisfaction, especially when resources are scarce

By applying the equimarginal principle, decision-makers can ensure that resources are used
efficiently and effectively, leading to optimal outcomes.

THE TIME PERSPECTIVE IN DECISION-MAKING:

The time perspective principle in managerial economics states that when making decisions,
managers should consider both the short-term and long-term effects on revenues and
costs. The principle emphasizes the importance of balancing short-term and long-term
effects before making decisions.

The distinction between short-run and long-run is based on how quickly decisions can be
made and how quickly factors of production can be varied:
 Short-run
A period when some factors are fixed, but others can be varied. For example, increasing
the quantity of variable factors can increase production.
 Long-run
A period when all factors of production can be varied. For example, setting up a new
factory is a long-term decision.

The time perspective in decision-making refers to the way individuals consider time when
making choices. It involves:

1. Time horizon: The length of time considered when making a decision.

2. Time discounting: The tendency to value immediate rewards over future rewards.
3. Time preference: The relative importance of present versus future consequences.
4. Time constraints: The limitations and deadlines that affect decision-making.

Time perspectives can be:

1. Short-term (focused on immediate gains)

2. Medium-term (balancing short-term and long-term goals)
3. Long-term (prioritizing future consequences)

Decision-makers with a Short-term perspective may prioritize quick fixes over sustainable
solutions and Long-term perspective may invest in future benefits, even if it means short-
term sacrifices.

Factors influencing time perspective:

1. Age and experience

2. Cultural and personal values
3. Risk tolerance
4. Goals and priorities
5. Environmental and situational factors

Effective decision-making considers both short-term and long-term implications, weighing

the trade-offs between immediate needs and future consequences.

THE DISCOUNTING PRINCIPLE IN DECISION-MAKING:

The discounting principle in decision-making refers to the tendency to value immediate
rewards or benefits more highly than future ones. This principle suggests that:

1. People tend to prefer smaller, immediate rewards over larger, delayed rewards.
2. The value of a reward decreases as the delay in receiving it increases.
3. Decision-makers "discount" future benefits, making them less influential in the decision-
making process.

Types of discounting:
1. Exponential discounting: Values decline gradually over time.
2. Hyperbolic discounting: Values decline rapidly at first, then more slowly.

Factors influencing discounting:

1. Time horizon: Longer delays lead to greater discounting.
2. Risk and uncertainty: Greater uncertainty increases discounting.
3. Impatience: Some individuals naturally prioritize immediate gratification.
4. Context: Environmental and situational factors can influence discounting.

Implications of discounting:
1. Short-term focus: Decision-makers may prioritize immediate gains over long-term
benefits.
2. Inconsistent decisions: Discounting can lead to inconsistent choices over time.
3. Overconsumption: Discounting can result in overconsumption of resources.

To mitigate discounting's impact:

1. Use objective criteria for decision-making.
2. Consider long-term consequences explicitly.
3. Break down long-term goals into shorter-term objectives.
4. Seek diverse perspectives to balance short-term and long-term views.

OPPORTUNITY COST :
An opportunity cost is the value of the option not taken when a business makes a decision.
Opportunity cost is the forgone benefit that would have been derived from an option other
than the one that was chosen.

For example, if the business is deciding whether to purchase two new tractors, the
opportunity cost of not doing so would be the potential revenue and profitability lost by not
being able to take on another project.

Key aspects of opportunity cost:

1. Implicit cost: Not explicitly visible, but still present.
2. Alternative uses: Resources can be used in different ways.
3. Scarcity: Limited resources force choices and trade-offs.
4. Choice and sacrifice: Selecting one option means sacrificing others.

Opportunity cost is relevant in:

1. Resource allocation decisions.
2. Investment decisions.
3. Time management and prioritization.
4. Career choices and education.

To minimize opportunity costs:

1. Identify alternative options.
2. Evaluate the potential benefits and drawbacks of each.
3. Choose the option that maximizes value.
4. Consider long-term implications.
Opportunity cost is not just about financial costs; it's also about the value of time, resources,
and potential benefits forgone.