Unit – 1 INTRODUCTION

Any discussion on a subject must start by explaining what the subject is all about i.e., by
defining the subject.
The principal fact about Economics to be remembered always is that it is a social
science.
The word ‘Economics’ originates from the Greek work ‘Oikonomikos’ which can be
divided into two parts:
(a) ‘Oikos’, which means ‘House’, and
(b) ‘Nomos’, which means ‘Management’.

The discipline of economics has gained widespread popularity in context of both; areas
of academics and relating to formulation of policies. Lately, the understanding of
economic issues has become quite indispensable for all sections in the society -
individuals, households, business units, institutions, as well as governments. Everyone
wants to get rich; wants to increase their wealth holding; wants to have hold over
productive resources; wants to expand their business activities. People want to earn
profits, and exercise control over the market and other economic system; people want
to raise their living standard and enjoy more consumption; people want to make their
future secure; everyone wants to grow from the current position. This explains that
every aspect of human existence is affected by economics, directly or indirectly due to
pervasive nature of economic issues and problems. That is why, people want to update
their knowledge of economic issues and take advantages of that to satisfy their wants.
Besides, people want to grow even in the adverse circumstances or at least survive
under these circumstances. This shows that people want to become economically
stronger and viable. For this reason, it becomes impossible to remain indifferent to this
subject matter.

1. LEADING DEFINITIONS OF ECONOMICS

Economics was originally introduced as a science of statecraft. It was concerned with
the collection of revenue for the state i.e., government. Advisors to the government were
also required to point out the best possible way of spending the revenue. Over a period
of time economists have emphasized different aspects of economic activities, and have
arrived at different definitions of economics hand in hand with the stages of
development of economics.
Stages as Economics developed as a subject:
1. Wealth Definition
2. Material Welfare Definition
3. Scarcity and Choice Definition
4. Development and Growth Definition
 1.1. ECONOMICS AS A SCIENCE OF WEALTH: ADAM SMITH
During the eighteenth and the early part of nineteenth century, Adam Smith, considered
to be the founding father of modern Economics, along with economists like J.B. Say and
Walker defined economics as the science of wealth. Adam Smith systematized the
concept in the form the book which was entitled as, ‘‘An Enquiry into the Nature and
Cause of the Wealth of Nations’’ published in 1776.
The central point in Smith’s definition is wealth creation. Implicitly, Smith identified
wealth with welfare. He maintained that the discipline of economics is meant to identify
the factors (that is causes) which make one economy richer than the other. He assumed
that, the wealthier a nation, the happier its citizens are. Thus, it was important to find
out, how a nation could become wealthy. Economics is the subject which is concerned
with an objective of how to make a nation wealthy in order to grow rich and to acquire
political & military strength.

MAIN CHARACTERISTICS OF WEALTH DEFINITION

(i) Exaggerated Emphasis on Wealth: These wealth centred definitions gave too much
importance to the creation of wealth in an economy. The classical economists believed
that economic prosperity of any nation depends only on the accumulation of wealth.
(ii) Inquiry into the Creation of Wealth: These definitions show that economics also
deals with an inquiry into the causes behind the creation of wealth.
(iii) A Study on the Nature of Wealth: The term ‘wealth’ does not have a universally
accepted meaning. However, these definitions have indicated that wealth of a nation
includes only material manufactured goods. It is for this reason that to Adam Smith,
labour was ‘productive’ if it produced material goods. In contrast, those who produced
non-tangible services like teaching, music, etc. were non-productive. Thesepersons
were ‘parasites’ living on the wealth produced by others. This led Adam Smith to
conclude that for increasing the wealth of a nation, the use of labour should be primarily
for “productive purposes”.

1.2. ECONOMICS AS A SCIENCE OF MATERIAL WELFARE: A. MARSHALL

After marginalising the earlier definitions of economics focussing on wealth, it became
necessary to come out with more acceptable and wider definition of economics. It is so
because more knowledge was accumulated by this time with regard to economics.
Economists started taking note of the fact that actions of human beings are not guided
by only economic motives. Non-economic considerations also play an equally important
role in them. For this reason, theories dealing with the determination of wage rates of
labour, prices of other inputs, and the distribution of national income between members
of society, became an integral part of economics. But, for the sake of analytical
simplicity, economists still viewed economics as a study of that part of human
behaviour which could be measured in money terms and which could be attributed to a
desire for economic gain. Under this definition the emphasis was given by two
important economists namely; A. Marshall and A.C.Pigou. Marshall’s definition is an
admirable example of this approach, while Pigou adopted a definition of economics
which was primarily concerned with the welfare dimension only. Therefore, Alfred
Marshall came up with the importance of wealth. He emphasised the role of the
individual in the creation and the use of wealth. He wrote: “Economics is a study of
man in the ordinary business of life. It enquires how he gets his income and how
he uses it. Thus, it is on the one side, the study of wealth and on the other and
more important side, a part of the study of man”. Marshall, therefore, stressed the
supreme importance of man in the economic system. Marshall’s definition is considered
to be material-welfare centred definition of economics.
Alfred Marshall published his book, “Principles of Economics” in 1890, where he
provided his definition of economics as “Political economy or economics is a study of
mankind in the ordinary business of life; it examines that part of individual and social
action which is most closely connected with the attainment and with the use of the
material requisites of well-beings. Thus, it is on the one side, a study of wealth; and on
the other, and more important side, a part of the study of man.
That is, he laid emphasis from wealth to material welfare. According to him, wealth
acted only as means to attain the ends and the wealth should not be treated as an end in
itself. According to Marshall, “End is the human welfare.” Marshall was the pioneer of
welfare thought.
MAIN CHARACTERISTICS OF MATERIAL WELFARE DEFINITION
(i) Study of Material Requisites of Well-being: These definitions indicate that economics
studies only the material aspects of well-being. Thus, these definitions emphasise the
materialistic aspects of economic welfare.
(ii) Concentrates on the Ordinary Business of Life: These definitions show that
economics deals with the study of man in the ordinary business of life. Thus, economics
enquires how an individual gets his income and how he uses it.
(iii) A Stress on the Role of Man: These definitions stressed on the role of man in the
creation of wealth or income.

1.3. ECONOMICS AS A SCIENCE OF SCARCITY AND CHOICE: L.ROBBINS

Marshall’s definition was the most popular and accepted definition of economics at one
time. Lionel Robbins has however offered most scientific definition in his famous book
published in 1932, titled “An Essay on the Natureand Significance of Economic
Science”.
According to him, ‘‘Economics is the science, which studies human behaviours as a
relationship between ends and scarce means which have alternative uses.’’ Robbins
based his definition of economics on the following facts.
– The ends or wants of an economy are unlimited in number and variety, and they keep
increasing with the passage of time.
– An economy always has shortage of resources compared with to the wants to be
satisfied.
– It is possible to select between several alternative resources for satisfying a given
want.
– Man has therefore, to choose between wants.
– Similarly, it is possible to use a given resource for the satisfaction of several
alternative wants.
Since scarce resources are limited in supply, according to Robbins definition, such
scarce resources might be put for alternative uses. It is implied here that the alternative
uses to which the commodity can be put should be of varying degrees of importance, so
that, it becomes possible to select the use or the uses to which the commodity is to be
put. The scarcity definition has sharply defined the scope of economics. According to
this approach certain universal truth are regarded as the basis of economic problems.
Every individual and economy has unlimited wants and scarce means to satisfy these
wants. Inability to satisfy unlimited wants with limited resources creates the problems
of choice making i.e., fixing priority of wants to be satisfied. As resources can be put to
alternative uses, we will have to take decision as to which specific want should be
satisfied with particular means. In this way, choice making or decision making is the
means of tackling all these economic problems.

MAIN CHARACTERISTICS OF SCARCITY AND CHOICE DEFINITION

Robbins maintains that if we define economics with an emphasis on its welfare aspects,
we will have to judge the existing performance of the economy and suggest possible
improvement in its structure and working. Such a use of economics for “normative
purposes”, that is, for drawing policy inferences, necessitates that the society should
have a widely accepted set of goals. However, this condition is satisfied only in theory.
In reality, no society possesses a universally agreed set of goals. Moreover, there is no
agreement regarding the relative emphasis to be accorded to even the accepted goals..
For example, modern economies are usually faced with the problem of both
unemployment and inflation. And it is generally agreed that an economy should get rid
of them. In practice. However, it is not possible to do so. If an attempt is made to reduce
unemployment, inflationary forces become stronger and prices go up. And if price are
prevented from rising, unemployment level increases to an unacceptable level. In other
words, though both goals are desirable in themselves, it is not possible to achieve them
simultaneously. They are contradictory to each other. At the most they can be achieved
only partially. But there is seldom any agreement as to the exact balance between the
two which the economy should aim at. Similarly, another example of the society facing
contradictory goals is the choice between consuming away its current national income
or saving it for capital accumulation and economic growth. This choice is more difficult
for developing countries where the existing level of consumption is very low and there
is a strong need for economic growth as well. Yet another example, we can expect a
general agreement that eradication of unemployment, poverty and regional economic
disparities should be achieved. But there is bound to be a difference of opinion in
deciding the order of their priority.
 1.4. ECONOMICS AS A SCIENCE OF DEVELOPMENT & GROWTH: PAUL
SAMUELSON
Samuelson has also given similar but somewhat different definition of economics as
given by Robbins. He has emphasised upon the twin themes of economics—scarcity
and efficiency.
Professor Samuelson offered more comprehensive definitions of economics as under.
“Economics is the study of how people and society end up choosing, with or without the
use of money, to employ scarce productive resources that could have alternative uses to
produce various commodities over time and distributing them for consumption, now or
in the future, among various persons or groups in society. It analyses costs and benefits
of improving patterns of resource allocation”.
The above definition is very comprehensive in the sense that, it does not restrict to
material well-being or money measure as a limiting factor. But it considers economic
growth over time. His book Economics: an Introductory Analysis, first published in
1948, was one of his famous works on economics.

MAIN CHARACTERISTICS OF DEVELOPMENT AND GROWTH DEFINITION

(i) Growth-orientation: Economic growth is measured by the change in national output
over time. The definition says that, economics is concerned with determining the
pattern of employment of scarce resources to produce commodities ‘over time’. Thus,
the dynamic problems of production have been brought within the purview of
economics.

(ii) Dynamic Allocation of Consumption: Similarly, under this definition, Economics is

concerned with the pattern of consumption, not only now but also in the future. Thus,
the problem of dividing the use of income between present consumption and future
consumption has been brought within the orbit of economics.
(iii) Distribution: The modern definition also concerns itself with the distribution of
consumption among various persons and groups in a society. Thus, while the problem
of distribution is implicit in the earlier definitions, the modern definition makes it
explicit.
(iv) Improvement of Resource Allocation: The definition also says that, economics
analyses the costs and benefits of improving the pattern of resource allocation.
Improvement of resource allocation and better distributive justice are synonymous
with economic development. Thus, issues of development of a less developed economy
have also been made subjects of the study of economics.

2. NATURE OF ECONOMICS
Nature of economics is to discuss whether Economics is science or art or both and if it is
a science whether it is a positive science or a normative science or both.
2.1. ECONOMICS – AS A SCIENCE AND AS AN ART
The very first question to describe the nature of economics is to ask - whether
economics is a science or an art or both.
(i) Economics as a Science: A subject is considered science if:
– It is a systematised body of knowledge which studies the relationship between cause
and effect.
– It is capable of measurement.
– It has its own methodological apparatus.
– It should have the ability to forecast.
– If we analyse economics, we find that it has all the features of science.
Like science, it studies cause and effect relationship between economic phenomena. To
understand, let us take the law of demand. It explains the cause and effect relationship
between price and quantity demanded for a commodity. It says, given other things
constant, as price rises, the demand for a commodity falls and vice versa. Here, the
cause is price and the effect is fall in quantity demanded. Similarly like science, it is
capable of being measured; the measurement is in terms of money. It has its own
methodology of study (induction and deduction) and it forecasts the future market
condition with the help of various statistical and non-statistical tools. Thus, a major
portion of economic laws are of this type and therefore, economics is science.
(ii) Economics as an Art: A discipline of study is termed an art if it tells us how to do a
thing that is to achieve an end (objective). It is noteworthy that the final justification for
studying economics lies in the possibility of our ability to use it for solving economic
problems faced by us. Prof. J. M. Keynes says that “An art is a system of rules for the
achievement of a given end.”
Art is nothing but practice of knowledge. Whereas science teaches us to know, art
teaches us to do. Unlike science which is theoretical, art is practical. If we analyse
economics, we find that it has the features of being an art also. Its various branches,
consumption, production, public finance, etc. provide practical solutions to various
economic problems. It helps in solving various economic problems which we face in our
day-to-day life.
Thus, economics is both a science and an art. It is science in its methodology and art in
its application.

2.2. Economics as Positive Science and Economics as Normative Science

(i) Positive Science: As stated above, Economics is a science. But the question arises,
whether it is a positive science or a normative science. A positive or pure science
analyses cause and effect relationship between variables but it does not pass value
judgment. In other words, it states what is and not what ought to be. Professor Robbins
emphasised the positive aspects of science but Marshall and Pigou have considered the
ethical aspects of science which obviously are normative. According to Robbins,
economics is concerned only with the study of the economic decisions of individuals
and the society as positive facts but not with the ethics of these decisions. Economics
should be neutral between ends. It is not for economists to pass value judgments and
make pronouncements on the goodness or otherwise of human decisions. An individual
with a limited amount of money may use it for buying liquor and not milk, but that is
entirely his business. A community may use its limited resources for making guns rather
than butter, but it is no concern of the economists to condemn or appreciate this policy.
Economics only studies facts and makes generalizations from them. It is a pure and
positive science, which excludes from its scope the normative aspect of human
behaviour. Complete neutrality between ends is, however, neither feasible nor
desirable. It is because in many matters the economist has to suggest measures for
achieving certain socially desirable ends. For example, when he suggests the adoption of
certain policies for increasing employment and raising the rates of wages, he is making
value judgments; or that the exploitation of labour and the state of unemployment are
bad and steps should be taken to remove them. Similarly, when he states that the
limited resources of the economy should not be used in the way they are being used and
should be used in a different way; that the choice between ends is wrong and should be
altered, etc. he is making value judgments.
(ii) Normative Science: As normative science, economics involves value judgments. It
is prescriptive in nature and described ‘what ought to be’ or ‘what should be the things’.
For example, the questions like what should be the level of national income, what
should be the wage rate, how much of national product be distributed among people -
all fall within the scope of normative science. Thus, normative economics is concerned
with welfare propositions.
Thus, it is unnecessary to debate the question as to whether economics is a science or
an art; whether it is positive or normative science. Basically, it is both. So, we should
acknowledge the usefulness of both. The scope of improving the scope of economy will
always be there.

3. Scope of Business Economics:

The scope of Business economics is not yet clearly laid out because it is a developing
science. Even then the following fields may be said to generally fall 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
These divisions of business economics constitute its subject matter.
Recently, Business economists have started making increased use of Operation
Research methods like Linear programming, inventory models, Games theory, queuing
up theory etc., have also come to be regarded as part of Business Economics.
1. Demand Analysis and Forecasting: A business firm is an economic organisation
which is engaged in transforming productive resources into goods that are to be sold in
the market. A major part of Business decision making depends on accurate estimates of
demand. A forecast of future sales serves as a guide to management for preparing
production schedules and employing resources. It will help management to maintain or
strengthen its market position and profit base. Demand analysis also identifies a
number of other factors influencing the demand for a product. Demand analysis and
forecasting occupies a strategic place in Business Economics.
2.Cost and production analysis: A firm’s profitability depends much on its cost of
production. A wise manager would prepare cost estimates of a range of output, identify
the factors causing are cause variations in cost estimates 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 is supposed to carry out the production function
analysis in order to avoid wastages of materials and time. Sound pricing practices
depend much on cost control. The main topics discussed under cost and production
analysis are: Cost concepts, cost-output relationships, Economics and Diseconomies of
scale and cost control.
3.Pricing decisions, policies and practices: Pricing is a very important area of
Business Economics. In fact, price is the genesis of the revenue of a firm ad as such the
success of a business firm largely depends on the correctness of the price decisions
taken by it. The important aspects dealt with this area are: Price determination in
various market forms, pricing methods, differential pricing, product-line pricing and
price forecasting.
4.Profit management: Business firms are generally organized for earning profit and in
the long period, it is profit which provides the chief measure of success of a firm.
Economics tells 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 likely to accrue to the firm at different levels of output. The more
successful a manager is in reducing uncertainty, the higher are the profits earned by
him. In fact, profit-planning and profit measurement constitute the most challenging
area of Business Economics.
5.Capital management: The problems relating to firm’s capital investments are
perhaps the most complex and troublesome. Capital management implies planning and
control of capital expenditure because it involves a large sum and moreover the
problems in disposing the capital assets off are so complex that they require
considerable time and labour. The main topics dealt with under capital management are
cost of capital, rate of return and selection of projects.

4. Role of a Business Economist

A Business 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 Business 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. The internal factors are
those factors that are under the control of an organization. These factors include
formulation of price policy, expansion or contraction of business, level of efficiency, and
determination of wage policy. On the other hand, external factors include economic
policies of the government, fluctuations in economic conditions, and labor laws. All
these internal and external factors directly or indirectly influence the performance of an
organization. Therefore, a Business economist needs to carefully study and analyze
these factors.
Besides this, a Business 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.
Thus, a Business economist guides the management of an organization regarding the
environment of the economy and its impact on the activities of an organization. In India,
the importance of a Business economist is growing rapidly. Nowadays, all large
organizations and industrial houses are hiring Business economists so that they can
take efficient business decisions.

5. Responsibilities of Business Economist

The following points highlight the top five responsibilities of Business economist.
5.1. To make a reasonable profit on capital employed:
He must have a strong conviction that profits are essential and his main obligation is to
assist the management in earning reasonable profits on capital employed in the firm.
5.2. He must make successful forecasts by making in depth study of the
internal and external factors:
This will have influence over the profitability or the working of the firm. He must aim at
lessening if not fully eliminating the risks involved in uncertainties. He has a major
responsibility to alert management at the earliest possible time in case he discovers any
error in his forecast, so that the management can make necessary changes and
adjustments in the policies and programmes of the firm.
5.3. He must inform the management of all the economic trends:
A Business economist should keep himself in touch with the latest developments of
national economy and business environment so that he can keep the management
informed with these developments and expected trends of the economy.
5.4. He must establish and maintain contacts with individuals and data sources:
(i) To establish and maintain contacts:
A Business economist should establish and maintain contacts with individuals and data
sources in order to collect relevant and valuable information in the field.
(ii) To develop personal relations:
To collect information he should develop personal relations with those having
specialised knowledge of the field.
(iii) To join professional associations and should take active part in their
activities:
The success of this lies in how quickly he gathers additional information in the best
interest of the firm.
5.5. He must earn full status in the business and only then he can be helpful to the
management in good and successful decision-making:
(i) He must receive continuous support for himself and his professional ideas by
performing his function effectively.
(ii) He should express his ideas in simple and understandable language with the
minimum use of technical words, while communicating with his management
executives.

6. Significance of Business Economics :

The significance of business economics can be discussed as under :

1. Business economic is concerned with those aspects of traditional economics which
are relevant for business decision making in real life. These are adapted or modified
with a view to enable the manager take better decisions. Thus, business economic
accomplishes the objective of building a suitable tool kit from traditional economics.
2. It also incorporates useful ideas from other disciplines such as psychology, sociology,
etc. If they are found relevant to decision making. In fact, business economics takes the
help of other disciplines having a bearing on the business decisions in relation various
explicit and implicit constraints subject to which resource allocation is to be optimized.
3. Business economics helps in reaching a variety of business decisions in a complicated
environment. Certain examples are :
(i) What products and services should be produced?
(ii) What input and production technique should be used?
(iii) How much output should be produced and at what prices it should be sold?
(iv) What are the best sizes and locations of new plants?
(v) When should equipment be replaced?
(vi) How should the available capital be allocated?
4. Business economics makes a manager a more competent model builder. It helps him
appreciate the essential relationship Characterising a given situation.
5. At the level of the firm. Where its operations are conducted though known focus
functional areas, such as finance, marketing, personnel and production, business
economics serves as an integrating agent by coordinating the activities in these different
areas.
6. Business economics takes cognizance of the interaction between the firm and society,
and accomplishes the key role of an agent in achieving the its social and economic
welfare goals. It has come to be realised that a business, apart from its obligations to
shareholders, has certain social obligations. Business economics focuses attention on
these social obligations as constraints subject to which business decisions are taken. It
serves as an instrument in furthering the economic welfare of the society through
socially oriented business decisions.

Conclusion :
The usefulness of business economics lies in borrowing and adopting the toolkit from
economic theory, incorporating relevant ideas from other disciplines to take better
business decisions, serving as a catalytic agent in the process of decision making by
different functional departments at the firm’s level, and finally accomplishing a social
purpose by orienting business decisions towards social obligations.
 Managerial Economics: 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:

Content:
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

7. 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 uncer-
tainty, 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.