CHAPTER ONE

THE ECONOMIC NATURE OF DECISION MAKING

1, MEANING AND DEFINITION OF MANAGERIAL ECONOMICS

DEFINITION
Managerial economics is about the criteria for rational decision making by managers of business
enterprises
“The integration of economic theory with business practice for the purpose of facilitating
decision making and forward planning of management”
Managerial economics helps the managers to analyze the problems faced by the business unit and
to take vital decisions.
SCOPE OF MANAGERIAL ECONOMICS
The scope of managerial economics refers to its area of study.
Economics is dealing the decisional problems of both business and non-business organizations,
Business economics deals only the problems of business organizations.
Business economics giving solution to the problems of a business unit or profit oriented unit.
Managerial economics giving solution to the problems of non-profit organizations like schools,
hospital etc., also.
The scope covers two areas of decision making
(A) Operational or internal issues and
(B) Environmental or external issues.
A) Operational/internal issues
These issues are those which arise within the business organization and are under the control of
the management.
They pertains to simple questions of what to produce, when to produce, how much to produce and
for which category of consumers.
The following aspects may be said to be fall under internal issues;-
1. Demand analysis and Forecasting: - A study of the determinants of demand is necessary for
forecasting future demand of the product.
2. Cost analysis: - The factors causing variation of cost must be found out and allowed for it
management to arrive at cost estimates. This will helps for more effective planning and sound
pricing practices.
3. Pricing Decisions: The pricing is an important area of managerial economics. Theories
regarding price fixation helps the firm to solve the price fixation problems. 4. Profit Analysis: -
Profit planning become necessary under the conditions of uncertainty.
5. Capital budgeting: - The manager has to calculate correctly the profitability of investment
and to properly allocate the capital.
Success of the firm depends upon the proper analysis of capital project and selecting the best one.
6. Production and supply analysis: - Production analysis is proceeds in physical terms while
cost analysis proceeds in monitory term.
Important aspects of supply analysis are; supply schedule, curves and functions, law of supply,
elasticity of supply and factors influencing supply.
B) Environmental or external issues
It refers to the general business environment in which the firm operates.
A study of economic environment should include the types of economic system in the country.
1. The general trend in production, employment, income, prices, savings and investments
2. Trends in the working of financial institutions like banks, financial corporations, insurance
companies etc..
3. Magnitude and trends in foreign trade.
4. Trends in labour and capital market.
5. Government economic policies viz., industrial policy, monitory policies, fiscal policy, price
policy etc…
OBJECTIVES AND NEEDS OF MANAGERIAL ECONOMICS
The basic objective of managerial economics is to analyze the economic problems faced by the
business.
Other objectives are:-
1. To integrate economic theory with business practice.
2. To apply economic concepts and principles to solve business problems.
3. To allocate the scares resources in the optimal manner.
4. To make all-round development of a firm. 5. To minimize risk and uncertainty
6. To helps in demand and sales forecasting.
7. To help in profit maximization.
8. To help to achieve the other objectives of the firm like industry leadership, expansion,
Implementation of policies etc.
NEED AND IMPORTANCE OF MANAGERIAL ECONOMICS
In order to solve the problems of decision making, data are to be collected and analyzed in the
light of business objectives. Managerial economics provides help in this area.
The importance of Managerial economics given in the following points:
1. It provides tool and techniques for managerial decision making.
2. It gives answers to the basic problems of business management.
3. It supplies data for analysis and forecasting.
4. It provides tools for demand forecasting and profit planning.
5. It guides the managerial economist.
6. It helps in formulating business policies.
7. It assists the management to know internal and external factors influence the business.
AREAS OF BUSINESS DECISION MAKING
a) Selection of product.
b) Selection of suitable product mix.
c) Selection of method of production.
d) Product line decision.
e) Determination of price and quantity.
f) Decision on promotional strategy.
g) Optimum input combination.
h) Allocation of resources.
i) Replacement decision. j) Make or buy decision.
k) Shut down decision.
l) Decision on export and import.
m) Location decision.
n) Capital budgeting.
FUNCTIONS AND RESPONSIBILITIES OF MANAGERIAL ECONOMIST
A managerial economist can play an important role by assisting the management to solve the
difficult problems of decision making and forward planning.
Following are the important specific functions of managerial economist;
1. Sales forecasting.
2. Market research.
3. Production scheduling
4. Economic analysis of competing industry.
5. Investment appraisal.
6. Security management analysis.
7. Advise on foreign exchange management.
8. Advice on trade.
9. Environmental forecasting.
10. Economic analysis of agriculture Sales forecasting
The responsibilities of managerial economists are the following;
1. To bring reasonable profit to the company.
2. To make accurate forecast.
3. To establish and maintain contact with individual and data sources.
4. To keep the management informed of all the possible economic trends.
5. To prepare speeches for business executives.
6. To participate in public debates
7. To earn full status in the business team.
DECISION MAKING
Decision making is an integral part of modern management. Decision making is the process of
selecting one action from two or more alternative course of actions.
Resources such as land, labor and capital are limited and can be employed in alternative uses, so
the question of choice is arises.
AREAS OF DECISION MAKING
a) Selection of product.
b) Selection of suitable product mix.
c) Selection of method of production.
d) Product line decision.
e) Determination of price and quantity.
f) Decision on promotional strategy.
g) Optimum input combination.
h) Allocation of resources.
i) Replacement decision.
j) Make or buy decision.
k) Shut down decision.
l) Decision on export and import.
m) Location decision.
n) Capital budgeting.
The process of managerial decision making
 Establishing objectives
 Defining the problem
 Identifying possible alternative solutions
 Evaluating alternative course of action
 Implementing the decision

Dimensions of the Decision Problem

1 Multiple Goals
The decision maker may be confronted with a multiplicity of goals. Since it is technically not
possible to try to maximize simultaneously the values of multiple conflicting goals, the decision
maker has to choose one of the goals for primary pursuit. The other goals, expressed as minimum
or maximum acceptable values, can then be regarded as constraints on the pursuit of the primary
goal. The object of the decision is to maximize the value of the primary goal, subject to
realization of satisfactory levels of subordinate goals.
2 Multiple Strategies
With respect to any single goal, a decision involves multiple possible courses of action, or
strategies. The rational choice is the alternative that yields the greatest relative positives or the
largest sum of net benefits (positives less negatives), given the decision maker's set of
preferences.

3 Marginal Changes
In many cases, the choices are not mutually-exclusive alternative courses of action; rather they
involve more or less of the same course of action. The range of possible alternatives includes
larger or smaller quantities to be selected. Typically, the decision problem is to select some
quantity that is an alternative to the present one. Assuming that the alternative quantities are
arrayed from smallest to largest, or vice-versa, choosing to shift from one to another involves
additions to or subtractions from benefits or costs. Economists speak of such additions and
subtractions as incremental changes, or marginal changes if they are the smallest possible changes
that can be made. The rational choice in such cases is to make a quantitative change that will yield
the greatest marginal benefit relative to marginal cost. The application of the calculus to marginal
analysis is the subject of Chapter two.

4 Multiple Outcomes
Often the possible alternative courses of action can be identified, but each decision alternative
may have several outcome possibilities. If the decision maker can in some meaningful sense
assess the probability, p, of the occurrence of each possible outcome, V, for each of the alternative
courses of action, he may then compute the expected value of each alternative. The expected
value is a probability-weighted average of the possible outcomes for each decision alternative,
(1) EV = p1V1 + p2V2 + ... + pkVk,or
(1') EV = j=1,k (pjVj),

Where EV is the expected value of the alternative, p is the probability of the outcome V for each
of the k possible outcomes of the alternative. The presumption here is that the sum of the
probabilities of the possible outcomes is 1.0. Each outcome may itself be a net difference between
benefit (b) and cost (c), or V = b - c. Other things remaining the same, the rational decision then is
the choice of the alternative that promises the largest expected value of possible outcomes.

An extension of the expected value concept may be employed in decision situations that unfold in
stages such that subsequent stages depend upon what happens in previous stages. In such cases,
the probability of occurrence of an ultimate outcome is a conditional probability, i.e., the product
of the probabilities of the final outcome and all prior stages
5 Risk
Other things may not be the same, however, if the range of outcome variability differs from one
alternative to another. It is typical for decision alternatives to have different expected values, but
even if two decision alternatives have approximately the same expected values, one may have a
wider range of possible outcome variability than the other. Risk is inherent in the dispersion of
possible outcomes about the mean of all such outcomes. To illustrate, suppose that decision
alternatives A and B may each result in any of five possible outcomes with probabilities of
occurrence as indicated in Table A1-1. It is readily apparent that the possible outcomes for
alternative A span a narrower range than do those of alternative B even though each has an
expected value of $900. Figure A1-2 employs bar-charts in panel (a) to illustrate the probability
distributions of the outcomes of the two alternatives. A common measure of risk associated with a
decision alternative is the standard deviation (sigma) of the alternative's possible outcomes,
 = [j=1,k (Vj - EV)2pj]1/2.

The justification for using the standard deviation as a measure of risk is the assumption that
outcome probability distributions tend to be normally distributed about their means as illustrated
by the smooth probability distribution curves drawn in panel

Table A1-1. Probable outcomes of two possible decision alternatives.

(b) of Figure A1-2. If this assumption is valid, then the mean of the distribution plus and minus
(one / two / three) standard deviations contains (68.26 / 95.44 / 99.74) percent of the outcomes in
the distribution. The decision alternative with the wider range of outcome variability, i.e., greater
standard deviation, is said to be the riskier of the two. If the expected values are equal, the lower-
risk decision alternative would be preferred by most people. Since  A is only 238.7 while B is
402.5, alternative A is the lower-risk alternative.

However, when the expected values of two decision alternatives differ substantially, so also will
their standard deviations be of different magnitudes, and will therefore not serve as a reliable
basis for comparing risks. In such cases, the decision maker may compute a coefficient of
variation, v, for each decision alternative, where v is the ratio of the standard deviation to its
respective expected value, v =  / EV.

The decision alternative with the smaller coefficient of variation is the less-risky alternative. It is
not uncommon for a decision alternative with a higher expected value of outcomes to also be
riskier in the sense of having a wider range of outcome possibilities. In addition to assessing the
riskiness of the decision alternatives, the decision maker must also be able to rationally make
comparisons of the expected values of outcomes (or returns) in light of

Figure A1-2. Probability distributions of two decision alternatives.

6 Imperfect Knowledge.
Only rarely does a decision maker have perfect knowledge of a decision environment, the
possible alternative courses of action that may be taken, or the range of outcomes that may result
from each choice. Where multiple outcomes are possible, a risky situation is said to exist if the
decision maker can both identify all of the possible outcomes and meaningfully assess the
probabilities of occurrence of each of the possible outcomes. An uncertain situation occurs if the
decision maker either cannot identify some of the outcomes, or cannot meaningfully estimate the
probabilities of their occurrence. The decision maker may attempt to deal with uncertainty by
seeking additional information about outcomes or their probabilities of occurrence. But after all
available information is acquired and there is a persisting aura of uncertainty, the decision still has
to be made.

Decision theorists have suggested a number of decision rules for situations involving uncertainty,
i.e., where outcomes cannot be identified or their probabilities of occurrence cannot be
meaningfully assessed. The two that seem to be most useful are the maximin and the minimax
regret decision rules. In the former, the objective is to identify the worst-case outcomes of all of
the decision strategies under consideration, and then choose the one that yields the least-negative
effects, i.e., the best of the worst-case scenarios. This is an extremely conservative approach that
is most appropriate to the need to avoid ultimate failure of the enterprise. Its prime deficiency is
that it considers only failure states, and does not take into account the possibilities of success.

The minimax regret rule requires that the decision maker perceive the best possible outcome of
the decision strategies, and then compute the regret associated with all other strategies as the
difference between each and the best of the alternate strategies. The strategy of choice then is the
one that minimizes the regret that follows from failure to select the best outcome.

7 The Time Dimension

Economists refer to a time frame during which some matters can be changed (e.g., the number of
workers employed), but others cannot (e.g., the size of plant or the number of assembly lines) as
the short run. Short-run decisions usually affect the current situation or the immediate future. The
long run is a period longs enough so that any- and everything can be changed. Long-run decisions
usually have their impacts only after the passage of some time, and do not affect current
operations in any significant sense. Most short-run decisions within the business enterprise are to
increase or decrease something already being done and thus require marginal comparisons of
benefits and costs. Long-run decisions usually affect the scale of the enterprise's operations, and
often involve starting something new or stopping some operation currently under way. Given the
sharpest possible contrast, short-run decisions are "more-or-less," whereas long-run decisions are
"go-no go" decisions.
8 Entrepreneurial Decisions
The managerial context involves making relatively low-risk, routine decisions in regard to
processes that change in smooth, continuous fashion, about which much can be known or
discovered, and to which marginal analysis is applicable. In contrast, the entrepreneurial decision
is risk-laden because it involves innovative discontinuities in operations, about which little can be
known in advance, and to which marginal analysis is less likely to be applicable

Chapter two
Analysis of Risk and Uncertainty
Introduction:

Various managerial decision making theories were discussed in the previous chapters under
certainty but many of the choices that business people make involve considerable uncertainty. A
manager investing in new product development, adoption of new technology or new market entry
faces various risks. Therefore this chapter focuses on the factors to be considered by the managers
to take better decisions with risk under uncertain situations.

Types of Risks:

Economic risk: Choice of loss due the fact that all possible outcomes and their probability of
occurrence are unknown.

Uncertainty: When the outcomes of managerial decisions cannot be predicted with absolute
accuracy but all possibilities and their associated probabilities of occurrence are known.

Business risk: Chance of loss associated with a given managerial decision.

Market risk: Chance that a portfolio of investments can lose money due to volatility in the
financial market.

Inflation risk: A general increase in the price level will undermine the real economic value of
any legal agreement that involves a fixed promise to pay over an extended period.
Interest rate risk: The changing interest rates affect the value of any agreement that involves a
fixed promise to pay over a specified period.

Credit risk: May arise when the other party fails to abide by the contractual obligations.

Liquidity risk: Difficulty of selling corporate assets and investments.

Derivative risk: Chance that volatile financial derivatives could create losses on investments by
increasing price volatility.79

Cultural risk: Risk may arise due to loss of markets differences due to distinctive social customs.

Currency risk: Is the probable loss due to changes in the domestic currency value in terms of
expected foreign currency.

Government policy risk: Chance of loss because of domestic and foreign government policies.

The above listed various types of risks are involved in business.

Therefore it is essential for the manager to understand the type of risk and strategies to overcome
the same. The manager must know the possible outcomes of a particular event, action or decision.
The manager must be aware of the probability of risks in business. (Probability means likelihood
that a given outcome will occur)

For example; a purchase of share may lead to three probable results i.e. either the price will
increase, decrease or it can be the same. Objective interpretation relies on the frequency with
which certain events tend to occur. Out of 100 shares, if 25 have increased and 75 have remained
in the same level in the market then the probability of incurring profit is ¼.

If there is no past experience then we go for subjective probability and based on our perception of
occurrence we may measure the probability.

But manager’s perceptions differ therefore they make different choices.

In general probabilities are measured in two ways they are expected value and variability.

Expected value: The probable payoffs associated with all possible outcomes are called as
expected value.

Expected value = P(s) (40/share) + P (f) (20/share)

= ¼(40) + ¾ (20) = 25.

Variability: The extent to which the possible outcomes of an uncertain situation differ. This
difference is called as deviation; it means difference between expected outcome and the actual
outcome.80

Manager’s attitudes toward risk affect the decision making. The preference towards risk is
classified as, risk loving, risk aversion and risk neutral.

Risk loving: Arises when the payoff is greater than the expected value.

Risk Aversion: Is the behavior of the mangers when the payoff is less than the expected value.

Risk neutral: Behavior takes place when the expected value is equal to the payoff.

There are four ways to manage the risk and uncertainty:

1. Insurance (Business risks are transferred through Insurance

Policies)

2. Hedging is a mechanism whereby the expected loss is to be offset by an expected profit from
another contract.

3. Diversification is a method of managing the risk where the risk is spread to various
investments and thus the risk is minimized to each investment.

4. Adjusting risk is the mechanism whereby the provision is made to offset the expected loss.

Decision under Uncertainty:

1. The maximax rule: Deals with selecting the best possible outcome for each decision and
choosing the decision with the maximum payoff for all the best outcomes.

2. The Maximin rule: Deals with selecting a worst outcome for each investment decision and
choosing the decision with the maximum worst payoff.

3. The Minimax rule: Deals with determining the worst potential regret associated with each,
decision, then choosing the decision with the minimum worst potential regret.

The above mentioned criteria may help to measure the minimum expected opportunity loss. The
game theory may help the manager to overcome various problems and at the same time to take a
better decision in the uncertain business world with minimum risk. Computer based simulation
methods are also available to solve this problem. Sensitivity analysis which is less expensive and
commonly used can also be used
 Chapter three

Production Analysis

Reading Objectives:

At the end of reading of this chapter the reader will be able to understand that production is a
function of land, labour, capital and organization. The mangers will have to procure the right
level of these factors based on factors like diminishing marginal utility economies of large scale
operations, law of return, scales etc., with a view of maximizing the output with minimum cost so
as to earn larger profit to the firm/ industry.

Introduction:

Production is an important economic activity which satisfies the wants and needs of the people.
Production function brings out the relationship between inputs used and the resulting output. A
firm is an entity that combines and processes resources in order to produce output that will satisfy
the consumer’s needs. The firm has to decide as to how much to produce and how much input
factors (labor and capital) to employ to produce efficiently. This chapter helps to understand the
set of conditions for efficient production of an organization.

Factors of production include resource inputs used to produce goods and services. Economist
categories input factors into four major categories such as land, labor, capital and organization.

Land: Land is heterogeneous in nature. The supply of land is fixed and it is a permanent factor of
production but it is productive only with the application of capital and labor. Labor: The supply of
labor is inelastic in nature but it differs in productivity and efficiency and it can be improved.

Capital: is a man made factor and is mobile but the supply is elastic.
Organization: the organization plans, , supervises, organizes and controls the business activity and
also takes risks. Production Function Production function indicates the maximum amount of
commodity ‘X’ to be produced from various combinations of input factors. It decides on the
maximum output to be produced from a given level of input, and how much minimum input can
be used to get the desired level of output. The production function assumes that the state of
technology is fixed. If there is a change in technology then there would be change in production
function.

Q = f (Land, Labour, Capital, Organization)

Q = f (L, L, C, O)49

The production manager’s responsibility is that of identifying the right combination of inputs for
the decided quantity of output. As a manager, he has to know the price of the input factors and the
budget allocation of the organization. The major objective of any business organization is
maximizing the output with minimum cost. To achieve the maximum output the firm has to
utilize the input factors efficiently. In the long run, without increasing the fixed factors it is not
possible to achieve the goal. Therefore it is necessary to understand the relationship between the
input and output in any production process in the short and long run.

Cobb Douglas Production Function:

This is a function that defines the maximum amount of output that can be produced with a given
level of inputs. Let us assume that all input factors of production can be grouped into two
categories such as labour (L) and capital (K).The general equilibrium for the production function
is Q = f (K, L)

There are various functional forms available to describe production.

In general Cobb-Douglas production function (Quadratic equation) is widely used

Q = A KαLβ

Q = the maximum rate of output for a given rate of capital (K) and labour (L).
Short Run Production Function:

In the short run, some inputs (land, capital) are fixed in quantity. The output depends on how
much of other variable inputs are used. For example if we change the variable input namely
(labour) the production function shows how much output changes when more labour is used. In
the short run producers are faced with the problem that some input factors are fixed. The firms
can make the workers work for longer hours and also can buy more raw materials. In that case,
labour and raw material are considered as variable input factors. But the number of machines and
the size of the building are fixed. Therefore it has its own constraints in producing more goods.

In the long run all input factors are variable. The producer can appoint more workers, purchase
more machines and use more raw materials. Initially output per worker will increase up to an
extent. This is known as the Law of Diminishing Returns or the Law of Variable Proportion. To
understand the law of diminishing returns it is essential to know the basic concepts of production.

Measures Of Productivity Total production (TP): the maximum level of output that can be
produced with a given amount of input. Average Production (AP): output produced per unit of
input AP = Q/L Marginal Production (MP): the change in total output produced by the last unit of
an input Marginal production of labor = Δ Q / Δ L (i.e. change in the quantity produced to a given
change in the labour) Marginal production of capital = Δ Q / Δ K (i.e. change in the quantity
produced to a given change in the capital)

Production Function:

A production function, like any other function can be expressed and analysed by any one or
more of the three tools namely table, graph and equation. The firm has a set of fixed variables. As
long with that it increases the labour force from 1 unit to 10 units. The increase in input factor
leads to increase in the output up to an extent. After that it starts declining. Marginal production
increases in the initial period and then it starts declining and it become negative. The firm should
stop increasing labor force if the marginal production is zero- that is the maximum output that can
be derived with the available fixed factors.

When the production function is expressed as an equation it shall be as follows:

 Q = f (Ld, L, K, M, T )It can be expressed as Q = f1, f2, f3, f4, f5 > 053Where,

Q = Output in physical units of good X

Ld = Land units employed in the production of Q

L = Labour units employed in the production of Q

K = Capital units employed in the production of Q

M = Managerial Units employed in the production of Q

T = Technology employed in the production of Q

f = Unspecified function

fi = Partial derivative of Q with respect to ith input.

This equation assumes that output is an increasing function of all inputs.

The Law Of Diminishing Returns

In the combination of input factors when one particular factor is increased continuously without
changing other factors the output will increase in a diminishing manner. Let us assume that a
person preparing for an examination continuously prepares without any break. The output or the
understanding and the coverage of the syllabus will be more in the beginning rather than in the
later stages. There is a limit to the extent to which one factor of production can be substituted for
another. The total production increases up to an extent and it gets saturated or there won’t be any
change in the output due to the addition of the input factor and further it leads to negative impact
on the output. That means the marginal production declines up to an extent and it reaches zero and
becomes negative. The point at which the MP becomes zero is the maximum output of the firm
with the given set of input factors. This law is applicable in all human activities and business
activities. For example with two sewing machines and two tailors, a firm can produce a maximum
of 14 pairs of curtains per day. The machines are used only from 9 AM to 5 PM and the machines
lie idle from 5 pm onwards. Therefore the firm appoints 2 more tailors for the second shift and the
production goes up to 28 units. Then adding two more labour to assist these people will increase
the output to 30 units. When the firm appoints two more people, then there won’t be any change
in their production because their Marginal productivity is zero. There is no addition in the total
production. That means there is no use of appointing two more 54 tailors. Therefore, there is a
limit for output from a fixed input factors but in the long run purchase of one more sewing
machine alone will help the firm to increase the production more than 30 units.

The Law of Returns to Scale

In the long run the fixed inputs like machinery, building and other factors will change along with
the variable factors like labour, raw material etc. With the equal percentage of increase in input
factors various combinations of returns occur in an organization. Returns to scale: the change in
percentage output resulting from a percentage change in all the factors of production. They are
increasing, constant and diminishing returns to scale.

Increasing returns to scale may arise: if the output of a firm increases more than in
proportionate to an increase in all inputs. For example the input factors are increased by 50% but
the output has doubled (100%).

Constant returns to scale: when all inputs are increased by a certain percentage the output
increases by the same percentage. For example input factors are increased by 50% then the output
has also increased by 50 percentages. Let us assume that a laptop consists of 50 components we
call it as a set. In case the firm purchases 100 sets they can assemble 100 laptops but it is not
possible to produce more than 100 units.

Diminishing returns to scale: when output increases in a smaller proportion than the increase in
inputs it is known as diminishing return to scale. For example 50% increment in input factors lead
to only 20% increment in the output.

From the graph given below we can see the total production (TP) curve and the marginal
production curve (MP) and average production curve (AP). It is classified into three stages; let us
understand the stages in terms of returns to scale.
 Stage I: The total production increased at an increasing rate. We refer to this as increasing stage
where the total product, marginal product and average production are increasing.55

Stage II: The total production continues to increase but at a diminishing rate until it reaches the
next stage. Marginal product, average product are declining but are positive. The total production
is at the maximum level at the end of the second stage with a zero marginal product.

Stage III: In this third stage total production declines and marginal product becomes negative.
And the average production also started decline. Which implies that the change in input factors
there is a decline in the overall production along with the average and marginal?

ISO-Quant’s

To understand the production function with two variable inputs, iso-quant curve is used. These
curves show the various combinations of two variable inputs resulting in the same level of output.
The shape of an Iso-quant reflects the ease with which a producer can substitute among inputs
while maintaining the same level of output. From the graph we can understand that the iso-quant
curve indicates various combinations of capital and labor usage to produce 100 units of motor
pumps. The points a, b or any point in the curve indicates the same quantum of production. If the
production increases to 200 or 300 units definitely the input usage will also increase therefore the
new iso-quant curve for 200 units (Q1) is shifted upwards. Various iso-quant curves presented in
a graph is called as iso- quant map.

Iso-cost: different combination of inputs that can be purchased at a given expenditure level.

Expansion path: Optimal input combinations as the scale of production expand. From the graph
it is clear that the optimum combination is selected based on the tangency point of iso cost
(budget line) and iso- quant ie., a, b respectively. The point ‘a’ indicates that to produce 100 units
of motor the best combination of capital and labour are OC and OM which is within the budget.
Over a period of time a firm will face various optimum levels if we connect all points we derive
expansion path of a firm.
Managerial Uses of Production Function:

Production functions are logical and useful. Production analysis can be used as aids in decision
making because they can give guidance to obtain the maximum output from a given set of inputs
and how to obtain a given output from the minimum aggregation of inputs. The complex
production functions with large numbers of inputs and outputs are analyzed with the help of
computer based programmers.

Chapter four

Cost Analysis

Reading Objectives:

At the end of reading this chapter the reader will be able to understand the concepts like fixed
cost, variable cost, average cost, and marginal cost. The concept of the marginal costing is the
contribution of the 20thcentury. The concept like break even analysis, cost volume profit analysis
is the important tools used to take various managerial decisions. The concept like average
revenue decides the level of output to earn profit. At the same time the concept like marginal cost
is the tool available in the hands of the producers to decide that level of output where MC = AR
i.e., the equilibrium position of the suppliers and consumers.

Introduction:

A production function tells us how much output a firm can produce with its existing plant and
equipment. The level of output depends on prices and costs. The most desirable rate of output is
the one that maximizes total profit that is the difference between total revenue and total cost
Entrepreneurs pay for the input factors- Wages for labor, price for raw material, rent for building
hired, interest for borrowed money. All these costs are included in the cost of production. The
economist’s concept of cost of production is different from accounting.
 This chapter helps us to understand the basic cost concepts and the cost output relationship in the
short and long runs. Having looked at input factors in the previous chapter it is now possible to
see how the law of diminishing returns affect short run costs.

Cost Determinants

The cost of production of goods and services depends on various input factors used by the
organization and it differs from firm to firm. The major cost determinants are:

1. Level of output: The cost of production varies according to the quantum of output. If the size
of production is large then the cost of production will also be more.

2. Price of input factors: A rise in the cost of input factors will increase the total cost of
production.

3. Productivities of factors of production: When the productivity of the input factors is high
then the cost of production will fall.

4. Size of plant: The cost of production will be low in large plants due to mass production with
mechanization.

5. Output stability: The overall cost of production is low when the output is stable over a period
of time.

6. Lot size: Larger the size of production per batch then the cost of production will come down
because the organizations enjoy economies of scale.

7. Laws of returns: The cost of production will increase if the law of diminishing returns applies
in the firm.

8. Levels of capacity utilization: Higher the capacity utilization, lower the cost of production

9. Time period: In the long run cost of production will be stable.

10. Technology: When the organization follows advanced technology in their process then the
cost of production will be low.

11. Experience: over a period of time the experience in production process will help the firm to
reduce cost of production.

12 .Process of range of products: Higher the range of products produced, lower the cost of
production.

13. Supply chain and logistics: Better the logistics and supply chain, lower the cost of
production.

14. Government incentives: If the government provides incentives on input factors then the cost
of production will be low.

Types of Costs

There are various classifications of costs based on the nature and the purpose of calculation. But
in economics and for accounting purpose the following are the important cost concepts.

Actual cost/ Outlay cost/ Absolute cost / Accounting cost: The cost or expenditure which a firm
incurs for producing or acquiring a good or service. (Eg. Raw material cost)

Opportunity cost: The revenue which could have been earned by employing that good or
service in some other alternative uses. (Eg. A land owned by the firm does not pay rent. Thus a
rent is an income forgone by not letting it out)

Sunk cost: Are retrospective (past) costs that have already been incurred and cannot be
recovered.

Historical cost: The price paid for a plant originally at the time of purchase.

Replacement cost: The price that would have to be paid currently for acquiring the same plant.
Incremental cost: Is the addition to costs resulting from a change in the nature of level of
business activity. Change in cost caused by a given managerial decision.

Explicit cost: Cost actually paid by the firm. If the factors of production are hired or rented then it
is an explicit cost.

Implicit cost: If the factors of production are owned by a firm then its cost is implicit cost.

Book cost: Costs which do not involve any cash payments but a provision is made in the books of
accounts in order to include them in the profit and loss account to take tax advantages.

Social cost: Total cost incurred by the society on account of production of a good or service.

Transaction cost: The cost associated with the exchange of goods and services.

Controllable cost: Costs which can be controllable by the executives are called as controllable
cost.

Shut down cost: Cost incurred if the firm temporarily stops its operation. These can be saved by
continuing business.

Economic costs are related to future. They play a vital role in business decisions as the costs
considered in decision - making are usually future costs. They are similar in nature to that of
incremental, imputed explicit and opportunity costs.

Determinants of Short –Run Cost

Fixed cost: Some inputs are used over a period of time for producing more than one batch of
goods. The costs incurred in these are called fixed cost. For example amount spent on purchase of
equipment, machinery, land and building.

Variable cost: When output has increased the firm spends more on these items. For example the
money spent on labor wages, raw material and electricity usage. Variable costs vary according to
the output. In the long run all costs become variable.
Total cost: The market value of all resources used to produce a good or service.

Total Fixed cost: Cost of production remains constant whatever the level of output.

Total Variable cost: Cost of production varies with output.

Average cost: Total cost divided by the level of output.

Average variable cost: Variable cost divided by the level of output.

Average fixed cost: Total fixed cost divided by the level of output.

Marginal cost: Cost of producing an extra unit of output.

Short Run Cost Output Relationship

Fixed cost curve is a horizontal line which is parallel to the ‘X’ axis. This cost is constant with
respect to output in the short run. Fixed cost does not change with output. It must be paid even if
‘0’ units of output are produced. For example: if you have purchased a building for the business
you have invested capital on building even if there is no production.

Total fixed cost (TFC) consists of various costs incurred on the building, machinery, land, etc..
For example if you have spent Rs. 2 Lakhs and bought machinery and building which is used to
produce more than one batch of commodity, then the same cost of Rs. 2 Lakhs is fixed cost for
all batches.

The total variable costs vary according to the output. Whenever the output increases the firm has
to buy more raw materials, use more electricity, labour and other sources therefore the TVC curve
is upward sloping. The total cost consists of fixed (TFC) and variable costs (TVC). The TFC of
Rs. 2 Lakhs is included with the variable cost throughout the production schedule so the total cost
(TC) is above the TVC line.

Cost Output Relationship In The Long Run

 In the long run costs fall as output increases due to economies of scale, consequently the average
cost AC of production falls. Some firms experience diseconomies of scale if the average cost
begins to increase. This fall and rise derives a U shaped or boat shaped average cost curve in the
long run which is denoted as LAC. The minimum point of the curve is said to be the optimum
output in the long run. It is explained graphically in the chart given below.

Economies Of Scale

Economies of scale exist when long run average costs decline as output is increased.
Diseconomies of scale exist when long run average cost rises as output is increased. It is
graphically presented in the following graph. The economies of scale occur because of (i)
technical economies: the change in production process due to technology adoption. (ii)
Managerial economies (iii) purchasing economies, (iv) marketing economies and (v) financial
economies.

Economies of scale means a fall in average cost of production due to growth in the size of the
industry within which a firm operates.

Diseconomies Of Scale: Arises due to managerial problems. If the size of the business becomes
too large, then it becomes difficult for management to control the organizational activities
therefore diseconomies of scale arise.

Factors Causing Economies Of Scale:

There are various factors influencing the economies of scale of an organization. They are
generally classified in to two categories as Internal factors and External factors.

Internal Factors:

1. Labour economies: if the labour force of a firm is specialized in a specific skill then the
organization can achieve economies of scale due to higher labour productivity.
2. Technical economies: with the use of advanced technology they can produce large quantities
with quality which reduces their cost of production.

3. Managerial economies: the managerial skills of an organization will be advantageous to

achieve economies of scale in various business activities.

4. Marketing economies: use of various marketing strategies will help in achieving economies of
scale.

5. Vertical integration: if there is vertical integration then there will be efficient use of raw
material due to internal factor flow.

6. Financial economies: the firm’s financial soundness and past record of financial transactions
will help them to get financial facilities easily.

7. Economies of risk spreading: having variety of products and diversification will help them to
spread their risk and reduce losses.

8. Economies of scale in purchase: when the organization purchases raw material in bulk reduces
the transportation cost and maintains uniform quality.

External Factors:

1. Better repair and maintenance facilities: When the machinery and equipments are repaired and
maintained, then the production process never gets affected.

2. Research and Development: research facilities will provide opportunities to introduce new
products and process methods.

3. Training and Development: continuous training and development of skills in the managerial,
production level will achieve economies of scale.

4. Economies of location: the plant location plays a major role in cutting down the cost of
materials, transport and other expenses.
5. Economies of Information Technology: advanced Information technology provides timely
accurate information for better decision making and for better services.

6. Economies of by-products: Organizations can increase the economies of scale by minimizing

waste and can be environmental responsible by using the by- products of the organization.72

Factors Causing Diseconomies Of Scale:

1. Labour union: continuous labour problem and dissatisfaction can lead to diseconomies of
scale.

2. Poor team work: Poor performance of the team leads to diseconomies of scale.

3. Lack of co-ordination: lack of coordination among the work force has a major role to play in
causing diseconomies of scale.

4. Difficulty in fund raising: difficulties in fund raising reduce the scale of operation.

5. Difficulty in decision making: the managerial inability, delay in decision making is also a
factor that determines the economies of scale.

6. Scarcity of Resources: raw material availability determines the purchase and price. Therefore
there is a possibility of facing diseconomies in firms.

7. Increased risk: growing risk factors can cause diseconomies of scale in an organization. It is
essential to reduce the same.

Economies of scope: producing variety to get cost advantage. In retail business it is commonly
used. Product diversification within the same scale of plant will help them to achieve success.

Lessons For Managers:

 To achieve reasonable return the firm should go for larger plants or expand their plant
for optimum utilization of available resources.
 Build market share to achieve the scale which in turn reduces the cost of production.
  All business activities of the organization leads to economies of scale directly or
indirectly

CHAPTER FIVE
ETHICAL DIMENSIONS OF MANAGERIAL DECISIONS

1 Ethics in Management
Ethical dimensions of managerial decision making were not much discussed prior to the late
twentieth century, perhaps because discussion of them might betray the existence of problems.
There are now both management textbooks and management courses with titles containing the
term "ethics." Of course, there really is no such thing as a particular variety of ethics peculiar to
the managerial decision setting. The discussion should be about ethics in the generic sense, but as
applied to managerial decision settings.

Managerial decision making involves complex interactions between producers and consumers,
employers and employees, managers and owners, business executives and members of the
communities in which their firms operate. While these relationships are essentially economic in
nature, they also have ethical dimensions. Some of these dimensions include the work
environment, the effects of pollution and depletion of natural resources, and the safety of
consumers.

Managerial decision making, whether in the profit, not-for-profit, or public sectors, must be based
upon moral foundations if relationships are to be reliable and predictable. Nonetheless, we hear
and read of a variety of practices in both public and private sectors which most people would
judge to be unethical, among them bribery, embezzlement, breaking contracts, price fixing,
collusion, deceptive advertising, falsification of expense accounts, underreporting of income or
padding of expenses on tax reports, use of substandard materials, producing and selling products
which fail to function as advertised, failing to divulge to consumers possible product dangers, and
so on. Any of these behaviors may erode the moral foundation of commerce and make business
activity both unreliable and unpredictable.
In the private sector, the pursuit of profit has traditionally been viewed as the chief motivation to
engage in productive activity. The pursuit of profit cannot be regarded as a morally neutral
activity because the receipt of profit income may lead to inequality in the distribution of income
between those who are entrepreneurially successful and those who are not or who do not choose
to behave in an entrepreneurial fashion.

A challenge to the legitimacy and authority of privately owned and managed business enterprise
has emerged in the United States during the second half of the twentieth century. The challenge
focuses upon the legitimacy of business, its right to exist, and the right of people to own and use
business property to their own private benefit. Statistical evidence in support of this contention is
implicit in numerous surveys and polls which indicate that many Americans believe that the
ethical standards of business are lower than those of American society as a whole.

A Framework for Thinking about Ethics

In order to provide a framework for thinking about ethics in managerial decision contexts, it will
be convenient to employ a classification scheme provided by W. Michael Hoffman and Jennifer
Mills Moore in Business Ethics: Readings and Cases in Corporate Morality (McGraw-Hill, Inc.,
New York, 1990).

In simplest terms, morality may be defined as what is good or right for human beings. Ethics
involves choices in regard to moral precepts. A choice may be ethical or unethical depending
upon whether behavioral rules are obeyed, or whether the choice yields good or right outcomes
for those who are parties to the decision, and perhaps also for "innocent third parties." Hoffman
and Moore identify three ethical orientations which cover most of the positions which can be
taken by business decision makers.

1.Ethical Relativism
Ethical relativism is the position that there is no one universal standard or set of standards by
which to judge the morality of an action. An ethical relativist may hold the same act to be morally
right for one society, but morally wrong for another. A similar distinction may be applied to two
individuals within the same society. An act which is taken to be moral in one set of circumstances
may be regarded as immoral in another (situational ethics). A problem of ethical relativism is that
each person's ethics are specific to the person; no comparative moral judgments are possible. An
ethical relativist may base morality upon social customs and conventions. Students of
international business often are urged to adopt a polycentric world view (tolerance and
appreciation for cultures alien to one's own) incorporating ethical relativism. "When in Rome, do
as the Romans do," even if it involves engaging in acts that would be unacceptable at home (like
paying bribes).

2Ethical Absolutism
At the opposite end of the ethical spectrum from ethical relativism is Ethical Absolutism. Ethical
absolutists believe in the existence of universal standards of ethical behavior. For Immanuel Kant
(1724-1804), ethical criteria were "categorical imperatives" in the sense that they are absolute and
unconditional, irrespective of the consequences. Examples of Judeo-Christian scriptural dictums
which may serve as categorical imperatives include those found in the Ten Commandments (e.g.,
prohibitions against stealing and lying), scriptures relating to oppression (see the accompanying
essay on "Exploitation"), the Golden Rule ("Do unto others as you would have them do unto
you"), and Jesus' command to love one's neighbor as oneself (Matthew 19:19, 22:39; Mark 12:31,
33; Luke 10:27). Religious fundamentalists of the late twentieth century, whether Moslem, Jew,
or Christian, would perhaps be most comfortable with categorical imperatives in the form of
scriptural dictums to guide their behavior.
3 Consequentialism

The intermediate range of the ethical spectrum is occupied by a variety of positions which focus
upon the outcomes of behavior. Consequentialism is the belief that the consequences of an action
are the sole bases for judging whether an action is right or wrong. For a consequentiality there is
no universal standard of ethical behavior; any action which yields a desirable outcome can be
rationalized as ethical. For consequentiality the end justifies the means as ethical, or if it is an
undesirable end, the end indicts the means as unethical.

3 Consequentiality Positions
Consequentialism dichotomizes into ethical egoism and utilitarianism. Ethical egoism is the belief
that every person ought always to act so as to promote the greatest possible balance of good over
evil for himself. Therefore, an act contrary to one's self interest is an unethical act. Ethical egoists
can argue that others' interests should be respected because treating others well also promotes
their own self interest in the long run. The Golden Rule is not incompatible with ethical egoism.

In contrast to ethical egoism, utilitarianism holds that people ought to act so as to promote the
greatest total balance of good over evil, or the greatest good for the greatest number. A rule
utilitarian would obey those rules which experience has shown generally promote social welfare,
even when doing so does not always lead to good consequences. An act utilitarian may hold that
one ought to act so as to maximize total good even if doing so violates rules which usually
promote social welfare.

Milton Friedman in Essays in Positive Economics (The University of Chicago Press, Chicago,
1953) raises an interesting question in regard to means and ends: If the end does not justify the
means, then what does? He goes on to suggest that if a person is serious in raising this question,
for him the means are actually a more important end than the end which had been contemplated.
We may infer that such a person is less likely to be an act utilitarian than a rule utilitarian or a
categorical imperativist.

We may infer that some variety of consequentialism must underlie the rationale of any dictator
who assumes absolute political authority. A society which finds itself with a dictator can only
hope him or her to be a benevolent act utilitarian rather than an autocrat who is an ethical egoist.
Likewise, societies with democratic policies should attempt to elect act utilitarians rather than
ethical egoists. Act utilitarianism is perhaps the ethical orientation most consistent with the
pragmatism of late-twentieth century American social and political liberalism. Late twentieth-
century Christians who are religious liberals might tend toward rule utilitarianism, whereas
Christian fundamentalists are more likely to be categorical imperativists.

While numerous scriptural references imply care for other members of society, there do not
appear to be any explicit scriptural dictums which are congruent with act utilitarianism. Although
Cain's question in Genesis 4:9 ("Am I my brother's keeper?") went unanswered, an affirmative
answer often is adduced to it. A liberal translation of "brother" to refer to all of humanity would
seem to suggest an act utilitarian orientation. In Luke 10:29, a lawyer asks Jesus, "And who is my
neighbor?" Jesus replies with the story of the Good Samaritan which concludes that the neighbor
is the one who showed mercy to the injured man. Although never stated explicitly, the implication
is that "neighbor" refers to anyone encountered, and in the limit all of humanity. The latter
interpretation implies an act utilitarian ethical orientation.

In 1776, Adam Smith (who trained as a moral philosopher) tied ethical egoism and utilitarianism
together when he asserted (in The Wealth of Nations) that pursuit of self-interest by each member
of society may contribute more to the common weal (welfare) than the individual either knows or
intends.

4 The Role of Justice in Ethics

The concept of justice plays an important role in ethical considerations in American society.

A. Procedural Justice

Procedural justice is achieved when appropriate procedures are employed, as for example when
universal rules are obeyed. However, the use of just procedures may not yield desirable results.
The Golden Rule, "Do unto others as you would have them do unto you," is an example of a
categorical imperative which would achieve procedural justice, but which may not result in
desirable consequences if others choose not to reciprocate.

B. Distributive Justice

Distributive justice is achieved when benefits and burdens of economic activity are distributed
fairly, but this begs a question of what constitutes fairness. The egalitarian notion of distributive
justice is an equal (or as nearly equal as possible) distribution of benefit and burden. Non-
egalitarians may hold that fairness is achieved when the benefits and burdens are distributed on
the basis of some specific criterion, such as need, merit, effort, hard work, or contribution to
society.

The principle of justice underlying American capitalism has tended to emphasize contribution to
society recognized by market demand as the criterion for judging the fairness and hence the
justice of distribution. Americans typically have not expected everyone to end up with an equal
share of benefits and burdens; rather, those who receive more do so because of their greater
contribution.
5 Ethical Orientations of Managerial Decision Makers
It can be argued that managerial decision makers must behave relatively more ethically than less
so in order to ensure continuance and reliability of commercial relationships. Are managerial
decision makers, by training, social conditioning, or innate character (among those who select
themselves into commercial occupations), inclined to be ethical relativists, ethical egoists,
utilitarians, or categorical imperativists? We are likely to find some of each kind in any walk of
life, including commerce. A pure speculation is that the for-profit sector has a natural attraction
for ethical egoists. Those who are intimately engaged in international business operations
probably become drawn to ethical relativism. Managers who are professing Christians are more
likely to be rule utilitarians or categorical imperativists. Social liberals who are act utilitarians are
likely to be drawn into public sector managerial settings or politics.

Although American business interests may be characterized by egoism as a predominant guiding

principle of their ethics, Adam Smith's premise that there often is a convergence of private
interest with the public weal goes a long way toward explaining why some may engage in actions
which serve their own self interests while at the same time engaging in rhetoric to the effect that
they are also contributing to the public welfare. Whether there is reality beyond the rhetoric is
subject to scrutiny and debate. This issue is made more obscure because some in the non-business
public take self-righteous positions in criticizing the apparently self-serving actions of American
business decision makers.

6 Social Responsibility
In the last couple of decades, the American business community has given the appearance of
becoming more socially aware and responsible. This may be a manifestation of the quest for
legitimacy in the face of the challenge to the power and authority wielded by business executives.
Many businesses have created and displayed business ethics statements. Some have gone to great
lengths to indoctrinate their employees to act upon the tenants of their company ethics statements.
For others such statements may be little more than marketing ploys. To the extent that business
executives take their corporate ethics statements seriously and back them up with civic generosity
and ethical behavior, this suggests that they are becoming less egoistic and more utilitarian in
ethical orientation.
The Macroeconomic Setting

1 The Role of the Government

We have made numerous allusions in previous chapters to the interrelations between the firm and
the government. Our purpose in this chapter is to delve into these relationships, but our task is
made all the more interesting and challenging by the recent events transpiring in Eastern Europe,
the former Soviet Union, China, and other parts of the world where socialism has been the
predominant form of economic organization for a half century or more.

2 Forms of Economic Systems

The nature of the relationship between the microeconomic productive unit (i.e., the "firm" in our
previous discussions) and the state depends critically upon the form of economic system in place
in the society. Although it is possible to identify a wide range of economic system types
(including communalism, tribalism, feudalism, and traditionalism), we shall limit consideration to
the three which seem to be most pertinent to circumstances of the modern world: socialism,
capitalism, and fascism.

In the extreme form of authoritarian socialism, the microeconomic productive unit may be little
more than an appendage of the state. Indeed, there is little point in making distinctions among
micromanagement (i.e., the management of the productive unit), industrial organization and
policy, and the macro management (i.e., the implementation of macropolicy) of the entire
economy. They are all tied up together. For all intents and purposes, there is virtually no freedom
of enterprise in authoritarian socialism.

Efforts at centralized and authoritarian direction of the economy seem to have revealed
inefficiencies almost everywhere they have been tried. However, societies employing such forms
of economic organization seem to be backing away from them in favor of capitalism. Capitalism
is distinguished by private ownership of productive resources which are organized by markets.
Rather than being highly centralized, decision making in capitalism is widely dispersed to the
managements of a myriad of microeconomic productive units, i.e., individuals and the firms or
enterprises which compose the economy.
In most forms of capitalism there is a cleavage between the microeconomic productive units and
the state which functions as government. In the purest form of capitalism, the state owns no
productive resources and engages in no productive activity. Its role is closely circumscribed to
providing a legal and social environment which is hospitable to the functioning of the private
economy. By the same token, the privately-owned productive units have no significant governing
responsibility or authority, but they enjoy a maximum of freedom of enterprise. It is these entities
which have been the focus of managerial economic analysis thus-far in this text.

Between the extremes of authoritarian socialism and pure capitalism is possible a wide range of
governmental productive activity as well as the use of market mechanisms in conjuction with
central planning. The terms "mixed capitalism" and "mixed socialism" are used to describe these
intermediate forms of economic organization. The exercise of decision-making authority by the
managers of enterprises depends critically upon the nature of the relationship between their
organizations and the government.

Fascism is a curious combination of the characteristics of socialism and capitalism. Resources

remain privately owned as in capitalism, but the state (often in the form of a dictatorship)
exercises centralized authority to impose production quotas to be met by the privately-owned
enterprises. In fascism, freedom of enterprise is severely restricted. Although fascism has an
infamous twentieth-century history, the most prominent examples of it have been eliminated from
the world scene. But there almost certainly are examples of functional fascism in today's "third
world." And some Western societies are experimenting with a softer variant, statism, which
involves increasing willingness to rely upon the powers of the state to treat social, political, and
economic problems.

3 The Applicability of Managerial Decision Criteria

The managerial economic principles and decision criteria elaborated in earlier chapters have been
postulated for the context of privately-owned, profit-motivated business enterprises operating
within market capitalism. It is not clear that these principles and criteria are also applicable to
microeconomic production units in a centrally planned and directed economy. Nor is it clear that
they can apply to governmental departments and their subdivisions and agencies, or to
organizations in the not-for-profit sector of a market economy (churches, charitable organizations,
educational institutions, health-care organizations, etc.). These are similar in that while each is
oriented toward pursuit of some mission, that mission is not to realize the maximum possible
amount of net income. It therefore appears that decision criteria which are postulated for profit-
oriented firms may not be applicable to not-for-profit organizations.

One problem is that in both the government agency and the not-for-profit sector, the financial
requirement is simply to remain within budget (i.e., a budgetary non-negativity constraint), rather
than to maximize profit (net revenue). A similar constraint usually is imposed upon a factory in a
centrally-planned economy. However, this is not unlike satisficing, i.e., the pursuit of a target
return on invested capital, in the for-profit sector of a market economy as originally hypothesized
by Herbert Simon (discussed in Chapter A4). In the government agency and the not-for-profit
organization, the target return is simply zero rather than some positive net amount. If for-profit
business firm managers can target some (any) positive amount of net income (rather than try to
realize the maximum possible), it should be feasible for the managers of not-for-profit
organizations to employ the same decision criteria in pursuit of a zero or non-negative return.
Zero should be as good a target as some positive amount.

In the previous chapter we examined the thesis that managers of some for-profit business firms
may attempt to optimize rather than maximize with respect to profit. Optimization means
maximization of a primary goal subject to one or more constraints which are imposed by the
existence of subsidiary goals. William Baumol hypothesized that many managers, instead of
attempting to achieve the maximum possible profit, actually pursue some non-profit goal, e.g.,
sales volume or share of market, subject to a minimum acceptable profit constraint (e.g., a target
return on invested capital). The Baumol model is elaborated in the previous chapter.

In the not-for-profit sector, the organization always has some mission to accomplish or some goal
to pursue. Often the mission or goal can be expressed in some quantifiable but non-pecuniary
form. For example, in a charitable organization such as the Salvation Army, the mission may be
to provide the most welfare services (meals, shelter, etc.) to constituents while not over expending
the budget. The manager of a (former) Soviet factory may be required to meet an output quota
imposed by the contral plan while remaining within the factory's budget. These are fairly straight-
forward applications of the Baumol thesis taking the minimum acceptable amount of profit as
zero (i.e., no loss or negative profit).
Production units in centrally planned economies and not-for-profit organizations in market
economies are notorious for inefficient operation in the sense that costs tend to be excessive and
goal achievement seems to be deficient in comparison to comparable for-profit enterprises. A
significant problem in these situations is that it is very difficult to provide the manager with
performance incentives. It is also difficult to link the process of mission pursuit to any factor
which constitutes a performance incentive for the manager. This linkage often is achieved in the
for-profit sector of the market economy by letting the manager share in the net income of the
enterprise (bonuses, stock options). But this is a problem of linkage, not a problem of the
applicability of managerial decision criteria.

A final problem which we shall note is that of organizational bureaucracy. Typically there are
several levels of management in any complex organization. The managerial decision criteria
which we have described in earlier chapters are most appropriately employed at the highest level
of managerial policy making where the managers can take a view which oversees the whole
enterprise. These principles may be of lesser applicability at any intermediate level with-in the
bureaucracy where the department or division-level manager (bureaucrat) can see and exercise
control over only the few variables associated with the department. But bureaucracy is no less a
problem for the corporation in the for-profit sector than for a charitable organization in the not-
for-profit sector or the factory in a centrally planned economy.

The conclusion to which we have been moving is that the managerial decision criteria elaborated
in earlier chapters should be applicable to decision making in not-for-profit organizations and
government agencies, but there are other problems of performance-incentive linkage and
bureaucracy which must be dealt with.

4 Benefit-Cost Analysis
If the principal objective of a not-for-profit organization is to maximize some aspect of its non-
pecuniary mission, the marginal comparison criteria applied in the for-profit sector to revenues
and costs should be equally applicable in the not-for-profit sector to the quantifiable
characteristics of the mission being pursued. "Benefit-cost" analysis may provide decision criteria
for the organization manager in the government and not-for-profit sectors. The sum of all benefits
(non-pecuniary as well as revenue) resulting from mission pursuit constitutes the numerator, B, of
the benefit-cost ratio. Its denominator, C, consists of the sum of all costs (non-pecuniary as well
as pecuniary) incurred in pursuing the mission. If the value of the ratio is a number greater than
unity (i.e., B/C > 1), then the activity under analysis is justifiable; any benefit-cost ratio less than
unity (i.e., B/C < 1) suggests that the activity is unwarranted.

Simple benefit-cost analysis has been extended to the concept of marginal benefit-cost analysis.
This version is applicable to situations where the question is whether to do more or less of the
activity which is already in progress. The numerator of the marginal benefit-cost ratio includes
only the additional benefits which are expected to flow from some increment of the activity; the
denominator sums only the increased costs incurred by the activity increment. The same decision
criterion holds for the marginal as for the simple benefit-cost ratio: a value greater than unity
warrants the activity increment while a value less than unity indicates that the activity increment
should not be undertaken. While marginal benefit-cost analysis has been used most often as a
decision criterion in the not-for-profit sector, it is apparent that the for-profit criteria of marginal
revenue and marginal costs are special cases of marginal benefits and costs where the benefits and
costs are pecuniary values (or equivalents).

Both simple and marginal benefit-cost analyses are subject to bias and fraught with the potential
for abuse. The bias follows from the requirement to include all benefits (psychic and other non-
pecuniary benefits as well as any revenues resulting from the activity) and all relevant costs (non-
pecuniary psychic and opportunity costs as well as explicit money costs). The problem is that a
decision maker who is has a predisposition favoring a proposed activity tends to exhaustively
identify all possible benefits and also tends to overestimate their money value equivalents. A
decision maker with such a predisposition also tends to be more casual about identifying the
relevant costs, and may also be inclined to underestimate their money value equivalents. By the
same token, a decision maker with a predisposition against an activity tends to do the opposite,
i.e., to casually overlook some benefits and underestimate the values of those identified, while
exhaustively finding all relevant costs and carefully estimating their full money-value equivalents.
Because of the subjectivity involved, it is entirely possible for two decision makers, confronted by
precisely the same prospects and with the same information, to estimate widely divergent benefit-
cost ratios and reach opposite decisions about whether to proceed with the activity.
 5 Points of Contact between the Firm and the Government
Because capitalism (or market economy) is the form of economic organization to which the world
seems to be drawn, we shall presume its general characteristics in subsequent discussion of the
role of government. Given this presumption, there are six principal points of contact between
firms and the government.

(1) Along with other entities in the economy, the government is a demander of goods and services
from private-sector business firms; i.e., firms function as suppliers to the government. Since
the government is likely to be the single largest economic entity in any economy, the
prospect of supplying the government should provide market opportunities for a great many
firms in the economy. However, firms seeking to function as suppliers to government should
be aware of becoming too highly dependent upon government orders.

(2) Firms pay taxes to the government. The taxes may be related to the firms' profits, their sales,
their inventories or other assets, or the wages which they pay to their employees. Tax-related
record keeping and reporting often become burdensome to business firms, and tax liabilities
and rates are subject to change at the dictatorial or parliamentary whims of the state.

(3) Depending upon the government's particular political, social, and military programs, various
firms in the economy may become objects of support by the government. Such support may
take the forms of subsidies, approval of licenses, preferential contracts, or other
encouragements. The government may attempt to structure such activity as a coherent
industrial policy for the promotion of international competitiveness of domestic companies.

(4) In pursuit of its agenda, government's interests in firms may extend beyond support to efforts
to control the activities of firms. Objects of governmental controls may include directions of
research and development efforts, determination of product mixes and item specifications,
selection of capital investment alternatives, eligibilities for import or export licenses, and
employment practices. These activities may become elements in a more comprehensive
industrial policy.

(5) The private sector may become an object of regulation by the government in the interest of
employees, consumers, or other interests in the economy. Such regulation almost always
 imposes additional costs upon business firms, and consequently squeezes profits or results in
higher market prices.

(6) And finally, the private sector may become the object of efforts either to promote and
encourage competition, or to stifle or prevent competition. In the former case, "antitrust" or
"antimonopolies" laws may be enacted and enforced; in the latter case the government may
become the prime mover in the effort to "rationalize" or cartellize industry (also a possible
component of industrial policy).

In their extreme manifestations, points (1) and (4) above may devolve to the characteristics of
fascism. We may also note that the government can effect a ready transformation to the
characteristics of socialism simply by nationalizing private-sector firms so that they become
government-owned and directed enterprises. Our purpose in making these observations and
otherwise identifying the various points of contact between firms and the government is to note
that the operation of government in a capitalistic economy may pose threats to private sector firms
as well as provide opportunities which they may attempt to exploit.

6 Rationales for Governmental Involvement in the Market Economy

The most fundamental role for government to play in the market economy is the maintenance of
an environment which is hospitable to the functioning of market economy and the exercise of
entrepreneurship. At very minimum this means establishing the rules for holding, transferring,
and arbitrating disputes over the possession of private property, determining weights and
measures, providing a stable money supply, insuring the sanctity of contracts, and otherwise
maintaining law and order. John Stuart Mill during the nineteenth century referred to these
minimal roles for government as the "night-watchman" functions.

Beyond the night-watchman functions are four other significant rationales for governmental
involvement in the market economy: to maintain competition, to reallocate resources, to
redistribute incomes, and to stabilize the economy. Each of these rationales is founded upon some
fault, shortcoming, or failure in the functioning of the market.

From this perspective it may be noted that any problem in the functioning of a market may invite
some response from government to address the perceived problem. And if market mechanisms
exhibit traumatic failure or become fundamentally distrusted by the political leadership of the
society, these constitute the rationales for shifting to fascism by conferring product-mix decision
making upon a central authority, or to socialism by nationalizing privately-owned productive
resources and imposing central planning and direction. By the same token, failure of authoritarian
socialism constitutes the rationale for shifting from authoritarian control to some form of market
economy. It appears that this latter phenomenon is being widely experienced in the Eastern
Europe even as some economies of the West experiment with more statist orientations.

7 The Maintenance of Competitive Conditions

Viable competition among business firms in each market is the sine qua non of market capitalism.
It is competition which ensures that firms efficiently produce only those goods and services
demanded by the consumers of the society. But there is an inherent divergence of interest between
the firms in an industry and their customers. Although customers surely benefit from adequate
competition(lower prices, higher quality merchandise, greater product variety), firms might
achieve greater profits in cooperation with each other or as sole monopolists of their respective
markets.

Governments of democratic societies then find rationale to undertake the promotion and
preservation of competitive conditions in their economies. This is usually done by enacting
legislation which declares the existence of monopoly to be unlawful (in the U.S. this is
accomplished by Section 1 of the Sherman Antitrust Act) and the perpetrator of monopoly to be
guilty of an unlawful act (Sherman, Section 2), or which enumerates specific acts or activities
which diminish competition and which are thus unlawful (the Clayton, Robinson-Patman, and
Wheeler-Lea acts). But the enactment of legislation alone is not enough. The government must
further establish an enforcement authority (in the U.S., the Federal Trade Commission and the
Antitrust Division of the Department of Justice) and resolve to make effective the enforcement of
the relevant legislation. This resolve may differ significantly according to the political party in
office and the particular agenda which it is attempting to implement.

The managerial implications of the determined enforcement of laws which are intended to
preserve and maintain competition are that managers of business firms must make themselves
knowledgeable of the pertinent laws, and they must make calculated judgments as to whether to
risk violating such laws in any of their sourcing, producing, or marketing activities. It may also be
worthwhile to note that in a society governed by law (as is the U.S.), innocence is presumed until
guilt has been established. The significance of this is that no act undertaken by the management of
a business firm is necessarily in violation of the law until it has been tested in the courts.

In a legal environment of presumed innocence, even though a law may declare a certain act
unlawful and other firms engaging in the act have been indicted and successfully prosecuted, the
act may be repeated by yet another firm. In order for the firm to be penalized under the law, the
act must be detected, indicted by an appropriate legal authority, and successfully prosecuted in
court. Because failure may occur at any of these stages, the management of a firm may behave
rationally to assess the probability of detection, the probability of indictment if detected, the
probability of successful prosecution if indicted, and the magnitude of the penalty if found guilty
under the law. Then if the "expected value" of the penalty (i.e., the conditional probabilities
multiplied by the likely penalty) is judged small enough, the management may deliberately
assume the risks of detection and prosecution by engaging in the act. Indeed, it is not uncommon
for business firms to maintain legal staffs or contingency funds to cover legal fees and any
penalties which are actually assessed.

Two cautionary notes are appropriate at this point. First, even though the behavior described in
the paragraph above may be rational, the reader should not take this acknowledgement as an
advocacy of the assumption of risk in knowingly breaking the law. And second, although the
liability of corporate shareholders is limited to their investment in the firm, corporate managers
should beware of the possibility of both criminal prosecution and civil liability suits when their
firms have been found guilty of violation of the law.

8 Rationales for Reallocation, Redistribution, and Stabilization

We shall devote Chapter E2 to the governmental rationale for reallocating resources in the
economy. Suffice it to say at this point that the rationale is based upon the conclusion that the
particular allocation of resources resulting from the normal functioning of the market economy is
not satisfactory and needs adjustment. This conclusion may emerge if there are so-called "public
goods" desired by society but not producible in response to market incentives, or if there are
positive or negative externalities (or "spillovers") resulting from the market production of goods
or services. The managerial implication of this rationale is that declining profits or losses will
likely emerge in industries from which resources are diverted, but profitable opportunities should
be found in industries toward which resources are reallocated.
The income redistribution rationale follows from a social and political judgment that incomes are
being inequitably distributed across the population of the society by the normal functioning of the
market economy. There is little doubt that any market economy distributes incomes unequally
because of the fundamental reward mechanism of capitalism: to each according to his or her
contribution to the process of production of demanded goods and services. Since members of any
population possess differential abilities and experience varying intensities of drive and
motivation, there will occur different contributions to the production process, and as a
consequence an unequal distribution of income.

Social action becomes warranted only when it is judged that the inequality of distribution is also
inequitable. The governmental vehicles for redistribution include progressivity of income and
profits taxation, the taxation of capital appreciation, and any of a wide range of possible transfer
payments. One managerial implication of governmental redistribution is that business net
incomes, assets, and wages paid are likely to be objects of taxation to raise revenue for
redistribution to lower-income members of society. Another is that businesses catering to transfer
recipient clienteles may benefit from the redistributions. However, there may be little hope for
managements of business firms to exert significant control or influence upon the political process
which determines how incomes are to be redistributed.

9 The Government's Potential for Stabilizing the Economy

The rationale for bringing the offices of government to bear upon the stability of the economy is
based upon the view that market economies are naturally unstable, that the degree of instability is
intolerable, and that some force must be applied to counteract the natural instability of the market
economy. Of course, the only entity in the economy which can possibly bring enough force to
bear upon the problem of instability is the government.