Unit 1

Concept of Economy
ECONOMY

• The economic system is composed of people, firms/organizations and government.

It addresses the problems such as allocation of limited resources.
• Economic system is an organised way where people, a state or a nation allocate
available resources and distribute goods and services to society, the national
community.
• Economics is a social science that deals with production, distribution and
consumption of goods and services.
• It is a system where decisions are taken related to what to produce, how to produce
and how to distribute in a particular society.
There are three types of Economy

▪ Capitalist Economy

▪ Socialist Economy

▪ Mixed Economy
(a) Capitalist Economy

• It is an economic system where the means of production are owned privately and
operated for profit. Such an economy exists in the countries like U.S.A., U.K and
many other countries.
• A country's trade and industry are controlled and owned by private owners and
their aim is to get profit. All the decisions are made by each owner for earning
profit.
• Decisions related to production, distribution of goods and price for products are
based on competition in market. The Profit motive is the main objective of all
economic activity.
• Land, capital, machinery, technology etc. are owned by few people. It is called as
capitalist class. Most of people work in the companies owned by capitalist class
and receive wages or salaries.
(b) Socialist Economy

• It is an economic system where the means of production like land, capital,

technology, etc. are owned by state and operated for the welfare of society.
Such an economy exists in the countries like U.S.S.R., China.
There is no private ownership.
• A country's trade and industry are controlled and owned by the public sector
enterprises and their aim is towards the interest of general people and their
welfare. Decisions related to production, distribution of goods and price for
products are based on general welfare.
• The prime objective of a socialist economy is ‘social equality’ and distribution of
wealth according to the contribution to society, hence it can be said that the
benefit to society is the main objective of all economic activity.
• All profit goes to the State, welfare of the people and economic development.
• Land, capital, machinery, technology, etc. are owned by the State. Every citizen is
employed. The available resources are distributed by a central authority with an
intention to the overall interests of the State. It is also called as ‘market
socialism’. There exists a public sector.
(c) Mixed Economy

• It is an economic system where the public sector enterprises as well as private

sector enterprises both exist. Means of production are owned by both. Such an
economy exists in India and many other countries.
• A part of country's trade and industry are controlled and owned by private owners,
but they have to work under the prevailing law and follow the guidelines given by
government.
The government of country intervenes to avoid undue concentration of economic
power and exploitation of people by monopolists, whereas some enterprises are
controlled and owned by Government.
• Decisions related to production, distribution of goods and price for products are
determined according to market structure but under the prevailing rules.
Profit motive along with the development of society are the main objectives of
all economic activity.
Economics
• The origin of the term ‘economics’ lies in the greek word oiken and nomos. It
means ‘laws of households’. It means significance of economics to households.
• Economics is a social science, which deals with the study about the behaviour of
people, where wants are unlimited and means are scares which have alternative
uses.
• It is the study of how people make choices from the available resources. As the
resources are scarce and wants are unlimited, there is a need to make choices from
scarce resources.

Economics is the study how human beings make choice to allocate scarce resources to
satisfy their unlimited wants in such a manner that consumer can maximise their
satisfaction, producer can maximise their profits and society can maximise its social
welfare.
Microeconomics

‘Micro’ means small. Microeconomics is the branch of economics that deals with the
individual units, company or consumer. These individual units may be either a person or a
firm or a group of persons or firms. Thus, micro-economics gives a microscopic view of the
economy. It is the study of individual consumers and producers in specific markets. The
micro economics is the study of an economic behavior of a particular individual, firm or a
household.
Macroeconomics

Macroeconomics on the other hand, studies the economic phenomena at the national
aggregate level. Specifically, macroeconomics is the study of working and performance
of the economy as a whole.
It studies what factors and forces determine the level of national output or national income,
rate of economic growth, employment, price level, and economic welfare. Besides,
macroeconomics studies how government of a country formulates its macroeconomic
policies—taxation and public expenditure policies (the fiscal policy), monetary policy,
price policy, employment policy, foreign trade policy, etc., to resolve the problems of the
country. Macroeconomics studies how these policies affect the economy.
Managerial Economics in Decision
Making Process
• Decision making is an important part of today's business organizations. Making a decision
is one of the most difficult tasks faced by entrepreneurs and managers.
• Managers has to take a decision regarding allocation of available scare resources.
Decision regarding for production, inventory, cost, revenue, marketing and investment
etc.
a. Managerial Economics helps to solve the basic problems such as what to be produce,
how to be produce and how to distribute.
b. Business economics help in making Business Policies to maximize the profit of any
organization and at the same time minimize cost.
c. It helps managers in production planning for the successful operation and production.
It acts as a balance bridge between the production tools and operating systems and
where to go.
d. Managerial economics helps managers to consider short period and long period for
planning and in cost control decisions.
e. Tools explained in managerial economics like demand forecasting techniques, which
helps managers to forecast demand for their products. The managerial economic helps
in anticipating risk in advance and provide strategies so that any firm can be protected
against future risks.
f. Managerial economics helps managers to decide on the planning and control of the
risk. Investment planning can be done effectively.
g. It helps in preparing pricing policy as per the elasticity of goods and services. If the
demand of commodity is inelastic, high price can be imposed or vice-versa.
h. Managerial economics guides us how to distribute the profits and invest in where to
make the business more profitable in the coming year and more growth in the business
field.
Concept of Firm and Market
Objectives of a Firm

• Profit Maximization:
Generating profits is the primary economic objective of business. Profitability ensures the
business can cover its costs, provide returns to investors, and reinvest in growth and
expansion.
• Cost Minimization:
Businesses aim to minimize costs while maintaining the quality of goods or services.
• Revenue Growth:
Businesses seek to increase their revenue over time by expanding their customer base,
introducing new products or services, entering new markets, or improving sales and
marketing strategies.
• Market Share Expansion:
Achieving a larger market share allows businesses to capture a greater portion of the
market demand for their products or services.
• Risk Management:
Businesses aim to mitigate risks and uncertainties that could negatively impact their
financial performance.
• Long-Term Sustainability:
Businesses strive for long-term sustainability by balancing short-term profitability with
environmental, social, and governance (ESG) considerations.
• Financial Stability:
Maintaining financial stability is essential for business continuity and resilience. This
involves managing cash flow effectively, maintaining adequate liquidity, and avoiding
excessive debt or financial leverage.
Profit Maximization Model
The conventional economic theory assumes profit maximization as the only objective of
business firms, profit measured as Total Revenue - Total Cost.
• TC curve shows total economic costs of output.
• Total revenue equals total economic costs at point OM output.
• TR intersects TC curve at point B, it is a breakeven point for the organization.
• Beyond this breakeven point, an organization starts earning profits. Profits go on
increasing till output reaches at OQ level.
• At point OQ, the difference between total revenue and total cost is maximum.
• The distance between point J and point K is the profit.
• Profits are highest at OQ level of output, it can be expressed as:

• From the figure, it can be observe that slope of TR and TC curves corresponding to
output level OQ are the same as the slope of the tangents drawn to these curves are
same at this output level.
• It can be observe from figure, that TP is the total profit curve, which initially goes up
and then beyond point N, it starts falling down, which shows that profits are maximum
at output level OQ.
Alternate Objective of Business Firm
 Baumol’s Hypothesis of Sales Revenue Maximization

Baumol has postulated maximization of sales revenue as an alternative to profit

maximization objective. He attributes this objective to the dichotomy between ownership
and management in large business corporations.
This dichotomy gives managers an opportunity to set their goals other than profit
maximization goal which most owners and businessmen pursue. Given the opportunity,
managers choose to maximize their own utility function.
According to Baumol, the most plausible factor in managers’ utility functions is
maximization of the sales revenue for the following reasons.
According to Baumol, the most plausible factor in managers’ utility functions is
maximization of the sales revenue for the following reasons.
• First, managers’ salary and other benefits are more closely related to sales revenue than
to profits.
• Second, banks and financial corporations look at and lay a great emphasis on sales
revenue while financing a corporation.
• Third, trend in sales revenue is a readily available indicator of the performance of the
firm. It helps also in handling the employee’s problem of awarding efficiency and
penalizing inefficiency.
• Fourth, increasing sales revenue enchances the prestige, reputation and perks of
managers while profits go to the owners.
• Fifth, managers find profit maximization a difficult objective to fulfill consistently over
time and at the same level. Profits may fluctuate with changing conditions.
• Finally, growing sales strengthen competitive spirit of the firm in the market whereas
decreasing sales put the survival of the firm at risk. Criticism: Baumol’s sales
maximization hypothesis
 Marris’s Hypothesis of Maximization of Firm’s Growth Rate

Marris, managers maximize firm’s balanced growth rate subject to managerial and financial
constraints.
He defines firm’s balanced growth rate
(G) as G = GD = GC
• GD = growth rate of demand for firm’s product and
• GC = growth rate of capital supply to the firm.
In simple words, a firm’s growth rate is balanced when demand for its product and supply
of capital to the firm increase at the same rate.
 Marris translates the two growth rates into two utility functions:
(i) manager’s utility function
(ii) owner’s utility function. Manager’s utility function (Um) and owner’s utility function
(Uo) are expressed as follows.
• Um = f (salary, power, job security, prestige, status)
• Uo = f (output, capital, market-share, profit, public esteem).

Owners’ utility function (Uo) implies growth of demand for firm’s product product and
supply of capital to the firm. Therefore, maximization of Uo means maximization of
‘demand for firm’s product’ or ‘growth of capital supply’.
According to Marris, by maximizing these variables, managers maximise both their
own utility function and that of the owners. The managers can do so because most
of the variables (e.g., salaries, status, job security, power, etc.) appearing in their
own utility function and those appearing in the utility function of the owners (e.g.,
profit, capital market, share, etc.) are positively and strongly correlated with a
single variable, i.e., size of the firm.
Therefore, managers seek to maximize the size of the firm. Maximization of size of
the firm depends on the maximization of its growth rate. The managers, therefore,
seek to maximize a steady growth rate.
 Williamson’s Hypothesis of Maximization of Managerial Utility

Williamson argues that managers are very careful in pursuing the objectives other than
profit maximization The managers seek to maximize their own utility function subject to a
minimum level of profit. Managers’ utility function (U) is expressed below:
U = f(S, M, ID)
where,

• S = additional expenditure on staff

• M = Managerial emoluments
• ID = Discretionary investments
According to Williamson’s hypothesis, managers maximize their utility function subject to a
satisfactory profit. A minimum profit is necessary to satisfy the shareholders and also to
secure the job of managers. The utility functions which managers seek to maximize include
both quantifiable variables like salary and slack earnings anti non-quantitative variable such
as prestige power, status, job security, professional excellence, etc.

The non-quantifiable variables are expressed in order to make them work effectively in
terms of expense preference defined as satisfaction derived out of certain types of
expenditures.