Managerial Economics

By Dr. Ravi Kumar Gupta

 What Is Economics?
Economics is a social science concerned with the production,
distribution, and consumption of goods and services. It studies how
individuals, businesses, governments, and nations make choices on
allocating resources to satisfy their wants and needs, trying to
determine how these groups should organize and coordinate efforts to
achieve maximum output.

Economics can generally be broken down into :

(1) Macroeconomics:-which concentrates on the behavior of the
aggregate economy, and
(2) Microeconomics:- which focuses on individual consumers and
businesses.
 Macroeconomics
Thus, Macro Economics is the study and analysis of an economy as a
whole. It studies not individual economic units like a household, a
firm or an industry but the whole economic system. Macroeconomics
is the study of aggregates and averages of the entire economy.

Macro Economics involves the study of:

• Behavior of an economic system as a whole
• Aggregates and averages covering the entire economy
• Behavior of large aggregators such as:
• Total Employment
• National Product
• National Income
• General Price-Levels etc.
Nature of Macro-economics

• It is a study of national aggregates

• It studies economic growth
• It ignores individual differences between aggregates
Scope of Macro-economics
Macroeconomics Theories

There are six significant theories under macroeconomics:

(1) Economic Growth and Development: evaluation of country’s

economy in terms of per capita income.

(2) Theory of National Income: evaluation of national income, including

the income, expenditure and budgeting.

(3) Theory of Money: Macroeconomics analyzes the functions of the

reserve bank in the economy, the inflow and outflow of money, along
with its impact on the employment level.
Continued…..

(4) Theory of International Trade: It is a field of study that enlightens

upon the export and import of goods or services.

(5) Theory of Employment: helps to figures out the level of

unemployment and prevailing employment issues and opportunities in
the country.

(6) Theory of General Price Level: the analysis of product pricing and
how these price levels fluctuate because of inflation or deflation.
Macroeconomics Policies

The government and the reserve bank functions together while

determining the macroeconomic policies, for the nation’s welfare and
development.
The two segments of this section are as follows:

(1) Fiscal Policy: meeting the deficit of income over the expenditure; it
is a form of budgetary decision under macroeconomics.

(2) Monetary Policy: Monetary policy is framed by the reserve bank in

collaboration with the government. These policies are the measures
taken to maintain economic stability and growth in the country by
regulating the various interest rates.
 Microeconomics
The part of economics whose subject matter of study is individual
units, i.e. a consumer, a household, a firm, an industry, etc. It
analyses the way in which the decisions are taken by the economic
agents, concerning the allocation of the resources that are limited in
nature.
It studies consumer behaviour, product pricing, firm’s behaviour.
Factor pricing, etc.
According to Spencer and Siegelman, “Micro Economics is the
integration of economic theory with business practices for the
purpose of facilitating Decision Making and forward planning by
Management”
Nature of Micro-economics

• Micro in nature.
• It is pragmatic i.e. a practical subject.
• It is Normative – i.e. descriptive as well as prescriptive.
• It is conceptual.
• Micro Economics aims at Problem solving.
• Micro Economics borrows from mathematical, operational,
research, statistical and accounting principles and tools to
analyze and determine relationships between various economic
variables.
Scope of Micro-economics

• Demand Analysis and Forecasting

• Cost and Product Analysis
• Pricing decision
• Profit Management
• Capital Management
• Analysis of Business Environment
• Business decisions related to economic concepts
 Managerial Economics
Managerial economics is a discipline which deals with the application
of economic theory to business management. It deals with the use of
economic concepts and principles of business decision making.
Formerly it was known as “Business Economics” but the term has
now been discarded in favor of Managerial Economics.

Managerial Economics may be defined as the study of economic

theories, logic and methodology which are generally applied to seek
solution to the practical problems of business.

According to Spencerand Seegelman “Business Economics

(Managerial Economics) is the integration of economic theory with
business practice for the purpose of facilitating decision making and
forward planning by management.”
Nature of Managerial economics

(1) Micro in nature;-Managerial economics is concerned with the

analysis of finding optimal solutions to decision making problems of
businesses/ firms.

(2) Pragmatic:- It is a practical and logical approach towards the day to

day business problems.

(3) Positive as well as Normative science:- Managerial economics

describes, what is the observed economic phenomenon (positive
economics) and prescribes what ought to be (normative economics)

(4) Conceptual in nature:- Managerial economics is based on strong

economic concepts.
Continued……

(5) Macro in nature:- A business functions in an external environment,

i.e. it serves the market, which is a part of the economy as a whole.

(6) Multi-disciplinary:- It uses many tools and principles belonging to

various disciplines such as accounting, finance, statistics,
mathematics, production, operation research, human
resource, marketing, etc.

(7) Science and Art both:- It come up with ‘technique to solve the
problem’(Science) and also involves ‘application of those
techniques’(Art) to solve the business problems.
Scope of Managerial Economics

(1) Demand Analysis and Forecasting:- A major part of managerial

decision making depends on accurate estimates of demand. A forecast
of future sales serves as a guide to management for preparing
production schedules and employing resources. Demand analysis and
forecasting occupies a strategic place in Managerial Economics.

(2) Cost and production analysis:- A wise production manger concerned

with the volume of production, process, capital and labour required,
cost involved, etc. to minimize cost of production by applying
managerial economic concepts like- Cost concepts, cost-output
relationships, Economics and Diseconomies of scale and cost control
etc.
Continued……
(3) Pricing Theory and Analysis of Market Structure:- It focuses on
the price determination of a product keeping in mind the competitors,
market conditions, cost of production, maximizing sales volume, etc.

(4) Profit Analysis and Management:- Business firms are generally

organized for earning profit and in the long period, it is profit which
provides the chief measure of success of a firm. Economics tells us
that profits are the reward for uncertainty bearing and risk taking.

(5) Capital and Investment Decisions: Capital is the most critical factor
of business. Capital management implies planning and control of
capital expenditure. The main topics dealt with under capital
management are cost of capital, rate of return and selection of projects.
Role of Managerial Economics in business
decision making

The performances of firms get analyzed in the framework of an

economic model. The economic model of a firm is called the theory of
the firm. Business decisions include many vital decisions like whether
a firm should undertake research and development program, should a
company launch a new product, etc.

Business decisions made by the managers are very important for the
success and failure of a firm. Complexity in the business world
continuously grows making the role of a manager or a decision maker
of an organisation more challenging! The impact of goods production,
marketing, and technological changes highly contribute to the
complexity of the business environment.
Managerial Economics and Decision
Making:

 A decision is simply a selection from two or more courses

of action.

 The Essence of an economics is the solution to an

economic problem.

 When two or more alternative courses of economic action

are available there is the problem of choice- The economic
problem
Optimization:
 Optimization is the act of choosing the best alternative out of all the
available ones.

 It describes how decisions or choice among alternatives are taken or

should be made.

 It is important in efficiently managing an enterprise’s resources and

thereby maximizing shareholder wealth.

 Optimization is a paint which is either maximum or minimum.

 It helps in making decision.

Some of important Business Decision Problems

Product Price and Output

 Make or Buy decision
 Production Technique
 Advertising media and intensity
 Inventory management decision
 Investment and Financing Decision
 Cost Decision
 Marketing decision
 Decision Sciences
Tools and Techniques of analysis:

 Numerical Analysis
 Statistical Analysis
 Forecasting
 Game Theory
 Optimization

Managerial Economics is use of Economics concepts and Decision

Science Methodologies to solve managerial decision Problems.
Steps of Decision Making Process

6. Sensitivity Analysis

5. Make a Choice

4. Forecast the
Consequences
3. Discover the
Alternatives
2. Determine the
Objective
1. Define The Problem
1.Define the Problem

What is the problem and how does it influence managerial

objectives are the main questions. Decisions are usually
made in the firm’s planning process. Managerial decisions
are at times not very well defined and thus are sometimes
source of a problem.
2. Determine the Objective

In practice, there may be many problems while setting the

objectives of a firm related to profit maximization and
benefit cost analysis. Are the future benefits worth the
present capital? Should a firm make an investment for
higher profits for over 8 to 10 years? These are the
questions asked before determining the objectives of a
firm.
3. Discover the Alternatives

For a sound decision framework, there are many questions

which are needed to be answered such as − What are the
alternatives? What factors are under the decision maker’s
control? What variables constrain the choice of options?
The manager needs to carefully formulate all such
questions in order to weigh the attractive alternatives.
4. Forecast the Consequences

Forecasting or predicting the consequences of each

alternative should be considered. Conditions could change
by applying each alternative action so it is crucial to
decide which alternative action to use when outcomes are
uncertain.
5. Make a Choice

Once all the analysis and scrutinizing is completed, the

preferred course of action is selected. In this step, the
objectives and outcomes are directly quantifiable. It all
depends on how the decision maker puts the problem, how
he formalizes the objectives, considers the appropriate
alternatives, and finds out the most preferable course of
action.
6. Sensitivity Analysis

Sensitivity analysis helps us in determining the strong

features of the optimal choice of action. It helps us to
know how the optimal decision changes, if conditions
related to the solution are altered. Thus, it proves that the
optimal solution chosen should be based on the objective
and well structured. Sensitivity analysis reflects how an
optimal solution is affected, if the important factors vary or
are altered.
Principles of Managerial Economics
Economic principles assist in rational reasoning and defined thinking.
They develop logical ability and strength of a manager. Some
important principles of managerial economics are:
1. Incremental Principle
Incremental concept is closely related to the mar­ginal cost and marginal
revenues of economic theory. The two major concepts in this analysis
are incremental cost and incremental revenue. Incremental cost
denotes change in total cost, whereas incremental revenue means
change in total revenue resulting from a decision of the firm.
The incremental principle may be stated as follows:
(i) It increases revenue more than costs.
(ii) It decreases some cost to a greater extent than it increases others.
(iii) It increases some revenues more than it decreases others.
(iv) It reduces costs more than revenues.
 2. Equi-marginal Principle

Marginal Utility is the utility derived from the additional unit of a

commodity consumed. The laws of equi-marginal utility states that a
consumer will reach the stage of equilibrium when the marginal
utilities of various commodities he consumes are equal. According to
the modern economists, this law has been formulated in form of law of
proportional marginal utility. It states that the consumer will spend his
money-income on different goods in such a way that the marginal
utility of each good is proportional to its price, i.e.,
MRP1 / MC1 = MRP2 / MC2 = MRP3 / MC3
Where, MRP is marginal revenue product of inputs and MC represents
marginal cost.
Thus, a manger can make rational decision by allocating/hiring resources
in a manner which equalizes the ratio of marginal returns and marginal
costs of various use of resources in a specific use.
 3. Opportunity Cost Principle

By opportunity cost of a decision is meant the sacrifice of

alternatives required by that decision. If there are no sacrifices, there
is no cost. According to Opportunity cost principle, a firm can hire a
factor of production if and only if that factor earns a reward in that
occupation/job equal or greater than it’s opportunity cost. Opportunity
cost is the minimum price that would be necessary to retain a factor-
service in it’s given use. It is also defined as the cost of sacrificed
alternatives. For instance, a person chooses to forgo his present
lucrative job which offers him Rs.50000 per month, and organizes his
own business. The opportunity lost (earning Rs. 50,000) will be the
opportunity cost of running his own business.
 4. Time Perspective Principle

According to this principle, a manger/decision maker should give due

emphasis, both to short-term and long-term impact of his decisions,
giving apt significance to the different time periods before reaching
any decision. Short-run refers to a time period in which some factors
are fixed while others are variable. The production can be increased by
increasing the quantity of variable factors. While long-run is a time
period in which all factors of production can become variable. Entry
and exit of seller firms can take place easily. From consumers point of
view, short-run refers to a period in which they respond to the changes
in price, given the taste and preferences of the consumers, while long-
run is a time period in which the consumers have enough time to
respond to price changes by varying their tastes and preferences.
 5. Discounting Principle

According to this principle, if a decision affects costs and revenues in

long-run, all those costs and revenues must be discounted to present
values before valid comparison of alternatives is possible. This is
essential because a rupee worth of money at a future date is not worth
a rupee today. Money actually has time value. Discounting can be
defined as a process used to transform future dollars into an equivalent
number of present dollars. For instance, $1 invested today at 10%
interest is equivalent to $1.10 next year.
FV = PV*(1+r)t
Where, FV is the future value (time at some future time), PV is the
present value (value at t0, r is the discount (interest) rate, and t is the
time between the future value and present value.
 6. Risk and Uncertainty

Managerial decisions are actions of today which bear fruits in future

which is unforeseen. Future is uncertain and involves risk. The
uncertainty is due to unpredictable changes in the business cycle,
structure of the economy and government policies.
This means that the management must assume the risk of making
decisions for their institution in uncertain and unknown economic
conditions in the future. Firms may be uncertain about production,
market prices, strategies of rivals, etc. Under uncer­tainty, the
consequences of an action are not known immediately for certain.
Also dynamic changes are external to the firm, they are beyond the
control of the firm. The result is that the risks from unexpected
changes in a firm’s cost and revenue data cannot be estimated and
therefore the risks from such changes cannot be insured. But products
must attempt to predict the future cost and revenue data of their firms
and determine the output and price policies.
 Profit analysis
Concept of profit:-
The term profit has different meanings for different people like
economist, businessman, entrepreneur etc.
“Profit simply means income over and above your all expenses.”
In accounting, profit is excess of revenue after all expenses of business.
But in economics, profit is reward of entrepreneur’s effort of
combining all factors of production and bearing risk of uncertainty.
Profit in economics is termed as a pure profit or economic profit or
just profit.
Profit differs from the return in three respects namely:
a. Profit is a residual income, while return is a total revenue
b. Profits may be negative, whereas returns, such as wages and interest
are always positive
c. Profits have greater fluctuations than returns
 Types of Profit
On the basis of fields, profit can be classified into two types, which are
explained as follows:
i. Accounting Profit:
• Refers to the balance of total income of an organization after deducting all
expenses and costs, including both manufacturing and overhead expenses.
The cost generally include explicit costs. The accounting profit is used for
determining the taxable income of an organization and assessing its
financial stability.
The accounting profit is calculated as:
Accounting Profit= TR-(W + R + I + M) = TR- Explicit Costs
TR = Total Revenue
W = Wages and Salaries
R = Rent
I = Interest
M = Cost of Material
Continued…..

ii. Economic Profit:

Unlike the accounting profit, economic profit consider both the costs i.e.
explicit and implicit costs while calculating profit.
The economic profit is calculated as:
Economic profit = Total revenue-(Explicit costs + implicit costs)
Alternatively, economic profit can be defined as follows:
Pure profit = Accounting profit-(opportunity cost + unauthorized
payments, such as bribes)
Economic profit is not always positive; it can also be negative, which is
called economic loss. Economic profit indicates that resources of a
business are efficiently utilized, whereas economic loss indicates that
business resources can be better employed elsewhere.
 Theories of Profit
Profits of businesses depend on the successful management of risks and
uncertainties by entrepreneurs. These risks can be cost risks due to
change in wage rates, prices, or technology, and other market risks.
Different economists have presented different views on profit.
Hawley’s Risk Theory of Profit:
The risk theory of profit was given by F. B. Hawley in 1893. According to
Hawley, “profit is the reward of risk taking in a business.
According to him, the greater the risk, the higher is the expected profit.
The risks arise in the business due to various reasons, such as non-
availability of crucial raw materials, introduction of better substitutes
by competitors, obsolescence of a technology, fall in the market prices,
and natural and manmade disasters. Risks in businesses are inevitable
and cannot be predicted. According to Hawley, an entrepreneur is
rewarded for undertaking risks.
 Schumpeter’s Innovation Theory of Profit
Joseph Schumpeter propounded a theory called innovation according to
which profits are the reward for innovation He advocated that
innovation is the introduction of a new product, new technology, new
method of production, and new sources of raw materials. This helps in
lowering the cost of production or improving the quality of
production. Innovation also includes new policy or measure by an
entrepreneur for an organization.
In general, innovation can take place in two ways, which are as
follows:
a. Reducing the cost of production and earning high profit. The cost of
production can be reduced by introducing new machines and
improving production techniques.
b. Stimulating the demand by enhancing the existing improvement or
finding new markets.
 Profit Forecasting in Managerial Economics

Profit planning cannot be done without proper profit forecasting. Profit

forecasting means projection of future earnings after considering all
the factors affecting the size of business profits, such as firm’s
pricing policies, costing policies, depreciation policy, and so on. A
thorough study including a proper estimation of both economic as well
as non-economic variables may be necessary for a firm to project its
sales volume, costs and subsequently the profits in future.
 Approaches to Profit Forecasting

According to Joel Dean, a famous economist, there are three approaches

to profit forecasting, which are as follows:

1. Spot Projection: Spot projection includes projecting the profit and loss
statement of a business firm for a specified future period. Projecting of
profit land loss statement means forecasting each important element
separately. Forecasts are made about sales volume, prices and costs of
producing the expected sales. The prediction of profits of a firm is
subject to wide margins of error, from forecasting revenues to the
inter-relation of the various components of the income statement.
Continued….

2. Break-Even Analysis: It helps in identifying functional relations of

both revenues and costs to output rate, keeping in consideration the
way in which output is related to the profits. It also helps in doing so
by relating profits to output directly by the usual data used in break-
even analysis.

3. Environmental Analysis: It helps in relating the company’s profits to

key variable, in the economic environment such as the general
business activity and the general price level. These variables are not
considered by a business firm.
 The Concept of Profit Standards

Standards of reasonable profits are determined when a firm chooses to

make only reasonable profits rather than to maximize its profit. The
questions that arise in this regard are as follows:
• What form of profit standards should be used?
• How should reasonable profits be determined?
These questions can be understood after going through the following
explanatory points.
Forms of Profit Standards
Profit standards is determined in terms of the following:
• Aggregate money terms
• Percentage of sales, and
• Percentage return on investment.
Continued….

All these standards are determined for each product separately. Among all
the forms of profit standards, the total net profit of the firm is more
common than other standards. But when the purpose is to discourage
the competitors, then the target rate of return on investment is the
appropriate profit standard, provided the cost curves of competitors’
are similar. The profit standard in terms of ratio to sales is not an
appropriate standard because this ratio varies widely from firm to
firm, even they will have the same return on capital invested. These
differences are following:
• Vertical integration of production process
• Intensity of mechanization
• Capital structure
• Turnover
Continued….
Setting the Profit Standard
The following are the important criteria that are considered while setting
the standards for a reasonable profit.
1. Capital-Attracting Standard: An important criterion of profit
standard is that it must be high enough to attract external capital such
as debt and equity. But there are certain problems associated with this
criterion, which are as follows:
• Capital structure of the firms such as the proportions of bonds, equity
and preference shares, which affects the cost of capital and thereby the
rate of profit.
• If the profit standard is based on current or long run average cost of
capital or not. The problem in this case arises as it may also vary
widely from company to company.
Continued….

2. Plough-Back Standard: This standard is appropriate in case company

depends on its own sources for financing its growth. This standard of
profit is used when liquidity is to be maintained by a firm and a debt is
to be avoided as per the profit policy of the firm. This standard is
socially less acceptable than capital attracting standard. From society’s
point of view, it is more desirable that all earnings are distributed to
stockholders and they should decide the further investment pattern.
On the other hand, retained earnings which are under the control or
the management are likely to be wasted on low-earning projects
within a business firm. But to choose the most suitable policy among
marketing and management the abilities of the management and
outside investors are to be considered.
Continued….

3. Normal Earnings Standard: Another important criterion for setting

standard of reasonable profit is the normal earnings of firms of an
industry over a period. This serves as a valid criterion of reasonable
profit, provided it should take into consideration the following points:
• Attracting external capital
• Discouraging growth of competition
• Keeping stockholders satisfied.
When average of normal earnings of a group of firms is used, then only
comparable firms are chosen. However, none of these standards of
profits is perfect. A standard should, therefore be chosen after giving
due consideration to the existing market conditions and public
attitudes.
 Four Major Challenges that Indian
Economy Faces in 2020
The Indian economy is going through a turbulent period with key
indicators hinting at a prolonged slowdown. The corona virus
pandemic has weakened all sectors of the Indian economy since April
and a recovery seems unlikely this year.
• From contraction in growth to rising inflation and unemployment,
challenges are aplenty. The sharply surging corona virus cases make
the case for recovery worse.
• India’s GDP growth is expected to remain in negative zone for the
entire year and projections for June quarter signal how adversely
Covid-19 has disrupted the livelihood, particularly of the poor.
A recent SBI Ecowrap report said the national GDP may contract by 16.5
per cent in the first quarter of the current fiscal. The report also
mentioned that India’s economic recovery could take much longer
than expected.
 1. Weak Demand

Stagnated demand seems to be the biggest challenge for the economy at

the moment. Demand for key goods and commodities like fuel, food,
consumer goods and electricity has fallen over the last few months.

While India’s demand woes began in 2019, the corona virus pandemic
only worsened the scenario. India’s consumer demand is declining due
to drop in household incomes in the wake of major job losses in the
wake of a raging pandemic that has forced closures of factories and
businesses.
 2. Ballooning Unemployment

The latest unemployment figures, released by the Centre for Monitoring

Indian Economy (CMIE), are another evidence of economic weakness.
The CMIE data show that nearly five million or 50 lakhs salaried jobs
were lost in July, taking the total number of layoffs in the formal
sector to over 1.8 crore.

While some businesses in the informal sector have reopened post-

lockdown relaxations, they are struggling to survive due to lack of
demand, and constrained by the lack of available workforce.

Experts say most informal businesses depend on the cash flowing from
the formal economy i.e. salaried jobs. The economic situation could
worsen further if more salaried jobs are lost.
 3. Lack of Fiscal Stimulus

Many noted economists have made it clear that India needs another round
of fiscal stimulus to support growth. While the government, at the start
of the pandemic, announced a fiscal stimulus package of nearly Rs 21
lakh crores, most of it was focused on bank credit for businesses.
Experts said the government’s inability to provide direct fiscal stimulus,
like many other countries, is due to India’s stretched fiscal deficit. The
fiscal deficit has already hit a record $88.5 billion over April to June,
which is over 83 per cent of the target for the current financial year.
Lower tax collections and front-loaded spending are some of the reasons
pushing the fiscal deficit higher. Finance Minister Nirmala Sitharaman
has, however, promised to take some steps for businesses that have
been hurt most — travel, tourism, hospitality — once they are allowed
to completely reopen.
 4. Rising Inflation

Rising inflation has complicated the economic situation further. In July,

retail inflation rose to 6.93 per cent, way above the RBI’s medium-
term target of 4 per cent.

Economists say it is an unusual situation where prices of food items like

vegetables, pulses, meat and fish are on the rise despite weak demand.

The July inflation figure at 6.93 per cent is worrisome when compared to
the 3.15 per cent on the consumer price index (CPI) in July 2019. This
reduces the possibility of a rate cut by the RBI in near future. It also
means that demand for loans could remain lower due to elevated
interest rates. Low demand for loans means lesser new business
activities, and fewer new employment opportunities.