Managerial Economics

Introduction
Meaning & Definition of Managerial Economics:-
The synthesis of economic theory with business practice is known as Managerial
Economies. The various tools which are provided by economics, applied to the
business management. Alternatively, the application on economic theory to
the problems of management is referred to as managerial economics. The
solving on problems at the level of the firm by applying economics is known as
managerial economics. The business executive is capable of assuming and
analysing of things and thus profit maximisation is the emphasis on economics
resulting in getting satisfactory profits.
According to Spencer and Siegelman, "Managerial economics is the integration of
economic theory with business practice for the purpose of facilitating decision-
making and forward planning by management. According to Me Nair and
Meriam, "Managerial economics is the use of economic modes of thought to
analyse business situation".
According to Jeal Dean, "The purpose of managerial economics is to how
economic analysis can be used in formulating policies".
• According to Mansfield, "Managerial economics is concerned
with application of economic concepts and economic analysis to
the problems of formulating rational managerial decision".
• The other names for managerial economics are, Business
Economics or Economics for Firms.
• Managerial economics is a venture to use economics and
economic logic in Formulating the policies of business. Thus,
managerial economics is that form of economic knowledge which
is used in the analysis of business problems or taking the relevant
business decisions and devising forward plans.
NATURE OF MANAGERIAL ECONOMICS
Following are the nature of managerial economics:
1)Micro-Economic in Nature: The branch of economics which deals with the
individual units of an economy is called micro-economics. These individual units
may be either a firm or a person or a group of firms or a group or persons.
2)Pragmatic: Managerial economics is practical in nature. Rigid and abstract
theoretical frameworks are provided by managerial economics to managers. It
is said to be pragmatic in nature because it avoids complex abstract issues of
economic theories at one end, while at another end it incorporates
complications which is ignored by economic theory in order to analyse the
overall situation where managerial decisions are to be taken.
3) Related to Normative Economics: Economics can also be classified as positive
economics or normative economics. Positive economics states the economic
phenomenon that is observed and normative economics determines what
should be done which means discriminating the ideal from the actual.
4) Conceptual in Nature: Managerial economics is based on the solid conceptual
foundation of economics. The subject matter of managerial economics is not
irrational. Analysis of business problems on the basis of established concepts is
the objective of managerial economics.
5) Utilises Some Theories of Macro-Economics: Macro-economics envisages all the
individual matters that are integrated to be the part of analysis of the problems
of the economy as of a nation not pertaining to an individual that is being
operated in the environment affects and gets affected. Thus, majority of the
aspects that are related in such a manner becomes the subject-matter of micro-
economics,
6) Problem Solving in Nature: Managerial economics not only analyses the
managerial problems of the business units but it aims to resolve the business
problems also which provides optimal solutions. Hence, it is problem solving in
nature.
7) Managerial Economics Deals with the Application of Economics: Managerial
economics studies and deals with economic theory that are applied to business
management. The relevant aspects of economic theory like demand, supply,
production, pricing, markets, etc., must be carefully understood by the
managers which facilitate them to manage the business in an organised manner
by applying the principles of economics in making managerial decisions.
Following are some of the important aspects of economic theory which can
applied to business management:
• Demand Analysis: It includes Laws of demand, elasticity of demand,
determinants of demand etc.
• Production Analysis: It includes Laws of variable proportions, Law of returns to
scale, economies and diseconomies of scale etc.
• Market Analysis: It includes nature of product market like perfect competition,
monopoly, oligopoly. monopolistic competition. Product pricing and output
decisions in different forms of market etc.
8) Managerial Economics is the Study of Allocation of Resources: Proper
allocation of resources is fundamental in managing business. The theory of
economics deals with the problems of resource allocation such as what to
produce, how to produce and for whom to produce. Thus, theory of
economics, which is the fundamental managerial economics, specifies the
significance of the allocation of resources to the application of the principles of
managerial economics, Allocation of resources includes the following
concepts:
• Input Allocation: It includes raw materials, labour hours, machine hours, etc.
Output Allocation: It includes meeting customer's demand in different
segments of market at different locations.
• Allocation of Funds: It includes efficiency of usage of cash and other resources.
Ratio analysis and financial statement analysis helps in making decisions about
fund allocation.
9) Inter-disciplinary: Managerial economics being a new discipline is the
integrated form of multi-disciplines. Its techniques, tools, theories and
contents emerge from different subjects, such as Economics, Management,
Statistics, Mathematics, Accountancy, Sociology and Psychology,
SCOPE OF MANAGERIAL ECONOMICS
Following areas included in the scope of managerial economics:
1)Demand Analysis and Forecasting: Every organization is established with the
economic motive to perform the function of converting its raw material into
semi- finished goods and then further into the finished product which
generates profit for the organization. The analysis of the demand forms the
bases for organizational decision-making. The forecasting of future sales helps
the management of the organization to prepare production schedule and to
properly allocate the resources and in turn also helps the management in
increasing the market share and profits. The main areas taken into
consideration are demand determinants. demand distinctions and demand
forecasting.
2) Cost and Production Analysis: The estimation of cost and production are also
important in the organizational decision-making. In order to make the effective
plans in the organization the fluctuations in the cost estimates must be
considered. The main areas for the purpose of analysis of cost and production
required to be considered are Cost Concepts and Classifications, Cost-Output
Relationships, Economies and Diseconomies of Scale of Production.
3) Pricing Decision, Policies and Practices: The income or profits also depends on
the change in the prices of the organization hence the pricing decision becomes
one of the important component of managerial economics. The areas that are
taken into consideration under it includes the price determination in numerous
market forms like pricing policies, pricing method, differential pricing,
productive and price forecasting
4)Profit Management: The profits for the organizations are the key factor for every
concern and hence, proper management of the profits becomes the foremost
purpose in the organisation. Due to the fluctuations in the costs and revenues,
the profits of the organization are not certain. The main areas that are taken
into consideration under it are nature and measurement of Profit, Profit
Policies and Techniques of profit planning like Break-Even Analysis.
5)Capital Management: Capital refers to the sum of money required to start a
business and hence, its management is the essential feature for any
organization. Capital management means to make an effective plan and control
the capital expenditure as it include the huge amount of money invested in the
business. The organization of capital assets is also difficult as it involves much
time and labour. The important areas included in it are cost of capital, rate of
return and selection of projects.
6)Analysis of Business Environment: The business environment plays a major role
in decision-making of the organization and in turn, affects the performance of
the organization. There are basically two factors of business environment i.e.
internal and external. The analysis of both the factors is important but the
external factors like economic factors affect the organization at large hence, it
must be given more priority. There are various theories and policies of macro-
economics helping in the analysis of business environment like income and
employment theory, monetary policy, fiscal policy, industrial policy, foreign
trade policy and other direct controls. The areas included in the analysis of
business environment are macro-economic theory and government policies.
7)Allied Disciplines: The factors taken into consideration in the organizational
decision-making are of qualitative nature. In order to accurately assess the
relationship between the economic variables various tools are used like linear
programming techniques which help to increase or decrease the objective
function. Hence, all such techniques also contribute to the effective decision-
making of the firms. The main areas or the tools taken into consideration in
the scope of managerial economics are mathematical tools, statistical
technique and accounting principles.
Significance of Managerial Economics:-
1. Decision Support: Managerial economics provides a systematic framework
for decision-making. Managers often face complex choices regarding
production, pricing, resource allocation, and investment. By employing
economic principles, managers can make informed decisions that align with
the organization's goals.
2. Optimization of Resources: A fundamental aspect of managerial economics is
the optimization of resources. Through cost-benefit analysis and marginal
analysis, managers can identify the most efficient allocation of resources,
maximizing output while minimizing costs.
3. Profit Maximization: Managerial economics helps businesses pursue profit
maximization by analyzing market conditions, determining optimal pricing
strategies, and identifying cost-effective production methods. This is crucial for
the long-term sustainability and growth of the organization.
4. Market Analysis and Forecasting: Managers use managerial economics to
analyze market trends, understand consumer behavior, and forecast demand
for products or services. This information is essential for formulating effective
marketing strategies and staying competitive in the market.
5. Risk Management: In a dynamic business environment, managers face
uncertainties and risks. Managerial economics assists in assessing and
managing risks by incorporating risk analysis and decision-making under
uncertainty into the decision-making process.
6. Policy Formulation: Managerial economics contributes to the formulation of
organizational policies by providing insights into the economic implications of
different policy choices. This includes pricing policies, investment policies, and
strategies for entering new markets.
7. Efficiency Improvement: By focusing on optimization and resource allocation,
managerial economics helps improve overall efficiency within an organization.
Identifying and addressing inefficiencies leads to cost reduction and improved
productivity.
8. Strategic Planning: Managerial economics plays a crucial role in strategic
planning. Managers use economic analysis to evaluate the long-term impact of
various decisions on the organization's competitiveness and sustainability,
considering factors such as market trends, technological advancements, and
regulatory changes.
9. Understanding External Environment: Managerial economics helps managers
understand and respond to changes in the external economic environment.
Awareness of factors like inflation rates, interest rates, and global economic
trends enables organizations to adapt to external conditions.
10. Performance Evaluation: Managerial economics provides tools for evaluating
the performance of different business units or projects. Performance metrics
derived from economic analysis help in assessing the success of strategies and
initiatives.
11. Resource Utilization in Multinational Companies: In the context of
multinational companies, managerial economics aids in optimizing resource
utilization across different countries, considering factors like exchange rates,
trade policies, and international market conditions.
Uses of Managerial economics:-
Decision-making
Managerial economics helps managers make decisions about production, pricing,
investment, and more.
Forecasting
Managerial economics can help managers forecast future market conditions and
demand for products and services.
Optimization
Managerial economics can help managers optimize production processes, pricing
strategies, and marketing campaigns.
Risk analysis
Managerial economics can help managers evaluate and manage risks through
techniques such as risk analysis.
Market analysis
Managerial economics can help managers understand market conditions and
allocate resources to maximize overall utility.
Understanding macroeconomic factors
Managerial economics can help managers understand the impact of
macroeconomic factors, such as inflation, interest rates, and government
policies, on their organizations.
ROLE OF MANAGERIAL ECONOMIST
Following are the roles of managerial economics condition of certainty
1) Analysis of External Factors: Internal factors are in the control of management
but external factors are not in control of management. The firm has no control
on the external factors because they are operating outside the firm. These
factors create the business environment and include prices, national income
and output, business cycle, the firm. After studying and analysing these factors,
managerial economist can effectively determine the business policies. Certain
relevant questions relating to these factors are:
• What are the present trends in national and international economics?
• What phase of the business cycle lies immediately ahead?
• Where the possibilities of expansions and contractions are likely to occur in
most frequent manner?
• What are the expectations about the prices and availability of raw-material?
• What are the possibilities of demand and prices of finished products?
• ls competition likely to increase or decrease?
• Will the availability and cost of credit tend to increase or decrease demand?
• What changes are expected in government policies and control?
• What are the demand prospects in new and established markets?
• How will the change in consumption pattern and fashion tend to affect the
demand of the firm's product?
2) Analysis of Internal Factors: The business operations which are known as
internal factors (internal issues) can be operated within the firm. The
management can solve various problems which are related to business
operations such as price determination, use of installed capacity, investment
decisions, expansion and diversification of business, etc., with the help of
managerial economists. Relevant questions in this context are as follows:
• What will be the reasonable sales and profit targets for the next year?
• What will be the most appropriate production schedules and inventory policy
for the next five or six months?
• What sorts of modifications are required in reference to the wages and pricing
policies?
• How much cash will be available in the coming months and how it should be
invested?
3) Specific Functions: The various specific functions which are performed by the
managerial economists for the business management and management
consultants are as follows: i) Sales forecasting. ii) Market research, iii) Economic
analysis of competing firms, iv) Pricing problem of the industry. v) Evaluation of
capital projects, vi) Advice on foreign exchange.vii) Advice on trade and public
relations, viii) Economic analysis of agriculture, ix) Analysis of under-developed
economies,(x) Environmental forecasting.
To provide economic intelligence, managerial economist may also render general
intelligence services to the management through economic information of the
general interest. This information is related to the competitor's prices and their
sales policies, tax rates, tariffs rates, etc. In fact published material may be
available on these items. It would be useful for the firm to have someone who
can understand their impact on business. The managerial economist can
discharge this job with competence.
RESPONSIBILITIES OF MANAGERIAL ECONOMIST
Following are the main responsibilities of a managerial economist:
1) To Make Reasonable Profits on Capital Employed: A managerial economist
must have a belief that the profits are essential for the firm and his main
responsibility is to guide the management in earning the rational profits on
capital investment. He should always help the management to improve the
capacity of the firm for earning more profits. The academic knowledge,
experience, expertise and business skills of the managerial economist will not
be useful for the firm if he fails to perform the responsibility.
2) Successful Forecasts: It is necessary that the successful forecasts must be done
by the managerial economists with the use of detailed study of internal and
external factors which affect the profitability or the working of the firm. The
main objective is to reduce or fully eliminate the risk associated with
uncertainties. It is the major responsibility of the managerial economists to
alert management as early as possible if there is any mistake in the forecast.
This facilitates the management to make required changes and adjustment in
the policies and programmes of the firm.
3) Knowledge of Sources of Economic Information: For collecting quickly the
relevant and valuable information in the field, a managerial economist should
establish and maintain close relationship with the specialists and data sources
Managerial economists should develop personal relation with the persons who
are having specialist knowledge of the field. He should also join professional
associations and must take active part in the activities. The success of a
managerial economist depends on how quickly he collects the necessary
information which is very important for the firm.
4)Status in the Firm: A managerial economist must give full time to the business
team because it will be helpful for the management in formulating successful
business policies. He should be always ready and even take initiative for
handling special assignments. He can win constant support for the professional
ideas from the management side when the performance is very efficient in an
atmosphere where the resources and advice are widely sought and used.
While communicating with the executives of the firm, the economist needs to
be very careful and he must have to express his ideas and suggestions in an
easy and understandable language by avoiding the technical jargons and by
minimising the use of technical words
 Theory of the firm
The theory of the firm is a collection of economic theories that explain and predict
the behavior, structure, existence, and market relationship of a corporation,
company, or firm.
In economics, a firm is a single business entity that produces or sells goods or
services, while an industry is a group of firms that work in similar or related
activities:
• Firm
A firm is a profit-seeking business that sells products or services to
consumers. Firms can be partnerships, corporations, or limited liability
companies.
• Industry
An industry is a group of firms that produce a specific product or
service. Industries can be retail, wholesale, or service industries.
OBJECTIVES OF FIRM
Once we understand the various organisational structures and ownership forms,
there is need to understand another important dimension of business, i.e.,
• why do people do business?
• What motivates the owners/investors/promoters to take so much of risk and
conduct their own businesses, rather than going for a secured employment?
• Is it only maximisation of profits that drives businesses?
• Or is it something beyond?
These questions have been puzzling scholars for a long time. The complication has
been multiplied by the evolution of different types of firm structures. Consider
single ownership firms; it would be reasonable to accept that single owners
would aim at maximum profits. But what about other forms of business? Do
they also run on the same objective? From our earlier discussion in this chapter,
we have see that sole proprietorship forms had given way to partnership and
joint stock structures, which implies that businesses no longer remained
restricted in the hands of a “single owner”.
In other words, emergence of other firm structures led to the evolution of
“managers”, and owners and managers became two distinct groups. Thus,
profit making was conceived to be the sole objective of a business for quite a
long time, until scholars came up with alternate objectives of sales
maximisation, and thereafter, growth maximisation. These objectives further
gave way to more advanced thought on “satisfying” as the objective of an
organisation and the perspective of separation of management from
ownership. Whatever be the form of ownership,
one thing is definite, that every business has some objective, which provides the
framework for all the functions, strategies and managerial decisions of that
business. It determines both short-term and long-term perspective of the firm.
We would deal with various prominent thoughts on objectives of firm in the
following sections.
• Profit maximization: A company can increase its revenues by setting higher
prices, but it needs to cut costs or implement other programs to maximize its
profits.
• Market share: A company can increase its market share by innovating its
products, using targeted marketing, and forming strategic partnerships.
• Social objectives: A company can have social objectives such as producing
quality goods and services, adopting fair-trade practices, and contributing to
society's welfare.
• Survival: A company can have survival objectives such as finding its first
customers, reducing losses, or minimizing fixed costs.
• Increasing shareholder value: A company's reputation and profits can affect its
overall value, which can increase shareholder interest and commitment.
• Customer satisfaction: A company can aim to satisfy its customers.
• Corporate social responsibility: A company can aim to be socially responsible.
Alternate objectives of firm:-
• A firm's main objective is to maximize profit, but firms may have other
objectives as well:
• Survival: A short-term objective to gain market share and consumer loyalty
• Long-term growth: A focus on sustainability and growth rather than short-
term profits
• Employee satisfaction: Prioritizing employee training, work-life balance, and
workplace culture can create a more motivated workforce
• Social responsibility: A firm may pursue ethics and social responsibility
• Protecting shareholder value: A firm may pay better dividends to
shareholders
Baumol's Model (Sales Revenue Maximising Model)
• According to Baumol, every firm is more focused on sales maximisation
because it tends to achieve both short-run and long-run objective of the
management, whereas short-run revenue maximisation will not support long-
run profit maximisation.
• Baumol's model, also known as the revenue maximization model, is a
managerial economics theory that suggests that companies should focus on
maximizing sales revenue rather than profits. The model is based on the idea
that higher sales can lead to higher managerial salaries and market share,
which incentivizes managers to focus on revenue.
• Baumol's model was based on the following assumptions: i) The basic aim of
the organisation in long run is to maximize the total sales revenue with a
minimum profit constraint. ii) The firm sets a minimum constraint of profit,
which is determined according to competition and market value of firm's
shares.
• Prof. Baumol, in his book 'Business behaviour, Value and Growth' has
propounded a theory of Sales Maximisation. Main aim of a firm is to maximise
sales. By sales he meant total revenue earned by the sale of goods. That is why
this goal is also referred to as Sales Maximisation Goal. According to this
theory, once profits reach acceptable levels, the goal of the firms become
maximisation of sales revenue rather than maximisation of profits.
• Number of arguments has also been passed by Baumol to support his theory.
Those are as follows:
• Every firm has sensitivity towards sales: even slightest decline in sales are much
concerned by firms
• The sales of the firm are directly tend to influence the bank credit, creditors and
the capital market
• Decline in sales will also cover the way for its own distributors and dealers to
stop taking interest in particular product
• The unpopularity of the product may stop the consumer to buy the particular
product
• Sales are the revenue generators for the firm and if the declined then the firm
needs to cut down its expenses through cutting down its staff and other
operating expenses
• The extent of the sales is directly proportional to the salaries of the worker and
the management
Baumol model for revenue maximisation through sales is depicted in figure 1.5
where TC- total cost curve, TR. Total Revenue Curve, TP Total profit curve and
MP- Minimum profit. It can be seen from the diagram that a firm attains
maximum profit for the output level OQ, the corresponding point is denoted
by B in the TP curve. But the objective of the firm is to maximise the sales
rather than its profit: thereby sales maximisation output is denoted by OK
where the total revenue generated correspondingly is denoted by KL in the TR
curve. From the curve, it can be interpreted that sales maximisation output OK
is higher than profit maximisation OK. But the sales maximisation is subject to
minimum profit constraint. For sales maximisation, the firm produces output
to a certain level to cover the minimum profit and to generate highest total
revenue, whose point is OD, the DC here represents the minimum profit
generated which is equivalent to OM for the output level DC. DE represents
the total revenue generated for the output level OD.
In Baumol's model, the point of profit maximisation output, OQ is smaller than sale
maximisation output OD. In the model, lower price under sales maximisation is
that both total revenue and total output are equally higher while under profit
maximisation, total output is much less as compared to total revenue. Imagine if
QB is joined to TR in figure 1.5. "If at the point of maximum profit," writes
Baumol, "the firm earns more profit than the required minimum, it will pay the
sales maximiser to lower his price and increase his physical output".
• Marris’ Hypothesis of Maximisation of Growth Rate
• Working on the principle of segregation of managers from owners, Marris
proposed that owners (shareholders) aim at profits and market share, whereas
managers aim at better salary, job security and growth. These two sets of goals
can be achieved by maximising balanced growth of the firm (G), which is
dependent on the growth rate of demand for the firm’s products (GD) and
growth rate of capital supply to the firm (GC). Hence, growth rate of the firm is
balanced when the demand for its product and the capital supply to the firm
grow at the same rate. Marris further said that firms face two constraints in the
objective of maximisation of balanced growth, which are as follows:
(i) Managerial Constraint Among managerial constraints, Marris stressed on the
importance of the role of human resource in achieving organisational
objectives. According to him, skills, expertise, efficiency and sincerity of team
managers are vital to the growth of the firm. Non availability of managerial skill
sets in required size creates constraints for growth; organisations on their high
levels of growth may face constraint of skill ceiling among the existing
employees. New recruitments may be used to increase the size of the
managerial pool with desired skills; however new recruits lack experience to
make quick decisions, which may pose as another constraint.
 (ii) Financial Constraint This relates to the prudence needed in managing financial
resources. Marris suggested that a prudent financial policy will be based on at
least three financial ratios, which in turn set the limit for the growth of the firm.
In order to prove their discretion managers will normally create a trade off and
prefer a moderate debt equity ratio (r1), moderate liquidity ratio (r2) and
moderate retained profit ratio (r3). (Let us mention here that the ratios used in
the financial constraint are dealt with in detail in any standard textbook on
Financial Management and are beyond the scope of this book). However, a brief
description is given hereunder:
(a) Debt equity ratio (r1) This is the ratio between borrowed capital and owners’
capital. High value of debt equity ratio may cause insolvency; hence, a low value
of this ratio is usually preferred by managers to avoid insolvency.
b) Liquidity ratio (r2) This is the ratio between current assets and current liabilities
and is an indicator of coverage provided by current assets to current liabilities.
According to Marris, a manager would try to operate in a region where there is
sufficient liquidity and safety and hence would prefer a high liquidity ratio. But a
higher then would imply low yielding assets, since liquid assets either do not
earn at all (like cash and inventory), or earn low returns (like short-term
securities).
(c) Retention ratio (r3) This is the ratio between retained profits and total profits.
In other words, it is the inverse of dividend payout ratio, i.e., the retained
profits are that portion of net profit which is not distributed among
shareholders. A high retention ratio is good for growth, as retained profits
provide internal source of funds. However, a higher r3 would imply greater
volume retained profits, which may antagonise the shareholders. Hence,
managers cannot afford to keep a very high value of retention ratio. Marris
explained his hypothesis of Growth Maximisation with the help of set of
functions which are as follows:
• G = GD = GC …(2)
• GD = f(d, k) …(3)
• = f(r, p) …(4) where is d is diversification; k is success rate; r is financial security
ratio derived from weighted average of three financial ratios and p is a constant
rate at which profit increases). The above proposition is subject the following
constraints:
• Um = f(salary, power, status, job security) …(5)
• where Um = Utility function of managers and
• Uo = f(profit, market share, brand image) …(6)
• where Uo = Utility function of shareholders The most interesting dimension in
this model is that, although managers and owners (or shareholders) have
different utility functions, yet the two are highly correlated. Managers try to
maximise their utility function Um, but that is dependent upon growth of the
company. Hence, managers must make efforts to maximise GD and GC.
• On the other hand, Uo is maximised when G is maximised; hence for
maximisation of Um, managers must aim at maximisation of Uo. This results in
forcing the managers to aim at keeping all the above mentioned financial ratios
at moderate levels. Marris’ model, however, is not devoid of limitations.
Though it gives a very simplistic solution to a very complex problem and ignores
the role of other constraints like government, social groups, elasticity of
demand, and phases of business cycle, which play a crucial role in determining
the growth pattern of the firm.
• Williamson’s Model of Managerial discretion:
• Oliver Williamson’s model is a combination of the objectives of profit
maximisation and growth maximisation. Williamson emphasised upon the fact
that in modern businesses, ownership is separate from management and
modern managers have discretionary powers to set the goals of firms. He
further said that managers would apply their discretionary power in such a way,
as to maximise their own utility function, with the constraint of maintaining
minimum profit to satisfy shareholders. The utility function of managers, namely
Um, is dependent upon managers’ salary (measurable); job security, power,
status, professional satisfaction (all non measurable); and the power to
influence firm’s objectives. To formalise the model, Williamson took measurable
proxy variables like perks of the manager, office facilities like company car, and
slack payments like a luxurious environment in the office, and expenditure that
takes place at the discretion of the manager, heading a large pool of workers,
which is directly related to his power and status. Slack payments are the ones
whose removal may not make the manager leave the company, but their
presence not only ensures stable and better performance, but is also preferred
by the manager, as these payments are generally far less conspicuous than
monetary benefits. Williamson’s model can be written as following:
• Um = f (S, M, ID) …(7) where Um is manger’s utility function; S is salary; M is
managerial emoluments and ID is power of discretionary investment.
• ID = pD…(8) where pD is discretionary profit
• pD = Actual profit – Minimum profit – Tax …(9)
• Therefore, it can be said that: Um = f (S, pD) …(10)
• S and are pD substitutable, i.e., an increase in S is only possible by decrease in
pD and vice versa. It is easy to understand that since S is represented in terms
of salary and other benefits and is actually an item of expenditure, it has
negative relation with profit. Managers’ interest is in increasing their salary;
hence their goal is to maximise Um. At the same time, they are aware that
they have to keep their shareholders happy; therefore they try to find an
optimum combination of S and pD.