Managerial economics book @ bec doms bagalkot mba

1. MANAGERIAL ECONOMICS
SYLLABUS
Unit 1 Managerial economics: Meaning, nature and scope;
Economic theory and managerial economic; Managerial
economics and business decision making; Role of
managerial economics.
Unit 2 Demand Analysis: Meaning, types and determinants of
demand.
Unit 3 Cost Concepts: Cost function and cost output
relationship; Economics and diseconomies of scale; Cost
control and cost reduction.
Unit 4 Production Functions: Pricing and output decisions
under competitive conditions; Government control over
pricing; Price discrimination; Price discount and
differentials.
Unit 5 Profit: Measurement of profit; Profit planning and
forecasting; Profit maximization; Cost volume profit
analysis; Investment analysis.
Unit 6 National Income: Business cycle; Inflation and deflation;
Balance of payment; Their implications in managerial
decision.
LESSON – 1
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2. NATURE & SCOPE OF MANAGERIAL ECONOMICS
The terms Managerial Economics and Business Economics are often
used interchangeably. However, the terms Managerial Economics has
become more popular and seems to displace Business Economics.
DECISION-MAKING AND FORWARD PLANNING
The chief function of a management executive in a business firm is
decision-making and forward planning. Decision-making refers to the
process of selecting one action from two or more alternative courses of
action. Forward planning on the other hand is arranging plans for the
future. In the functioning of a firm the question of choice arises
because the available resources such as capital, land, labour and
management, are limited and can be employed in alternative uses.
The decision-making function thus involves making choices or
decisions that will provide the most efficient means of attaining an
organisational objectives, for example profit maximization. Once a
decision is made about the particular goal to be achieved, plans for
the future regarding production, pricing, capital, raw materials and
labour are prepared. Forward planning thus goes hand in hand with
decision-making. The conditions in which firms work and take
decisions, is characterised with uncertainty. And this uncertainty not
only makes the function of decision-making and forward planning
complicated but also adds a different dimension to it. If the knowledge
of the future were perfect, plans could be formulated without error
and hence without any need for subsequent revision. In the real
world, however, the business manager rarely has complete
information about the future sales, costs, profits, capital conditions.
etc. Hence, decisions are made and plans are formulated on the basis
of past data, current information and the estimates about future that
are predicted as accurately as possible. While the plans are
implemented over time, more facts come into the knowledge of the
businessman. In accordance with these facts the plans may have to be
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3. revised, and a different course of action needs to be adopted.
Managers are thus engaged n a continuous process of decision-
making through an uncertain future and the overall problem that they
deal with is adjusting to uncertainty.
To execute the function of ‘decision-making in an uncertain
frame-work’, economic theory can be applied with considerable
advantage. Economic theory deals with a number of concepts and
principles relating to profit, demand, cost, pricing, production,
competition, business cycles and national income, which are aided by
allied disciplines like accounting. Statistics and Mathematics also can
be used to solve or at least throw some light upon the problems of
business management. The way economic analysis can be used
towards solving business problems constitutes the subject matter of
Managerial Economics.
DEFINITION
According to McNair the Merriam, Managerial Economics consists of
the use of economic modes of thought to analyse business situations.
Spencer and Siegelman have defined Managerial Economics as
“the integration of economic theory with business practice for the
purpose of facilitating decision-making and forward planning by
management.”
The above definitions suggest that Managerial economics is the
discipline, which deals with the application of economic theory to
business management. Managerial Economics thus lies on the margin
between economics and business management and serves as the
bridge between the two disciplines. The following Figure 1.1 shows the
relationship between economics, business management and
managerial economics.
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4. APPLICATION OF ECONOMICS TO BUSINESS MANAGEMENT
The application of economics to business management or the
integration of economic theory with business practice, as Spencer and
Siegelman have put it, has the following aspects :
• Reconciling traditional theoretical concepts of economics
in relation to the actual business behavior and conditions:
In economic theory, the technique of analysis is that of model
building. This involves making some assumptions and, drawing
conclusions on the basis of the assumptions about the behavior
of the firms. The assumptions, however, make the theory of the
firm unrealistic since it fails to provide a satisfactory
explanation of what the firms actually do. Hence, there is need
to reconcile the theoretical principles based on simplified
assumptions with actual business practice and develop
appropriate extensions and reformulation of economic theory.
For example, it is usually assumed that firms aim at
maximising profits. Based on this, the theory of the firm
suggests how much the firm will produce and at what price it
would sell. In practice, however, firms do not always aim at
maximum profits (as they may think of diversifying or
introducing new product etc.) To that extent, the theory of the
firm fails to provide a satisfactory explanation of the firm’s
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5. actual behavior. Moreover, in actual business language, certain
terms like profits and costs have accounting concepts as
distinguished from economic concepts. In managerial
economics, an attempt is made to merge the accounting
concepts with the economics, an attempt is made to merge the
accounting concepts with the economic concepts. This helps in
a more effective use of financial data related to profits and costs
to suit the needs of decision-making and forward planning.
• Estimating economic relationships: This involves the
measurement of various types of elasticities of demand such as
price elasticity, income elasticity, cross-elasticity, promotional
elasticity and cost-output relationships. The estimates of these
economic relationships are to be used for the purpose of
forecasting.
• Predicting relevant economic quantities: Economic
quantities such as profit, demand, production, costs, pricing
and capital are predicated in numerical terms together with
their probabilities. As the business manager has to work in an
environment of uncertainty, the future needs to be foreseen so
that in the light of the predicted estimates, decision-making and
forward planning may be possible.
• Using economic quantities in decision-making and forward
planning: This involves formulating business policies for
establishing future business plans. This nature of economic
forecasting indicates the degree of probability of various
possible outcomes, i.e., losses or gains that will occur as a
result of following each one of the available strategies. Thus, a
quantified picture gets set up, that indicates the number of
courses open, their possible outcomes and the quantified
probability of each outcome. Keeping this picture in view, the
business manager is able to decide about which strategy should
be chosen.
• Understanding significant external forces: Applying economic
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6. theory to business management also involves understanding the
important external forces that constitute the business
environment and with which a business must adjust. Business
cycles, fluctuations in national income and government policies
pertaining to taxation, foreign trade, labour relations,
antimonopoly measures, industrial licensing and price controls
are typical examples. The business manager has to appraise the
relevance and impact of these external forces in relation to the
particular business unit and its business policies.
CHARACTERISTICS OF MANAGERIAL ECONOMICS
There are certain chief characteristics of managerial economics, which
can help to understand the nature of the subject matter and help in a
clear understanding of the following terms:
• Managerial economics is micro-economic in character. This is
because the unit of study is a firm and its problems. Managerial
economics does not deal with the entire economy as a unit of
study.
• Managerial economics largely uses that body of economic
concepts and principles, which is known as Theory of the Firm
or Economics of the Firm. In addition, it also seeks to apply
profit theory, which forms part of distribution theories in
economics.
• Managerial economics is concrete and realistic. I avoids difficult
abstract issues of economic theory. But it also involves
complications ignored in economic theory in order to face the
overall situation in which decisions are made. Economic theory
ignores the variety of backgrounds and training found in
individual firms. Conversely, managerial economics is
concerned more with the particular environment that influences
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7. decision-making.
• Managerial economics belongs to normative economics rather
than positive economics. Normative economy is the branch of
economics in which judgments about the desirability of various
policies are made. Positive economics describes how the
economy behaves and predicts how it might change. In other
words, managerial economics is prescriptive rather than
descriptive. It remains confined to descriptive hypothesis.
• Managerial economics also simplifies the relations among
different variables without judging what is desirable or
undesirable. For instance, the law of demand states that as
price increases, demand goes down or vice-versa but this
statement does not imply if the result is desirable or not.
Managerial economics, however, is concerned with what
decisions ought to be made and hence involves value
judgments. This further has two aspects: first, it tells what aims
and objectives a firm should pursue; and secondly, how best to
achieve these aims in particular situations. Managerial
economics, therefore, has been described as normative
microeconomics of the firm.
• Macroeconomics is also useful to managerial economics since it
provides an intelligent understanding of the business
environment. This understanding enables a business executive
to adjust with the external forces that are beyond the
management’s control but which play a crucial role in the well
being of the firm. The important forces are: business cycles,
national income accounting, and economic policies of the
government like those relating to taxation foreign trade, anti-
monopoly measures and labour relations.
DIFFFFERENCE BETWEEN MANAGERIAL ECONOMICS AND
ECONOMICS
The difference between managerial economics and economics can be
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8. understood with the help of the following points:
• Managerial economics involves application of economic
principles to the problems of a business firm whereas;
economics deals with the study of these principles only.
Economics ignores the application of economic principles to the
problems of a business firm.
• Managerial economics is micro-economic in character, however,
Economics is both macro-economic and micro-economic.
• Managerial economics, though micro in character, deals only
with a firm and has nothing to do with an individual’s economic
problems. But microeconomics as a branch of economics deals
with both economics of the individual as well as economics of a
firm.
• Under microeconomics, the distribution theories, viz., wages,
interest and profit, are also dealt with. Managerial economics on
the contrary is mainly concerned with profit theory and does not
consider other distribution theories. Thus, the scope of
economics is wider than that of managerial economics.
• Economic theory assumes economic relationships and builds
economic models. Managerial economics adopts, modifies and
reformulates the economic models to suit the specific conditions
and serves the specific problem solving process. Thus,
economics gives the simplified model, whereas managerial
economics modifies and enlarges it.
• Economics involves the study of certain assumptions like in the
law of proportion where it is assumed that “The variable input
as applied, unit by unit is homogeneous or identical in amount
and quality”. Managerial economics on the other hand,
introduces certain feedbacks. These feedbacks are in the form of
objectives of the firm, multi-product nature of manufacture,
behavioral constraints, environmental aspects, legal
constraints, constraints on resource availability, etc. Thus
managerial economics, attempts to solve the complexities in real
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9. life, which are assumed in economics. this is done with the help
of mathematics, statistics, econometrics, accounting, operations
research, etc.
OTHER TERMS FOR MANAGERIAL ECONOMICS
Certain other expressions like economic analysis for business
decisions and economics of business management have also been
used instead of managerial economics but they are not so popular.
Sometimes expressions like ‘Economics of the Enterprise’, ‘Theory of
the Firm’ or ‘Economics of the Firm’ have also been used for
managerial economics. It is, however, not appropriate t use theses
terms because managerial economics, though primarily related to the
economics of the firm, differs from it in the following respects:
• First, ‘Economics of the Firm’ deals with the theory of the firm,
which is a body of economic principles relating to the firm
alone. Managerial economics on the other hand deals with the,
application of the same principles to business.
• Secondly, the term ‘Economics of the firm’ is too simple in its
assumptions whereas managerial economics has to reckon with
actual business behaviour, which is much more complex.
SCOPE OF MANAGERIAL ECONOMICS
As regards the scope of managerial economics, there is no general
uniform pattern. However, the following aspects may be said to be
inclusive under managerial economics:
• Demand analysis and forecasting.
• Cost and production analysis.
• Pricing decisions, policies and practices.
• Profit management.
• Capital management.
These aspects may also be defined as the ‘Subject-Matter of
Managerial Economics’. In recent years, there is a trend towards
integrations of managerial economics and operations research. Hence,
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10. techniques such as linear programming, inventory models and theory
of games have also been regarded as a part of managerial economics.
Demand Analysis and Forecasting
A business firm is an economic Organisation, which transforms
productive resources into goods that are to be sold in a market. A
major part of managerial decision-making depends on accurate
estimates of demand. This is because before production schedules can
be prepared and resources are employed, a forecast of future sales is
essential. This forecast can also guide the management in maintaining
or strengthening the market position and enlarging profits. The
demand analysis helps to identify the various factors influencing
demand for a firm’s product and thus provides guidelines to
manipulate demand. Demand analysis and forecasting, thus, is
essential for business planning and occupies a strategic place in
managerial economics. It comprises of discovering the forces
determining sales and their measurement. The chief topics covered in
this are:
• Demand determinants
• Demand distinctions
• Demand forecasting.
Cost and Production Analysis
A study of economic costs, combined with the data drawn from the
firm’s accounting records, can yield significant cost estimates. These
estimates are useful for management decisions. The factors causing
variations in costs must be recognised and thereby should be used for
taking management decisions. This facilitates the management to
arrive at cost estimates, which are significant for planning purposes.
An element of cost uncertainty exists in this because all the factors
determining costs are not always known or controllable. Therefore, it
is essential to discover economic costs and measure them for effective
profit planning, cost control and sound pricing practices. Production
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11. analysis is narrower in scope than cost analysis. The chief topics
covered under cost and production analysis are:
• Cost concepts and classifications
• Cost-output relationships
• Economics of scale
• Production functions
• Cost control.
Pricing Decisions, Policies and Practices
Pricing is a very important area of managerial economics. In fact price
is the origin of the revenue of a firm. As such the success of a usiness
firm largely depends on the accuracy of price decisions of that firm.
The important aspects dealt under area, are as follows:
• Price determination in various market forms
• Pricing methods
• Differential pricing product-line pricing and price forecasting.
Profit Management
Business firms are generally organised with the purpose of making
profits. In the long run, profits provide the chief measure of success.
In this connection, an important point worth considering is the
element of uncertainty existing about profits. This uncertainty occurs
because of variations in costs and revenues. These are caused by
factors such as internal and external. If knowledge about the future
were perfect, profit analysis would have been a very easy task.
However, in a world of uncertainty, expectations are not always
realised. Thus profit planning and measurement make up the difficult
area of managerial economics. The important aspects covered under
this area are:
• Nature and measurement of profit.
• Profit policies and techniques of profit planning.
Capital Management
Among the various types and classes of business problems, the most
complex and troublesome for the business manager are those relating
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12. to the firm’s capital investments. Capital management implies
planning and control and capital expenditure. In this procedure,
relatively large sums are involved and the problems are so complex
that their disposal not only requires considerable time and labour but
also top-level decisions. The main elements dealt with cost
management are:
• Cost of capital
• Rate of return and selection of projects.
The various aspects outlined above represent the major
uncertainties, which a business firm has to consider viz., demand
uncertainty, cost uncertainty, price uncertainty, profit uncertainty
and capital uncertainty. We can, therefore, conclude that managerial
economics is mainly concerned with applying economic principles and
concepts to adjust with the various uncertainties faced by a business
firm.
MANAGERIAL ECONOMICS AND OTHER SUBJECTS
Yet another useful method of explaining the nature and scope of
managerial economics is to examine its relationship with other
subjects. The following discussion helps to understand relationship
between managerial economics and economics, statistics,
mathematics, accounting and operations research.
Managerial Economics and Economics
Managerial economics is defined as a subdivision of economics that
deals with decision-making. It may be viewed as a special branch of
economics bridging the gulf between pure economic theory and
managerial practice. Economics has two main divisions-
microeconomics and Macroeconomics. Microeconomics has been
defined as that branch where the unit of study is an individual or a
firm. It is also called “price theory” (or Marshallian economics) and is
the main source of concepts and analytical tools for managerial
economics. To illustrate, various micro-economic concepts such as
elasticity of demand, marginal cost, the short and the long runs,
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13. various market forms, etc., are all of great significance to managerial
economics.
Macroeconomics, on the other hand, is aggregative in character
and has the entire economy as a unit of study. The chief contribution
of macroeconomics to managerial economics is in the area of
forecasting. The modern theory of income and employment has direct
implications for forecasting general business conditions. As the
prospects of an individual firm often depend greatly on general
business conditions, individual firm forecasts rely on general business
forecasts.
A survey in the U.K. has shown that business economists have
found the following economic concepts quite useful and of frequent
application:
• Price elasticity of demand
• Income elasticity of demand
• Opportunity cost
• Multiplier
• Propensity to consume
• Marginal revenue product
• Speculative motive
• Production function
• Liquidity preference
• Business economists have also found the following main areas
of economics as useful in their work. Demand theory
• Theory of firms – price, output and investment decisions
• Business financing
• Public finance and fiscal policy
• Money and banking
• National income and social accounting
• Theory of international trade
• Economies of developing countries.
Thus, it is obvious that Managerial Economics is very closely
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14. related to Economics.
Managerial Economics and Statistics
Statistics is important to managerial economics in several ways.
Managerial economics calls for the organising quantitative data and
deriving a useful measure of appropriate functional relationships
involved in decision-making. For instance, in order to base its pricing
decisions on demand and cost considerations, a firm should have
statistically derived or calculated demand and cost functions.
Managerial economics also employs statistical methods for
experimental testing of economic generalisations. The generalisations
can be accepted in practice only when they are checked against the
data from the world of reality and are found valid. Managers do not
have exact information about the variables affecting decisions and
have to deal with the uncertainty of future events. The theory of
probability, upon which statistics is based, provides logic for dealing
with such uncertainties.
Managerial Economics and Mathematics
Mathematics is yet another important subject closely related to
managerial economics. This is because managerial economics is
mathematical in character, as it involves estimating various economic
relationships, predicting relevant economic quantities and using them
in decision-making and forward planning. Knowledge of geometry,
trigonometry ad algebra is not only essential but also certain
mathematical tools and concepts such as logarithms and exponential,
vectors, determinants, matrix, algebra, calculus, differential as well as
integral, are the most commonly used devices. Further, operations
research, which is closely related to managerial economics, is
mathematical in character. It provides and analyses data ad develops
models, benefiting from the experiences of experts drawn from
different disciplines, viz., psychology, sociology, statistics and
engineering.
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15. MANAGERIAL ECONOMICS AND ACCOUNTING
Managerial economics is also closely related to accounting, which is
concerned with recording the financial operations of a business firm.
In fact, a managerial economist depends chiefly on the accounting
information as an important source of data required for his decision-
making purpose. for instance, the profit and loss statement of a firm
shows how well the firm has done and whether the information it
contains can be used by managerial economist to throw significant
light on the future course of action that is whether the firm should
improve its productivity or close down. Therefore, accounting data
require careful interpretation, reconstruction and adjustments before
they can be used safely and effectively. It is in this context that the
link between management accounting and managerial economics
deserves special mention. The main task of management accounting is
to provide the sort of data, which managers need if they are to apply
the ideas of managerial economics to solve business problems
correctly. The accounting data should be provided in such a form that
they fit easily into the concepts and analysis of managerial economics.
Managerial Economics and Operations Research
Operations research is a subject field that emerged during the Second
World War and the years thereafter. A good deal of interdisciplinary
research was done in the USA. as well as other western countries to
solve the complex operational problems of planning and resource
allocation in defence and basic industries. Several experts like
mathematicians, statisticians, engineers and others teamed up
together and developed models and analytical tools leading to the
emergence of this specialised subject. Much of the development of
techniques and concepts, such as linear programming, inventory
models, game theory, etc., emerged from the working of the operation
researchers. Several problems of managerial economics are solved by
the operation research techniques. These highlight the significant
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16. relationship between managerial economics and operations research.
The problems solved by operation research are as follows:
• Allocation problems: An allocation problem confronts with the
issue that men, machines and other resources are scarce,
related to the number sand size of the jobs that need to be
completed. The examples are production programming and
transportation problems.
• Competitive problems: competitive problems deal with
situations where managerial decision-making is to be made in
the face of competitive action. That is, one of the factors to be
considered is: “What will competitors do if certain steps are
taken?” Price reduction, for example, will not lead to increased
market share if rivals follow suit.
• Waiting line problems : Waiting line problems arise when a
firm wants to know how many machines it should install in
order to ensure that the amount of ‘work-in-progress’ waiting to
be machined is neither too small nor too large. Such situations
arise when for example, a post office, or a bank wants to know
how many cash desks or counter clerks it should employ in
order to balance the business lost through long guesses against
the cost of installing more equipment or hiring more labour.
• Inventory problems: Inventory problems deal with the
principal question: “What is the optimum level of stocks of raw-
materials, components or finished goods for the firm to hold?”
The above discussion explains that the managerial economics is
closely related to certain subjects such as economics, statistics,
mathematics and accounting. A trained managerial economist
combines concepts and methods from all these subjects by bringing
them together to solve business problems. In particular, operations
research and management accounting are getting very close to
managerial economics.
USES OF MANAGERIAL ECONOMICS
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17. Managerial economics achieves several objectives. The principal
objectives are as follows:
• It presents those aspects of traditional economics, which are
relevant for business decision-making in real life. For this
purpose, it picks from economic theory those concepts,
principles and techniques of analysis, which are concerned with
the decision-making process. These are adapted or modified in
such a way that it enables the manager to take better decisions.
Thus, managerial economics attains the objective of building a
suitable tool kit from traditional economics.
• Managerial economics also incorporates useful ideas from other
disciplines such as psychology, sociology, etc. If they are found
relevant for decision-making. In fact, managerial economics
takes the aid of other academic disciplines that are concerned
with the business decisions of a manager in view of the various
explicit and implicit constraints subject to which resource
allocation is to be optimised.
• It helps in reaching a variety of business decisions even in a
complicated environment. Certain examples of such decisions
are those decisions concerned with:
o The products and services to be produced
o The inputs and production techniques to be used
o The quantity of output to be produced and the selling
prices to be subscribed
o The best sizes and locations of new plants
o Time of replacing the equipment
o Allocation of the available capital
• Managerial economics helps a manager to become a more
competent model builder. Thus, he can pick out the essential
relationships, which characterise a situation and leave out the
other unwanted details and minor relationships.
• At the level of the firm, functional specialists or functional
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18. departments exist, e.g., finance, marketing, personnel,
production etc. For these various functional areas, managerial
economics serves as an integrating agent by co-ordinating the
different areas. It then applies the decisions of each department
or specialist, those implications, which are pertaining to other
functional areas. Thus managerial economics enables business
decision-making to operate not with an inflexible and rigid but
with an integrated perspective. This integration is important
because the functional departments or specialists often enjoy
considerable autonomy and achieve conflicting goals.Managerial
economics keeps in mind the interaction between the firm and
society and accomplishes the key role of business as an agent
in attaining social economic welfare. There is a growing
awareness that besides its obligations to shareholders, business
enterprise has certain social obligations as well. Managerial
economics focuses on these social obligations while taking
business decisions. By doing so, it serves as an instrument of
furthering the economic welfare of the society through socially
oriented business decisions.
Thus, it is evident that the applicability and usefulness of
managerial economics is obtained by performing the following
activates:
• Borrowing and adopting the tool-kit from economic theory.
• Incorporating relevant ideas from other disciplines to achieve
better business decisions.
• Serving as a catalytic agent in the course of decision-making by
different functional departments/specialists at the firm’s level.
• Accomplishing a social purpose by adjusting business decisions
to social obligations.
ECONOMIC THEORY AND MANAGERIAL ECONOMICS
Economic theory offers a variety of concepts and analytical tools that
can assist the manager in the decision-making practices. Problem
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19. solving in business has, however, found that there exists a wide
disparity between the economic theory of a firm and actual observed
practice, thus necessitating the use of many skills and be quite useful
to examine two aspects in this regard:
• The basic tools of managerial economics which it has borrowed
from economics, and
• The nature and extent of gap between the economic theory of
the firm and the managerial theory of the firm.
Basic Economic Tools in Managerial Economics
The most significant contribution of economics to managerial
economics lies in certain principles, which are basic to the entire
range of managerial economics. The basic principles may be identified
as follows:
1. Opportunity Cost Principle
The opportunity cost of a decision means the sacrifice of alternatives
required by that decision. This can be best understood with the help
of a few illustrations, which are as follows:
• The opportunity cost of the funds employed in one’s own
business is equal to the interest that could be earned on those
funds if they were employed in other ventures.
• The opportunity cost of the time as an entrepreneur devotes to
his own business is equal to the salary he could earn by seeking
employment.
• The opportunity cost of using a machine to produce one product
is equal to the earnings forgone which would have been possible
from other products.
• The opportunity cost of using a machine that is useless for any
other purpose is zero since its use requires no sacrifice of other
opportunities.
• If a machine can produce either X or Y, the opportunity cost of
producing a given quantity of X is equal to the quantity of Y,
which it would have produced. If that machine can produce 10
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20. units of X or 20 units of Y, the opportunity cost of 1 X is equal
to 2 Y.
• If no information is provided about quantities produced, except
about their prices then the opportunity cost can be computed in
terms of the ratio of their respective prices, say Px/Py.
• The opportunity cost of holding Rs. 500 as cash in hand for one
year is equal to the 10% rate of interest, which would have been
earned had the money been kept as fixed deposit in a bank.
Thus, it is clear that opportunity costs require the ascertaining
of sacrifices. If a decision involves no sacrifice, its opportunity
cost is nil.
For decision-making, opportunity costs are the only relevant
costs. The opportunity cost principle may be stated as under:
“The cost involved in any decision consists of the sacrifices of
alternatives required by that decision. If there are no sacrifices, there
is no cost.”
Thus in macro sense, the opportunity cost of more guns in an
economy is less butter. That is the expenditure to national fund for
buying armour has cost the nation of losing an opportunity of buying
more butter. Similarly, a continued diversion of funds towards defence
spending, amounts to a heavy tax on alternative spending required for
growth and development.
2. Incremental Principle
The incremental concept is closely related to the marginal costs and
marginal revenues of economic theory. Incremental concept involves
two important activities which are as follows:
• Estimating the impact of decision alternatives on costs and
revenues.
• Emphasising the changes in total cost and total cost and total
revenue resulting from changes in prices, products, procedures,
investments or whatever may be at stake in the decision.
The two basic components of incremental reasoning are as follows:
• Incremental cost: Incremental cost may be defined as the
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21. change in total cost resulting from a particular decision.
• Incremental revenue: Incremental revenue means the change in
total revenue resulting from a particular decision.
The incremental principle may be stated as under:
A decision is obviously a profitable one if:
o It increases revenue more than costs
o It decreases some costs to a greater extent than it
increases other costs
o It increases some revenues more than it decreases other
revenues
o It reduces costs more that revenues.
Some businessmen hold the view that to make an overall profit,
they must make a profit on every job. Consequently, they refuse
orders that do not cover full cost (labour, materials and overhead)
plus a provision for profit. Incremental reasoning indicates that this
rule may be inconsistent with profit maximisation in the short run. A
refusal to accept business below full cost may mean rejection of a
possibility of adding more to revenue than cost. The relevant cost is
not the full cost but rather the incremental cost. A simple problem will
illustrate this point.
IIIustration
Suppose a new order is estimated to bring in additional revenue of Rs.
5,000. The costs are estimated as under:
Labour Rs. 1,500
Material Rs. 2,000
Overhead (Allocated at 120% of labour cost) Rs. 1,800
Selling administrative expenses
(Allocated at 20% of labour and material cost) Rs. 700
Total Cost Rs. 6,000
The order at first appears to be unprofitable. However, suppose,
if there is idle capacity, which can be, utilised to execute this order
then the order can be accepted. If the order adds only Rs. 500 of
overhead (that is, the added use of heat, power and light, the added
wear and tear on machinery, the added costs of supervision, and so
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22. on), Rs. 1,000 by way of labour cost because some of the idle workers
already on the payroll will be deployed without added pay and no
extra selling and administrative cost then the incremental cost of
accepting the order will be as follows.
Labour Rs. 1,500
Material Rs. 2,000
Overhead Rs. 500
Total Incremental Cost Rs. 3,500
While it appeared in the first instance that the order will result
in a loss of Rs. 1,000, it now appears that it will lead to an addition of
Rs. 1,500 (Rs. 5,000- Rs. 3,500) to profit. Incremental reasoning does
not mean that the firm should accept all orders at prices, which cover
merely their incremental costs. The acceptance of the Rs. 5,000 order
depends upon the existence of idle capacity and labour that would go
unutilised in the absence of more profitable opportunities. Earley’s
study of “excellently managed” large firms suggests that progressive
corporations do make formal use of incremental analysis. It is,
however, impossible to generalise on the use of incremental principle,
since the observed behaviour is variable.
3. Principle of Time Perspective
The economic concepts of the long run and the short run have become
part of everyday language. Managerial economists are also concerned
with the short-run and long-run effects of decisions on revenues as
well as on costs. The actual problem in decision-making is to maintain
the right balance between the long-run and short-run considerations.
A decision may be made on the basis of short-run considerations, but
may in the course of time offer long-run repercussions, which make it
more or less profitable than it appeared at first. An illustration will
make this point clear.
IIIustration
Suppose there is a firm with temporary idle capacity. An order for
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23. 5,000 units comes to management’s attention. The customer is willing
to pay Rs. 4.00 per unit or Rs. 20,000 for the whole lot but not more.
The short-run incremental cost (ignoring the fixed cost) is only Rs.
3.00. Therefore, the contribution to overhead and profit is Re. 1.00 per
unit (Rs. 5,000 for the lot. However, the long-run repercussions of the
order ought to be taken into account are as follows:
• If the management commits itself with too much of business at
lower prices or with a small contribution, it may not have
sufficient capacity to take up business with higher
contributions when the opportunity arises. The management
may be compelled to consider the question of expansion of
capacity and in such cases; even the so-called fixed costs may
become variable.
• If any particular set of customers come to know about this low
price, they may demand a similar low price. Such customers
may complain of being treated unfairly and feel discriminated.
In response, they may opt to patronise manufacturers with
more decent views on pricing. The reduction or prices under
conditions of excess capacity may adversely affect the image of
the company in the minds of its clientele, which will in turn
affect its sales.
It is, therefore, important to give due consideration to the time
perspective. The principle of time perspective may be stated as under:
‘A decision should take into account both the short-run and long-run
effects on revenues and costs and maintain the right balance between
the long-run and short-run perspectives.”
Haynes, Mote and Paul have cited the case of a printing
company. This company pursued the policy of never quoting prices
below full cost though it often experienced idle capacity and the
management was fully aware that the incremental cost was far below
full cost. This was because the management realised that the long-run
repercussions of pricing below full cost would make up for any short-
run gain. The management felt that the reduction in rates for some
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24. customers might have an undesirable effect on customer goodwill
particularly among regular customers not benefiting from price
reductions. It wanted to avoid crating such an “image” of the firm that
it exploited the market when demand was favorable but which was
willing to negotiate prices downward when demand was unfavorable.
4. Discounting Principle
One of the fundamental ideas in economics is that a rupee tomorrow
is worth less than a rupee today. This seems similar to the saying that
a bird in hand is worth two in the bush. A simple example would
make this point clear. Suppose a person is offered a choice to make
between a gift of Rs. 100 today or Rs. 100 next year. Naturally he will
choose the Rs. 100 today.
This is true for two reasons. First, the future is uncertain and
there may be uncertainty in getting Rs. 100 if the present opportunity
is not availed of. Secondly, even if he is sure to receive the gift in
future, today’s Rs. 100 can be invested so as to earn interest, say, at 8
percent so that. one year after the Rs. 100 of today will become Rs.
108 whereas if he does not accept Rs. 100 today, he will get Rs. 100
only in the next year. Naturally, he would prefer the first alternative
because he is likely to gain by Rs. 8 in future. Another way of saying
the same thing is that the value of Rs. 100 after one year is not equal
to the value of Rs. 100 of today but less than that. To find out how
much money today is equal to Rs. 100 would earn if one decides to
invest the money. Suppose the rate of interest is 8 percent. Then we
shall have to discount Rs. 100 at 8 per cent in order to ascertain how
much money today will become Rs. 100 one year after. The formula is:
Rs. 100
1+i
V=
where,
V = present value
i = rate of interest.
Now, applying the formula, we get
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25. Rs. 100
1+i
V=
100
1.08
=
If we multiply Rs. 92.59 by 1.08, we shall get the amount of money,
which will accumulate at 8 per cent after one year.
92.59 x 1.08 = 99.0072
= 1.00
The same reasoning applies to longer periods. A sum of Rs. 100
two years from now is worth:
Rs. 100 Rs. 100 Rs. 100
(1+i)2 (1.08)2 1.1664
V= = =
Similarly, we can also check by computing how much the
cumulative interest will be after two years. The principle involved in
the above discussion is called the discounting principle and is stated
as follows: “If a decision affects costs and revenues at future dates, it
is necessary to discount those costs and revenues to present values
before a valid comparison of alternatives is possible.”
5. Equi-marginal Principle
This principle deals with the allocation of the available resource
among the alternative activities. According to this principle, an input
should be allocated in such a way that the value added by the last
unit is the same in all cases. This generalisation is called the equi-
marginal principle.
Suppose a firm has 100 units of labour at its disposal. The firm
is engaged in four activities, which need labour services, viz., A, B, C
and D. It can enhance any one of these activities by adding more
labour but sacrificing in return the cost of other activities. If the value
of the marginal product is higher in one activity than another, then it
should be assumed that an optimum allocation has not been attained.
Hence it would, be profitable to shift labour from low marginal value
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26. activity to high marginal value activity, thus increasing the total value
of all products taken together. For example, if the values of certain
two activities are as follows:
Value of Marginal Product of labour
Activity A = Rs. 20
Activity B = Rs. 30
In this case it will be profitable to shift labour from A to activity
B thereby expanding activity B and reducing activity A. The optimum
will be reach when the value of the marginal product is equal in all the
four activities or, when in symbolic terms:
VMPLA = VMPLB = VMPLC = VMPLD
Where the subscripts indicate labour in respective activities.
Certain aspects of the equi-marginal principle need
clarifications, which are as follows:
• First, the values of marginal products are net of incremental
costs. In activity B, we may add one unit of labour with an
increase in physical output of 100 units. Each unit is worth 50
paise so that the 100 units will sell for Rs. 50. But the increased
output consumes raw materials, fuel and other inputs so that
variable costs in activity B (not counting the labour cost) are
higher. Let us say that the incremental costs are Rs. 30 leaving
a net addition of Rs. 20. The value of the marginal product
relevant for our purpose is thus Rs. 20.
• Secondly, if the revenues resulting from the addition of labour
are to occur in future, these revenues should be discounted
before comparisons in the alternative activities are possible.
Activity A may produce revenue immediately but activities B, C
and D may take 2, 3 and 5 years respectively. Here the
discounting of these revenues will make them equivalent.
• Thirdly, the measurement of value of the marginal product may
have to be corrected if the expansion of an activity requires an
alternative reduction in the prices of the output. If activity B
represents the production of radios and it is not possible to sell
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27. more radios without a reduction in price, it is necessary to
make adjustment for the fall in price.
• Fourthly, the equi-marginal principle may break under
sociological pressures. For instance, du to inertia, activities are
continued simply because they exist. Similarly, due to their
empire building ambitions, managers may keep on expanding
activities to fulfil their desire for power. Department, which are
already over-budgeted often, use some of their excess resources
to build up propaganda machines (public relations offices) to
win additional support. Governmental agencies are more prone
to bureaucratic self-perpetuation and inertia.
Gaps between Theory of the Firm and managerial Economics
The theory of the firm is a body of theory, which contains certain
assumptions, theorems and conclusions. These theorems deal with
the way in which businessmen make decisions about pricing, and
production under prescribed market conditions. It is concerned with
the study of the optimisation process.
For optimality to exist profit must be maximised and this can
occur only when marginal cost equals marginal revenue. Thus, the
optimum position of the firm is that which maximises net revenue.
Managerial economics, on the other hand, aims at developing a
managerial theory of the firm and for the purpose it takes the help of
economic theory of the firm. However, there are certain difficulties in
using economic theory as an aid to the study of decision-making at
the level of the firm. This is because for the purposes of business
decision-making it fails to provide sufficient analytical tools that are
useful to managers. Some of the reasons are as follows:
• Underlying all economic theory is the assumption that the
decision-maker is omniscient and rational or simply that he is
an economic man. Thus being omniscient means that he knows
the alternatives that are available to him as well as the outcome
of any action he chooses. The model of “economic man” however
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28. as an omniscient person who is confronted with a compete set
of known or probabilistic outcomes is a distorted representation
of reality. The typical business decision-maker usually has
limited information at his disposal, limited computing ability
and a limited number of feasible alternatives involving varying
degrees of risk. Further, the net revenue function, which he is
expected to maximise, and the marginal cost and marginal
revenue functions, which he is expected to equate, require
excessive knowledge of information, which is not known and
cannot be obtained even by the most careful analysis. Hence, it
is absurd to expect a manager to maximise and equalise certain
critical functional relationships, which he does not know and
cannot find out.
• In micro-economic theory, the most profitable output is where
marginal cost (MC) and marginal revenue (MR) are equal. In
Figure 1.2, the most profitable output will be at ON where
MR=MC. This is the point at which the slope of the profit
function or marginal profit is zero. This is highlighted in Figure
1.3 where the most profitable output will be again at ON. In
economic theory, the decision-maker has to identify this unique
output level, which maximises profit.
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29. In real world, however, a complexity often arises, viz., certain
resource limitations exist. As a result, it is not possible to attain the
maximum output level (ON). In practical terms the maximum output
possible as a result of resource limitations is, say, OM. Now the
problem before the decision-maker is to find out whether the output,
which maximises profit, is OM or some other level of output to the left
of OM. It is obvious that economic theory is of no help for ON level of
output because it is not relevant in view of the resource limitations. A
managerial economist here has to take the aid of linear programming,
which enables the manager to optimise or search for the best values
within the limits set by inequality conditions.
BSPATIL

30. • Another central assumption in the economic theory of the
firm is that the entrepreneur strives to maximise his residual
share, or profit. Several criticisms of this assumption have
been made:
o The theory is ambiguous, as it doesn’t clarify. Whether
it is short or long run profit that is to be maximised.
For example, in the short run, profits could be
maximised by firing all research and development
personnel and thereby eliminating considerable
immediate expenses. This decision would, however,
have a substantial impact on long-run profitability.
o Certain questions create some confusion around the
concept of profit maximisation. Should the firm seek to
maximise the amount of profit or the rate of profit?
What is the rate of profit? Is it profit in relation to total
capital or profit in relation to shareholders’ equity?
o There is no allowance for the existence of “psychic
income” (Income other than monetary, power, prestige,
or fame), which the entrepreneur might obtain from
the firm, quite apart from his monetary income.
o The theory does not recognise that under modern
conditions, owners and managers are separate and
distinct groups of people and the latter may not be
motivated to maximise profits.
o Under imperfect competition, maximisation is an
ambiguous goal, because actions that are optimal for
one will depend on the actions of the other firms.
o The entrepreneur may not care to receive maximum
profits but may simply want to earn “satisfactory
profits”. This last point is particularly relevant from the
behavioural science standpoint because it introduces a
concept of satiation. The notion of satiation plays no
role in classical economic theory. To explain business
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31. behaviour in terms of this theory, it is necessary to
assume that the firm’s goals are not concerned with
maximising profit, but with attaining a certain level or
rate of profit, holding a certain share of the market or
a certain level of sales. Firms would try to satisfy
rather than maximise. But according to Simon the
satisfying model damages all the conclusions that can
be derived concerning resource allocation under
perfect competition. It focuses on the fact that the
classical theory of the firm is empirically incorrect as a
description of the decision-making process. Based on
this notion of satiation, it appears that one of the main
strengths of classical economic theory has been
seriously weakened.
• Most corporate undertakings involve the investment of
funds, which are expect to produce revenues over a number
of years. The profit maximisation criterion provides no basis
for comparing alternatives that can promise varying flows of
revenue and expenditure over time.
• The practical application of profit maximisation concept also
has another limitation. It provides no explicit way of
considering the risk associated with alternative decisions.
Two projects generating similar expected revenues in the
future and requiring similar outlays might differ vastly as
regarding the degree of uncertainty with which the benefits
to be generated. The greater the uncertainty associated with
the benefits, the greater the risk associated with the project.
• Baumol on the other hand is of the view that firms do not
devote all their energies to maximising profit. Rather a
company will seek to maximise its sales revenue as long as a
satisfactory level of profit is maintained. Thus Baumol has
substituted “Total sales revenue” for profits. Also, two
decision criteria or objectives have been advanced viz., a
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32. satisfactory level of profit and the highest sales possible. In
other words, the firm is no longer viewed as working towards
one objective alone. Instead, it is portrayed as aiming at
balancing two competing and non-consistent goals. Baumol’s
model is based on the view that managers’ salaries, their
status and other rewards often appear as closely related to
the companies’ size in which they work and is measured by
sales revenue rather than their profitability. As such,
managers may be more concerned to increased size than
profits. And the firm’s objective thus becomes sales
maximisation rather than profits maximisation.
• Empirical studies of pricing behaviour also give results that
differ from those of the economic theory of firm as can be
seen from the following examples:
o Several studies of the pricing practices of business
firms have indicated that managers tend to set prices
by applying some sort of a standard mark-up on costs.
They do not attempt to estimate marginal costs,
marginal revenues or demand elasticities, even if these
could be accurately measured.
o For many firms, prices are more often set to attain, a
particular target return on investment, say, 10 per
cent, than to maximise short or long-run profits.
o There is some evidence that firms experiencing
declining market shares in their industry strive more
vigorously to increase their sales than do competing
firms, which are experiencing steady or increasing
market shares.
• An alternative model to profit maximisation is the concept of
wealth maximisation, which assumes that firms seek to
maximise the present value of expected net revenues over all
periods within the forecasted future.
• As pointed out by Haynes and Henry, a study of the
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33. behaviour of actual firms shows that their decisions are not
completely determined by the market. These firms have some
freedom to develop decisions, strategies or rules, which
become part of the decision-making system within the firm.
This gap in economic theory has led to what has come to be
known as ‘Behavioural Theory of the Firm’. This theory,
however, does not replace the former but rather powerfully
supplements it. The behavioural theory represents the firm
as an adoptive institution. It learns from experience and has
a memory. Organisational behaviour, is embodies into
decision rules and standard operating procedures. These
may be altered over long run as the firm reacts to “feedback”
from experience. However, in the short run, decisions of the
organisation are dominated by its rules of thumb and
standard methods.
CONCLUSION
The various gaps between the economic theory of the firm and the
actual decision-making process at the firm level are many in number.
They do, however, stress that economic theory seriously needs major
fixing up and substantial changes are in progress for creating better
and different models. Thus the classical economic concepts like those
of rational man is undergoing important changes; the notion of
satisfying is pushing aside the aim of maximisation and newer lines
and patterns of thoughts are being developed for finding improved
applications to managerial decision-making. A strong emphasis is laid
on quantitative model building, experimentation and empirical
investigation and newer techniques and concepts, such as linear
programming, game theory, statistical decision-making, etc., are being
applied to revolutionise the approaches to problem solving in business
and economics.
MANAGERIAL ECONOMIST: ROLE AND RESPONSIBILITIES
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34. A managerial economist can play a very important role by assisting
the management in using the increasingly specialised skills and
sophisticated techniques, required to solve the difficult problems of
successful decision-making and forward planning. In business
concerns, the importance of the managerial economist is therefore
recognised a lot today. In advanced countries like the USA, large
companies employ one or more economists. In our country too, big
industrial houses have understood the need for managerial
economists. Such business firms like the Tatas, DCM and Hindustan
Lever employ economists. A managerial economist can contribute to
decision-making in business in specific terms. In this connection, two
important questions need be considered:
1. What role does he play in business, that is, what particular
management problems lend themselves to solution through
economic analysis?
2. How can the managerial economist best serve management,
that is, what are the responsibilities of a successful managerial
economist?
Role of a Managerial Economist
One of the principal objectives of any management in its decision-
making process is to determine the key factors, which will influence
the business over the period ahead. In general, these factors can be
divided into two categories:
• External
• Internal
The external factors lie outside the control of management
because they are external to the firm and are said to constitute
business environment. The internal factors lie within the scope and
operations of a firm and hence within the control of management, and
they are known as business operations. To illustrate, a business firm
is free to take decisions about what to invest, where to invest, how
much labour to employ and what to pay for it, how to price its
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35. products, and so on. But all these decisions are taken within the
framework of a particular business environment, and the firm’s degree
of freedom depends on such factors as the government’s economic
policy, the actions of its competitors and the like.
Environmental Studies of a Business Firm
An analysis and forecast of external factors constituting general
business conditions, for example, prices, national income and output,
volume of trade, etc., are of great significance since they affect every
business firm. Certain important relevant factors to be considered in
this connection are as follows:
• The outlook for the national economy, the most important local,
regional or worldwide economic trends, the nature of phase of
the business cycle that lies immediately ahead.
• Population shifts and the resultant ups and downs in regional
purchasing power.
• The demand prospects in new as well as established markets.
Impact of changes in social behaviour and fashions, i.e.,
whether they will tend to expand or limit the sales of a
company’s products, or possibly make the products obsolete?
• The areas in which the market and customer opportunities are
likely to expand or contract most rapidly.
• Whether overseas markets expand or contract and the affect of
new foreign government legislations on the operation of the
overseas plants?
• Whether the availability and cost of credit tend to increase or
decrease buying, and whether money or credit conditions ahead
are likely to easy or tight?
• The prices of raw materials and finished products.
• Whether the competition will increase or decrease.
• The main components of the five-year plan, the areas where
outlays have been increased and the segments, which have
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36. suffered a cut in their outlays.
• The outlook to government’s economic policies and regulations
and changes in defence expenditure, tax rates tariffs and import
restrictions.
• Whether the Reserve Bank’s decisions will stimulate or depress
industrial production and consumer spending and how will
these decisions affect the company’s cost, credit, sales and
profits.
Reasonably accurate data regarding these factors can enable the
management to chalk out the scope and direction of their own
business plans effectively. It will also help them to determine the
timing of their specific actions. And it is these factors, which present
some of the areas where a managerial economist can make effective
contribution. The managerial economist has not only to study the
economic trends at the micro-level but also must interpret their
relevance to the particular industry or firm where he works. He has to
digest the ever-growing economic literature and advise top
management by means of short, business-like practical notes. In
mixed economy like that of India, the managerial economist
pragmatically interprets the intentions of controls and evaluates their
impact. He acts as a bridge between the government and the industry,
translating the government’s intentions and transmitting the reactions
of the industry. In fact, the government policies emerge out of the
performance of industry, the expectations of the people and political
expediency.
Business Operations
A managerial economist can also be helpful to the management in
making decisions relating to the internal operations of a firm in
respect of such problems as price, rate of operations, investment,
expansion or contraction. Certain relevant questions in this context
would be as follows:
• What will be a reasonable sales and profit budget for the next
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37. year?
• What will be the most appropriate production schedules and
inventory policies for the next six months?
• What changes in wage and price policies should be made
now?
• How much cash will be available next month and how should
it be invested?
Specific Functions
The managerial economists can play a further role, which can cover
the following specific functions as revealed by a survey pertaining to
Brittain conducted by K.J.W. Alexander and Alexander G. Kemp:
• Sales forecasting.
• Industrial market research.
• Economic analysis of competing companies.
• Pricing problems of industry.
• Capital projects.
• Production programmes.
• Security / Investment analysis and forecasts.
• Advice on trade and public relations.
• Advice on primary commodities.
• Advice on foreign exchange.
• Economic analysis of agriculture.
• Analysis of underdeveloped economics.
• Environmental forecasting.
The managerial economist has to gather economic data, analyse all
relevant information about the business environment and prepare
position papers on issues facing the firm and the industry. In the case
of industries prone to rapid theological advances, the manager may
have to make continuous assessment of tl1e impact of changing
technology. The manager' may need to evaluate the capital budget in
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38. the light of short and long-range financial, profit and market
potentialities. Very often, he also needs to prepare speeches for the
corporate executives. It is thus clear that in practice, managerial
economists perform many and various functions. However, of all
these, the marketing functions, i.e., sales force listing an industrial
market research, are the most important.
For this purpose, the managers may collect statistical records of
the sales performance of their own business and those rehiring to
their rivals, carry out analysis of these records and report on trends in
demand, their market shares, and the relative efficiency of their retail
outlets. Thus, while carrying out heir functions, the managers may
have to undertake detailed statistical analysis. There are, of course,
differences in the relative importance of· the various functions
performed from firm to firm and in the degree of sophistication of the
methods used in performing these functions. But there is no doubt
that the job of a managerial economist requires alertness and the
ability to work uriderpressure.
Economic Intelligence
Besides these functions involving sophisticated analysis, managerial
economist may also provide general intelligence service. Thus the
economist may supply the management with economic information of
general interest such as competitors
prices and products, tax rates, tariff rates, etc.
Participating in Public Debates
Many well-known business economists participate in public debates.
The government and society alike are seeking their advice and views.
Their practical experience in business and industry adds prestige to
their views. Their public recognition enhances their protégé in the
.firm itself.
Indian Context
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39. In the Indian context, a managerial economist is expected to perform
the following functions:
• Macro-forecasting for demand and supply.
•Production planning at macro and micro levels.
•Capacity planning and product-mix determination.
•Economics of various production lines.
•Economic feasibility of new production lines / processes and
projects.
•Assistance in preparation of overall development plans.
•Preparation of periodical economic reports bearing on various
matters such as the company's product-lines, future growth
opportunities, market pricing situation, general business,. and
various national/international factors affecting industry and
business.
•Preparing briefs; speeches, articles and papers for top
management for various chambers, Committees, Seminars,
Conferences, etc
Keeping management informed of various national and
International Developments on economic/industrial matters.
With the adoption of the new economic policy, the macro-
economic environment is changing fast and these changes have
tremendous implications for business. The managerial economists
have to playa much more significant role. They ha'1e to constantly
measure the possibilities of translating the rapidly changing economic
scenario into workable business opportunities. As India marches
towards globalisation, the managerial economists will have to
interpret the global economic events and find out how the firm can
avail itself of the various export opportunities or of establishing plants
abroad either wholly owned or in association with local partners.
Responsibilities of a Managerial Economist
Besides considering the opportunities that lie before a managerial
economist it is necessary to take into account the services that are
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40. expected by the management. For this, it is necessary for a
managerial economist to thoroughly recognise the responsibilities
and obligations. A managerial economist can serve the management
best by recognising that the main objective of the business, is to
make a profit on its invested capital. Academic training and the
critical comments from people outside the business may lead a
managerial economist to adopt an apologetic or defensive attitude
towards profits. There should be a strong personal conviction on part
of the managerial economist that profits are essential and it is
necessary to help enhance the ability of the firm to make profits.
Otherwise it is difficult to succeed in serving management.
Most management decisions necessarily concern the future, which
is rather uncertain. It is, therefore, absolutely essential that a
managerial economist recognises his responsibility to make
successful forecast. By making the best possible forecasts and
through constant efforts to improve, a managerial' ng, the risks
involved in uncertainties. This enables the management to· follow a
more orderly course of business planning. At times, it is required for
the managerial economist to reassure the management that an
important trend will continue. In other cases, it is necessary to point
out the probabilities of a turning point in some activity of importance
to management. In any case, managerial economist must be willing to
make fairly positive statements about impending economic
developments. These can be based upon the best possible
information and analysis. The management's confidence in a
managerial economist increases more quickly and thoroughly with
a record of successful forecasts, well documented in advance and
modestly evaluated when the actual results become available.
A few consequences to the above proposition need also be
emphasised here.
•First, a managerial economist has a major responsibility to alert
managelI1ent at the earliest possible moment in' case there is an
err6r' in his forecast. This will assist the mallagement in making
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41. appropriate adjustment in policies and programmes and strengthen
his oWn position as a member of the management team by
keeplrighis fingers on the economic pulse of the
business.
•Secondly, a managerial economist must establish and maintain
many contacts with individuals and data sources: which would not
be immediately available to the other members of the management.
Extensive familiarity with reference sources and material is
essential. It is still more important that the known individuals who
are specialists in particular fields have a bearing on tpe managerial
economist's work. For this purpose, it is required that managerial
economist joins professional associations and tak~ active part in
them. In fact, one of the best means of determining the quality of a
managerial economist is to evaluate his ability to obtain
information quickly by personal contacts rather than by lengthy
research from either readily available or obscure reference sources.
Within any business, there' may be a wealth of knowledge and
experience but the managerial economist would be really useful ifit
is possible pn his part to supplement the existing know-how with
additional information and in the quickest possible manner.
Again, if a managerial economist is to be really helpful to the
management in successful decision-making and forward planning, it
is necessary'" to able to earn full status on the business team.
Readiness to take up special assignments, be that in study teams,
committees or special projects is another important requirement. This
is because it is necessary for the managerial economist to win
continuing support for himself and his professional ideas. Clarity of
expression and attempting to minimise the use of technical
terminology while communJcating his ideas to management
executives is also an essential role so as to win approval.
To conclude, a managerial economist has a very important role to
play by helping management in successful decision-making and
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42. forward planning. But to discharge his role successfully, it is
necessary to recognise the 'relevant responsibilities and obligations.
To some business executives, however, a managerial economist is still
a luxury or perhaps even a necessary evil. It is not surprising,
therefore, to find that while tneir status is improving and their
impor;ance is gradually rising, managerial economists in certain firms
still 'feel quite insecure. Nevertheless, there is a definite and growing
realisation that they can contribute significantly to the profitable
growth of firms and effective solution oftMir problems, and this'
promises them a positive future.
REVIEW QUESTIONS
1.What is managerial economics? How does it differ from traditional
economics?
2.Discuss the nature and scopeofmanagerial economics.
3.Show the significance of economic analysis in business decisions.
4.Managerial Economics is perspective rather than descriptive in
character? Examine this statement.
5.Assess the contribution and limitations of economic analysis to
business decision-making.
6.Briefly explain the five principles, which are basic to the entire
gamut of managerial economics.
7.Explain the role of marginal analysis in determining optimal
solution if managerial economics. How does it compare with break-
even analysis?
8.Discuss some of the important economic concepts and
techniques that help busirless management.
9.Explain the various functions of a managerial economist. How
can he best serve the management?
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43. LESSON – 2
DEMAND ANALYSIS
Demand is one of the crucial requirements for the existence of any
business firm. Firms are interested in their profit and sales, both
of which depend partially upon the demand for the product. The
decisions, which management makes with respect to production,
advertising, cost allocation, pricing, inventory holdings, etc. call
for an analysis of demand. While how much a firm can produce
depends upon its capacity and demand for its products. If there is
no demand for a product, its production is unworthy. If demand
falls short of production, one way to balance the two is to create
new demand through more and better advertisements. The more
the future demand for a product, the more inventories the firm
would hold. The larger the demand for a firm's product, the higher
is the price it can charge.
Demand analysis seeks to identify and measure the forces that
determine sales. Once this is done the alternative ways of
manipulating or managing demand can easily be inferred.
Although, demand for a finri's product reflects what the
consumers buy, this can be influenced through manipulating the
factors on which consumers base their demands. Demand
analysis attempts to estiinate the demand for a product in future,
which further helps to plan production based on the estimated
demand.
MEANING OF DEMAND
Demand for a good implies the desire of an individual to acquire the
product. It also includes willingness and ability of ail individual to
pay for the product. For example, a miser's desire for and his ability
to pay for a car is not demand, for he does not have the necessary
will to pay for the car. Similarly, a poor person's desire for· and his
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44. willingness to pay for a car is not demand because he lacks the
necessary purchasing power. One can also imagine an individual,
who possesses both the will and the purchasing power to pay for a
good. But this purchasing power is not the demand for that good,
this is because he does not have the desire to buy that product.
Therefore, demand is successful when there are all the three factors:
desire, willingness and ability. It should also be noted that demand
for any goods or services has no meaning unless it is stated with
reference to time, price, competing product, consumer's incomes,
tastes and preferences. This is because demand varies with
fluctuations in these factors. For example, the demand for an
Ambassador car in India is 40,000 is meaningless unless it is stated
that this was the demand ·in 1976 when an Ambassador car's price
was around thirty thousand rupees. The price of the competing cars’
prices were around the same, a Bajaj scooter's price was around five
thousand rupees and petrol price was around three and a half
rupees per litre. In 1977, the demand for Ambassador cars could be
different if any of the above factors happened to be different.
Furthermore, it should be noted that a product is defined with
reference to its particular quality. If its quality changes it can be
deemed as another product. Thus, the demand for any product is
the desire, wi1lihigness and ability to buy the product with reference
to a partkular time and given values of variables on which it
depends.
TYPES OF DEMAND
The demand for various kinds of goods is generally classified on the
basis of kinds of consumers, suppliers of goods, nature of goods,
duration of consumption goods, interdependence of demand, period
of demand and nature of use of goods (intermediate or final), The
major classifications of demand are as follows:
•Individual and market demand
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45. •Demand for firm's prodtictand industry's products
•Autonomous and derived demand
•Demand for durable and non-durable goods
•Short-term and long-term demand
Individual and Market Demand
The quantity of a product, which an individual is willing to buy at a
particular price during a specific time period, given his money
income, his taste, and prices of other commodities (particularly
substitutes and complements), is called 'individual's demand for a
product'. The total quantity, which all comsumers are willing to buy
at a given price per time unit, given their money income, taste, and
prices of other commodities is known as 'market demand for the
good'. In other words, the market demand for a good is the sum of
the individual demands of all the c6-nsumers of a product, over a
time period at given prices.
Demand for Firm's Product and Industry's Products
The quantity of a firm's yield, that can be disposed of at a given price
over a period refers to the demand for firm's product. The aggregate
demand for the product of all firms of an industry is known as the
market-demand or demand for industry's product. This distinction
between the two kinds of demand is not of much use in a highly
competitive market since it merely signifies the distinction between a
sum and its parts. However, where market structure is oligopolistic,
a distinction between the demand for firm's product and industry's
product is useful from managerial point of view. The product of each
firm is so differentiated from the products of the rival firms that
consumers treat each product different from the other. This gives
firms an opportunity to plan the price of a product, advertise it in
order to capture a larger market share thereby to enhance profits.
For instance, market of cars, radios, TV sets, refrigerators, scooters,
toilet soaps and toothpaste, all belong to this category of markets.
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46. In case of monopoly and perfect competition, the distinction
between demand for a firm's product and industry's product is not
of much use from managerial point of view. In case of monopoly,
industry is one-firmindustiy andthe demand for firm's product is the
same as that of the industry. In case of perfect competition,
products of all firms .of the industry are homogeneous and price for
each firm is determined by industry. Firms have little opportunity to
plan the prices permissible under local conditions and
advertisement by a firm becomes effective for the whole industry.
Therefore, conceptual distinction between demand for film's product
and industry's product is not much use in business decisions
making.
Autonomous and Derived Demand
An Autonomous demand for a product is one that arises
independently of the demand for any other good whereas a derived
demand is one, which is derived from demand of some other good. To
look more closely at the distinction between the two kinds of demand,
consider the demand for commodities, which arise directly from the
biological or physical needs of the human beings, such as demand for
food, clothes and shelter. The demand for these goods is autonomous
demand. Autotnomous demand also arises as a' result of
demonstration effect, rise in income, and increase in population and
advertisement of new produCts. On the other hand, the demand for a
good that arises because of the demand for some other good is called
derived demand. For instance, demand for land, fertiliser and
agricultural tools and implements are derived demand, since the
demand of goods, depends on the demand of food. Similarly, demand
for steel, bricks, cement etc., is a derived demand because it is
derived from the demand for houses and other kind of buildings. [n
general, the demand for, producer goods or industrial inputs is a
derived one. Besides, demand for complementary goods (which
complement the use of other goods) or for supplementary goods
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47. (which supplement or provide additional utility from the use of other
goods) is a derived demand. For instance petrol is a complementary
goods for automobiles and a chair is a complement to a table.
Consider some examples of supplement goods. Butter is supplement
to bread, mattress is supplement to cot and sugar is supplement to
tea. Therefore, demand for petrol, chair, and sugar would be
considered as derived demand. The conceptual distinction between
autonomous demand and derived demand would be useful according
to the point of view of a bllsinessman to the extent the former can
serve as an indicator of the latter.
Demand for Durable and Non-durable Goods
Demand is often classified under demand for durable and non-
durable goods. Durable goods are those goods whose total utility is
not exhausted in single or short-run use. Such goods can be used
continuously over a period of time. Durable goods may be consumer
goods as well as producer goods. Durable consumer goods include
clothes, shoes, house furniture, refrigerators, scooters, and cars. The
durable producer goods include mainly the items under fixed assets,
such as building, plant and machinery, office furniture and fixture.
The durable goods, both consumer and producer goods, may be
further classified as semi-durable goods such as, clothes and
furniture and durable goods such as residential and factory buildings
and cars. On the other harid, non-durable goods are those goods,
which can be used only once such as food items and their total utility
is exhausted in a single use. This category of goods can also be
grouped under non-durable consumer and producer goods. All food
items such as drinks, soap, cooking fuel, gas, kerosene, coal and
cosmetics fall in the former category whereas, goods such as raw
materials', fuel and power, finishing materials and packing items
come in the latter category.
The demand for non-durable goods depends largely on their
current prices, consumers' income and fashion whereas the expected
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48. price, income and change in technology influence the demand for the
durable good. The demand for durable goods changes over a relatively
longer period. There is another point of distinction between demands
for durable and non-durable goods. Durable goods create demand for
replacement or substitution of the goods whereas non-durable goods
do not. Also the demand for non-durable goods increases or decreases
with a fixed or constant rate whereas the demand for durable goods
increases or decreases exponentially, i.e., it may depend· upon some
factors such as obsolescence of machinery, etg. For example, let us
suppose that the annual demand for cigarettes in a city is 10 million
packets and it increases at the rate of half-a-million packets per
annum on account of increase in population when other factors
remain constant. Thus, the total demand for cigarettes in the next
year will be 10.5 million packets and 11 million packets in the next to
next year and so on. This is a linear increase in the demand for a non-
durable good like cigarette. Now consider the demand for a durable
good, e.g., automobiles. Let us suppose: (i1 the existing number of
automobiles in a city, in a year is 10,000, (ii) the annual replacement
demand equals 10 per cent of the total demand, and (iii) the annual
autonomous increase ·in demand is 1000 automobiles. As such, the
total annual clemand for automobiles in four subsequent years is
calculated and presented in Table 2.1.
Table 2.1: Annual Demand for Automobiles
Beginning Total no. of Replacement Annual Total Annual
of the year automobiles demand autonomous demand increase
(Stock) demand in
, demand
1st year 10,000 - - 10,000 -
2nd year 10,000 1000 1000 _
12,000 2000
-3id year 12,000 1200 1000 14,200 2200
4th year 14,200 1420 1000 16,620 2420
Stock + Replacement + Autonomous demand = TotalDemand
It may be seen from the Table 2.1 that the total demand for
automobiles is increasing at an increasing rate due to acceleration
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49. in the replacement demand. Another factor, which might accelerate
the demand for automobiles and such durable goods, is the rate of
obsolescence of this category of goods.
Short-term and Long-term Demand
Short-term demand refers to the demand for goods that are demanoed
over a short period. In this category fall mostly the fashion consumer
goods, goods of seasonal use and inferior substitutes during the
scarcity period of superior goods. For instance, the demand for
fashion wears is short-term demand though the demand for the
generic goods such as trousers, shoes and ties continues to remain a
longterm demand. Similarly, demand for umbrella, raincoats,
gumboots, cold drinks and ice creams is of seasonal nature; 'The
demand for such goods lasts till the season lasts. Some goods of this
category are demanded for a very short period, i.e., 1-2 week, for
example, new greeting cards, candles and crackers on occasion of
diwali.
Although some goods are used only seasonally but are durable in
pature, e.g., electric fans, woollen garments, etc. The demand for such
goods is of also durable in nature but it is subject to seasonal
fluctuations. Sometimes, demand for certain gools suddenly increases
because of scarcity of their superior substitutes. For examp1e, when
supply of cooking gas suddenly decreases, demand for kerosene,
cooking coal and charcoal increases. In such cases, additional
demand is of shGrtterm nature. The long-term demand, on the hand,
refers to the demand, which exists over a long-period. The change in
long-term demand is visible only after a long period. Most generic
goods have long-term demand. For example, demand for consumer
and producer goods, durable and non-durable goods, is long-term
demand, though their different varieties or brands may have only
short-term demand. Short-term demand depends, by and large, on
the price of commodities, price of their substitutes, current disposable
income of the consumer, their ability to adjust their consumption
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50. pattern and their susceptibility to advertisement of a new product.
The long-term demand depends on the long-term income trends,
availability of better substitutes, sales promotion, and consumer
credit facility. The short-term and lcmg-term concepts of demand are
useful in designing new products for established producers, choice of
products for the new entrepreneurs, in pricing policy and in
determining advertisement expenditure.
DETERMIN!NTS OF MARKET DEMAND
The knowledge of the determinants of market demand for a product
and the nature of relationship between the demand and its
determinants proves very helpful in analysing and estimating demand
for the product. It may be noted at the very outset that a host of
factors determines the demand for a product. In general, following
factors determine market demand for a good:
• Price of the good- .
• Price of the related goods-substitutes, complements and
supplements
• Level of consumers' income
• Consumers' taste and preference
Advertisement of the product
• Consumers' expectations about future price and supply
position
• Demonstration effect and 'bend-wagon effect’
• Consumer-credit facility
•Population of the country
•Distribution pattern of national income.
These factors also include factors such as off-season discounts
and gifts on purchase of a good, level of taxation and general social
and political environment of the country. However, all these factors
are not equally important. Besides, some of them are not
quantifiable. For example, consumer's preferences, utility,
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51. demonstration effect and expectations, are difficult to measure.
However, both quantifiable and non-quantifiable determinants of
demand for a product will be discussed.
1. Price of the Product
The price of a product is one of the most important determinants of
demand in the long run and the only determinant in the short run.
The price and quantity demanded are inversely related to each other.
The law of demand states that the quantity demanded of a good or a
product, which its consumers would like to buy per unit of time,
increases when its price falls, and decreases when its price increases,
provided the other factors remain' same. The assumption 'other
factors remaining same' implies that income of the consumers, prices
of the substitutes and complementary goods, consumer's taste and
preference and number of consumers remain unchanged. The price-
demand relationship assumes a much greater significance in the
oligopolistic market in which outcome of price war between a firm and
its rivals determines the level of success of the firm. The firms have to
be fully aware of price elasticity of demand for their own products and
that of rival firm's goods.
2. Price of the Related Goods or Products
The demand for a good is also affected by the change in the price of
its related goods. The related goods may be the substitutes or
complementary goods.
Substitutes
Two goods are said to. be substitutes of each other if a change in price
of one good affects the deinand for the other in the same direction. For
instance goods X and Y are considered as substitutes for each other if
a rise in the price of X increase demand for Y, and vice versa. Tea and
coffee, hamburgers and hot-dog, alcohol and drugs are some examples
of substitutes in case of consumer goods by definition, the relation
between demand for a product and price of its substitute is of positive
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52. nature. When, price of the substitute of a product (tea) falls (or
increase), the demand for the product falls (or increases). The
relationship of this nature is shown in Figure 2.1 and 2.2.
Complementary Goods
A good is said to be a complement for another when it complements
the use of the other or when the two goods are used together in such
a way that their demand changes (increases or decreases)
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53. simultaneously. For example, petrol is a complement to car and
scooter, butter and jam to bread, milk and sugar to tea and 1 coffee,
mattress to cot, etc. Two goods are termed as complementary to each
other -i if an increase in the price of one causes a decrease in demand
for the other. By definition, there is an inverse relation between the
demand for a good and the price of its complement. For instance, an
increase in the price of petrol causes a decrease in the demand for car
and other petrol-run vehicles and vice versa while other thing's
remaining constant. The nature of relationship between the demand
for a product and the price of its complement is given in Figure 2.2.
3. Consume's Income
Income is the basic determinant of market demand since it
determines the purchasing power of a consumer. Therefore, people
with higher current disposable income spend a larger amount on
goods and services than those with lower income. Income-demand
relationship is of more varied nature than that between demand
and its other determinants. While other determinants of demand,
e.g., product's own price and the price ohts substitutes, are more
significant in the short-run, income as a determinant of demand is
equally important in both short run and long run. Before
proceeding further to discuss income-demand relationships, it will
be useful to note that consumer goods of different nature have
different kinds of relationship with consumers having different
levels of income. Hence, the managers need to be fully aware of the
kinds of goods they are dealing with and their relationship with the
income of consumers, particularly about the assessment of both
existing and prospective demand for a product.
For the purpose of income-demand analysis, goods and serv:ices
maybe grouped under four broad categories, which ate: (a) essential
consumer goods, (b) inferior goods, (c) normal goods, and (d) prestige
or luxury goods. To understand all these terms, it is essential to
understand the relationship between income and different kinds of
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