Module I: Introduction to Managerial Economics

Nature, Scope, Definitions of Managerial Economics, Application of

Managerial Economics to Business, Micro Vs. Macro Economics,
Opportunity Costs, Time Value of Money, Marginalism,
Incrementalism, Market Forces and Equilibrium.

Introduction to managerial economics

One standard definition for economics is the study of the production,
distribution, and consumption of goods and services. A second
definition is the study of choice related to the allocation of scarce
resources. The first definition indicates that economics includes any
business, nonprofit organization, or administrative unit. The second
definition establishes that economics is at the core of what managers
of these organizations do.

This book presents economic concepts and principles from the

perspective of “managerial economics,” which is a subfield of
economics that places special emphasis on the choice aspect in the
second definition. The purpose of managerial economics is to provide
economic terminology and reasoning for the improvement of
managerial decisions.

Most readers will be familiar with two different conceptual

approaches to the study of economics: microeconomics and
macroeconomics. Microeconomics studies phenomena related to
goods and services from the perspective of individual decision-
making entities—that is, households and businesses.
Macroeconomics approaches the same phenomena at an aggregate
level, for example, the total consumption and production of a region.
Microeconomics and macroeconomics each have their merits. The
microeconomic approach is essential for understanding the
behaviour of atomic entities in an economy. However, understanding
the systematic interaction of the many households and businesses
would be too complex to derive from descriptions of the individual
units. The macroeconomic approach provides measures and theories
to understand the overall systematic behaviour of an economy.

Since the purpose of managerial economics is to apply economics for

the improvement of managerial decisions in an organization, most of
the subject material in managerial economics has a microeconomic
focus. However, since managers must consider the state of their
environment in making decisions and the environment includes the
overall economy, an understanding of how to interpret and forecast
macroeconomic measures is useful in making managerial decisions.

Definition of Managerial Economics

Managerial economics is defined as the branch of economics which

deals with the application of various concepts, theories,
methodologies of economics to solve practical problems in business
management. It is also reckoned as the amalgamation of economic
theories and business practices to ease the process of decision
making. Managerial economics is also said to cover the gap between
the problems of logic and problems of policy.
Managerial economics is used to find a rational solution to problems
faced by firms. These problems include issues around demand, cost,
production, marketing, and it is used also for future planning. The
best thing about managerial economics is that it has a logical solution
to almost every problem that may arise during business management
and that too by sticking to the microeconomic policies of the firm.
When we talk of managerial economics as a subject, it is a branch of
management studies that emphasizes solving business problems
using theories of micro and macroeconomics. Spencer and Siegelman
have defined the subject as “the integration of economic theory with
business practice to facilitate decision making and planning by
management.” The study of managerial economics helps the
students to enhance their analytical skills, developing a mindset that
enables them to find rational solutions.
 “The purpose of managerial economics is to show how
economic analysis can be used in formulating business policies.”
– Joel Dean
 “Managerial Economics is the application of economic theory
and methodology to decision-making problems faced by both
public and private institutions.” – McGutgan and Moyer
 “Managerial economic is the application of economic principles
and methodologies to the decision-making process within the
firm or organization.” – Douglas
 “Managerial economic applies economic theory and methods
to business and administrative decision making.” – Pappas and
Hirschey
 “Managerial economic is concerned with business efficiency.” –
Christoper Savage and John R. Small

Nature of Managerial Economics

1. Art and Science
Management theory requires a lot of critical and logical thinking
and analytical skills to make decisions or solve problems. Many
economists also find it a source of research, saying it includes
applying different economic concepts, techniques, and methods to
solve business problems.
2. Microeconomics
Managers typically deal with the problems relevant to a single
entity rather than the economy as a whole. It is therefore
considered an integral part of microeconomics.
3. Uses of Macro Economics
A corporation works in an external world, i.e., it serves the
consumer, which is an important part of the economy. For this
purpose, managers must evaluate the various macroeconomic
factors such as market dynamics, economic changes, government
policies, etc., and their effect on the company.
4. Multidisciplinary
Managerial economics uses many tools and principles that belong
to different disciplines, such as accounting, finance, statistics,
mathematics, production, operational research, human resources,
marketing, etc.
5. Prescriptive or Normative Discipline
By introducing corrective steps managerial economics aims at
achieving the objective and solves specific issues or problems.
6. Management Oriented
This serves as an instrument in managers’ hands to deal effectively
with business-related problems and uncertainties. This also allows
for setting priorities, formulating policies, and making successful
decisions.
7. Pragmatic
The solution to day-to-day business challenges is realistic and
rational.
Different individuals take different views of the principles of
managerial economics. Others may concentrate more on customer
service and prioritize efficient production.

Scope of Managerial Economics

The definition of managerial economics is commonly used to deal
with various business problems within organizations. Both
microeconomics and macroeconomics have an equal effect on the
organization and its work. The following points illustrate its
significance:

Micro-economics applied to Operational Matters

The various theories or principles of microeconomics used to solve
the internal problems of the organization arising in the course of
business operations are as follows:

1. Demand Theory: Demand Theory emphasizes the

consumer’s behavior toward a product or service. This
considers the customers’ desires, expectations, preferences,
and conditions to enhance the manufacturing process.

2. Decisions on Production and Production Theory: This theory

is primarily concerned with the volume of production,
process, capital and labour, costs involved, etc. It aims to
optimize the production analysis to meet customer demand.

3. Market Structure Pricing Theory and Analysis: It focuses on

assessing a product’s price considering the competition,
market dynamics, production costs, optimizing sales volume,
etc.
 4. Exam and management of profit: the companies are
operating for assets; hence, they aim to maximize profit. It
also depends on demand from the market, input costs, level
of competition, etc.

5. Decisions on capital and investment theory: Capital is the

most important business element. This philosophy takes
priority over the proper distribution of the resources of the
company and investments in productive programs or
initiatives to boost operational performance.

Macro-Economics applied to Business Environment

Any organization is greatly affected by the environment in which it
operates. The business climate can be defined as:
1. Economic environment: A country’s economic conditions,
GDP, government policies, etc., have an indirect effect on the
company and its operations.
2. Social environment: The society in which the organization
works, like employment conditions, trade unions, consumer
cooperatives, etc also affect it.
3. Political environment: A country’s political system, whether
authoritarian or democratic, political stability, and attitude
towards the private sector, impact the growth and
development of the organization.
Micro Vs. Macro Economics
Opportunity cost
Opportunity cost is a concept in Economics that is defined as those
values or benefits that are lost by a business, business owners or
organisations when they choose one option or an alternative option
over another option, in the course of making business decisions.
In simple words, it can be said as the value that is lost when a
business is choosing between two or more alternatives. From an
investor perspective, opportunity cost will always mean that the
investment choices made will be carrying immediate loss or gain in
the future.
Opportunity costs can be viewed as a trade off. Trade offs happen in
decision making when one option is chosen over another option.
Opportunity costs sums up the total cost for that trade off.
For example, a certain kind of bamboo can be used to produce both
paper and furniture. If the business takes a decision to consider using
bamboo for furniture, then the society has to forego the number of
bamboos that could have been used for manufacturing paper.
Here, the opportunity cost of producing furniture is the number of
papers that are foregone.

Aspects of Opportunity Cost

The opportunity cost of a product is the best alternative that was
foregone. There cannot be any other alternative.

How to Calculate Opportunity Costs

Opportunity costs can be calculated using the following formula
Opportunity Cost = Return on investment for an option not chosen –
Return on investment for a chosen option

Limitations of Opportunity Costs

The following are the limitations of opportunity costs:
1. Future returns cannot be predicted accurately using opportunity
costs.
2. It is difficult to make quantitative comparison between two
available alternatives.
Time Value of Money

Marginalism
ADAM SMITH
struggled with what came to be called the paradox of “value in use”
versus “value in exchange.” Water is necessary to existence and of
enormous value in use; diamonds are frivolous and clearly not essential.
But the price of diamonds—their value in exchange—is far higher than
that of water. What perplexed Smith is now rationally explained in the
first chapters of every college freshman’s introductory economics text.
Smith had failed to distinguish between “total” utility and “marginal”
utility. The elaboration of this insight transformed economics in the late
nineteenth century, and the fruits of the marginalist revolution continue
to set the basic framework for contemporary MICROECONOMICS.

The marginalist explanation is as follows: The total utility or satisfaction

of water exceeds that of diamonds. We would all rather do without
diamonds than without water. But almost all of us would prefer to win a
prize of a diamond rather than an additional bucket of water. To make this
last choice, we ask ourselves not whether diamonds or water give more
satisfaction in total, but whether one more diamond gives greater
additional satisfaction than one more bucket of water. For this marginal
utility question, our answer will depend on how much of each we already
have. Though the first units of water we consume every month are of
enormous value to us, the last units are not. The utility of additional (or
marginal) units continues to decrease as we consume more and more.

Economists believe that sensible choice requires comparing marginal

utilities and marginal costs. They also think that people apply the
marginalism concept regularly, even if subconsciously, in their private
decisions. In southern states, for example, a much lower fraction of people
buy snow shovels than in northern states. The reason is that although snow
shovels cost about the same from state to state, the marginal benefit of a
snow shovel is much higher in northern states. But in discussions of
public-policy issues, where most of the benefits and costs do not accrue to
the individual making the policy decision (e.g., subsidies for HEALTH
CARE), the appeal of total utility and intrinsic worth as the basis for
decision can mask the insights of marginalism.
Incrementalism
Incremental analysis is a decision-making technique used in business
to determine the true cost difference between alternatives. Also
called the relevant cost approach, marginal analysis, or differential
analysis, incremental analysis disregards any sunk cost or past cost.
Incremental analysis is useful for business strategy including the
decision to self-produce or outsource a function.
Incremental analysis is a problem-solving approach that applies
accounting information to decision making. Incremental analysis can
identify the potential outcomes of one alternative compared to
another.
Market Forces and Equilibrium.
Market
A market is described as the total sum of all the purchasers and
sellers in the area or region being considered. The area may be the
earth, country, region, state, or city. The worth, expense and cost of
traded items are according to the supply & demand forces of a
market. The market can be, or virtual, a physical entity.
Types of markets
1] Perfect Competiton
In a perfect competition market structure, there are a large number
of buyers and sellers. All the sellers of the market are small sellers in
competition with each other. There is no one big seller with any
significant influence on the market. So all the firms in such a market
are price takers.
There are certain assumptions when discussing the perfect
competition. This is the reason a perfect competition market is pretty
much a theoretical concept. These assumptions are as follows,

The products on the market are homogeneous, i.e. they are

completely identical
All firms only have the motive of profit maximization
There is free entry and exit from the market, i.e. there are no barriers
And there is no concept of consumer preference
2] Monopolistic Competition
This is a more realistic scenario that actually occurs in the real world.
In monopolistic competition, there are still a large number of buyers
as well as sellers. But they all do not sell homogeneous products. The
products are similar but all sellers sell slightly differentiated products.

Now the consumers have the preference of choosing one product

over another. The sellers can also charge a marginally higher price
since they may enjoy some market power. So the sellers become the
price setters to a certain extent.

For example, the market for cereals is a monopolistic competition.

The products are all similar but slightly differentiated in terms of
taste and flavours. Another such example is toothpaste.

3] Oligopoly
In an oligopoly, there are only a few firms in the market. While there
is no clarity about the number of firms, 3-5 dominant firms are
considered the norm. So in the case of an oligopoly, the buyers are
far greater than the sellers.

The firms in this case either compete with another to collaborate

together, They use their market influence to set the prices and in turn
maximize their profits. So the consumers become the price takers. In
an oligopoly, there are various barriers to entry in the market, and
new firms find it difficult to establish themselves.

4] Monopoly
In a monopoly type of market structure, there is only one seller, so a
single firm will control the entire market. It can set any price it wishes
since it has all the market power. Consumers do not have any
alternative and must pay the price set by the seller.

Monopolies are extremely undesirable. Here the consumer loose all

their power and market forces become irrelevant. However, a pure
monopoly is very rare in reality.
Market forces
Market forces are the factors that influence the price and availability
of goods and services in a market economy, i.e. an economy with the
minimum of government involvement.

Market forces push prices up when supply declines and demand

rises, and drive them down when supply grows or demand contracts.
When demand equals supply for a product or service, the market is
said to have reached equilibrium.
To supply means to provide something that is wanted, i.e., to make it
available.

Invisible hand
Adam’s Smith’s ‘invisible hand’ referred to market forces.

British moral philosopher and pioneer of political economy, Adam

Smith (1723-1790), cited by many as the father of modern
economics, wrote in his books about the ‘invisible hand’ that
determined levels of supply, demand, the prices of goods and
services, as well as wealth creation and distribution.
Equilibrium
Equilibrium
MARKETS: Equilibrium is achieved at the price at which quantities
demanded and supplied are equal. We can represent a market in
equilibrium in a graph by showing the combined price and quantity
at which the supply and demand curves intersect.
Disequilibrium
Whenever markets experience imbalances—creating disequilibrium
prices, surpluses, and shortages—market forces drive prices toward
equilibrium.
A surplus exists when the price is above equilibrium, which
encourages sellers to lower their prices to eliminate the surplus.
A shortage will exist at any price below equilibrium, which leads to
the price of the good increasing.
Changes in equilibrium
Changes in the determinants of supply and/or demand result in a
new equilibrium price and quantity. When there is a change in supply
or demand, the old price will no longer be an equilibrium. Instead,
there will be a shortage or surplus, and price will subsequently adjust
until there is a new equilibrium.
For example, suppose there is a sudden invasion of aggressive
unicorns. There will be more people who want to buy unicorn
repellent at all possible prices, causing demand to increase. At the
original price, there will be a shortage of unicorn repellant, signaling
sellers to increase the price until the quantity supplied and quantity
demanded are once again equal.