UNIT I

Managerial Economics-

Managerial Economics can be defined as amalgamation of economic theory with business practices
so as to ease decision-making and future planning by management. Managerial Economics assists the
managers of a firm in a rational solution of obstacles faced in the firm’s activities. It makes use of
economic theory and concepts. It helps in formulating logical managerial decisions.

The key of Managerial Economics is the micro-economic theory of the firm. It lessens the gap between
economics in theory and economics in practice. Managerial Economics is a science dealing with effective
use of scarce resources. It guides the managers in taking decisions relating to the firm’s customers,
competitors, suppliers as well as relating to the internal functioning of a firm. It makes use of statistical
and analytical tools to assess economic theories in solving practical business problems.

The following figure tells the primary ways in which Managerial Economics correlates to managerial
decision-making.

The following figure tells the primary ways in which Managerial Economics correlates to managerial
decision-making.

Branches of Economics-

Managerial Economics and Economics: Managerial Economics has been described as economics
applied to decision making. It may be studied as a special branch of economics, bridging the gap
between pure economic theory and managerial practice. Economics has two main branches—micro-
economics and macro-economics.

Micro-economics:

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‘Micro’ means small. It studies the behavior of the individual units and small groups of units. It is a study
of particular firms, particular households, individual prices, wages, incomes, individual industries and
particular commodities. Thus micro-economics gives a microscopic view of the economy.

The roots of managerial economics spring from micro-economic theory. In price theory, demand
concepts, elasticity of demand, marginal cost marginal revenue, the short and long runs and theories of
market structure are sources of the elements of micro-economics which managerial economics draws
upon. It makes use of well-known models in price theory such as the model for monopoly price, the
kinked demand theory and the model of price discrimination.

Macro-economics:

‘Macro’ means large. It deals with the behavior of the large aggregates in the economy. The large
aggregates are total saving, total consumption, total income, total employment, general price level, wage
level, cost structure, etc. Thus macro-economics is aggregative economics.

It examines the interrelations among the various aggregates, and causes of fluctuations in them. Problems
of determination of total income, total employment and general price level are the central problems in
macro-economics.

Macro-economies are also related to managerial economics. The environment, in which a business
operates, fluctuations in national income, changes in fiscal and monetary measures and variations in the
level of business activity have relevance to business decisions. The understanding of the overall operation
of the economic system is very useful to the managerial economist in the formulation of his policies.

Nature of Managerial Economics-

Managers study managerial economics because it gives them insight to reign the functioning of the
organization. If manager uses the principles applicable to economic behavior in a reasonably, then it will
result in smooth functioning of the organisation.

1) Managerial Economics is a Science- Managerial Economics is an essential scholastic field. It can be

compared to science in a sense that it fulfills the criteria of being a science in following sense:

 Science is a Systematic body of Knowledge. It is based on the methodical observation.

Managerial economics is also a science of making decisions with regard to scarce resources with
alternative applications. It is a body of knowledge that determines or observes the internal and
external environment for decision making.

 In science any conclusion is arrived at after continuous experimentation. In Managerial

economics also policies are made after persistent testing and trailing. Though economic
environment consists of human variable, which is unpredictable, thus the policies made are not
rigid. Managerial economist takes decisions by utilizing his valuable past experience and
observations.

 Science principles are universally applicable. Similarly policies of Managerial economics are also
universally applicable partially if not fully. The policies need to be changed from time to time
depending on the situation and attitude of individuals to those particular situations. Policies are
applicable universally but modifications are required periodically.

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2) Managerial Economics requires Art- Managerial economist is required to have an art of utilizing
his capability, knowledge and understanding to achieve the organizational objective. Managerial
economist should have an art to put in practice his theoretical knowledge regarding elements of economic
environment.

3) Managerial Economics for administration of organization

Managerial economics helps the management in decision making. These decisions are based on the
economic rationale and are valid in the existing economic environment.

4) Managerial economics is helpful in optimum resource allocation

The resources are scarce with alternative uses. Managers need to use these limited resources optimally.
Each resource has several uses. It is manager who decides with his knowledge of economics that which
one is the preeminent use of the resource.

5) Managerial Economics has components of micro economics

Managers study and manage the internal environment of the organization and work for the profitable and
long-term functioning of the organization. This aspect refers to the micro economics study. The
managerial economics deals with the problems faced by the individual organization such as main
objective of the organization, demand for its product, price and output determination of the organization,
available substitute and complimentary goods, supply of inputs and raw material, target or prospective
consumers of its products etc.

6) Managerial Economics has components of macro economics

None of the organization works in isolation. They are affected by the external environment of the
economy in which it operates such as government policies, general price level, income and employment
levels in the economy, stage of business cycle in which economy is operating, exchange rate, balance of
payment, general expenditure, saving and investment patterns of the consumers, market conditions etc.
These aspects are related to macroeconomics.

7) Managerial Economics is dynamic in nature

Managerial Economics deals with human-beings (i.e. human resource, consumers, producers etc.). The
nature and attitude differs from person to person. Thus to cope up with dynamism and vitality managerial
economics also changes itself over a period of time.

Scope of Managerial Economics-

Managerial Economics deals with allocating the scarce resources in a manner that minimizes the cost. As
we have already discussed, Managerial Economics is different from microeconomics and macro-
economics. Managerial Economics has a more narrow scope - it is actually solving managerial issues
using micro-economics.

Main Scopes are as follows-

1) Demand analysis and forecasting - When a business manager decides to venture into a business, the
very first thing he needs to find out is the nature and amount of demand for the product, both at present
and in the future. A firm's performance and profitability depends upon accurate estimates of demand. The

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firm will prepare its production schedule on the basis of demand forecast. Demand analysis helps to
identify the factors influencing the demand for a firm's product and thus helps a manager in business
planning. Demand analysis and forecasting thus help him in the choice of the product and in planning
output levels.

The main topics covered under demand analysis and forecasting are the concepts of demand, demand
determinants, law of demand, its assumptions, elasticity of demand (price, income and cross elasticity),
demand forecasting, etc.

2) Cost and production analysis

 Estimation of the cost in production.

 Recognizing the factors, which are causing cost to firm.

 Suggests cost should be reduced for making good profits.

 Production analysis deals with, Minimum cost should be spend on raw materials and maximum
production should be obtained

3) Pricing decisions, policies and practices - Once a particular quantity of output is ready for sale, the
firm has to fix its price given the conditions in the market. Pricing is a very important aspect of
Managerial Economics as a firm's revenue earnings largely depend on its pricing policy. A correct pricing
policy makes a firm successful, while incorrect pricing may lead to its elimination. The topics covered
under this area are: price determination in various market forms such as perfect market, monopoly,
oligopoly, etc., pricing methods such as differential pricing and product-line pricing, and price
forecasting.

4) Profit management- Business firms are established with the objective of making profits and it is thus
the chief measure of success. For maximizing profits the firm needs to take care of pricing, cost aspects
and long-range decisions, i.e., it has to evaluate its investment decisions and carry out the best policy of
capital budgeting for the firm under a given set of conditions. If we know the future, profit analysis would
be an easy task. However, in a world of uncertainty our expectations are not always realized, so that profit
planning and measurement constitute a 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 like break-even analysis, cost-volume-profit analysis, etc.

5) Capital Management- Large amount of money is invested in the business and that amounts should be
managed efficiently.

6) Competition- Study of markets is one of the important aspects of the work of a managerial economist.
A manager should have clear knowledge of different markets existing in the environment. The
environment is not constant and goes on changing. Thus, the manager should know clearly about perfect
and imperfect markets so as to introduce the product in such markets where he can increase the sales
revenue. The main aspects are perfect market, monopoly market, monopolistic market, oligopoly market,
and price fixation under different market conditions.
There are two method of reasoning in theoretical economics. They are the deductive and inductive
methods.
As a matter of fact, deduction and induction are the two forms of logic that help to establish the truth.

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The Deductive Method:

Deduction Means reasoning or inference from the general to the particular or from the universal to the
individual. The deductive method derives new conclusions from fundamental assumptions or from truth
established by other methods. It involves the process of reasoning from certain laws or principles, which
are assumed to be true, to the analysis of facts.
Then inferences are drawn which are verified against observed facts. Bacon described deduction as a
“descending process” in which we proceed from a general principle to its consequences. Mill
characterised it as a priori method, while others called it abstract and analytical.
Deduction involves four steps: (1) Selecting the problem. (2) The formulation of assumptions on the basis
of which the problem is to be explored. (3) The formulation of hypothesis through the process of logical
reasoning whereby inferences are drawn. (4) Verifying the hypothesis. These steps are discussed as under.

(1) Selecting the problem:

The problem which an investigator selects for enquiry must be stated clearly. It may be very wide like
poverty, unemployment, inflation, etc. or narrow relating to an industry. The narrower the problem the
better it would be to conduct the enquiry.

(2) Formulating Assumptions:

The next step in deduction is the framing of assumptions which are the basis of hypothesis. To be fruitful
for enquiry, the assumption must be general. In any economic enquiry, more than one set of assumptions
should be made in terms of which a hypothesis may be formulated.

(3) Formulating Hypothesis:

The next step is to formulate a hypothesis on the basis of logical reasoning whereby conclusions are
drawn from the propositions. This is done in two ways: First, through logical deduction. If and because
relationships (p) and (q) all exist, then this necessarily implies that relationship (r) exists as well.
Mathematics is mostly used in these methods of logical deduction.

(4) Testing and Verifying the Hypothesis:

The final step in the deductive method is to test and verify the hypothesis. For this purpose, economists
now use statistical and econometric methods. Verification consists in confirming whether the hypothesis
is in agreement with facts. A hypothesis is true or not can be verified by observation and experiment.
Since economics is concerned with human behaviour, there are problems in making observation and
testing a hypothesis.

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For example, the hypothesis that firms always attempt to maximise profits, rests upon the observation that
some firms do behave in this way. This premise is based on a priori knowledge which will continue to be
accepted so long as conclusions deduced from it are consistent with the facts. So the hypothesis stands
verified. If the hypothesis is not confirmed, it can be argued that the hypothesis was correct but the results
are contradictory due to special circumstances.
Under these conditions, the hypothesis may turn out to the wrong. In economics, most hypotheses remain
unverified because of the complexity of factors involved in human behaviour which, in turn, depend upon
social, political and economic factors. Moreover, controlled experiments in a laboratory are not possible
in economics. So the majority of hypotheses remain untested and unverified in economics.

Merits of Deductive Method:

The deductive method has many advantages.

(1) Real: It is the method of “intellectual experiment,” according to Boulding. Since the actual world is
very complicated, “what we do is to postulate in our own minds economic systems which are simpler than
reality but more easy to grasp. We then work out the relationship in these simplified systems and by
introducing more and more complete assumptions, finally work up to the consideration of reality itself.”
Thus, this method is nearer to reality.

(2) Simple:The deductive method is simple because it is analytical. It involves abstraction and simplifies
a complex problem by dividing it into component parts. Further, the hypothetical conditions are so chosen
as to make the problem very simple, and then inferences are deduced from them.

(3) Powerful: It is a powerful method of analysis for deducing conclusions from certain facts. As pointed
out by Cairnes, The method of deduction is incomparably, when conducted under proper checks, the most
powerful instrument of discovery ever wielded by human intelligence.

(4) Exact: The use of statistics, mathematics and econometrics in deduction brings exactness and clarity
in economic analysis. The mathematically trained economist is able to deduce inferences in a short time
and make analogies with other generalisations and theories. Further, the use of the mathematical-
deductive method helps in revealing inconsistencies in economic analysis.

(5) Indispensable: The use of deductive method is indispensable in sciences like economics where
experimentation is not possible. As pointed out by Gide and Rist, “In a science like political economy,
where experiment is practically impossible, abstraction and analysis afford the only means of escape from
those other influences which complicate the problem so much.”

(6) Universal: The deductive method helps in drawing inferences which are of universal validity because
they are based on general principles, such as the law of diminishing returns.

Demerits of Deductive Method:

Despite these merits, much criticism has been levelled against this method by the Historical School which
flourished in Germany.

1 .Unrealistic Assumption: Every hypothesis is based on a set of assumptions. When a hypothesis is

tested, assumptions are indirectly tested by comparing their implications with facts. But when facts refute
the theory based on the tested hypothesis, the assumptions are also indirectly refuted. So deduction
depends upon the nature of assumptions. If they are unrealistic, in this method, economists use the ceteris
paribus assumption. But other things seldom remain the same which tend to refute theories.

2. Not Universally Applicable: Often the conclusions derived from deductive reasoning are not
applicable universally because the premises from which they are deduced may not hold good at all time
and places. For instance, the classicists assumed in their reasoning that particular conditions prevailing in

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England of their times were valid universally. This supposition was wrong. Prof. Lerner, therefore, points
out that the deductive method is simply “armchair analysis” which cannot be regarded as universal.

3. Incorrect Verification: The verification of theories, generalisations or laws in economics is based on

observation. And right observation depends upon data which must be correct and adequate. If a
hypothesis is deduced from wrong or inadequate data, the theory will not correspond with facts and will
be refuted. For instance, the generalisations of the classicists were based on inadequate data and their
theories were refuted. As pointed out by ircholson, “the great danger of the deductive method lies in the
natural aversion to the labour of verification.”

4. Abstract Method: The deductive method is highly abstract and requires great skill in drawing
inferences for various premises. Due to the complexity of certain economic problems, it becomes difficult
to apply this method even at the hands of an expert researcher. More so, when he uses mathematics or
econometrics.

5. Static Method: This method of analysis is based on the assumption that economic conditions remain
constant. But economic conditions are continuously changing. Thus this is a static method which fails to
make correct analysis.

6. Intellectually: The chief defect of the deductive method “lies in the fact that those who follow this
method may be absorbed in the framing of intellectual toys and the real world may be forgotten in the
intellectual gymnastics and mathematical treatment.”

The Inductive Method:

Induction “is the process of reasoning from a part to the whole, from particulars to generals or from the
individual to the universal.” Bacon described it as “an ascending process” in which facts are collected,
arranged and then general conclusions are drawn.
The inductive method was employed in economics by the German Historical School which sought to
develop economics wholly from historical research. The historical or inductive method expects the
economist to be primarily an economic historian who should first collect material, draw gereralisations,
and verify the conclusions by applying them to subsequent events. For this, it uses statistical methods.
The Engel’s Law of Family Expenditure and the Malthusian Theory of Population have been derived
from inductive reasoning.

The inductive method involves the following steps:

 The Problem: In order to arrive at a generalisation concerning an economic phenomenon, the

problem should be properly selected and clearly stated.

 Data: The second step is the collection, enumeration, classification and analysis of data by using
appropriate statistical techniques.

 Observation: Data are used to make observation about particular facts concerning the problem.

 Generalisation: On the basis of observation, generalisation is logically derived which establishes

a general truth from particular facts.

Thus induction is the process in which we arrive at a generalisation on the basis of particular observed
facts. The best example of inductive reasoning in economics is the formulation of the generalisation of
diminishing returns. When a Scottish farmer found that in the cultivation of his field an increase in the
amount of labour and capital spent on it was bringing in less than proportionate returns year after year, an
economist observed such instances in the case of a number of other farms, and then he arrived at the
generalisation that is known as the Law of Diminishing Returns.

Merits of Inductive Method:

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The chief merits of this method are as follows:

(1) Realistic: The inductive method is realistic because it is based on facts and explains them as they
actually are. It is concrete and synthetic because it deals with the subject as a whole and does not divide it
into component parts artificially

(2) Future Enquiries: Induction helps in future enquiries. By discovering and providing general
principles, induction helps future investigations. Once a generalisation is established, it becomes the
starting point of future enquiries.

(3) Statistical Method: The inductive method makes use of the statistical method. This has made
significant improvements in the application of induction for analysing economic problems of wide range.
In particular, the collection of data by governmental and private agencies or macro variables, like national
income, general prices, consumption, saving, total employment, etc., has increased the value of this
method and helped governments to formulate economic policies pertaining to the removal of poverty,
inequalities, underdevelopment, etc.

(4) Dynamic: The inductive method is dynamic. In this, changing economic phenomena can be analysed
on the basis of experiences, conclusions can be drawn, and appropriate remedial measures can be taken.
Thus, induction suggests new problems to pure theory for their solution from time to time.

(5) Histrico-Relative: A generalisation drawn under the inductive method is often histrico-relative in
economics. Since it is drawn from a particular historical situation, it cannot be applied to all situations
unless they are exactly similar. For instance, India and America differ in their factor endowments.
Therefore, it would be wrong to apply the industrial policy which was followed in America in the late
nineteenth century to present day India. Thus, the inductive method has the merit of applying
generalisations only to related situations or phenomena.

Demerits of Inductive Method:

However, the inductive method is not without its weaknesses which are discussed below.

(1) Misenterpretation of Data: Induction relies on statistical numbers for analysis that “can be misused
and misinterpreted when the assumptions which are required for their use are forgotten.”

(2) Uncertain Conclusions: Boulding points out that “statistical information can only give us
propositions whose truth is more or less probable it can never give us certainty.”

(3) Lacks Concreteness: Definitions, sources and methods used in statistical analysis differ from
investigator to investigator even for the same problem, as for instance in the case of national income
accounts. Thus, statistical techniques lack concreteness.

(4) Costly Method: The inductive method is not only time-consuming but also costly. It involves detailed
and painstaking processes of collection, classification, analyses and interpretation of data on the part of
trained and expert investigators and analysts

(5) Difficult to Prove Hypothesis: Again the use of statistics in induction cannot prove a hypothesis. It
can only show that the hypothesis is not inconsistent with the known facts. In reality, collection of data is
not illuminating unless it is related to a hypothesis.

(6) Controlled Experimentation not Possible in Economics: Besides the statistical method, the other
method used in induction is of controlled experimentation. This method is extremely useful in natural and
physical sciences which deal with matter. But unlike the natural sciences, there is little scope for
experimentation in economics because economics deals with human behaviour which differs from person
to person and from place to place.
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Further, economic phenomena are very complex as they relate to man who does not act rationally. Some
of his actions are also bound by the legal and social institutions of the society in which he lives. Thus, the
scope for controlled experiments in inductive economics is very little. As pointed Out by Friendman,
“The absence of controlled experiments in economics renders the weeding out of unsuccessful hypo-these
slow and difficult.”

Scarcity and Choice as Economic Problems

 The Problem of Scarcity:

We live in a world of scarcity. People want and need variety of goods and services. This applies equally to
the poor and the rich people. It implies that human wants are unlimited but the means to fulfil them are
limited. At any one time, only a limited amount of goods and services can be produced. This is because
the existing supplies of resources are extremely inadequate. These resources are land, labour, capital and
entrepreneurship.

These factors of production or inputs are used in producing goods and services that are called economic
goods which have a piece. These facts explain scarcity as the principal problem of every society and
suggest the Law of Scarcity, The law states that human wants are virtually unlimited and the resources
available to satisfy these wants are limited.

 The Problem of Choice:

Since are live in a world of scarcity, a society can produce only a small portion of goods and services that
its people want. Therefore, scarcity of resources gives rise to the fundamental economic problem of
choice. As a society cannot produce enough goods and services to satisfy all the wants of its people, it has
to make choices.

A decision to produce one good requires a decision to produce less of some other good. So choice
involves sacrifice. Thus every society is faced with the basic problem of deciding what it is willing to
sacrifice to produce the goods it wants the most.

Central Problems of an Economy:

The resources are scarce; the society has to make a number of choices.

There are few main categories of choices that a society must make:

1. What to goods and services produce and in what quantities?

2. How to produce these goods and services?

3. For whom to product them?

4. How efficiently are the resources being utilized?

5. Is the economy growing?

Circular Flow of Economic Activity

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The circular flow of economic activity is a model showing the basic economic relationships within a
market economy. It illustrates the balance between injections and leakages in our economy. Half of the
model includes injections, and half of the model includes leakages. The circular flow model shows where
money goes and what it's exchanged for. The model includes households, businesses and governments.
We also have the banking system that facilitates the exchange of money and, as we'll see in a minute,
helps to productively turn savings into investment in order to grow the economy. In the circular flow of
the economy, money is used to purchase goods and services. Goods and services flow through the
economy in one direction while money flows in the opposite direction.

The circular flow model shows the balance of economic injections and leakages

The factors of production include land, labor, capital and entrepreneurship. The prices that correspond to
these factors of production are rent, wages and profit. People in households buy goods and services from
businesses in an attempt to satisfy their unlimited needs and wants. Households also sell their labor, land,
and capital in exchange for income that they use to buy goods and services that firms produce. Businesses
sell goods and services to households, earning revenue and generating profits. Businesses also pay wages,
interest and profits to households in return for the use of their factors of production. Governments levy
taxes on households and businesses in order to provide certain benefits to everyone.

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National Income

The total net value of all goods and services produced within a nation over a specified period of time,
representing the sum of wages, profits, rents, interest, and pension payments to residents of the nation.

Measures of National Income

For the purpose of measurement and analysis, national income can be viewed as an aggregate of various
component flows. The most comprehensive measure of aggregate income which is widely known is Gross
National Product at market prices.

 Gross and Net Concept- Gross emphasizes that no allowance for capital consumption has been
made or that depreciation has yet to be deducted. Net indicates that provision for capital
consumption has already been made or that depreciation has already been deducted.

 National and Domestic Concepts- The term national denotes that the aggregate under
consideration represents the total income which accrues to the normal residents of a country due
to their participation in world production during the current year.

It is also possible to measure the value of the total output or income originating within the specified
geographical boundary of a country known as domestic territory. The resulting measure is called
"domestic product".

 Market Prices and Factor Costs- The valuation of the national product at market prices
indicates the total amount actually paid by the final buyers while the valuation of national product
at factor cost is a measure of the total amount earned by the factors of production for their
contribution to the final output.

GNP at market price = GNP at factor cost + indirect taxes - Subsidies.

NNP at market price = NNP at factor cost + indirect taxes - Subsidies

 Gross National Product and Gross Domestic Product- For some purposes we need to find the
total income generated from production within the territorial boundaries of an economy
irrespective of whether it belongs to the inhabitants of that nation or not. Such an income is
known as Gross Domestic Product (GDP) and found as −

GDP = GNP - Nnet Factor Income From Abroad

Net Factor Income from Abroad = Factor Income Received From Abroad - Factor Income Paid Abroad

 Net National Product- The NNP is an alternative and closely related measure of the national
income. It differs from GNP in only one respect. GNP is the sum of final products. It includes
consumption of goods, gross investment, government expenditures on goods and services, and net
exports.

GNP = NNP − Depreciation

NNP includes net private investment while GNP includes gross private domestic investment.

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  Personal Income- Personal income is calculated by subtracting from national income those types
of incomes which are earned but not received and adding those types which are received but not
currently earned.

Personal Income = NNP at Factor Cost − Undistributed Profits − Corporate Taxes + Transfer Payments

 Disposable Income- Disposable income is the total income that actually remains with individuals
to dispose off as they wish. It differs from personal income by the amount of direct taxes paid by
individuals.

Disposable Income = Personal Income − Personal taxes

 Value Added- The concept of value added is a useful device to find out the exact amount that is
added at each stage of production to the value of the final product. Value added can be defined as
the difference between the value of output produced by that firm and the total expenditure
incurred by it on the materials and intermediate products purchased from other business firms.

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