MCO-021

Managerial Economics
Indira Gandhi
National Open University
School of Management Studies

BLOCK 1
INTRODUCTION TO MANAGERIAL ECONOMICS 5
BLOCK 2
DEMAND AND REVENUE ANALYSIS 69
BLOCK 3
PRODUCTION AND COST ANALYSIS 131
BLOCK 4
PRICING DECISIONS 217
COURSE DESIGN AND PREPARATION TEAM
Prof. K. Ravi Sankar
Director. SOMS, *Prof. V. L. Mote (Retd.)
IGNOU, New Delhi II M, Ahmedabad
Pro. Qamar Ahsan
*Prof. G.S. Gupta
Retd . Prof. of Economics and Vice Chancellor,
IIM, Ahmedabad
Magadh University, Bihar
Prof. K.V. Bhanu Murthy *Prof. Arindam Banik
Former Dean IMI, New Delhi
Faculty of Commerce and Business
Delhi School of Economics, Delhi *Prof. Atmanand
MDI , Gurgaon
Prof. Sunitha Raju
Indian Institute of Foreign Trade
*Prof. Rajat Kathuria
New Delhi
IMI, New Del hi
Dr. Utpal Chattopadhyay
Associate Professor *Dr. C.G. Naidu
National Institute of Industrial Engineering, Planning & Development Division
Mumbai IGNOU, New Del hi
Prof. Biswajit Nag
Prof. Kamal Vagrecha
Indian Institute of Foreign Trade
School of Management Studies,
New Delhi
IGNOU, New Delhi
Dr. Alka Mittal
Associate Professor Prof. Nayantara Padhi
G.G. Singh Indraprastha University, Delhi School of Management Studies
IGNOU, New Delhi
Pro f. G. Subbayamma
School of Management Studies,
Sh. T.V. Vijay Kumar
IGNOU, New Delhi
School of Management Studies
Prof. Srilatha IGNOU, New Delhi
School of Management Studies,
IGNOU, New Delhi Course Coordinator and Editor:
Dr. Leena Singh
Prof. Neeti Agrawal SOMS, IGNOU
School of Management Studies, New Delhi
IGNOU, New Delhi
Prof. Anjali C. Ramteke
School of Management Studies
IGNOU, New Delhi
This course (MCO-021) is adopted from the MMPC-010: Managerial Economics, and the course
coordinator for adopted course MCO-021 is Dr. Anupriya Pandey, SOMS, IGNOU

Acknowledgement : Parts of this course is adopted from the earlier MS-09: Managerial Economics
course and the persons marked with (*) were the original contributors and the profiles are as it was in
that material.

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MCO-021: MANAGERIAL ECONOMICS
Managerial Economics can be viewed as an application of that part of
microeconomics that focuses on topics such as risk, demand, production, cost,
pricing, and market structure. Understanding these principles will help to develop
a rational decision-making perspective and will sharpen the analytical framework
that the executive must bring to bear on managerial decisions.
Individuals and firms interact in both the product and the factor markets. Prices
of outputs and inputs are determined in these markets and guide the decisions of
all market participants. The firm is an entity that organizes factors of production
in order to produce goods and services to meet the demands of consumers and
other firms. In a market system, the interplay of individuals and firms is not
subject to central control. The prices of both products and factors of production
guide this interaction. Within firms, however, transactions and information costs
are reduced. The size of the firm is limited because transaction costs within the
firm will rise as the firm grows, and because management skill is limited.
It is assumed that the goal of the firm is to maximize the value of the firm or the
present value of all future profits, defined as revenue less all costs, explicit and
implicit. Implicit costs such as the remuneration and interest that owners and
managers earn are not accounted and may result in an inefficient allocation of
resources. The objective of profit maximization is subject to legal, moral,
contractual, financial, and technological constraints. Some economists argue that
the firm’s objective is a “satisfactory” level of profit rather than maximum profit.
The principal-agent problem arises where the owner of a firm and the manager
of that firm have different objectives. The problem can be solved by tying part of
the manager’s salary to profits and /or changes in the price of the firm’s stock.
Profit plays two primary roles in the free-market system. First, it acts as a signal
to producers to increase or decrease the rate of output, or to enter or leave an
industry. Second, profit is a reward for entrepreneurial activity, including risk
taking and innovation. In a competitive industry, economic profits tend to be
transitory. The achievement of high profits by a firm usually results in other
firms increasing their output of that product, thus reducing price and profit. Firms
that have monopoly power may be able to earn above-normal profits over a
longer period; such profit does not play a socially useful role in the economy.
Different types of pricing strategies are adopted, keeping in mind, the varying
market structure for products.
The primary role of economics in management is in making optimizing decisions
where constraints apply. The application of the principles of managerial economics
will help manager ensure that resources are allocated efficiently within the firm,
and that the firm reacts to changes in the economic environment.
Block 1

INTRODUCTION TO MANAGERIAL ECONOMICS

Unit 1: Scope of Managerial Economics 9

Unit 2: The Firm: Stakeholders, Objectives and 22

Decisions Issues

Unit 3: Basic Concepts and Techniques 42

BLOCK 1 INTRODUCTION TO
MANAGERIAL ECONOMICS
This block provided an introduction to managerial economics and also highlights
its importance in the current economic environment. With the easing of controls
on the economy and with increasing amount of output being generated through
the market, firms have begun to exert positive influence in the production of
goods and services in India. The change began in 1991 with economic reforms
and has now acquired a momentum of its own. It is in the context of growing
liberalization of the Indian economy that a student of managerial economics will
need to understand and appreciate the importance of the subject. Block 1 provides
the student with the basic tool kit that aids understanding of the nature and process
of decision making by a manager.
Unit 1 defines the nature and scope of managerial economics. Economics is a
vast subject with a number of branches that have developed over time. This
includes economics of industry, public finance, international trade, and agricultural
economics. Broadly, economics may be divided into macroeconomics and
microeconomics. Macroeconomics, as the name suggests, is the study of the
overall economy and its aggregates such as Gross National Product, Inflation,
Unemployment, Exports, Imports, and Taxation Policy etc. On the other hand,
microeconomics deals with individual actors in the economy such as firms and
individuals. Managerial economics can be thought of an applied microeconomics.
Unit 2 introduces you to one of the major units of analysis of managerial
economics, considering a firm. The objectives of a firm are defined and explained
and a framework is provided for efficient allocation of resources within a firm.
The firm occupies centre stage in a market oriented economy and understanding
its rationale for existence and the nature of its operations will be explored in this
unit. You should, however, appreciate that since managerial economics chiefly
focuses on the firm, different aspects of firm’s behavior will be found in other
units of this course as well.
The concepts and techniques developed in Unit 3 are designed to increase the
effectiveness of decision making by providing an analytical framework used by
managers. Thus emphasis is placed on optimization techniques, both constrained
and unconstrained as well as an introduction to decision making under uncertainty.
 Scope of Managerial
UNIT 1 SCOPE OF MANAGERIAL Economics
ECONOMICS
Structure

1.0 Objectives
1.1 Introduction
1.2 Fundamental Nature of Managerial Economics
1.3 Scope of Managerial Economics
1.4 Appropriate Definitions
1.5 Managerial Economics and other Disciplines
1.6 Economic Analysis
1.7 Basic Characteristics: Decision-Making
1.8 Let Us Sum Up
1.9 Terminal Questions

1.0 OBJECTIVES
After studying this unit, you hould be able to:
 understand the nature and scope of managerial economics;
 familiarize yourself with economic terminology;
 develop some insight into economic issues;
 acquire some information about economic institutions; and
 understand the concept of trade-offs or policy options.

1.1 INTRODUCTION
For most purposes economics can be divided into two broad categories,
microeconomics and macroeconomics. Macroeconomics as the name
suggests is the study of the overall economy and its aggregates such as Gross
National Product, Inflation, Unemployment, Exports, Imports, Taxation
Policy etc. Macroeconomics addresses questions about changes in
investment, government spending, employment, prices, exchange rate of the
rupee and so on. Importantly, only aggregate levels of these variables are
considered in the study of macroeconomics. But hidden in the aggregate data
are changes in output of a number of individual firms, the consumption
decision of consumers like you, and the changes in the prices of particular
goods and services.

Although macroeconomic issues are important and occupy the time of media
and command the attention of the newspapers, micro aspects of the economy
are also important and often are of more direct application to the day to day
problems facing a manager. Microeconomics deals with individual actors in
the economy such as firms and individuals. Managerial economics can be
thought of as applied microeconomics and its focus is on the interaction of
firms and individuals in markets.

When you read a newspaper or switch on a television, you hear economic

terminology used with increasing regularity. For a manager, some of these 9
Introduction to economic terms are of direct relevance and therefore it is essential to not only
Managerial Economics understand them but also apply them in relevant situations. For example,
GDP growth rate could impact the product a manager is marketing, change in
money supply by the RBI could impact inflation and affect the demand for
your product, fiscal deficit could affect interest rates and therefore investment
spending by a manager etc. The focus of managerial economics is on how the
firm reacts to changes in the economic environment in which it operates and
how it predicts these changes and devises the best possible strategies to
achieve the objectives that underlie its existence.

The economy is the institutional structure through which individuals and

firms in a society coordinate their desires. Economics is the study of how
human beings in a society go about achieving their wants and desires. It is
also defined as the study of allocation of scarce resources to satisfy individual
wants or desires. The latter is perhaps the best way to broadly define the
study of economics in general. The emphasis is on allocation of scarce
resources across competing ends. You should recognize that human wants are
unlimited whereas means to fulfill those desires are limited and therefore
choice is necessary. Choices necessarily involve trade-offs. For example, if
you wish to acquire an M.Com degree, you must take time off to devote to
study. Your time has many uses and when you devote more time to study you
are allocating it to a particular use in order to achieve your goal. Economics
would be a most uninteresting subject if resources were unlimited and no
trade offs was involved in decision making.

There are many general insights economists have gained into how the
economy functions. Economic theory ties together economists’ terminology
and knowledge about economic institutions. An economic institution is a
physical or mental structure that significantly influences economic decisions.
Corporations, governments, markets are all economic institutions. Similarly
cultural norms are the standards people use when they determine whether a
particular activity or behaviour is acceptable. For example, Hindus avoid
meat and fish on Tuesdays. This has an economic dimension as it has a direct
impact on the sale of these items on Tuesdays. Further, economic policy is
the action usually taken by the government, to influence economic events.
And finally, economic reasoning helps in thinking like an economist.
Economists analyze questions and issues on the basis of trade-offs i.e. they
compare the cost and the benefits of every issue and make decisions based on
those costs and benefits.

The market is perhaps the single most important and complex institution in
our economy. A market is not necessarily a physical location, but a
description of any state that involves exchange. The exchange could be
instantaneous or it could be over time i.e. exchange which is agreed today but
where the transaction takes place, say after 3 months. You will learn in this
course the myriad functions that markets perform, most significantly bringing
buyers and sellers together. Markets could be competitive or monopolistic,
with a large number of firms or a small number of firms, with free entry and
exit or government licensing restricting entry of firms and so on. The major
point is that firms operate in different types of markets and use the well-
established principles of managerial economics to improve profitability.
Managerial economics draws on economic analysis for such concepts as cost,
demand, profit and competition. It attempts to bridge the gap between the
10
purely analytical problems that intrigue many economic theorists and the Scope of Managerial
day-to-day decisions that managers must face. It offers powerful tools and Economics
approaches for managerial policy-making. It will be relevant to present here
several examples illustrating the problems that managerial economics can
help to address. These also explain how managerial economics is an integral
part of business. Demand, supply, cost, production, market, competition,
price etc. are important concepts in real business decisions.

1.2 FUNDAMENTAL NATURE OF

MANAGERIAL ECONOMICS
A close relationship between management and economics has led to the
development of managerial economics. Management is the guidance,
leadership and control of the efforts of a group of people towards some
common objective. While this description does inform about the purpose or
function of management, it tells us little about the nature of the management
process. Koontz and O’Donell define management as the creation and
maintenance of an internal environment in an enterprise where individuals,
working together in groups, can perform efficiently and effectively towards
the attainment of group goals. Thus, management is :

 Coordination,
 An activity or an ongoing process,
 A purposive process, and
 An art of getting things done by other people.

On the other hand, economics as stated above is engaged in analyzing and

providing answers to manifestations of the most fundamental problem of
scarcity. Scarcity of resources results from two fundamental facts of life:

 Human wants are virtually unlimited and insatiable, and

 Economic resources to satisfy these human demands are limited.

Thus, we cannot have everything we want; we must make choices broadly in

regard to the following:

 What to produce?
 How to produce? and
 For whom to produce?

These three choice problems have become the three central issues of an
economy as shown in figure 1.1. Economics has developed several concepts
and analytical tools to deal with the question of allocation of scarce resources
among competing ends. The non-trivial problem that needs to be addressed is
how an economy through its various institutions solves or answers the three
crucial questions posed above. There are three ways by which this can be
achieved. One, entirely by the market mechanism, two, entirely by the
government or finally, and more reasonably, by a combination of the first two
approaches. Realistically all economies employ the last option, but the
relative roles of the market and government vary across countries. For
example, in India the market has started playing a more important role in the
11
Introduction to economy while the government has begun to withdraw from certain
Managerial Economics activities. Thus, the market mechanism is gaining importance. A similar
change is happening all over the world, including in China. But there are
economies such as Myanmar and Cuba where the government still plays an
overwhelming part in solving the resource allocation problem. Essentially,
the market is supposed to guide resources to their most efficient use. For
example if the salaries earned by MBA degree holders continue to rise, there
will be more and more students wanting to earn the degree and more and
more institutes wanting to provide such degrees to take advantage of this
opportunity. The government may not force this to happen, it will happen on
its own through the market mechanism. The government, if anything, could
provide a regulatory function to ensure quality and consumer protection.

According to the central deduction of economic theory, under certain

conditions, markets allocate resources efficiently. ‘Efficiency’ has a special
meaning in this context. The theory says that markets will produce an
outcome such that, given the economy’s scarce resources, it is impossible to
make anybody better-off without making somebody else worse-off.

Figure 1.1: Three Choice Problems of an Economy

In rich countries, markets are too familiar to attract attention. Yet, certain awe
is appropriate. Let us take an incident where Soviet planners visited a
vegetable market in London during the early days of perestroika, they were
impressed to find no queues, shortages, or mountains of spoiled and
unwanted vegetables. They took their hosts aside and said: “We understand,
you have to say it’s all done by supply and demand. But can’t you tell us
what’s really going on? Where are your planners and what are their
methods?”

The essence of the market mechanism is indeed captured by the supply-and

demand diagram that you will become familiar with in Block 4. At the place
where the curves intersect, a price is set such that demand equals supply.
There, and only there, the benefit from consuming one more unit exactly
matches the cost of producing it. If output were less, the benefit from
consuming more would exceed the cost of producing it. If output were
higher, the cost of producing the extra units would exceed the extra benefits.
So the point where supply equals demand is “efficient”.

However, the conditions for market efficiency are extremely demanding—far

too demanding ever to be met in the real world. The theory requires “perfect
12 competition”: there must be many buyers and sellers; goods from competing
suppliers must be indistinguishable; buyers and sellers must be fully Scope of Managerial
informed; and markets must be complete—that is, there must be markets not Economics
just for bread here and now, but for bread in any state of the world. (What is
the price today for a loaf to be delivered in Timbuktu on the second Tuesday
in December 2020 if it rains?)

In other words, market failure is pervasive. It comes in four main varieties:

Monopoly: By reducing his sales, a monopolist can drive up the price of his
good. His sales will fall but his profits will rise. Consumption and production
are less than the efficient amount, causing a deadweight loss in welfare.

Public goods: Some goods cannot be supplied by markets. If you refuse to

pay for a new coat, the seller will refuse to supply you. If you refuse to pay
for national defence, the “good” cannot easily be withheld. You might be
tempted to let others pay. The same reasoning applies to other “non-
excludable” goods such as law and order, clean air, and so on. Since private
sellers cannot expect to recover the costs of producing such goods, they will
fail to supply them.

Externalities: Making some goods causes pollution: the cost is borne by

people with no say in deciding how much to produce. Consuming some
goods (education, anti-lock brakes) spreads benefits beyond the buyer; again,
this will be ignored when the market decides how much to produce. In the
case of “good” externalities, markets will supply too little; in the case of
“bads”, too much.

Information: In some ways a special kind of externality, this deserves to be

mentioned separately because of the emphasis placed upon it in recent
economic theory. To see why information matters, consider the market for
used cars. A buyer, lacking reliable information, may see the price as
providing clues about a car’s condition. This puts sellers in a quandary: if
they cut prices, they may only convince people that their cars are rubbish.

The labour market, many economists believe, is another such ‘market for
lemons’. This may help to explain why it is so difficult for the unemployed to
price themselves into work.

When markets fail, there is a case for intervention. But two questions need to
be answered first. How much does market failure matter in practice? And can
governments put the failure right? Markets often correct their own failures. In
other cases, an apparent failure does nobody any harm. In general, market
failure matters less in practice than is often supposed.

Monopoly, for instance, may seem to preclude an efficient market. This is

wrong. The mere fact of monopoly does not establish that any economic
harm is being done. If a monopoly is protected from would-be competitors by
high barriers to entry, it can raise its prices and earn excessive profits. If that
happens, the monopoly is undeniably harmful. But if barriers to entry are
low, lack of actual (as opposed to potential) competitors does not prove that
the monopoly is damaging: the threat of competition may be enough to make
it behave as though it were a competitive firm. Many economists would
accept that an American multinational technology corporation for instance, is
13
Introduction to a near-monopolist in some parts of the personal-computer software business–
Managerial Economics yet would argue that the firm is doing no harm to consumers because its
markets remain highly contestable. Because of that persistent threat of
competition, the company prices its products keenly. In this and in other
ways it behaves as though it were a smaller firm in a competitive market.

Even on economic grounds (never mind other considerations), there is no tidy

answer to the question of where the boundary between state i.e. governments
and market should lie. Markets do fail because of monopoly, public goods,
externalities, lack of information and for other reasons. But, more than critics
allow, markets find ways to mitigate the harm–and that is a task at which
governments have often been strikingly unsuccessful. All in all, a strong
presumption in favour of markets seems wise. This is not because classical
economic theory says so, but because experience seems to agree. And as
stated above, the real world seems to be moving in the direction of placing
more reliance on markets than on governments.

1.3 SCOPE OF MANAGERIAL ECONOMICS

From the point of view of a firm, managerial economics, may be defined as
economics applied to “problems of choice” or alternatives and allocation of
scarce resources by the firms. Thus managerial economics is the study of
allocation of resources available to a firm or a unit of management
among the activities of that unit. Managerial economics is concerned with
the application of economic concepts and analysis to the problem of
formulating rational managerial decisions. There are four groups of problem
in both decisions-making and forward planning which are discussed below:

Resource Allocation: Scare resources have to be used with utmost efficiency

to get optimal results. These include production programming and problem of
transportation etc. How does resource allocation take place within a firm?
Naturally, a manager decides how to allocate resources to their respective
uses within the firm, while as stated above, the resource allocation decision
outside the firm is primarily done through the market. Thus, one important
insight you can draw about the firm is that within it resources are guided by
the manager in a manner that achieves the objectives of the firm. More will
be said about this in Unit 2.

Inventory and queuing problem: Inventory problems involve decisions

about holding of optimal levels of stocks of raw materials and finished goods
over a period. These decisions are taken by considering demand and supply
conditions. Queuing problems involve decisions about installation of
additional machines or hiring of extra labour in order to balance the business
lost by not undertaking these activities.

Pricing Problem: Fixing prices for the products of the firm is an important
decision-making process. Pricing problems involve decisions regarding
various methods of prices to be adopted.

Investment Problem: Forward planning involves investment problems.

These are problems of allocating scarce resources over time. For example,
investing in new plants, how much to invest, sources of funds, etc.
14
 Scope of Managerial
Study of managerial economics essentially involves the analysis of certain Economics
major subjects like:

 The business firm and its objectives

 Demand analysis, estimation and forecasting
 Production and Cost analysis
 Pricing theory and policies
 Profit analysis with special reference to break-even point
 Capital budgeting for investment decisions
 Competition.

Demand analysis and forecasting help a manager in the earliest stage in

choosing the product and in planning output levels. A study of demand
elasticity goes a long way in helping the firm to fix prices for its products.
The theory of cost also forms an essential part of this subject. Estimation is
necessary for making output variations with fixed plants or for the purpose of
new investments in the same line of production or in a different venture. The
firm works for profits and optimal or near maximum profits depend upon
accurate price decisions. Theories regarding price determination under
various market conditions enable the firm to solve the price fixation
problems. Control of costs, proper pricing policies, break-even analysis,
alternative profit policies are some of the important techniques in profit
planning for the firm which has to work under conditions of uncertainty.
Thus managerial economics tries to find out which course is likely to be the
best for the firm under a given set of conditions.

1.4 APPROPRIATE DEFINITIONS

According to McNair and Meriam, “Managerial economics is the use of
economic modes of thought to analyze business situations.” According to
Prof. Evan J Douglas, ‘Managerial economics’ is concerned with the
application of economic principles and methodologies to the decision making
process within the firm or organisation under the conditions of uncertainty”.
Spencer and Siegelman define it as “The integration of economic theory
with business practices for the purpose of facilitating decision making and
forward planning by management.” According to Hailstones and Rothwel,
“Managerial economics is the application of economic theory and analysis to
practice of business firms and other institutions.” A common thread runs
through all these descriptions of managerial economics which is using a
framework of analysis to arrive at informed decisions to maximize the firm’s
objectives, often in an environment of uncertainty. It is important to
recognize that decisions taken while employing a framework of analysis are
likely to be more successful than decisions that are knee jerk or gut feel
decisions.

Activity 1

1. Development of managerial economics is the result of close

interrelationship between management and economics. Discuss.

15
Introduction to 2. Which statement is true of the basic economic problem?
Managerial Economics
(i) The problem will exist as long as resources are limited and
desires are unlimited.
(ii) The problem exists only in less developed countries.
(iii) The problem will disappear as production expands.
(iv) The advancement of technology will cause the problem to
disappear.

3. Why is decision making by any management truly economic in

nature?

1.5 MANAGERIAL ECONOMICS AND OTHER

DISCIPLINES
Managerial economics is linked with various other fields of study like–

Microeconomic Theory: As stated in the introduction, the roots of

managerial economics spring from micro-economic theory. Price theory,
demand concepts and theories of market structure are few elements of micro
economics used by managerial economists. It has an applied bias as it applies
economic theories in order to solve real world problems of enterprises.

Macroeconomic Theory: This field has little relevance for managerial

economics but at least one part of it is incorporated in managerial economics
i.e. national income forecasting. The latter could be an important aid to
business condition analysis, which in turn could be a valuable input for
forecasting the demand for specific product groups.

Operations Research: This field is used in managerial economics to find out

the best of all possibilities. Linear programming is a great aid in decision
making in business and industry as it can help in solving problems like
determination of facilities on machine scheduling, distribution of
commodities and optimum product mix etc.

Theory of Decision Making: Decision theory has been developed to deal

with problems of choice or decision making under uncertainty, where the
applicability of figures required for the utility calculus are not available.
Economic theory is based on assumptions of a single goal whereas decision
theory breaks new grounds by recognizing multiplicity of goals and
persuasiveness of uncertainty in the real world of management.

Statistics: Statistics helps in empirical testing of theory. With its help, better
decisions relating to demand and cost functions, production, sales or
distribution are taken. Managerial economics is heavily dependent on
statistical methods.
16
Management Theory and Accounting: Maximization of profit has been Scope of Managerial
Economics
regarded as a central concept in the theory of the firm in microeconomics. In
recent years, organisation theorists have talked about “satisficing” instead of
“maximizing” as an objective of the enterprise. Accounting data and
statements constitute the language of business. In fact the link is so close that
“managerial accounting” has developed as a separate and specialized field in
itself.

1.6 ECONOMIC ANALYSIS

Economic activity is the constant effort to match ends to means because of
scarcity of resources. The optimal economic activity is to maximize the
attainment of ends, the means and their scarcities or to minimize the use of
resources, given the ends and their priorities.

Decision making by management is truly economic in nature because it

involves choices among a set of alternatives - alternative courses of action.
The optimal decision making is an act of optimal economic choice,
considering objectives and constraints. This justifies an evaluation of
managerial decisions through concepts, precepts, tools and techniques of
economic analysis of the following types:

Micro and Macro Analysis: In micro-analysis the problem of choice is

focused on single individual entities like a consumer, a producer, a market
etc. Macro analysis deals with the problem in totality like national income,
general price level etc.

Partial and General Equilibrium Analysis: To attain the state of stable

equilibrium, the economic problem may be analyzed part by part - one at a
time - assuming “other things remaining the same.” This is partial
equilibrium analysis. In general equilibrium analysis the assumption of
“given” or “other things remaining equal” may be relaxed and
interdependence or interactions among variables may be allowed.

Static, Comparative Static and Dynamic Analysis: This is in reference to

time dimension. A problem may be analyzed in the following manner:

- allowing no change at a point of time (static)

- allowing once for all change at a point of time (comparative static)
- allowing successive changes over a period of time (dynamic).

Positive and Normative Analysis: In positive economic analysis, the

problem is analyzed in objective terms based on principles and theories. In
normative economic analysis, the problem is analyzed based on value
judgement (norms). In simple terms, positive analysis is ‘what it is’ and
normative analysis is ‘what it should be.’ For example, CEOs in private
Indian enterprises earn 15 times as much as the lowest paid employee is a
positive statement, a description of what is. A normative statement would be
that CEOs should be paid 4-5 times the lowest paid employee.
17
Introduction to Activity 2
Managerial Economics
1. The major groups of problems in decision making are:

(i)
(ii)
(iii)
(iv)

2. The 3 choice problems of an economy are:

(i)
(ii)
(iii)

The problems arise due to.......................................................................

3. Name the kind of economic analysis that is appropriate for each of the
following:

(i) The Furucture company has expansion plans ............................

(ii) The telecommunication company is making loss ......................
(iii) The real estate is facing recession .............................................
(iv) The population growth in India is alarming ..............................
(v) There is a bearish trend in the stock market ..............................

1.7 BASIC CHARACTERISTICS: DECISION-

MAKING
Managerial Economics serves as ‘a link between traditional economics and
the decision making sciences’ for business decision making.

The best way to get acquainted with managerial economics and decision
making is to come face to face with real world decision problems.

Case Study of an American multinational retail company

India is one of the biggest retail markets in the world in terms of size and the
growth potential in future. An American multinational retail company looked
at this potential and decided to choose among different alternatives of
entering foreign markets such as strategic partnership, joint venture, FDI,
wholly owned subsidiary etc. Joint ventures were chosen as the first step of
entering the new market keeping in mind several economic and regulatory
restrictions (of India as 100% FDI was not allowed in multi brand retailing).
It decided to enter India in 2007 via joint venture with an Indian enterprise by
setting up cash-and-carry wholesale outlets where it planned to supply to an
Indian retail company which would help it in getting share in consumer
market of India. But this did not fulfill the dream of the multinational and this
venture did not survive for long and ended in 2014.
18
The American retail giant had two options; to leave India or stay back. The Scope of Managerial
company stayed back as it looked at the consumer market potential and it had Economics
invested too much already. It kept looking at different options and then in
2018 it acquired 77% stake of an Indian e-commerce company for $16 billion
(about `1.05 lakh crore). The decision to acquire the Indian e-commerce
company was well thought as it is one of the biggest e-commerce company in
India which would give access to a large number of consumers of India and
on the other hand would help in giving direct competition to its old rival an
American e-commerce company. These types of major decision-making
problems are faced by managers in business world and the managers have to
choose the best alternative from the available alternatives for the firm.

The basic characteristics of managerial economics can now be enumerated

as:

 It is concerned with “decision making of an economic nature.”

 It is “micro-economic” in character.
 It largely uses that body of economic concepts and principles, which
is known as “theory of the firm.”
 It is “goal oriented and prescriptive.”
 Managerial economics is both “conceptual and metrical”. It includes
theory with measurement.

Figure 1.2: Decision-Making

Managerial economics should be thought of as applied microeconomics,

which focuses on the behavior of the individual actors on the economic stage;
firms and individuals.
19
Introduction to Figure 1.3: Basic Characteristics
Managerial Economics

1.8 LET US SUM UP

Managerial economics is used by firms to improve their profitability. It is the
economics applied to problems of choices and allocation of scarce resources
by the firms. It refers to the application of economic theory and the tools of
analysis of decision science to examine how an organisation can achieve its
objective most efficiently. Managerial decisions are evaluated through
concepts, tools and techniques of economic analysis of various types. It is
linked with various fields of study.

1.9 TERMINAL QUESTIONS

1. Discuss the nature and scope of managerial economics.
2. “Managerial economics is the integration of economic theory with
business practice for the purpose of facilitating decision-making and
forward planning by manager”. Explain and comment.
3. Define scarcity and opportunity cost. What role do these two concepts
play in the making of management decisions?
4. Managerial economics is often said to help the business student
integrate the knowledge gained in other courses. How is this
integration accomplished?
5. Compare and contrast microeconomics with macroeconomics.
Although managerial economics is based primarily on
microeconomics, explain why it is also important for managers to
understand macroeconomics.
6. Justify that managerial economics is economics applied in decision-
making.
7. What is the role of managerial economics in preparing managers?
20 8. How is managerial economics related to different disciplines?
 Scope of Managerial
FURTHER READINGS Economics

Haynes, W.W. (1979). Managerial Economics: Analysis and Cases (3rd Ed.).
Business Publications, Inc., Texas.

Adhikary, M. (1987). Managerial Economics (3rd Ed.). Khosla Publishers,

Delhi.

Baumol, W.J. (1979). Economic Theory and Operations Analysis (4th Ed.).
Prentice Hall India Pvt. Ltd., New Delhi.

21
Introduction to T
Managerial Economics
UNIT 2 THE FIRM: STAKEHOLDERS, O
OBJECTIVES AND DECISION
ISSUES
Structure

2.0 Objectives
2.1 Introduction
2.2 Objective of the Firm
2.3 Value Maximization
2.4 Alternative Objectives of the Firms
2.5 Goals of Real World Firms
2.6 Firm’s Constraints
2.7 Basic Factors of Decision-Making: The Incremental Concept
2.8 The Equi-Marginal Principle
2.9 The Discounting Principle
2.10 The Opportunity Cost Principle
2.11 The Invisible Hand
2.12 Let Us Sum Up
2.13 Terminal Questions

2.0 OBJECTIVES
After studying this unit, you should be able to:
 understand the rationale for existence of firms;
 understand the concept of economic profit and accounting profit;
 appreciate the use of opportunity cost; and
 differentiate between various objectives of the firm.

2.1 INTRODUCTION
The firm is an organisation that produces a good or service for sale and it
plays a central role in theory and practice of Managerial Economics. In
contrast to non-profit institutions like the ‘Ford Foundation’, most firms
attempt to make a profit. There are thousands of firms in India producing
large amount of goods and services; the rest are produced by the government
and non-profit institutions. It is obvious that a lot of activities of the Indian
economy revolve around firms.

One of the crucial determinants of a firm’s behaviour is the state of

technology. Technology imposes a limit on how much a firm can produce. It
is the sum total of society’s pool of knowledge concerning the industrial and
agricultural arts. Production is any activity that transforms inputs into output
and is applicable not only to the production of goods like steel and
automobiles, but also to production of services like banking and insurance.
22
The firm changes hired inputs into saleable output. An input is defined as The Firm: Stakeholders,
Objectives and Decision
anything that the firm uses in its production process. Most firms require a
Issues
wide array of inputs. For example, some of the inputs used by major steel
firms like XYZ or ABC are iron ore, coal, oxygen, skilled labour of various
types, the services of blast furnaces, electric furnaces, and rolling mills as
well as the services of the people managing the companies. To give another
example, the inputs in production and sale of “chaat” by a street vendor are
all the ingredients that go into making of the “chaat”, i.e. the stove, the
“carrier”, and the services of the vendor. The inputs or the factors of
production are divisible into two broad categories – human resources and
capital resources. Labour resource and entrepreneurial resource are the two
human resource inputs while land, man-made capital forests, rivers, etc. are
the two capital resources. Thus the four major factors of production (FOP)
are land, man-made capital, labour, and entrepreneur (organisation) while the
remuneration they get is rent, interest (capital rental), wage, and profit,
respectively.

The function of the firm, thus, is to purchase resources or inputs of labour

services, capital and raw materials in order to convert them into goods and
services for sale. There is a circular flow of economic activity between
individuals and firms as they are highly interdependent. Labour has no value
in the market unless there is a firm willing to pay for it. In the same way,
firms cannot rationalize production unless some consumer is willing to buy
their products. However, there is some incentive for each. Firms earn profits
for satisfying the consumption demand of individuals and in turn resource
owners get wage, rent and interest payment. In the process of supplying the
goods and services that consumers demand, firms provide employment to
workers and also pay taxes that government uses to provide service
(education, defence) that firms could not provide at all or as efficiently.

Essentially a firm exists because the total cost of production of output is

lower than if the firm did not exist. There are several reasons for lower costs.
Firstly, long term contract with labour saves the transaction costs because no
new contract has to be negotiated every time a labour is to be hired or given
new assignment. Secondly, there are government regulations like price-
control and sales taxes also saved by having the transaction within the firm.
Recall that sales tax is levied for transaction between firms and not within
firms. When transactions take place within a firm they may be cheaper and
hence such savings decrease the total cost of production of an output. In other
words, the existence of firms could be explained by the fact that it saves
transaction costs.

However, the size of the firm has to be limited because as the firms grow
larger, a point is reached where the cost of internal transaction becomes equal
to or greater than the cost of transaction between firms. When such a stage is
reached, it puts a limit to the size of the firm. Further, the cost of supplying
23
Introduction to additional services like legal, medical etc. within the firm exceeds the cost of T
O
Managerial Economics purchasing these services from other firms; as such services may be required
occasionally.

Let us consider the size of different kinds of firms around us and try to
understand the reasons for such differences. Why are service firms generally
smaller than capital-intensive firms like steel and automobile producing
companies What is the reason that a number of firms are choosing the BPO
route? A part of the explanation must lie in the fact that it is cheaper to
outsource than to absorb that activity within the firm. Consider a firm that
needs to occasionally use legal service. Under what conditions will it choose
to hire a full time lawyer and take her on its rolls and under what conditions
will the firm outsource the legal activity or hire legal services on a case-by-
case basis. Naturally, the answer depends upon the frequency of use for legal
services. The transaction cost framework demonstrates that the firm will
contract out if the cost of such an arrangement is lower and will prefer in-
house legal staff when the opposite is true.

Firms are classified into different categories as follows:

a) Private sector firms.
b) Public sector firms.
c) Joint sector firms.
d) Non-profit firms.

Figure 2.1: Interdependence of Consumers and Firms

Firms can also be classified on the basis of number of owners as:

a) One Person Company.

b) Partnership.
c) Corporations

Some firms mentioned below are different from above. They may provide
service to a group of clients for example, patients or to a group of its
24 members only.
 The Firm: Stakeholders,
a) Universities. Objectives and Decision
Issues
b) Public Libraries.
c) Hospitals.
d) Museums.
e) Churches.
f) Voluntary Organisations.
g) Cooperatives.
h) Unions.
i) Professional Societies, etc.

The concept of a firm plays a central role in the theory and practice of
managerial economics. It is, therefore, valuable to discuss the objectives of a
firm.

2.2 OBJECTIVE OF THE FIRM

The traditional objective of the firm has been profit maximization. It is still
regarded as the most common and theoretically the most plausible objective
of business firms. We define profits as revenues less costs. But the definition
of cost is quite different for the economist than for an accountant. Consider
an independent businessperson who has an M.Com degree and is considering
investing `1 lakh in a retail store that s/he would manage. There are no other
employees. The projected income statement for the year as prepared by an
accountant is as shown below:

Sales `90,000
Less: Cost of Goods Sold `40,000
Gross Profit: `50,000
Less:
Advertising `10,000
Depreciation `10,000
Utilities `3,000
Property Tax `2,000
Misc. `5,000 =`30,000
Net Accounting Profit `20,000

This accounting or business profit is what is reported in publications and in

the quarterly and annual financial reports of businesses.

The economist recognizes other costs, defined as implicit costs. These costs
are not reflected in cash outlays by the firm, but are the costs associated with
foregone opportunities. Such implicit costs are not included in the accounting
statements but must be included in any rational decision making framework.
There are two major implicit costs in this example. First, the owner has `1
lakh invested in the business. Suppose the best alternative use for the money
is a bank account paying a 10 per cent interest rate. This risk less investment
would return `10,000 annually. Thus, `10,000 should be considered as the
implicit or opportunity cost of having `1 lakh invested in the retail store.
25
Introduction to Let us consider the second implicit cost, which includes the manager’s time T
O
Managerial Economics and talent. The annual wage return on an M.Com degree may be taken as
`35,000 per year. This is the implicit cost of managing this business rather
than working for someone else. Thus, the income statement should be
amended in the following way in order to determine the economic profit:

Sales `90,000
Less: Cost of Goods Sold `40,000
Gross Profit: `50,000
Less:
Advertising `10,000
Depreciation `10,000
Utilities `3,000
Property Tax `2,000
Misc. `5,000 =`30,000

Accounting Profit `20,000

Less: Implicit
Costs:
Return on ` 1 lakh of
capital `10,000
Foreign Wages `35,000 =`45,000
Net “Economic Profit” (–) `25,000

Looking at this broader perspective, the business is projected to lose `25,000

in the first year. ` 20,000 accounting profit disappears when all relevant costs
are included. Another way of looking at the problem is to assume that `1 lakh
had to be borrowed at, say, 10 per cent interest and an M.Com graduate hired
at `35,000 per year to run the store. In this case, the implicit costs become
explicit and the accounting made explicit. Obviously, with the financial
information reported in this way, an entirely different decision might be made
on whether to start this business or not.

Thus, we can say that economic profit equals the revenue of the firm minus
its explicit costs and implicit costs. To arrive at the cost incurred by a firm, a
value must be put to all the inputs used by the firm. Money outlays are only a
part of the costs. As stated above, economists also define opportunity cost.
Since the resources are limited, and have alternative uses, you must sacrifice
the production of a good or service in order to commit the resource to its
present use. For example, if by being the owner manager of your firm, you
sacrifice a job that offers you ` 2,00,000 per annum, then two lakhs is your
opportunity cost of managing the firm. Similarly, if Suresh Kumar was not
playing cricket, he could have earned a living (perhaps, not such a good one!)
by being a cricket commentator. Suresh’s opportunity cost of playing cricket
is the amount he could have earned being a cricket commentator.

The assignment of monetary values to physical inputs is easy in some cases

and difficult in others. All economic costing is governed by the principle of
opportunity cost. If the firm maximizes profits, it must evaluate its costs
26 according to the opportunity cost principle. Assigning costs is straightforward
when the firm buys an input in a competitive market. Suppose the firm The Firm: Stakeholders,
spends ` 20,000 on buying electricity. For its factory, it has sacrificed claims Objectives and Decision
Issues
to whatever else Rs 20,000 can buy and thus the purchase price is a
reasonable measure of the opportunity cost of using that electricity. The
situation is the same for hired factors of production. However, a cost must be
assigned to factors of production that the firm neither purchases, nor hires
because it already owns them. The cost of using these inputs is implicit costs
and has to be imputed. Implicit costs arise because the alternative
(opportunity) cost doctrine must be applied to the firm. The profit calculated
after including implicit as well as explicit costs in total cost is called
economic profit.

Profit plays two primary roles in the free-market system. First, it acts as a
signal to producers to increase or decrease the rate of output, or to enter or
leave an industry. Second, profit is a reward for entrepreneurial activity,
including risk taking and innovation. In a competitive industry, economic
profits tend to be transitory. The achievement of high profits by a firm
usually results in other firms increasing their output of that product, thus
reducing price and profit. Firms that have monopoly power may be able to
earn above-normal profits over a longer period; such profit does not play a
socially useful role in the economy.

Although, profit maximization is a dominant objective of the firm, other

important objectives of the firm, other than profit maximization that we will
discuss in this unit are:

1. Maximization of sales revenue.

2. Maximization of firm’s growth rate.
3. Maximization of manager’s own utility or satisfaction.
4. Making a satisfactory rate of profit.
5. Long-run survival of the firm.
6. Entry-prevention and risk avoidance.

Activity 1

1. “Among the various objectives of a modern firm, profit maximization

is the most important”. Comment.

2. Outline the circular flow of economic activity between individuals

and firms.

2.3 VALUE MAXIMIZATION

Most firms have sidelined short-term profit as their objective. Firms are often
found to sacrifice their short-term profit for increasing the future long-term
profit. Thus, the theory states that the objective of a firm is to maximize
wealth or value of the firm. For example, firms undertake research and
development expenditure, expenditure on new capital equipment or major
marketing programmes which require expenditure initially but are meant to
27
Introduction to generate future profits. The objective of the firm is thus to maximize the T
Managerial Economics present or discounted value of all future profits and can be stated as: O

( )= + + ……+
(1 + ) (1 + ) (1 + )

=
(1 + )

Where, PV = Present Value of all expected future profits of the firm.

…. = Expected profit in 1, 2........................n years.
r = Appropriate discount rate
t = Time period 1 ……….n.

Assumed profit is equal to total revenue (TR) minus total cost (TC), then the
value
of the firm can also be stated as:
TR − TC
Value of the irm =
(1 + r)

Thus maximizing the discounted value of all future profits is equivalent to

maximizing the value of the firm.

A careful inspection of the equation suggests how a firm’s managers and

workers can influence its value. For example, in a company, the marketing
managers and sales representatives work hard to increase its total revenues,
while its production managers and manufacturing engineers strive to reduce
its total costs. At the same time, its financial managers play a major role in
obtaining capital, and hence influence the equation, while its research and
development personnel invent and reduce its total costs. All of these diverse
groups affect the company’s value, defined here as the present value of all
expected future profits of the firm.

Figure 2.2: Determination of the value of the firm

28
 The Firm: Stakeholders,
2.4 ALTERNATIVE OBJECTIVES OF THE Objectives and Decision
FIRMS Issues

Economists have also examined other objectives of firms. We shall discuss

some of them here. According to Baumol, most managers will try to
maximize sales revenue. There are many reasons for this. For example, the
salary and other earnings of managers are more closely related to sales
revenue than to profits. Banks and financers look at sales revenue while
financing the corporation. The sales revenue trend is a readily available
indicator of performance of the firm. Growth in sales increases the
competitive strength of the firm. However, in the long run, sales
maximization and profit maximization may converge into one objective.

Another economist Robin Marris assumes that owners and managers have
different utility functions to maximize. The manager’s utility function (Um)
and Owner’ utility functions (Uo) are:

Um = f (Salary, job, power, prestige, status)

Uo = f (Output, capital, profit, share)

By maximizing the variables, managers maximize both their own utility

function and that of the owners. Most of the variables of both managers and
owners are correlated with a single variable, namely, the size of the firm.
Maximization of these variables depends on the growth rate of the firm.
Thus, Marris argues that managers will attempt to maximize growth rate of
firms. However, this objective does not completely discard the profit
maximization objective.

According to Oliver Williamson, managers seek to maximize their own

utility function subject to a minimum level of profit. The utility function
which managers seek to maximize include both quantifiable variables like
salary and slack earnings and non-quantifiable variables like power, status,
security of job, etc. The model developed by Cyert-March focuses on
satisficing behaviour of managers. The firm has to deal with an uncertain
business world and managers have to satisfy a variety of groups-staff,
shareholders, customers, suppliers, authorities, etc. All these groups have
often-conflicting interests in the firm. In order to reconcile between the
conflicting interests and goals, managers form an aspiration level of the firm
combining the following objectives – production, sales and market share,
inventory and profit. The aspiration levels are modified and revised on the
basis of achievements and changing business environment.

As is true with most economic models, the application will depend upon the
situation and one cannot say that a particular model is better than the other. In
general, one can assert that the profit maximising assumption seems to be a
reasonable approximation of the real world, although in certain cases there
might be a deviation from this objective.
29
Introduction to T
Managerial Economics
2.5 GOALS OF REAL WORLD FIRMS O

By now we know that firms that maximize profits are not just concerned
about short-run profits, but are more concerned with long-term profits. They
may not take full advantage of a potential monopolistic situation, for
example, many stores have liberal return policies; many firms spend millions
on improving their reputation and want to be known as ‘good’ citizens. The
decision maker’s income is often a cost of the firm. Most real-world
production takes place in large corporations with 8-9 levels of management,
thousands of stakeholders and boards of directors. Self-interested decision
makers have little incentive to hold down their pay. If their pay is not held
down, firm’s profit will be lower. Most firms manage to put some pressure on
managers to make at least a pre-designated level of profit.

In the modern corporation, the owners or stakeholders (i.e. the principals)

hire managers (i.e., agents) to conduct the day-to-day operations of the firm.
These managers are paid a salary to represent the interest of the owners,
ostensibly, to maximize the value of the firm. A board of directors is elected
by the owners to meet regularly with the managers to oversee their activity
and to try to ensure that the managers are, in fact, acting in the best interest of
the owners.

Because of the difficulty of monitoring the managers on a continual basis, it

is possible that goals other than profit-maximization may be pursued. In
addition to those mentioned earlier, the managers may seek to enhance their
positions by spending corporate funds on fancy offices, excessive and
expensive travel, club memberships, and so forth. In recent years, many
corporations have taken action to align the interests of owners with the
interests of the managers by tying a large share of managerial compensation
to the financial performance of the firm.

For example, the manager may be given a basic salary plus potentially large
bonuses for meeting such goals as attaining a specified return on capital,
growth in earnings, and/or increase in the price of the firm’s stock. With
regard to the latter, the use of stock options awarded to top managers is a
most effective way to ensure that managers act in the interest of the
shareholders. Typically, the arrangement provides that the manager is to
receive an option to buy a specified number of shares of common stock at the
current market price for a specified number of years. The only way the
executives can benefit from such an arrangement is if the price of stock rises
during the specified term. The option is exercised by buying the shares at the
specified price, and the gain equals the increase in share price multiplied by
the number of shares purchased. Sometimes the agreement specifies that the
stock must be held for several years following purchase. Essentially, this
option arrangement makes the manager a de facto owner, even if the option
has not been exercised. In almost every case of a report of unusually high
executive compensation, the largest part of that compensation is associated
with gains from stock options.

Emergence of oligopoly, a market structure characterized by the existence of

a few large firms, mergers and amalgamations have made the structure of
industries concentrated so that few large (dominant) firms account for a
30 major portion of an industry’s output. This shifts the pressure on each firm to
maximize profit independently and leads to joint profit maximizations The Firm: Stakeholders,
through cartels and collusions. Profit maximization may not be the only Objectives and Decision
Issues
inevitable objective.

India’s Global Companies and their Objectives: One of the most

significant business and economic trends of the late twentieth century is the
rise of ‘global’ or ‘stateless’ corporation. The trends toward global companies
are unmistakable and are accelerating. The sharpest weapon that a
corporation can develop to survive and thrive, in the globalised market place
is competitiveness. Its corner stone as articulated by strategy guru Michael
Porter is its ability to create more value on a sustainable basis, for the
customer than its rivals can.

Many Indian corporations such as an Indian multinational conglomerate

Pharmaceutical company among others are competing on the world stage.
Whatever product or service a company offers it must meet the customers
wants in the most satisfactory manner. This should be the aim of the
company. The competitiveness of Company in the global market place comes
from both quality and scale. The challenge is to remain at the top. That
challenge is linked with productivity. Pharmaceutical Company's greatest
strength lies in the fact that it is strongly backward integrated. It helps them
manage cost across the entire value chain making them extremely cost
competitive. Cost leadership is a function of scale and technology. By
upgrading technology, Pharmaceutical Company's could continue to be a cost
leader. A company has to continuously upgrade itself on several parameters:
production efficiency, product development, quality management and
marketing skills.

This competitiveness - defined by Michael Porter as the sustained ability to

generate more value for customers than the cost of creating that value. Many
new entrepreneurs and new industries are emerging who are able to operate
successfully in this changed environment

2.6 FIRM’S CONSTRAINTS

Decision-making by firms takes place under several restrictions or
constraints, such as:

Resource Constraints: Many inputs may be available in a limited or fixed

quantity e.g., skilled workers, imported raw material, etc.

Legal Constraints: Both individuals and firms have to obey the laws of the
State as well as local laws. Environmental laws, employment laws, disposal
of wastes are some examples.

Moral Constraints: These imply to actions that are not illegal but are
sufficiently consistent with generally accepted standards of behaviour.

Contractual Constraints: These bind the firm because of some prior

agreement such as a long-term lease on a building or a contract with a labour
union that represents the firm’s employees. 31
Introduction to Decision-making under these constraints with optimal results is a T
Managerial Economics fundamental part of managerial economics. O

2.7 BASIC FACTORS OF DECISION-MAKING:

THE INCREMENTAL CONCEPT
Incremental reasoning involves estimating the impact of decision alternatives.
The two basic concepts in the incremental analysis are:

Incremental Cost (IC)

Incremental Revenue (IR)

Incremental cost is defined as the change in total cost as a result of change in

the level of output, investment etc. Incremental revenue is defined as the
change in total revenue resulting from a change in the level of output, prices
etc. A manager always determines the worth of a decision on the basis of the
criterion that IR>IC.

A decision is profitable if

 it increases revenue more than it increases cost

 it reduces some costs more than it increases others
 it increases some resources more than it decreases others
 it decreases costs more than it decreases revenues.

To illustrate the above points, let us take a case where a firm gets an order
that can get it additional revenue of ` 2,000. The normal cost of production of
this order is–

Labour : ` 600
Materials : ` 800
Overheads : ` 720
Selling and administration expenses : ` 280
Full cost : ` 2,400

Comparing the additional revenue with the above cost suggests that the order
is unprofitable. But, if some existing facilities and underutilized capacity of
the firm were utilized, it would add much less to cost than ` 2,400. For
example, let us assume that the addition to cost due to this new order is, say,
the following:

Labour : ` 400
Materials : ` 800
Overheads : ` 200
Total incremental Cost : ` 1,400

In the above case the firm would earn a net profit of ` 2000 – ` 1400 = ` 600,
while at first it appeared that the firm would make a loss of ` 400 by
32 accepting the order.
The worth of such a decision can be judged on the basis of the following The Firm: Stakeholders,
theorem. Objectives and Decision
Issues

Theorem I: A course of action should be pursued upto the point where its
incremental benefits equal its increment costs.

According to the theorem, the firm represented in Table 2.1 will produce only
seven units of output as its Marginal Revenue (MR)= Marginal Cost (MC)1 at
that level of output. As can be calculated from the Table, the MC of 8th unit
is more than its MR. Hence the firm gets negative profit from 8th unit and
thus is advised not to produce it.

The acceptance or rejection of an order by a firm for its product depends on

whether the resultant costs are greater or less than the resultant revenue. If
these principles are not followed, the equilibrium position would be
disturbed. But the problem with the concept of marginalism is that the
independent variable may be subject to “bulk changes” instead of “unit
changes”. For example, a builder may not change one labourer at a time, but
many of them together. Similarly, the output may change because of a change
in process, pattern or a combination of factors, which may not always be
measured in unit terms. In such cases, the concept of marginalism is changed
to incrementalism. Or, in other words, incrementalism is more general,
whereas marginalism is more specific. All marginal concepts are incremental
concepts, but all incremental concepts need not be marginal concepts.

Table 2.1 : Profit Function of a Firm

Unit of Total Total Cost Total Profit Average Marginal

Output Revenue Profit Profit

1 2 3 4 5 6
1 20 15 5 5.0 -
2 40 29 11 5.5 6
3 60 42 18 6.0 7
4 80 52 28 7.0 10
5 100 65 35 7.0 7
6 120 81 39 6.5 4
7 140 101 39 5.6 0
8 160 125 35 4.4 -4

2.8 THE EQUI-MARGINAL PRINCIPLE

According to this principle, different courses of action should be pursued
upto the point where all the courses provide equal marginal benefit per unit of
cost. It states that a rational decision-maker would allocate or hire his
resources in such a way that the ratio of marginal returns and marginal costs
of various uses of a given resource or of various resources in a given use is
the same. For example, a consumer seeking maximum utility (satisfaction)
1
Marginal Revenue is the additional revenue from selling one more unit, while Marginal
Cost is the additional cost of producing one more unit. 33
Introduction to from his consumption basket, will allocate his consumption budget on goods T
Managerial Economics and services such that O

/ = / = ………= /
Where = marginal utility from good one,
= marginal cost of good one and so on,

Similarly, a producer seeking maximum profit would use the technique of

production (input-mix.) which would ensure

/ = / = ……… /

Where = Marginal revenue product of input one (e.g. Labour),

= Marginal cost of input one and so on.

It is easy to see that if the above equation was not satisfied, the decision
makers could add to his utility/profit by reshuffling his resources/input e.g. if
/ > / the consumer would add to his utility by buying more
of good one and less of good two. Table 2.2 summarizes this principle for
different sellers.

Example: A multi-commodity consumer wishes to purchase successive units

of A, B and C. Each unit costs the same and the consumer is determined to
have a combination including all the three items. His budget constraint is
such that he cannot buy more than six units in all. Again, he is subject to
diminishing marginal utility i.e. as he has more of an item, he wants to
consume less of it. Table 2.3 shows the optimization example:

Table 2.2: The Equi-Marginal Principle

Unit Equi-Marginal Principle

Multi-market seller = = = ……………
Multi-plant monopolist = = = ……………
Multi-factor employer = = = ……………
Multi-product firm = = = ……………
Multi-commodity consumer = = = ……………

MR=marginal revenue; MC=marginal cost; MP=marginal product;

Mπ=marginal profit; MU=marginal utilities.

Table 2.3 : Optimization Example

MARGINAL UTILITES
Units Item A Item B Item C
1 10 9 8
2 9 8 7
3 8 7 6
4 7 6 5
5 6 5 4
6 5 4 3
34
The utility maximizing consumer will end up with a purchase of 3A+2B+1C The Firm: Stakeholders,
because that combination satisfies equi-marginalism: Objectives and Decision
Issues

= = =8

In the real world, often the equi-marginalism concept has to be replaced by

equi-incrementalism. This is because, changes in the real world are discrete
or lumpy and therefore the concept of marginal change may not always
apply. Instead, changes will be incremental in nature, but the decision rule or
optimizing principle will remain the same

2.9 THE DISCOUNTING PRINCIPLE

Many transactions involve making or receiving cash payments at various
future dates. A person who takes a house loan trades a promise to make
monthly payments for say, fifteen or twenty years for a large amount of cash
now to pay for a home. This case and other similar cases relate to the time
value of money. The time value of money refers to the fact that a rupee to be
received in the future is not worth a rupee today. Therefore, it is necessary to
have techniques for measuring the value today (i.e., the present value) of
rupees to be received or paid at different points in the future. This section
outlines the approach to analyzing problems that involve payment and/or
receipt of money at one or more points in time.

One may ask how much money today would be equivalent to ` 100 a year
from now if the rate of interest is 5%. This involves determining the present
value of ` 100 to be received after one year. Applying the formula –

100
=
1.05

we obtain ` 95.24,

` 95.24 will accumulate to an amount exactly equal to ` 100 in one year at

the interest rate of 5 per cent. Looked at another way, you will be willing to
pay maximum of ` 95.24 for the benefit of receiving ` 100 one year from
now if the prevailing interest rate is 5 per cent.

The same analysis can be extended to any number of periods. A sum of ` 100
two years from now is worth:

100
=
1.05

= `90.70 today.

In general, the present value of a sum to be received at any future date can be
found by the following formula:

=
(1 + )
35
Introduction to PV = present value, Rn = amount to be received in future, i = rate of interest, T
Managerial Economics n = number of years lapsing between the receipt of R. O

If the receipts are made available over a number of years, the formula
becomes:

= + ++ + ….+
1+ (1 + ) (1 + ) (1 + )

=
(1 + )

In the above formula if = , = etc., it becomes an ‘annuity’. An

annuity has been defined as series of periodic equal payments. Although the
term is often thought of in terms of a retirement pension, there are many other
examples of annuities. The repayment schedule for a home loan is an annuity.
A father’s agreement to send his son ` 1000 each month while he is in
college is another example. Usually, the number of periods is specified, but
not always. Sometimes retirement benefits are paid monthly as long as a
person is alive. In other case, the annuity is paid forever and is called
‘perpetuity.’

It must be emphasized that the strict definition of an annuity implies equal

payments. A contract to make 20 annual payments, which increase each year
by, say, 10 per cent, would not be an annuity. As some financial
arrangements provide for payments with periodic increase, care must be
taken not to apply an annuity formula if the flow of payments is not a true
annuity.

The present value of an annuity can be thought of as the sum of the present
values of each of several amounts. Consider an annuity of three ` 100
payments at the end of each of the next three years at 10 percent interest. The
present value of each payment is

1
= 100
1.10
1
= 100
1.10
1
= 100
1.10

and the sum of these would be

1 1 1
= 100 + 100 + 100
1.10 (1.10) (1.10)

OR

1 1 1
= 100 + +
1.10 (1.10) (1.10)
36
The present value of this annuity is The Firm: Stakeholders,
Objectives and Decision
PV = 100 (0.9091 + 0.8264 + 0.7513) = 100 (2.4868) = 248.68 Issues
Although this approach works, it clearly would be cumbersome for annuities
of more than a few periods. For example, consider using this method to find
the present value of a monthly payment for forty years if the monthly interest
rate is 1 per cent. That would require evaluating the present value of each of
amounts of 480 months (40×12 = 480) In general, the formula for the present
value of an annuity of A rupees per period for n periods and a discount rate of is
1 1 1
= = + ⋯+
(1 + ) (1 + ) (1 + )

2.10 THE OPPORTUNITY COST PRINCIPLE

The opportunity cost of anything is the return that can be had from the next
best alternative use. A farmer who is producing wheat can also produce
potatoes with the same factors. Therefore, the opportunity cost of a quintal of
wheat is the amount of the output of potatoes given up. The opportunity costs
are the ‘costs of sacrificed alternatives.’
Whenever the manager takes a decision he chooses one course of action,
sacrificing the other alternative courses. We can therefore evaluate the one,
which is chosen in terms of the other (next best) alternative that is sacrificed.
A machine can produce either X or Y. The opportunity cost of producing a
given quantity of X is the quantity of Y which it would have produced.
The opportunity cost of holding `1000 as cash in hand for one year is the
10% rate of interest, which would have been earned had it been invested in
the form of fixed deposits in the bank.
 all decisions which involve choice must involve opportunity cost
calculation,
 the opportunity cost may be either real or monetary, either implicit or
explicit, either non-quantifiable or quantifiable.
Opportunity costs’ relevance is not limited to individual decisions.
Opportunity costs are also relevant to government’s decisions, which affect
everyone in society. A common example is the guns-versus-butter debate.
The resources that a society has are limited; therefore its decisions to use
those resources to have more guns (more weapons) means that it must have
less butter (fewer consumer goods). Thus when society decides to spend 100
crore on developing a defence system, the opportunity cost of that decision is
100 crores not spent on fighting drugs, helping the homeless, or paying off
some of the national debt.
For the country as a whole, the production possibility reflects opportunity
costs. Figure 2.1 shows the Production Possibility Curve (PPC) reflecting the
different combinations of goods, which an economy can produce, given its
state of technology and total resources. It illustrates the menu of choices open
to the economy. Let us take the example that the economy can produce only
two goods, butter and guns. The economy can produce only guns, only butter
or a combination of the two, illustrating the tradeoffs or choice inherent in
such a decision. The opportunity cost of choosing guns over butter increases
as the production of guns is increased. The reason is that some resources are
relatively better suited to producing guns. The quantity of butter, which has
to be sacrificed to produce an additional unit of guns, is called the 37
Introduction to opportunity cost of guns (in terms of butter). Due to the increasing T
Managerial Economics opportunity cost of guns, the PPC curve will be concave to the origin. O
Increasing opportunity cost of guns means that to produce each additional
unit of guns, more and more units of butter have to be sacrificed. The basis
for increasing opportunity costs is the following assumptions:
i) Some factors of production are more efficient in the production of
butter and some more efficient in production of guns. This property of
factors is called specificity. Thus specificity of factors of production
causes increasing opportunity costs.

Figure 2.1: Production Possibility Curve

Figure 2.2: Production Possibility Curve - Linear

38
ii) The production of the goods require more of one factor than the other. The Firm: Stakeholders,
For example, the production of guns may require more capital than Objectives and Decision
Issues
that of butter. Hence, as more and more of capital is used in the
manufacture of guns, the opportunity cost of guns is likely to increase.

Let us assume that an economy is at point A where it uses all its resources in
the production of butter. Starting from A, the production of 1 unit of guns
requires that AC units of butter be given up. The production of a second unit
of guns requires that additional CD units of butter be given up. A third
requires that DE be given up, and so on. Since DE>CD>AC, and so on, it
means that for every additional unit of guns more and more units of butter
will have to be sacrificed, or in other words, the opportunity cost keeps on
increasing.

The opportunity cost of the first few units of guns would initially be low and
those resources, which are more efficient in the production of guns move
from, butter production to gun production. As more and more units of guns
are produced, however, it becomes necessary to move into gun production,
even for those factors, which are more efficient in the production of butter.
As this happens, the opportunity cost of guns gets larger and larger. Thus,
due to increasing opportunity costs the PPC is concave.

If the PPC curve were to be a straight line, the opportunity cost of guns
would always be constant. This would mean equal (and not increasing
amounts) of butter would have to be forgone to produce an additional unit of
guns. The assumption of constant opportunity costs is very unrealistic. It
implies that all the factors of production are equally efficient either in the
production of butter or in the production of guns.

For many of the choice society make opportunity costs tend to increase as we
choose more and more of an item. Such a phenomenon about choice is so
common, in fact, that it has acquired a name: the principle of increasing
marginal opportunity cost. This principle states that in order to get more of
something, one must give up ever-increasing quantities of something else. In
other words, initially the opportunity costs of an activity are low, but they
increase the more we concentrate on that activity.

2.11 THE INVISIBLE HAND

Adam Smith, the father of modern economics believed that there existed an
“invisible hand” which ruled over the economic system. According to him
the economic system, left to itself, is self-regulating. The basic driving force
in such a system is trying to enhance its own economic well-being. But the
actions of each unit, acting according to its own self-interest, are also in the
interests of the economy as a whole.

Producers are led by the profit motive to produce those goods and services
which the consumers want. They try to do this at the minimum possible cost
in order to maximize their profits. Moreover, if there is competition among a
number of producers, they will each try to keep the price of their product low
in order to attract the consumers. The goods produced are made available in
the market by traders. They also act in their own self-interest. However, in a
self-regulating economy, there is rarely any shortage of goods and services. 39
Introduction to Decisions to save and invest are also taken by the individual economic units. T
Managerial Economics For example, households save some of their income and deposit part of it in O
the banks, or invest it in shares and debentures and so on. The producers
borrow from the banking system and also issue shares and debentures to
finance their investments. In turn, they reinvest a part of their profits.

All the economic functions have been carried out by individuals acting in
isolation. There is no government or centralized authority to determine who
should produce what and in what quantity, and where it should be made
available. Yet in a self-regulating economy there is seldom a shortage of
goods and services. Practically everything you want to buy is available in the
market. Thus according to Adam Smith, the economic system is guided by
the “invisible hand”. In a more technical way we can say that the basic
economic problems in a society are solved by the operation of market forces.

2.12 LET US SUM UP

There is a circular flow of economic activity between individuals and firms
as they are highly interdependent. The firms’ existence is based on manifold
reasons. Firms are classified into different categories. Different firms
belonging to the same industry, facing the same market environment, behave
differently. Thus, the necessity for theories of the firm. Profit is defined as
revenues minus costs. But the definition of cost is quite different for
economist than for the accountant. Short-term profit has been sidelined by
most firms as their objective for increasing the future long-term profit. Real
world firms often have a set of complicated goals. The basic factors of
decision making can be outlined by various principles.

2.13 TERMINAL QUESTIONS

1. Write notes in about 200 words on the following:

a) The incremental concept

b) Opportunity cost
c) Scope of managerial economics
d) The Invisible Hand

2. ‘Managerial Economics serves as a link between traditional

economics and decision sciences for business decision-making.’
Elucidate.

3. Calculate, using the best estimates you can make:

a) Your opportunity cost of attending college.

b) Your opportunity cost of taking this course.
c) Your opportunity cost of attending yesterday’s lecture of your
course.

4. The following is the hypothetical production possibility table of India:

40
 Resources Devoted to Output of Clothing Output of Food The Firm: Stakeholders,
Clothing Objectives and Decision
Issues
100% 20 0
80% 16 5
60% 12 9
40% 8 12
20% 4 14
0% 0 15

a) Draw India’s production possibility curve.

b) What is happening to marginal opportunity costs as output of
food increases?
c) If the country gets better at the production of food, what will
happen to the production possibility curve?
d) If the country gets equally better at producing food and
producing clothing, what will happen to the production
possibility curve?

5. Use the following interest rates for government bonds for the risk-free
discount rate and answer the following:

Time of Maturity (years) Interest Rate (%)

1 5.75
2 6.00
3 6.25
4 6.50
5 6.75

a) Calculate the PV of a ` 1 lakh payment to be received at the

end of one year, 2 years, 3 years, 4 years and 5 years.

b) What is the present value of a firm with a 5 years life span that
earns the following stream of expected profit at the year-end?

Years Expected Profit (in Crores)

1 10
2 20
3 50
4 25
5 50

6. Value maximization has become the major objective of a modern

firm. Comment.

FURTHER READINGS
Dean, J. (1951). Managerial Economics. PrenticeHall.
Mote, V.L., Paul, S., & Gupta, G.S. (2016). Mangerial Economics Concepts
and Cases, Tata McGraw-Hill, New Delhi.
Koutsoyiannis, A. (2018). Modern Microeconomics (2nd Ed.). Macmillan
Publishers India Pvt. Ltd. 41
Introduction to
Managerial Economics
UNIT 3 BASIC CONCEPTS & TECHNIQUES
Structure

3.0 Objectives
3.1 Introduction
3.2 Opportunity Set
3.3 Variables and Constants
3.4 Derivatives
3.5 Partial Derivatives
3.6 Optimization Concept
3.7 Regression Analysis
3.8 Specifying the Regression Equation
3.9 Estimating the Regression Equation
3.10 Decision Under Risk
3.11 Uncertainty Analysis and Decision Making
3.12 Role of Managerial Economist
3.13 Let Us Sum Up
3.14 Terminal Questions

3.0 OBJECTIVES
After studying this unit, you should be able to:
 identify a wide range of techniques used in managerial economics;
 apply the techniques to understand the meaning of the results; and
 identify the strengths and weaknesses of the different methods.

3.1 INTRODUCTION
The manager needs various techniques to assist and help him in making
decisions that will ultimately maximize the value of the firm. These
techniques and tools are quantitative in nature. The introduction of some
commonly used tools used in managerial decision making becomes
imperative.

In this unit we are going to discuss some basic techniques which would be
helpful in understanding the concept of managerial economics, in turn
helping us to apply these techniques as and when required.

3.2 OPPORTUNITY SET

A set is a collection of distinct or well defined objects like (5, 6, 7) or (a, b,
c). For example listing of all residents of Delhi or all animals in a zoo is
difficult. Thus a set is also formed by developing a criterion for membership.
For example the set of all positive numbers between 1 and 10 or set of all
points lying on the line x + y = 4.

In managerial economics the need is to define an opportunity set of a decision

maker, i.e., the set of alternative actions which are feasible. For example, the
42 opportunity set of a consumer is the set of all combinations of goods which
the consumer can buy with his given income. Given the consumer’s budget Basic Concepts &
and prices of all goods, the opportunity set is well defined, and we can find Techniques
out whether the consumers can buy that combination of goods. If a person
consumes only two goods (x, y), whose prices are Rs. 5 and Rs. 4 per unit,
and his income is Rs. 100, then the opportunity set is as is shown in Figure
3.1.

Figure 3.1: Opportunity Set

O
X

If the consumer spends all his income on X, he can buy 20 units of X with no
Y (B). or if he spends all on good Y, then he buys 25 units of Y and no X
(A). All other alternatives of spending Rs. 100 will lie on the line AB. Hence
the area OAB constitutes the consumer's opportunity set.

3.3 VARIABLES AND CONSTANTS

Variables are a measure which change and can take a set of possible values
within a given problem. A constant or parameter is a quantity which does not
change in a given problem. For example, consider Y=a+bX; here, a and b are
constants and X and Y are variables. X is the independent variable or
exogenous variable while Y is the dependent or endogenous variable. The
value of X will be given from outside the system, while values of Y will be
determined from within the system (by the equation). X can assume different
values and this will cause Y to assume different values also.

We can show the relationship between two variables Q and P by a function,

such that for every value of P there is only one value of Q. In this case of
function is Q = Q(P). These are the basic building blocks of economic
models. The function Q=Q(P) is a demand function and its graph which
shows price on one and quantity on the other axis will give a demand curve.
P, is the argument of the function or the independent variable and Q is the
dependent’ variable. It indicates the cause-effect relationship between
variables. (P is the cause variable, while Q is the effect variable).
43
Introduction to A function can be represented by means of a table or graph.
Managerial Economics
Figure 3.2: Linear Function

Figure 3.3: Quadratic Function

Q

Figure 3.4: Quadratic Function

Q

44
 Figure 3.5: Cubic Function Basic Concepts &
Techniques

Five key functions of economics are represented graphically:

1. Demand (Linear)

Figure 3.6

2. Total Revenue (Quadratic)

Figure 3.7

45
Introduction to 3. Production (Short run) (Cubic)
Managerial Economics
Figure 3.8

4. Cost (Short Run) (Quadratic)

Figure 3.9

5. Profit (Short run) (Quadratic)

Figure 3.10

46
 Basic Concepts &
3.4 DERIVATIVES Techniques

The “slope” in mathematical use is the concept of ‘marginalism’ in economic

use. Thus if Y=Y(x), dy/dx stands for change in Y as result of one unit
change in X, i.e. marginal y of x. This slope or marginal function has
enormous use in managerial economics. Thus,

= Marginal demand of price, when Q=Q(P)

= Marginal sales of advertisement, when S=S(A)

= Marginal revenue of output, when R=R(Q)

= Marginal cost of output, when C=C(Q)

In case of ‘averages’

When marginal concept is divided by corresponding average concept, we get

the measure of economic concept of elasticity.

∗ =

∗ =

∗ =

Thus, such elasticities measure the proportion of change, e.g., if the

percentage change in demand is greater than the percentage change in price,
then

∗ >1

47
Introduction to
Managerial Economics ∗ <1

∗ =1 .

Elasticity is discussed in detail in Block 2.

The standard rules of differentiation in calculus are given in Appendix.

3.5 PARTIAL DERIVATIVES

In managerial economics, usually a function of several independent variables
is encountered instead of a single variable case shown above. For example, a
consumer’s demand for a product depends on the price of the product, price
of other related goods, income, tastes, etc. When the price changes, the effect
on quantity demanded of the goods can be analyzed only when all other
variables are kept constant. The functional relationship that is obtained
between the quantity demanded of a product and its own price is called a
Partial Function (a function of one variable when all other variables are kept
constant). The derivatives of the partial functions are known as partial
derivatives of the original function and is shown as / or ( ) or f’(x).
The conventional symbol used in maths for the partial derivative is delta, .
Partial derivatives are functions of all variables entering into the original
function f(x).

Examples:

(i) If = ( ; )

Then =2

And = 2 =2

/ / /
(ii) If =√ = ( ) =

/
/ /
Then = = / =

/
/ /
And = = / =

48
(iii) If = 4x + 3xy + 5y Basic Concepts &
Techniques

Then =8 +3

Then = 3 + 10

Remember the derivatives of a constant is 0, i.e / of 5y is 0. Thus in

the above equation while calculating / we hold x constant and hence
/ of 4x is 0. This gives / to be 8x+3y; and / to be 3x+10y.

, , , , are called first order partial derivatives.

The second order partial derivatives indicate that the function has been
differentiated partially twice with respect to a given variable, all other
variables being held constant. These are shown (in case of function Z=f(x,y))
by or and . Thus shows the rate of change of first order partial
derivatives fx with respect to x and y held constant.

Similarly is the second order partial derivatives of the function with

respect to y with x held constant.

3.6 OPTIMISATION CONCEPT

Optimisation is the act of choosing the best alternative out of the available
ones. It describes how decisions or choices among alternatives are taken or
should be made. All such optimisation problems have 3 elements:

a) Decision Variables: These are variables whose optimal values have

to be determined. For example, a production manager wants to know
at what level to set output in order to achieve maximum profit or
maximum sales revenue. Here output is the decision or choice
variable. Similarly labour, machine, time and raw materials are choice
variables if a works manager wants to know what amount of these are
to be used so as to produce a given output level at minimum cost. The
quantity of any choice variable must be measurable (20kg, 5
labourers, 10 hours, etc.)
b) The Objective Function: It is a mathematical relationship between
the choice variables and some variables whose values are to be
maximized or minimized. For example, the objective function could
relate profit to level of output or cost to amount of labour, machine,
time, raw materials, etc. in the above example.
c) The Feasible Set: The available set of alternatives is called a feasible
set.

A solution to an optimization problem is that set of values of the choice

variables which is in the feasible set and which yields maximum or minimum
of the objective function over the feasible set.
49
Introduction to Unconstrained Optimization Technique
Managerial Economics
For unconstrained optimization problem involving single independent
variable, we need to satisfy some “conditions”. In economics, the necessary
(first order) condition is called the equilibrium condition and sufficient
(second order) condition is called the stability condition (continuation of state
of equilibrium). There may be equilibrium but it may not be stable. Thus first
order condition does not guarantee second order condition. This is
summarized in Table 3.1.

Table 3.1: Optimization Conditions

Order Conditions Optimization Unconstrained

First order Necessary Maximization Maximization

Conditions
=0 =0

Second order Sufficient y y

<0 >0
Conditions x x

Y=y(x)
(assumed)

Some economic uses f these conditions are discussed below. Given a firm’s
demand function, P=45 – 0.5Q and the average function, AC=Q -8Q + 57 +
2/Q, we have to find the level of output Q which
a) Maximizes total revenue and,
b) Maximizes profit.

Solution
a) Since demand function is P=45-0.5Q the total revenue function will be,
TR=PQ = (45-0.5Q) Q=45 – 0.5 Q
To maximize TR, we find the derivative and set it to 0 (the first order or
necessary condition)

Now, = 45 − 2 (0.5)
= 45 − = 0
∴ = 45

The second order condition (sufficient conditions) needs to be

negative.

Since = 45 −

∴ = −1
50
 which is negative. Hence total revenue is maximized when output is 45 Basic Concepts &
Techniques
units.
b) From profit function
= −
=( )×
= (Q − 8Q + 57 + 2/Q) Q = Q − 8Q − 57Q + 2
= (45 − 0.5 )
= 45 − 0.5Q
After substituting TR and TC, we get
= 45 − 0.5Q − Q + 8Q − 57Q − 2

∴ = 45 − − 3Q − 16Q − 57

= −3Q + 15Q − 12

Now set =0

= −3Q + 15Q − 12 = 0
dividing by -3
Q + 5Q + 4 = 0
or (Q-4) (Q-1)=0
 =4 1

Constrained Optimisation Technique

There are many situations where the objective function has to be maximized
or minimized subject to certain constraints present in the problem. Thus a
consumer may be maximizing utility subject to the income constraint.

The techniques used to analyze such problems are based on that used for
unconstrained problems. The constrained problem is converted into
unconstrained one with the help of Lagrange Multiplier Technique and then
the latter is solved. In this technique, the objective function and constraint is
combined in one expression (Lag range expression) such that the constrained
maximization or minimization problems are reduced to unconstrained ones.

For example,

Maximize = − + 8x + 20
Subject to ≤ 2
(function of single independent variable)

The objective function (function to be optimized) is =− + 8x +

20, plotted on graph: 51
Introduction to Figure 3.11: Objective Function
Managerial Economics

The objective function =− + 8x + 20 can be written as =

−( − 4) + 36

Now −( − 4) has an unconstrained maximum value of zero at = 4.

However, our objective functions is −( − 4) + 36, and hence will have an
unconstrained maximum of 36 (at x=4). This is so for the first derivative test.

The second derivative test gives -2 since = −2x +

8; = −2.

Thus both test give x=4 as the above of the variable. This is the value at
which the objective function attains unconstrained maximum. However, the
problem has a constraint x=2. Thus we have to consider the function only up
to value of x=2 (graph) starting from x = −2. The maximum value of the
function is then 32 which occurs when x=2. Thus the constrained maximum
of the function = −( − 4) + 36 with constraint x=2 would occur at x=2
and not x=4.

The Lagrange expression for constrained maximization is formed as follows

= −( − 4) + 36 with constraint x=2 and x-2=0.

Combining, we get the Lagrange expression = [−( − 4) + 36] +

(x − 2).

Adding objective function and product of  (Lagrange Multiplier) and the

constraint function x-2=0. Now L is a function of x and we find:

and set them to 0



= −2( − 4) +  = 0


= ( − 2) = 0
52 
The last equation gives x=2. Hence the constrained maximum occurs at x=2. Basic Concepts &
Techniques

In this problem =2(x-4) = 2(2-4) = -4.

When applying Lagrange technique to solve economic decision problem, λ

will have an economic significance. For example in consumer’s utility
maximizing problem (where quantities of commodities are choice problems),
λ will be the marginal utility of money income. In producer’s cost
minimization profit, λ will be the marginal cost of production. In complex
problems, as many λ’s are there many constraints have to be used.

The problem with two independent variables can also be solved with
Lagrangian technique. To find out whether the optimized value is maximum
or minimum however, requires second derivative test as well as use of some
more determinants not to be discussed here

Activity 1

1. Draw graph of the following functions:

i) = 10 − 0.4
ii) = 15 − 2 + 4P
iii) = 100 + 0.8

2. A firm’s fixed costs are `6000.00 regardless of output (they do not

change when output changes), variable cost is `5 per unit of output
variable cost is dependent on output). Total cost = fixed costs + variable
costs. The selling price of the goods is `100 per unit. Let Q be the output.
State the:

i) Firms fixed cost function

ii) Variable cost function
iii) Total cost function
iv) Total revenue function

3. Maximize = 10 − 2y
Subject to x+y=12

4. Maximize = 737 − 8Q + 14A + QA − 4a + 20Q

Subject to 2Q+A=2.

Answers:

3. X=7, y=5, =-50

4. Q=0.52, A=0.96, 1= -6.36

3.7 REGRESSION ANALYSIS

A manager must often determine the total cost of producing various levels of
output. The relation between total cost (C) and quantity (Q) is,
53
Introduction to C = a + bQ + cQ2 + dQ3
Managerial Economics
Where a, b, c and d are parameters of the equation. Parameters are
coefficients in an equation that determine the exact mathematical relation
among the variables in the equation. If the numerical values of parameters are
determined, the manager knows the quantitative relation between output and
total cost. If the value of parameters of cost equation are calculated to be
a=1262, b=1, c=–0.03 and d=0.005, the equation becomes,

C = 1262 + 1Q –0.03Q2 + 0.005Q3

This equation can be used to compute the total cost of producing various
levels of output. If, for example, the manager wishes to produce 30 units of
output, the total cost can be calculated as

C = 1262 + 30 –0.03(30)2 + 0.005(30)3 = Rs. 1400.

Thus, in order for the cost function to be useful for decision making, the
manager must know the numerical value of the parameters.

The values of the parameters are often obtained by using a technique called
regression analysis. It determines the mathematical relation between a
dependent variable and one or more explanatory variables.

 Dependent variable: The variable whose variation is to be explained.

 Explanatory variables: The variables that are thought to cause the
dependent variable to take on different values

In the simple regression model, the dependent variable Y is related to only

one explanatory variable X, and the relation between X and Y is linear

Y=a+bX

Figure 3.12: Relation between sales and advertising expenditure

Expenses on advertising per month (crores)

54
This is the equation for a straight line, with X plotted along the horizontal Basic Concepts &
Techniques
axis and Y along the vertical axis. The parameter a is called the intercept
parameter because it gives the value of Y at the point where the regression
line crosses the Y-axis (X is equal to zero at this point). The parameter b is
called the slope parameter because it gives the slope of the regression line.
The slope of a line measures the rate of change in Y as X changes (DY/DX);
it is therefore the change in Y per unit change in X.

Intercept parameter: The parameter that gives the value of Y at the point
where the regression line crosses the Y-axis.

Slope parameter: The slope of the regression line, b = ∆Y/∆X, or the change
in Y associated with a one-unit change in X.

Y and X are linearly related in a regression model. The effect of change in X

on the value of Y is constant. A one-unit change in X causes Y to change by
a constant b units.

The figure shows the true relation between sales and advertising
expenditures. If a firm chooses to spend nothing on A, its sales are expected
to be `100 crores per month. If the firm spends `30 crores on A then it can
expect sales of `250 crores (=100 + 5 × 30). ∆S/∆A = 5, i.e., for every 1 unit
increase on advertising, the firm can expect a 5 unit increase in sales.
Regression involves identifying and calculating specific relationships
between the independent variables and the dependent variable. It involves a
number of stages which are described in another section.

Activity 2

1. In the equation R=a+bW the slope parameter is …………………… and

the intercept parameter is ………………. in the equation R=a+bW.

2. In Figure 3.12, what will be the monthly sales of the firm, if the
advertising expenditure is increased from `30 crores to `40 crores per
month?

3.8 SPECIFYING THE REGRESSION EQUATION

The first thing that the organisation carrying out the regression analysis needs
to do is to determine the range of variables which may affect demand for the
product concerned. For example, the own price of a good might reasonably
be expected to be a determinant of demand for most products, as would any
advertising being done by the firm. The question of whether there are any
substitute or complementary goods which need to be taken into account could
then be raised. In the case of, an expensive consumer durable good, the cost
and availability of credit might be a consideration. Any special ‘other’ factors
affecting demand could then be identified and so on. This choice of variables
has to be made before it is possible to progress to the next stage. 55
Introduction to Data Collection
Managerial Economics
Once the relevant variables have been identified, quantitative data need to be
assembled for each of them. This will be easier for some of the variables than
for others. In dealing with an established product, for example, the firm might
reasonably be expected to have access to a range of information regarding the
variables which it controls such as own price and advertising. What may be
more difficult to obtain, however, is information about competitors’ products.
On this front, price data can be obtained through observing retail prices, as
this information by definition is in the public domain and cannot be hidden.
This requires continued market observation, perhaps over a long period of
time. Likewise, information about product design changes can be obtained by
buying the competitors’ product(s), but this may be expensive if there are
many on the market. Confidential, commercially sensitive information such
as actual advertising expenditure by competitors and their proposed new
products present much more difficult problems in terms of access and may
have to be left out of the process altogether. Data on levels of disposable
income, population variables, interest rates and credit availability are easier
to obtain, for example from government statistics, but other variables are
more problematic. How can things like expectations and tastes be measured
for instance? In these cases the available data, perhaps resulting from market
surveys, may be qualitative rather than quantitative. Some means of
conversion need to be found if they are to be included in the regression
analysis at all. These are the things which the decision maker needs to keep in
mind while collecting and selecting data on the relevant variables. Once the
first two steps have been completed, the next stage is to specify the likely
form of the regression equation. There are two main forms which are used in
practice -the linear demand function and the non-linear or power function.
Both treat the demand for the product as the dependent variable, while the
independent variables are those which have previously been identified as
having an effect on demand. If, for example, the firm had decided that the
only variables affecting demand for a particular product are its own price and
advertising levels then the linear demand function would be
written as:

Q = a + bP + cA

Alternatively, under these conditions the exponential (power) function would

be written as:

In each case, the ‘a’ term represents the intercept of the-line drawn from the
equation with the vertical axis. The ‘b’ and ‘c’ terms represent the regression
coefficients with respect to own price and advertising respectively. These
show the impact of each of these variables on product demand. Once they
have been estimated it is possible to predict the level of demand for any set of
values of the independent variables simply by substituting them into the
equation.
56
The exponential form of the equation has the advantage that it can be Basic Concepts &
Techniques
rewritten to give direct estimates of the respective elasticities of demand for
the independent variables. This is done by taking the log-linear form of the
equation which in this case would be:

log Q = log a + b log P + c log A

Where ‘b’ and ‘c’ are the own price and advertising elasticities of demand
respectively. This is a much easier approach than calculating elasticities
through use of the linear form which involves using the equation:

to calculate the elasticities in each case. In this case values of P and Q need to
be obtained from the data set. Usually average values are substituted in the
above equation to estimate elasticities. This idea will be explored in greater
detail in Block 2.

Which of the two forms of equation is chosen depends upon the expected
relationship between the variables being included. In practice, however, the
actual relationship between them may not be known in advance. In this case,
the decision maker may experiment with both forms of equation in order to
find the one which most closely fits the data.

Activity 3

1. What are the things which the decision maker needs to keep in mind
while collecting and selecting data on the relevant variables?

2. Show that estimated coefficients using a log-linear technique are

estimates of elasticity with respect to the relevant variable.

3.9 ESTIMATING THE REGRESSION

EQUATION
Consider a firm with a fixed capital stock that has been rented under a long-
term lease for ` 100 per production period. The other input in the firm’s
production process is labour, which can be increased or decreased quickly
depending on the firm’s needs. In this case, the cost of the capital input
(`100) is fixed and the cost of labour is variable. The manager of the firm
wants to know the relationship between output and cost, that is, the firm’s
total cost function. This would allow the manager to predict the cost of any
specified rate of output for the next production period.

Specifically, the manager is interested in estimating the coefficients ‘a’ and

‘b’ of the function
Y = a + bX
57
Introduction to
Managerial Economics where the dependent variable Y is total cost and the independent variable X is
total output. If this function is plotted on a graph, the parameter ‘a’ would be
the vertical intercept (i.e., the point where the function intersects the vertical
axis) and ‘b’ would be the slope of the function. Recall that the slope of a
total function is the marginal function. As Y = a + bX is the total cost
function, the slope, ‘b’, is marginal cost or the change in total cost per unit
change in output.

Assume that data on cost and output have been collected for each of seven
production periods and are reported in Table 3.2. Note that there is a cost of
Rs. 100 associated with an output rate of zero. This represents the fixed cost
of the capital input, which must be paid regardless of the rate of output.
These data are shown as points in Figure 3.1. They suggest a definite upward
trend, but they do not trace out a straight line. The problem is to determine
the line that best represents the overall relationship between Y and X. One
approach would simply be to “eyeball” a line through these data in a way that
the data points were about equally spaced on both sides of the line. The
coefficient ‘a’ would be found by extending that line to the vertical axis and
reading the Y-coordinate at that point. The slope, ‘b’, would be found by
taking any two points on the line, { , } and
{ , } and using the slope formula
−
=
−

Although this approach could be used, the method is quite imprecise and can
be employed only when there is just one independent variable. What if
production cost depends on both the rate of output and the size of the plant?
To plot the data for these three variables (total cost, output, and plant size)
would require a three dimensional diagram; it would be nearly impossible to
eyeball the relationship in this case. The addition of another independent
variable, say average skill levels of the employees, would place the data set in
the fourth dimension, where any graphic approach is hopeless.

Table 3.2: Hypothetical Data on Total Cost and Total Output

Production period (Year) Total Cost ( )` Total Output ( )

2015 100 0
2016 150 5
2017 160 8
2018 240 10
2019 280 15
2020 370 23
2021 410 25

There is a better way. Statisticians have demonstrated that the best estimate
of the coefficients of a linear function is to fit the line through the data points
58
so that the sum of squared vertical distances from each point to the line is Basic Concepts &
Techniques
minimized. This technique is called ordinary least-squares regression (OLS).
including excel. Based on the output and cost data in Table 3.1, the least-
squares regression equation will be shown to be

= 87.08 + 12.21X

This equation is plotted in Figure 3.13. Note that the data points fall about
equally on both sides of the line. Consider an output rate of 5. As shown in
Table 3.2, the actual cost associated with this output level is 150. The value
predicted by the regression equation, referred to as , is 148.13. That is, =
87.08 + 12.21(5) =148.13. The deviation of the actual Y value from the
predicted value (i.e., the vertical distance of the point from the line), − is
referred to as the residual or the prediction error.

Figure 3.13: Total Cost, Total Output and Estimated

Regression Equation

There are many values that might be selected as estimators of ‘a’ and ‘b’, but
only one of those sets, defines a line that minimizes the sum of squared
deviations [i.e., that minimizes ( − ) ]. The equations for computing
the least-squares estimators and are:

( − )
=
( − )

and

= − ̅

When and − ̅ are the means of the Y and X variables.

Using the basic cost of output data and the example, the necessary
calculations are shown in Table 3.3. Substituting the appropriate values into
the following equations, the estimates and are computed to be:

( − )( − )
= = 12.21
( − )

= − = 237.14 − 12.21(12.29) = 87.08 59

Introduction to Table 3.3: Summary calculation for computing the Estimates and
Managerial Economics
Cost ( ) Output ( ) − − ( −) ( −)( −)

100 0 137.14 12.29 151.04 1,685.45

150 5 87.14 7.29 53.14 635.25

160 8 77.14 4.29 18.40 330.93

240 10 002.86 2.29 5.24 6.55

230 15 7.14 2.71 7.34 19.35

370 23 132.86 10.71 114.70 1,422.93

410 25 172.86 12.71 161.54 2,197.05

= 237.14 = 12.29 ( − ) ( − )( − )

=511.40 =6,245.71

Thus the estimated equation for the total cost function is:

= 87.08 + 12.2

The estimate of the coefficient a is 87.08. This is the vertical intercept of the
regression line. In the context of this example, = 87.08 is an estimate of
fixed cost. Note that this estimate is subject to error because it is known that
the actual fixed cost is ` 100. The value of is an estimate of the change in
total cost for a one-unit change in output (i.e., marginal cost). The value of ,
` 12.21, means that, on an average, a one-unit change in output results in
` 12.21 change in total cost. Thus is an estimate of marginal cost.

Activity 4

1. Suppose, for example, that the estimation process had given the
following figures for the coefficients:

log QD = log 200 – 1.5 log P + 2.4 log A

where QD is quantity demanded

P is own price and
A is advertising expenditure

What can we deduce from the estimated equation?

3.10 DECISION UNDER RISK

The focus of this section is decision making under risk. The objective will be
to develop guidelines for making rational decisions given the decision makers
60
attitudes towards risk. Attitudes towards risk may be of three types: (a) A Basic Concepts &
Techniques
risk-seeker is one who prefers risk, given a choice between more or less risky
investments, with identical expected money returns; he will select the riskier
investment. (b) A risk averter is one who when faced with the same situation
will select the less risky investment. (c) A risk-neutral person is one who
faced with the same situation will be indifferent to the choice. For him any
investment is equally preferable to the other. It is difficult to slot people in
one of these categories. You would perhaps have observed both risk averse
and risk seeking behaviour in the real world.

The analysis of risk is based largely on the concepts of probability and

probability distribution that are commonly encountered in elementary
statistics. First the terms strategy, states of nature and outcomes need to be
defined. A strategy is one of the many alternative plans or courses of action
that could be implemented in order to achieve managerial goal. A manager
might be considering three strategies to increase profits - build a more
modern plant which may produce at low cost, implement a new marketing
programme to increase sales or change the design of product to decrease cost
and increase sales.

A state of nature is a condition that may exist in the future and that will have
a significant effect on the success of a strategy. For example, the manager
may not be aware of the economic conditions in the future. The possible
states of nature may be normal, recession or boom.

The outcome results in either gain or loss based on a particular combination

of strategy and state of nature. The decision maker has no control over the
states of nature that will prevail in future but the future states of nature will
certainly affect the outcome of any strategy that he or she may adopt. The
particular decision made will depend, therefore, on the decision maker’s
knowledge or estimation of how a particular future state of nature will affect
the outcome of each particular strategy.

Given a set of outcomes, , and the probability of each occurring, , three

statistics relating to probability distributions can be used.

 The expected value of mean is a measure of expected return. This is

represented by

= ( )

Where is the probability of is the outcome.

 The standard deviation is a measure of risk. This is represented by

= ( − )
61
Introduction to  The coefficient of variation is a measure of risk per unit of money of
Managerial Economics return.

These statistics have a direct application in measuring the expected return and
risk associated with any business decision for which a set of outcomes and
their probabilities have been determined. The expected value, standard
deviation, and the coefficient will be referred to as risk-return evaluation
statistics.

Having defined risk and reviewed some of the related terminology, the task
now is to develop quantitative measures of return and risk and to show how
they are applied in decision making. We know that individuals have different
preferences concerning risk taking. It is also important that such preferences
be identified and their effect on decisions evaluated. Rational decision
making requires that the expected return be determined and the risk be
measured, and that there be information about the manager’s preference for
risk. The expected value, the standard deviation, and the coefficient of
variation will be referred to as risk-return evaluation statistics.

Let us take an example where two investments, I and II, are being considered.
Both investments require an initial cash outlay of Rs.100 and have a life of
five years. The return on each depends on the rate of inflation over the five-
year period. Of course, the inflation rate is not known with certainty, but
suppose that the collective judgment of economists is that the probability of
no inflation is 0.20, the probability of moderate inflation is 0.50, and the
probability of rapid inflation is 0.30. The outcomes are defined as the present
value of net profits for the next five years. These outcomes for each state of
nature (i.e., rate of inflation) for each investment are shown in table 3.3.

Analysis of these investments can be made by calculating and comparing the

three evaluation statistics for each alternative. The expected value µ is an
estimate of the expected return for the investment. Because risk has been
defined in terms of the variability in outcomes, the standard deviation  is a
measure of risk associated with the investment. The larger the µ the greater is
the risk. Risk per rupee of expected return is measured by the coefficient of
variation ( ).

The evaluation statistics for each investment alternative are computed as

follows:

= ( ) = 0.2(100) + 0.5(200) + 0.3(400) = 240

= ( − ) = 0.2(100 − 240) + 0.5(200 − 240) + 0.3(400 − 240)

= 111.36
62
 = = 111.36/240 = 0.46 Basic Concepts &
Techniques
= 0.2(150) + 0.5(200) + 0.3(250) = 205
= 0.2(150 − 205) + 0.5(200 − 205) + 0.3(250 − 205) = 0.35
0.35
= = 0.17
205

The expected return for investment I of ` 240 is higher than for Investment II
`.205, but I is a riskier investment because = 111.36 is greater than =
0.35. Also, risk per rupee of expected returns for I ( = 0.46) is higher than’
for ( = 0.17). Which is the better investment? The choice is not clear. It
depends on the investor’s attitude about taking risks. A young entrepreneur
may well prefer I, whereas an older worker investing in a retirement account
where risk ought to be minimized might prefer II. Generally higher returns
are associated with higher risk.

Table 3.3: Probability Distribution for Two Investment Alternatives

State of Nature Probability (Pi ) Outcome(Xi )
Investment I
No inflation 0.20 100
Moderate inflation 0.50 200
Rapid inflation 0.30 400
Investment II
No inflation 0.20 150
Moderate inflation 0.50 200
Rapid inflation 0.30 250

Decision Tree

Some strategic decisions are based on a sequence of decisions, states of

nature and possibly even strategic decisions. Alternative strategies can be
evaluated then, by using a decision tree, which traces sequences of strategies
and states of nature to arrive at a set of outcomes. The probability of each
outcome is found by multiplying the probabilities on each branch leading to
that outcome.

A decision tree shows two or more branches at each point where a decision or
event (state of nature) leads to the various outcomes. The decision tree
approach can be directly applied to managerial decision-making. A firm
entering a new market may decide to build a small or large plant (managerial
decisions). This has no probabilities. But there may be stochastic elements
(an outcome determined by chance) associated with each decision e.g.,
reaction of a major competitor and the economic condition. The competitor
may react by starting a national, regional, or a new advertising program. The
probability of each occurrence will depend on the size of the plant.

The possible economic conditions and then probabilities may be recession,

normal or boom. Here also the probability will depend on the size of the
plant. The probability of each combination is found by multiplying the
probability along each of the branches leading to the outcome. 63
Introduction to Decision trees are particularly useful if sequential decision-making is
Managerial Economics involved. In a game of chess, white has the first move. White has several
options at this stage. To keep the problem tractable, let us assume that there
are four possible moves for white : (i) move the king’s pawn two squares; (ii)
move the queen’s pawn two squares; (iii) move the king’s knight to king
bishop three; and (iv) move the queen’s knight to queen bishop three. In
chess notation, the four moves are - (i) e4; (ii) d4; (iii) Nf 3; and (iv) Nc 3.
Once white has made the first move, Black has several different moves at his
disposal. To keep the problem tractable, let us follow the decision tree only
when white has moved e4. Even then, Black has several moves at his
disposal. Let us assume that he has only four options - (i) move the king’s
pawn two squares (e5), (ii) move the queen’s pawn two squares (d5); (iii)
move the queen’s bishop’s pawn two squares (c5); and (iv) move the king’s
pawn one square (e6). Once white has moved e4 on the first move and Black
has moved e5 on the first move, white has several moves at his disposal. One
of them is, move the king’s knight to bishop three (Nf3). And so the game
goes on.

Figure 3.17 : Decision Tree

Each vertex or node indicates a decision to be taken by one of the players, the
number within the rectangle indicating whose turn it is to move. There need
not actually be two players, one of the players can be regarded as nature or
chance. The main advantage of using a decision tree is that it helps one to
isolate each chain and follow it through to the very end.

3.11 UNCERTAINTY ANALYSIS AND DECISION

MAKING
Certainty appears to be a theoretical and impractical state, as here the investor
has perfect knowledge of the investment environment such that he is definite
about the size, regularity and periodicity of flow of returns. Such situations
may exist in the short-run (e.g. fixed deposit in a nationalised bank).
64 However, long-run or long-range investments are not predictable as they are
influenced by many kinds of changes taking place with time: political, Basic Concepts &
Techniques
economic, market and technology etc.

Risk is more common in the real world. A situation with more than one
possible outcome to a decision such that the probability of each of these
outcomes can be measured is a risk situation. For example, tossing of a coin
(i.e. 50-50) or investing in a stock. The greater the number and range of
outcomes, the greater is the risk associated with the decision or action.
Uncertainty is a situation where there is more than one possible outcome to a
decision but the probability of each specific outcome occurring is not known
or even meaningful. This may be due to insufficient information or instability
in the nature of variables. In extremes cases of uncertainty, the outcomes may
itself be not clear. Decision making under uncertainty is necessarily
subjective.

A Case Study of an American multinational chain of fast food

restaurants Burger’s which failed miserably.

This is a case study of a well-known American fast-food company which

offers affordable as well as high quality products. On an average 11 million
people visit the restaurants all over the world. Burger’s are one of the most
important products of fast food companies; The Fast food restaurant itself
gets one order of burger for every two orders.

When health trends set in, the fast food restaurant noticed that its burger
sales were dipping in USA. To attract health-conscious customers back it
decided to launch new type of healthier burgers which contained 40% less fat
and 30% less calories. They launched new type of burgers based on several
assumptions such as their customers wanted healthier options and were ready
to pay more for that. It was a very calculated risk taken by the company
based on the ongoing trend of health.

The product which was launched as a game changer in fast food market,
failed to attract the customers and it was discontinued within one year. It was
a major blow to the global fast food giant which was struggling to provide
fast food at its restaurants. There were several explanations given by experts
on why this product could not stabilize. But one thing is clear, what
customers say/want and do are completely different things altogether, so
there is always uncertainty in business environment which cannot be
eliminated.

This case clearly shows that even a well-conceived strategy is risky and can
lead to results estimated to have a small probability of occurrence. Indeed
the failure rate for new products in the United States is a stunning 80 percent.

3.12 ROLE OF MANAGERIAL ECONOMIST

In general, managerial economics can be used by the goal-oriented manager
in two ways. First, given an existing economic environment, the principles of
managerial economics provide a framework for evaluating whether resources 65
Introduction to are being allocated efficiently within a firm. For example, economics can
Managerial Economics help the manager if profit could be increased by reallocating labour from a
marketing activity to the production line. Second, these principles help the
manager to respond to various economic signals. For example, given an
increase in the price of output or the development of a new lower-cost
production technology, the appropriate managerial response would be to
increase output. Alternatively, an increase in the price of one input, say
labour, may be a signal to substitute other inputs, such as capital, for labour
in the production process.

Thus, the working knowledge of the principles of managerial economics can

increase the value of both the firm and the manager.

3.13 LET US SUM UP

Various quantitative tools are used by the manager to help him in making
decisions.

An opportunity set is a set of alternative actions which are feasible. Variables

are things which can change and can take a set of possible values within a
given problem. A function shows the relation between two variables. It can
take different forms-linear, quadratic, cubic. Partial derivatives are functions
of all variables entering into the original function f(x). Optimisation is the act
of choosing the best alternative out of all available ones. Regression analysis
helps to determine values of the parameters of a function - Economic analysis
of risk becomes crucial with reference to decisions.

3.14 TERMINAL QUESTIONS

1. Find the present value of Rs.10,000 due in one year if the discount rate is
5 per cent, 8 per cent, 10 per cent, 15 per cent, 20 per cent and 25 per
cent.

2. Apply the decision making model to your decision to attend college at

MBA level.

3. Discuss with examples how managerial economics is an integral part of

business activity.

4. Suppose a seller has two markets to serve. The demand schedules in them
are given in the table. Suppose that he has 1400 units to sell and
maximize profits thereby. What prices will he set in the two markets?
Apply equi-incrementalism principle to get your answer. Could you have
applied equi-marginalism.

66
 Market A Market B Basic Concepts &
Techniques
Price ` Quantity Price ` Quantity
50 400 60 600
40 600 50 800
30 900 40 1100
20 1000 34 1400

[Hint: First get total revenue in each market by multiplying price with
quantity.]
5. A firm is producing two products x and y, and has the following profit
function = 64 − 2 + 4 − 4 + 32 − 14 . Find the profit
Maximizing levels of output for each of the two products. (Ans.: x = 40, y
= 24, p = 1650).
6. Maximize = 10 −2
Subject to x + y = 12
7. What are central or basic problems of an economy?
8. Which problems of an economy constitute the subject matter of
microeconomics

Appendix

The standard rules of differentiation in calculus are given below:

A. Basic rule: =
=

B. Additional rule: = ( )+ ( )
= +

C. Product rule: = ( )∗ ( )
= ( ) = ( )

( )
D. Quotient rule: = ( )

( ) − ( )
=

E. Chain rule: = [ ( )]
= ∗

F. Logarithm rule: = log

1
=

G. Exponential rule: =
= 67
Introduction to
Managerial Economics
FURTHER READINGS
Koutsoyiannis, A. (2018). Modern Microeconomics (2nd Ed.). Macmillian
Publishers India

Baumol, W.J.(1979). Economic Theory and Operations Analysis (4th Ed.)

Prentice Hall India, New Delhi.

Lewis, W.C., Jain, S.K., & Peterson, H.C. (2005). Managerial Economics (4th
Ed.). Pearson.

68