FUNDAMENTAL PRINCIPLES OF MANAGERIAL ECONOMICS

Opportunity Cost

• Attributed to alternative uses of scarce resources

• Natural & Man-made resources are scarce in relation to demand to satisfy needs, wants; have alternative uses

• For Example, a firm has 100 million & it has three alternatives

– Expand size of firm

– Set up a new production unit

– To buy shares in another firm

• Expected Annual Returns from the alternatives 20 million, 18 million & 16 million

• Rationally alternative 1 is the best

• Hence the 2nd alternative has to be sacrificed

• The returns of 18 million is called annual opportunity cost of an annual income of 20 million

• Opportunity Cost of availing an opportunity is the expected income foregone from the 2nd best opportunity of using the resources

Incremental Cost

• Applied to business decisions involving a large increase in total cost & revenue

• Incremental costs are costs arising due to business decision

• For example, setting up a new plant by a firm.

• This decision increases the total cost from 100 to 115 million

• 3 major components

• Present explicit costs

• Opportunity costs

• Future costs

• Fixed & Variable Cost

• Depreciation & advertising cost

Time Perspective

• All decisions taken with a certain time perspective

• It refers to duration of time period from the relevant past to the foreseeable future while making a decision

• Relevant past – period of past experience & trends for long run decisions

• All decisions do not have same time perspective

• For example, decision to buy explosive materials for manufacturing characters – short run time perspective

• Investment in plants, building, machinery, land, etc. – long run repercussions

• Should assess & determine in advance & make decisions accordingly

• For example, setting up a new Management Institute, short time perspective would be unwise and for buying explosive materials a long run one would be unwise

Discounting

• A rupee tomorrow is worth less than a rupee today

• For example, suppose a person is offered to make a choice between a gift of Rs. 100 today or Rs. 100 next year

• The question is “How much money today is equal to Rs 100 one year hence?”

• The Rs. 100 would have to be discounted at 8 percent

• If a decision affects costs and revenues at future dates, it is necessary to discount the costs & revenues to present values before a valid comparison of alternatives is possible

Equi-Marginal Principle

• Originally associated with consumption theory

• It suggests that available resources should be so allocated b/w alternative options that the MPG from the various activities are equalized

• For example, a firm has a total capital of 100 million; option of spending on three projects

GENERAL OBJECTIVES OF A FIRM / BUSINESS

Prof.K.D.Basava, Pg.no - 29

The general objectives of a firm/ business may be

broadly divided into three groups viz.

• A) Economic Objectives

• B) Social Objectives

• C) Human Objectives

A) Economic Objectives

1. Earning of adequate profit

2. Production of Wealth

3. Creation of Market

4. Innovation

5. Sales Maximization

6. Financial Soundness

B) Social Objectives

1. Supply of Quality Goods and Services

2. Reasonable and Fair Price

3. Employment

4. Control of Environmental Pollution

C) Human Objectives

1. Welfare of Labourers

2. Satisfaction of Consumers

3. Satisfaction of Shareholders

4. Alternative objectives of Business firms

5. According to the traditional theory of the firm, the

6. firm is totally controlled by the entrepreneur /owner/

7. proprietor. Its main objective is to earn maximum

8. profit.

9. But in the modern days the ownership & control of

10. the firms is in the hands of managers, CEO’s etc.

11. Therefore it is unrealistic to accept that the sole

12. objective of a modern firms is profit maximization.

13. These people have alternative objectives, which can be

14. classified into three categories.

15. They are

1. Managerial Theories:-

A) Baumol’s Hypothesis of sales revenue maximization

B) Marris’s Hypothesis of maximization of Firm’s growth rate

C) Williamson’s Hypothesis of maximization of managerial utility function.

2. Behavioural Theories : -

A) Simon’s Satisficing Theory.

B) Cyert and March’s Behavioural theory.

3. Agency Theory

This theory explains the Agent-principal relationship in

private & public firms.

1. Managerial Theories:-

M.L.Jhingan & J.K.Stephen Pg.No.513

A) Baumol’s Hypothesis of sales revenue maximization :

Prof.Baumol in his article “On the theory of Oligopoly”

presented a managerial theory of the firm based on the

sales maximization.

Assumptions:

The theory is based on the following assumptions:

1. There is a single period time horizon of the firm.

2. The firm aims at maximizing its total sales revenue in the long run subject to a profit constraint.

3. The firm’s minimum profit constraint is set competitively in terms of the current market value of its shares.

4. The firm is Oligopolistic.

5. Explanation :

6. Explanation :

Explanation :

Baumol’s findings of oligopoly firms in America reveal that they follow the sales maximization objectives.Being a consultant to a number of firms, Baumol observes that when asked how their business went last year, the business managers often responded, “ our sales were up to three million dollars.” Thus, according to Baumol, revenue or sales maximization rather than profit maximization is consistent with the actualbehaviour of firms i.e., sales maximization is regarded as the short-run and long-run goal of the management.He gives a number of arguments in support of his theory

1. A firm attaches great importance to the magnitude of sales and is much concerned about declining sales.

2. If the sales of a firm are declining, banks, creditors and the capital market are not prepared to provide finance to it.

3. Its own distributors and dealers might stop taking interest in it.

4. Consumers might not buy its product because of its unpopularity.

5. Firm reduces its managerial and other staff with fall in sales.

6. If firm’s sales are large, there are economies of scale, the firm expands and earns large profits.

7. Salaries of workers and management also depend to a large extent on more sales and the firm gives them bonus and other facilities.

8. By sales maximization, Baumol means maximization

9. of total revenue. It does not imply the sale of large

10. quantities of output, but refers to the increase in

11. money sales(in rupee, dollar, etc.).

12. The minimum profits are determined on the basis of

13. firm’s need to maximize sales and also to sustain

14. growth of sales

15. This theory can be explained with the help of the

16. following diagram

B) Marris’s Hypothesis of maximization of Firm’s growth rate

D.N.Dwivedi pg.No.35

Robin Marris – USA, managers maximize firm’s

Balanced Growth rate subject to managerial and

financial constraints. He defines firm’s Balanced

Growth rate(G) as

G = GD = GC

GD = growth rate of demand for firms product

GC = growth rate of capital supply to the firm.

Growth rates are translated into two utility functions

a) Manager’s utility function – Um

b) Owner’s utility function - Uo

c) Um = f( salary, power, job, security, prestige, status)

d) Uo = f( output, capital, market-share, profit, public, esteem).

e) According to Marris, by maximizing these variables,

f) managers maximize both their own utility function

g) and that of the owners. Both the variables are

h) positively and strongly correlated with a single

i) variable i.e., size of the firm. Therefore managers

j) seek to maximize a steady growth rate.

k) This theory can be explained with the help of the

l) following diagram

C ) Williamson’s Hypothesis of maximization of managerial utility function

According to Williamson managers have discretion

to pursue objectives other than profit maximization.

The mangers seek to maximize their own utility

function subject to minimum level of profit.

Managers utility function(U) is expressed as

U = f( S, M, ID )

Where S = additional expenditure on staff

M = managerial emoluments

ID = discretionary investments

The utility functions which managers seek to

maximize include –

1) salary, prestige, power, status, job security

utility, professional excellency etc funds for

discretionary investment.

Behavioural Theories

1. Simon’s Satisficing Theory

M.L.Jhingan & J.K.Stephen Pg.No.-519

Satisfactory Level of profit :

According to him the firms main objective is not

maximizing profit, but satisfactory level of profits;

Holding certain share of market or a certain level of

sales.

The firm aspires to achieve certain minimum or

target level of profits. It is based on the level of

production, sales, prices etc.

In this context, the firm may face three alternative

situations:

a) The actual achievement is less than the aspiration level;

b) The actual achievement is greater than the aspiration level; and

c) The actual achievement equals the aspiration level

2.Behavioural Theory of Cyert and March :

M.L.Jhingan & J.K.Stephen Pg.No.-522

D N Dwivedi Pg.No.36

Theory of satisfying various interest groups - often

conflicting.

Managers have to satisfy a variety of groups of

people who may have conflicting goals.

The different who may have to satisfy by the managers

are :-

1. Managerial staff

2. Labour

3. Share holders

4. Customers

5. Input suppliers

6. Financiers

The “satisfying behaviour” implies satisfying various

interest groups by sacrificing firms interest or objectives.

All these groups have some kind of expectations higher

or low from the firms and the firm seeks to satisfy all of

them in one way or the other by sacrificing some of its

interests.

In order to satisfy these groups, the firm can have the

following goals

1. Production goal,

2. Sales & Marketing share goal,

3. Inventory goal, and

4. Profit goal.

The inspirational level of the individual or groups with in the firm determine these goals;change overtime as a result of organizational learning. There may be conflicts among these goals.The conflicting interests can be reconciled bythe distribution of “side payment” to membersof the coalition. Besides side payments, the conflicting goals of the organization are resolved by subjecting them to a constant review. This is because ‘ aspiration levels’ of coalition members change with experience.

In fact, the aspiration levels change with the process of satisficing. Each person in the organization has a satisficing level for each of his goals. If these levels are reached, they will not seek more.