Mea

MANAGERIAL ECONOMICS

and

FINANCIAL ACCOUNTING

M. Kasi Reddy

Associate Professor

School of Management Studies

Chaitanya Bharathi Institute of Technology

Hyderabad

S. Saraswathi

Senior Assistant Professor

School of Management Studies

Chaitanya Bharathi Institute of Technology

Hyderabad

New Delhi - 110001

2012

MANAGERIAL ECONOMICS AND FINANCIAL ACCOUNTING

M. Kasi Reddy and S. Saraswathi

2007 by PHI Learning Private Limited, New Delhi. All rights reserved. No part of this book maybe reproduced in any form, by mimeograph or any other means, without permission in

writing from the publisher.

ISBN-978-81-203-3321-5

The export rights of this book are vested solely with the publisher.

Second Printing

January, 2012

Published by Asoke K. Ghosh, PHI Learning Private Limited, Rimjhim House, 111, PatparganjIndustrial Estate, Delhi-110092 and Printed by Mudrak, 30-A, Patparganj, Delhi-110091.

Contents

Preface

xiii

1. MANAGERIAL ECONOMICS: THE BASICS ............................................... 137

Learning Objectives

1

Introduction to Economics

1

Scarcity and Efficiency

2

Three Problems of Economic Organization

3

Limited Means and Unlimited Ends

3

Choosing between Ends

3

Deriving Maximum Satisfaction

4

Income and Employment

4

Economic Development

4

Evolution of Economics

4

Classical Stage

5Neo-classical Stage

6

New Stage

7

Modern Stage

9

Nature and Scope of Managerial Economics

9

Nature of Managerial Economics

9

Scope of Managerial Economics

19

Relationship of Managerial Economics with Other Disciplines

21

Relationship with Microeconomics

22

Relationship with Macroeconomics

22

Relationship with Mathematics

23

Relationship with Management Theory and Accounting

23

iii

iv

CONTENTS

Relationship with Statistics

24

Relationship with Operations Research

24

Relationship with Econometrics

25

Relationship with Decision Theory

25

Basic Concepts of Managerial Economics

26

Opportunity Cost Principle

26

Incremental Principle

27

Principle of Time Perspective

27

Discounting Principle

28

Equimarginal Principle

28

Managerial EconomistRole and Responsibilities

29

Role of a Managerial Economist

29

Responsibilities of a Managerial Economist

30

Summary

31

Exercises

33

2. DEMAND ANALYSIS .................................................................................... 38155

Learning Objectives

38

Introduction

38

Consumer Behaviour

39

UtilityThe Basis of Consumer Demand

39

Measurement of Utility

39

Total Utility

40

Marginal Utility

40

Law of Diminishing Marginal Utility

40

Why does Marginal Utility Decrease?

41

Assumptions of the Law

41

Exceptions to the Law

42

Law of Equimarginal Utility

43

Indifference Curve Analysis

44

Indifference Schedule

44

Indifference Curve

45

Indifference Map

45

Meaning of Demand

47

Individual Demand

48

Market Demand

48

Demand Schedule, Demand Curve and Demand Function

49

Demand Schedule

49

Demand Curve

51

Demand Function

53

CONTENTS

v

Determinants of Demand

54

Price of Commodity

55

Other Factors

56

Types of Demand

61

Derived Demand and Autonomous Demand

62

Demand for Producers Goods and Demand for Consumers Goods

63

Demand for Durable Goods and Demand for Non-durable Goods

63

New and Replacement Demand

64

Industry Demand and Firm Demand

64

Short-run Demand and Long-run Demand

65

Total Market Demand and Market Segment Demand

65

Law of Demand

65

Assumptions of the Law of Demand

67

Chief Characteristics of the Law of Demand

67

Why does the Demand Curve Slope Downwards?

68

Exceptions to the Law of Demand

69

Change in Demand

71

Movement along Demand Curve (Extension and Contraction in Demand)

71

Shifts in Demand Curve (Increase and Decrease in Demand)

72

Shift or Change in Demand versus a Movement along a Demand Curve

(Change in Quantity Demanded)

75

Elasticity of Demand

75

Elastic Demand and Inelastic Demand

77

Types of Elasticity of Demand

77

Methods of Measurement of Elasticity of Demand

85

Arc Elasticity

89

Income Elasticity of Demand

89

Cross-elasticity of Demand

92

Promotional Elasticity of Demand

94

Demand Forecasting

94

Passive Forecasts and Active Forecasts

95

Making a Forecast

96

Criteria for the Choice of a Good Forecasting Method

97

Types of Forecasting Problems and Methods

97

Selecting a Forecasting Method

98

Methods of Demand Forecasting

98

Market Structures

112

Market Structure Concept

112

Determinants of Market Structure

113

Classification of Market Structures

113

vi

CONTENTS

Perfect and Imperfect Markets

114

Perfect Competition

114

Imperfect Competition

130

Monopoly

130

Duopoly and Oligopoly

140

Monopolistic Competition

143

Summary

144

Exercises

145

Problems

155

3. PRODUCTION AND COST ANALYSIS ................................................... 156213

Learning Objectives

156

Introduction

156

Meaning of Production

157

Factors of Production

158

Land

158

Labour

158

Capital

159

Organization or Enterprise

160

Production Function

160

Assumptions of Production Function

162

Laws of Production

163

Production Function with One Variable Input

163

Production Function with Two Variable Inputs

166

Marginal Rate of Technical Substitution (MRTS)

168

Production Function with All Variable Inputs

171

Optimal Combination of Inputs

171

Producers Equilibrium

172

Cobb-Douglas Production Function

173

Economies and Diseconomies of Scale

174

Economies of Scale

174

Diseconomies of Scale

177

Cost Analysis

178

Actual Cost and Opportunity Cost

179

Incremental Costs (Differential Costs) and Sunk Costs

180

Explicit (or paid-out) Costs and Implicit (or imputed) Costs

180

Past Costs and Future Costs

181

Short-run and Long-run Costs

181

Fixed and Variable Costs

182

Out-of-pocket and Book Costs

182

Replacement Costs and Historical Costs

183

CONTENTS

vii

Urgent and Postponable Costs

183

Sunk, Shutdown and Abandonment Costs

183

Escapable and Unavoidable Costs

183

Cost-Output Relationship

184

Cost-Output Relationship in the Short Run

184

Marginal Cost

187

Relationship between Average Cost and Marginal Cost

187

Short-run Output Cost Curves

188

Cost-Output Relationship in the Long-Run

189

Break-Even Analysis

191

Determination of Break-Even Point

192

BEP in Terms of Physical Units

192

Break-Even Point in Terms of Sales Value

193

Contribution

193

Break-Even Chart

194

Alternative Form of Break-Even Chart

195

Profit-Volume (P/V) Analysis and P/V Ratio

195

Margin of Safety

198

Angle of Incidence

199

Assumptions in Break-Even Analysis

199

Managerial Uses of Break-Even Analysis

200

Limitations of Break-even Analysis

200

Summary

209

Exercises

210

4. CAPITAL MANAGEMENT AND INVESTMENT DECISIONS ............ 214284

Learning Objectives

214

Introduction

214

Significance of Capital

215

Capital Management

215

Working Capital

215

Capital Budgeting

232

Capital Budgeting Decisions

232

Meaning of Capital Budgeting

233

Importance of Capital Budgeting

233

Kinds of Capital Investment Proposals

234

Cash Flows and Accounting Flows

234

Factors Affecting Capital Investment Decisions

235

Capital Budgeting Process

235

Problems and Difficulties in Capital Budgeting

237

Methods of Capital Budgeting

237

viii

CONTENTS

Sources of Capital

266

Shares

266

Debentures

268

Retained Earnings

270

Loans

270

Summary

271

Exercises

273

Problems

276

5. ACCOUNTANCY ......................................................................................... 285450

Learning Objectives

285

Introduction

285

Meaning of Accounting

286

Definition of Accounting

286

Need for Accounting

287

Accountancy, Accounting and Book-Keeping

288

Objectives of Accounting

288

Parties Interested in Accounting Information

289

Branches of Accounting

291

Financial Accounting

291

Cost Accounting

291

Management Accounting

292

Advantages of Accounting

292

Limitations of Financial Accounting

292

The Accounting Process

293

Systems of Accounting

294

Generally Accepted Accounting Principles (GAAP)

295

Accounting Concepts

296

Accounting Conventions

299

Double Entry System

300

Meaning of Account

301

Rules of Debit and Credit

302

Advantages of Double Entry System

305

Journal

305

Advantages of Journal

307

Limitations of Journal

307

Compound Journal Entry

309

Opening and Closing Entries

312

Some Important Points in Journalising

315

CONTENTS

ix

Ledger

316

Ledger Posting

317

Balancing of Account

319

Interpretation of Ledger Accounts

319

Advantages of Ledger

320

Differences between Journal and Ledger

320

Subsidiary Books

326

Advantages of Subsidiary Books

326

Cash Journal or Cash Book

327

Purchases Journal or Purchases Book

327

Invoice

327

Posting of Purchases Book

329

Ledger Accounts

330

Sales Journal or Sales Book

330

Recording in the Sales Book

331

Ledger Posting

331

Purchases Returns Book

333

Debit Note

333

Recordings in the Purchases Returns Book

334

Posting the Purchases Returns Book

334

Sales Returns Book

336

Credit Note

336

Recording in the Sales Returns Book

336

Posting in the Sales Returns Book

336

Bills of Exchange

338

Definition of a Bills of Exchange

338

Bills Receivable and Bills Payable Books

338

Journal Proper

341

Types of Transactions Recorded in Journal Proper

342

Trial Balance

342

Preparation of Trial Balance

343

Limitations of Trial Balance

344

Errors

345

Cash Book

346

Dual Role of the Cash Book

347

Kinds of Cash Books

347

Simple Cash Book or Single Column Cash Book

347

Cash Discount

349

Double Column Cash Book

349

x

CONTENTS

Three-Column Cash Book

354

Posting

355

Balancing

356

Cash Book with Discount and Bank Columns Only

358

Petty Cash Book

359

Imprest System

360

Bank Reconciliation Statement

362

Method of Recoding Banking Transactions

362

Causes of Difference between Cash Book and Pass Book

363

Transactions that Appear in the Cash Book but not in the Pass Book

363

Transactions Appear in the Pass Book with No Entry in the Cash Book

364

Preparation of Bank Reconciliation Statement

365

Bank Overdraft

368

Final Accounts

370

Capital and Revenue

370

Classification of Expenditure

371

Revenue Expenditure Becoming Capital Expenditure

372

Classification of Receipts

373

Trading and Profit and Loss Account

373

Trading Account

374

Manufacturing Account

380

Profit and Loss Account

383

Important Points for Preparing Profit and Loss Account

385

Closing Entries for Profit and Loss Account

386

Closing of Drawings Account

386

Balance Sheet

391

Financial Analysis

413

Ratio Analysis

414

Ratio

414

Summary

424

Exercises

426

Problems

435

6. TYPES OF BUSINESS ORGANISATION ................................................. 451505

Learning Objectives

451

Introduction

451

Factors Influencing the Choice of Suitable Form of Organisation

452

Types of Business Organisation

453

Private Undertakings

454

Public Undertakings

454

CONTENTS

xi

Joint Sector Undertakings

454

Public Enterprises

488

Summary

497

Exercises

499

Glossary ................................................................................................................ 507521

Bibliography ......................................................................................................... 523525

Model Questions ................................................................................................... 527554

Present Value Tables (A.1 to A.4) ....................................................................... 555570

Index ..................................................................................................................... 571578

Preface

A business manager relies on economic and financial analysis for taking various decisions.

Managerial economics and financial accounting have therefore always been integral parts of business

studies. Besides, courses on these subjects are of recent origin in undergraduate engineeringdisciplines. This book would therefore be useful not only to students pursuing engineering courses butalso to students of M.B.A, M.Com., and C.A. courses.

The book presents the concepts and methods of managerial economics and financial

accounting, which help managers to arrive at the most appropriate solutions to business

problems. The objective of this book is not only to present the theory of the firm but also to bridgethe gap between economic theory and practical application. The emphasis is on

presenting modern economic and financial analysis in a way that is intuitive, interesting, and usefulfor students who have had no prior exposure to these fields.

Managerial economics is concerned with resource allocation, strategic, and tactical

decisions that are made by analysts, managers, and consultants in the private, public, and not-for-profit sectors of the economy. Managerial economists seek to achieve the objectives of theorganization in the most efficient manner, while considering both explicit and implicit

constraints on achieving the objective(s). Financial accounting, on the other hand, provides thenecessary financial information to the management. The major emphasis in managerial

economics as well as financial accounting is on providing the analytical tools and managerial insightsthat are essential for the solution of those business problems that have significant consequences, bothfor the firm and the society at large.

The text is divided into six chapters. The first chapter provides an overview of managerialeconomics, and introduces the key economic concepts and tools. In this chapter, the decision-makingprocess and the relationship between managerial economics and other areas of business andeconomic analysis are discussed. The chapter also gives a brief description of the nature, scope, andsubject matter of economics. The second chapter deals with various aspects of

demand analysis, estimation and forecasting. It also presents the theory of price determination underdifferent kinds of market conditions characterized by perfect competition, monopoly, xiii

xiv

PREFACE

monopolistic competition, and oligopoly. The third chapter presents production and cost

analysis. It is concerned with the theory of production, the cost concepts, and the costoutputrelationship. It also presents a brief description and various applications of break-even analysiscarried out by business decision-makers. The fourth chapter focusses on capital management, whichcomprises working capital management and fixed capital management (that is,

investment analysis). The fifth chapter presents accounting concepts, conventions, journal, ledger,trial balance, final accounts, and the Bank Reconciliation Statement. It also dwells upon financialanalysis. The sixth chapter presents the various types of business organizations and their suitabilityfor different business activities.

We sincerely hope that the students, learned teachers, and other readers will find the book useful.Suggestions and criticism for enhancing the utility of the book are welcome. We are thankful toPrentice-Hall of India for their interest, encouragement and co-operation, and for making our effortsuccessful by publishing this book.

M. Kasi Reddy

S. Saraswathi

C H A P T E R

1

Managerial Economics: The Basics

LEARNING OBJECTIVES

After studying this chapter you will be able to understand:

what is Economics

how Economics contributes to business decisions

what is Managerial Economics

how Economics is different from Managerial Economics

the characteristics and significance of Managerial Economics

the nature and scope of Managerial Economics

the relationship of Managerial Economics to other disciplines

the basic concepts of Managerial Economics

the role and responsibilities of managerial economists

INTRODUCTION TO ECONOMICS

Economics is a social science. It studies economic phenomena and related behaviour of the people.Economic behaviour relates to an essentially conscious effort to derive maximum gains from the useof scarce resources and opportunities available. Economics is fundamentally the study of how people

allocate their limited resources, which have alternative uses, to produce and consume goods andservices to satisfy their endless wants or to maximize their gains.

Economics as a branch of knowledge is concerned with the study of the allocation of scarce resourcesamong competing ends. Problems of resource allocation are constantly faced by

individuals, enterprises and nations. Over the years, the science of economics has developed avariety of concepts and analytical tools to deal with such allocation problems.

Of all subjects, Economics is most closely associated with everyday life at all levels. As a voter, youwill make decisions on issueson government deficit, on taxes, on free trade, on 1

2


inflation and unemploymentthat cannot be understood until you have mastered the rudiments of thissubject. Choosing your lifes occupation is the most important economic decision you will make.Your future depends not only on your own abilities but also on how economic

forces beyond your control affect your wages. Also, Economics may help you to invest the nest eggyou save from your earnings. Of course, studying Economics cannot make you a genius.

But without Economics the dice of life are loaded against you.

Scarcity and Efficiency

Over the last 30 years the study of Economics has expanded to include a vast range of topics.

Consider the following list:

Economics studies how the prices of labour, capital and land are set in the economy,

and how these prices are used to allocate resources.

Economics explores the behaviour of the financial markets, and analyses how they

allocate capital to the rest of the economy.

Economics examines the distribution of income, and suggests ways in which the poor

can be helped without harming the performance of the economy.

Economics looks at the impact of government spending, taxes and budget deficits on

growth.

Economics studies swings in the unemployment and production cycle, and develops

government policies for improving economic growth.

Economics examines the patterns of trade among nations, and analyses the impact of

trade barriers.

Economics looks at growth in developing countries, and proposes ways to encourage

the efficient use of resources.

Thus, Economics is the study of how societies use scarce resources to produce valuable

commodities and distribute them among different people. Beyond this definition are two key ideas inEconomics: that goods are scarce and that society must use its resources efficiently.

Indeed, Economics is an important subject because of the fact of scarcity and the desire for efficiency.

If infinite quantities of every good could be produced or if human desires were fully

satisfied, what could be the consequences? People would not worry about stretching out their limitedincomes, because they could have everything they wanted; businesses would not need to fret over thecost of labour or healthcare; governments would not need to struggle over taxes or spendingbecause nobody would care. Moreover, since all of us could have as much as we pleased, no onewould be concerned about the distribution of incomes among different people or classes.

In such an Eden of affluence, there would be no economic goods, that is, goods that are

scarce or limited in supply. All goods would be free, like sand in the desert or seawater at the beach.Prices and markets would be irrelevant. Indeed, economics would no longer be a useful subject. Butno society has reached a utopia of limitless possibilities. Goods are limited, while wants seemlimitless.

MANAGERIAL ECONOMICS: THE BASICS

3

Given unlimited wants, it is important that an economy makes the best use of its limited

resources. That brings us to the critical notion of efficiency. Efficiency denotes the most effective useof a societys resources in satisfying peoples wants and needs. The essence of Economics is toacknowledge the reality of scarcity, and then figure out how to organize

society in a way which produces the most efficient use of resources. That is where Economics makesits unique contribution.

Three Problems of Economic Organization

Every society must answer three fundamental questions.

What commodities are to be produced and in what quantities? A society must determine

how much of each of the many possible goods and services it will make, and when they

will be produced.

How are goods produced? A society must determine who will do the production, with

what resources, and what production techniques they will use.

For whom are goods produced? Who gets to eat the fruit of economic activity? Or, to

put it formally, how is the national product divided among different households?

Societies answer these questions in different ways. Societies are organized through alternativeeconomic systems, and economics studiesthe various mechanisms that a society can use to

allocate its scarce resources. There are mainly two systems of organizing an economy. At oneextreme, the government makes most economic decisions. At the other extreme, decisions are made inmarkets where individuals or enterprises voluntarily agree to exchange goods and

services, usually through payment of money.

Limited Means and Unlimited Ends

For gaining a rough idea of Economics, let us consider the following example. Ashok has just joineda college. Suppose his father has agreed to give him Rs. 5,000 per month to enable him to carry on hisstudies in the college. With this limited money at his disposal, he has to meet all his needs. He has topay tuition fee, hostel fee, mess charges and other dues of the college; he may like to go to a cinemaor entertain friends at a restaurant, buy books, stationery, etc.

In fact, he wants to do or to buy many things. But the amount of money that he has is limited whereashis wants, as we have seen, are unlimited. Economics can help him in such a situation.

It will help him to derive maximum satisfaction from the limited amount of money he has.

Choosing between Ends

Economics tells us how a person can satisfy his unlimited wants with his limited means. In otherwords, how he can use the scarce goods that he has with him to his best advantage, or how toeconomise. A man has only a limited amount of cash, housing accommodation or other things. But hewants to put them to so many uses. With the limited amount of cash he has, he wants to buy so manythings, but he cannot buy them all. He must, therefore, choose what 4


to buy and what not to buy. This is Economics. Economics is a science of choice when faced withscarce means and unlimited ends.

Deriving Maximum Satisfaction

In short, Economics teaches us to make the best use of our limited resources. It tells us how the scarcemeans at our disposal can be put to several alternative uses so as to derive maximum benefit out ofthem. It thus means sophisticated application of prudence or wisdom in the use of things. We shoulduse them in such a manner as to get the greatest amount of satisfaction possible. Economics tells ushow to do it.

Income and Employment

A recent idea in Economics is that besides studying the behaviour of an individual consumer orproducer deriving maximum benefit from the use of his limited resources, Economics should also beconcerned with the levels of income and employment in a country as well as the causes of theirfluctuation. Its study is thus intended to promote economic stability.

Economic Development

In respect of under-developed economies, Economics concerns itself with the study of

economic growth. The theory of economic growth and the theory of income and employment

are two recent additions to the subject of Economics.

Thus, Economics is a very wide-ranging subject. It concerns itself not only with the

behaviour of individual consumers and individual producers or firms, but also with industries,national income and economic growth. The span of Economics is almost all-pervasive. The

concepts and theories of Economics help us to economise, i.e. to achieve maximum output by usingminimum input.

EVOLUTION OF ECONOMICS

The word Economics is derived from the Greek words oikos (for house or settlement) and nomos(for laws or norms), which together mean skilled in household management. Although the word isvery old, the discipline of Economics as we understand it today is a relatively recent development.Modern economic thought emerged in the 17th and 18th centuries as the western world began itstransformation from an agrarian society to an industrial one.

The term Economics was coined around 1870 and popularized by influential neoclassical economistssuch as Alfred Marshall (who gave us the definition of welfare), as a substitute for the earlier termpolitical economy, which referred to the economy of polities or competing states. The term political

economy was used through the 18th and 19th centuries, with Adam Smith, David Ricardo and KarlMarx as its main thinkers. Today it is frequently referred to as the Classical economic theory.

Economics is a relatively new science; it came into being a little over two centuries ago, as shown inTable 1.1. So far it has developed into four main stages: the Classical (Adam MANAGERIALECONOMICS: THE BASICS

5

Smith, 1776) Stage, the Neo-Classical (Alfred Marshall, 1885) Stage, the New (Lionel Robbins,1932) Stage and the Modern (J.M. Keynes, 1936) Stage. Corresponding to these stages, there are fourdistinct definitions of the subject. Initially it was considered a science of wealth, through its fourfoldactivity of consumption, production, distribution and exchange.

Marshall related the subject to economic welfare, which is most closely connected with theattainment and the use of material requisites of well-being. However, Lionel Robbins (1932) gave thesubject a positive scientific basis. The modern view of Economics is that it is much more than merelya theory of value or of resource allocation. The credit for bringing about a revolution in economicthinking goes to the late Lord J. M. Keynes.

Table 1.1 Evolution of Economics

Stage

Period

Economist

Focus

Classical

1776

Adam Smith

Science of wealth

Neo-classical

1885

Alfred Marshall

Science of welfare

New

1932

Lionel Robbins

Science of scarcity or choice

Modern

1936

J. M. Keynes

Administration of scarce resources and of the

determinants of employment and income

Samuelson

Theory of economic growth and of economic

stability

Classical Stage

The Classical Stage was represented by Adam Smith. Adam Smith is generally regarded as the fatherof Economics. The author of The Wealth of Nations which was published in 1776, Smith definedEconomics as an inquiry into the nature and causes of the wealth of nations, i.e. the science of wealth.Smith offered another definition: Economics is The Science relating to the laws of production,distribution and exchange. Wealth was defined as the specialization of labour which allowed anation to produce more with its limited supply of labour and resources.

Many other earlier economists also defined Economics in a similar way. John Stuart Mill

defined Economics as The practical science of production and distribution of wealth.

For Mill, wealth is defined as the stock of useful things. According to the French economist J. B. Say,Economics is a study of the laws which govern wealth. According to the American economist F. A.Walker, Economics is that body of knowledge which relates to wealth.

Definitions in terms of wealth emphasize production and consumption, and do not deal

with the economic activities of those not significantly involved in these two processes (for example,retired people or beggars). This approach was criticized for paying exclusive attention to wealth, asif wealth was everything, and little attention was paid to man for whom wealth is really meant; JohnRuskin referred to political economy as a bastard science, the science of getting riches. Manyeconomists condemned this worship of Mammon (the god of wealth).

They accused Economics of selfishness and meanness, and therefore called it a dismal science.

Therefore, this definition was ultimately rejected.

6


Neo-classical Stage

In the Neo-classical Stage, Economics was called the Science of Material Welfare. AlfredMarshall, a pioneer neo-classical economist, reoriented Economics towards the study of

humanity and provided economic science with a more comprehensive definition. Marshall, in hisfamous book Principles of Economics, published in 1890, defines Economics as follows: PoliticalEconomy or Economics is a study of mankind in the ordinary business of life. It examines that partof individual and social action which is most closely connected with the attainment and with theuse of material requisites of well-being.

The following are the implications of this definition:

1. Economics is a study of mankind.

2. Human life has several aspectssocial, religious, economic and political; but

Economics is concerned only with the economic aspect of life.

3. Promotion of welfare is the ultimate goal, but the term welfare is used in a narrow sense to meanmaterial welfare only.

From the definition, it is quite clear that although Economics still studies wealth, wealth is notconsidered primarily important. In other words, it has been given a secondary place, the first placebeing given to man. It is for mans sake and for the sake of his welfare that wealth is studied. ThusEconomics could no longer be considered a science of selfishness or a dismal

science. Rather, it acquired great social importance because the promotion of human welfare becameits chief aim.

Besides Marshall, there are other economists who have defined Economics in terms of

welfare. According to Pigou, The range of enquiry becomes restricted to that part of social welfarethat can be brought directly or indirectly into relation with the measuring rod of money. According toEdwin Cannan, The aim of political economy or Economics is the

explanation of the general causes on which the material welfare of human beings depends.

Material welfare is that form of welfare which can be measured in money terms, and is

very different from general welfare which, being abstract, is difficult to be measured in quantitativeunits. Because of its focus on welfare, this particular branch of Economics is also known as WelfareEconomics. Wealth is a very convenient measure of human motives which

underlie all economic activity. Wealth represents the material means of satisfying human wants andconsequently of promoting human welfare. So far as Economics studies wealth, it can be legitimatelyregarded as studying the causes of material welfare.

Marshall clearly shows that economic activity is different from other activity. For example, a personvisits a friend (social activity), a voter casts his vote in an election (political activity), and a persongoes to a temple, mosque or church (religious activity). A farmer going to the fields or a worker goingto a factory performs an economic activity. They work to earn money.

With that money they will buy things to satisfy their wants. In other words, Economics deals withwants, efforts and satisfaction.

In the words of Marshall, man earns money to get material welfare. Marshall gives

importance to welfare and man. This definition came to be called the Welfare definition.


7

The definition given by Marshall remained current for a long time, but early in the 1930s, adistinguished economist named Lionel Robbins challenged this definition. The main points of hiscriticism of Marshalls definition are given as follows:

1. It is a classification rather than a definition. It classifies economic phenomena into material andnon-material types.

2. It confines itself to material welfare and thus unnecessarily narrows down the field

of study of Economics by ignoring the non-material aspects thereof.

3. This definition ignores non-material services like those of teachers, doctors, etc.

which also make an important contribution to economic welfare.

4. The distinction made in this definition between ordinary business of life and

extraordinary life is not clear.

5. According to this definition, Economics deals with persons living only in society. It

ignores others who also may have an economic problem.

6. Robbins main quarrel with the Marshallian definition is that the definition points

only to the material aspect, whereas actually Economics deals with both material

goods and non-material services. Hence, although the contents are correct, the label

is wrong.

New Stage

In the New Stage, Economics was described as the Science of Scarcity or Science of Choice.

Most contemporary definitions of Economics involve the notions of choice and scarcity.

Perhaps the earliest of these is by Lionel Robbins. A significant contribution was made by Robbins atthe London School of Economics on The Basis of Scarcity. He constructed a new definition ofEconomics in 1932 in his book entitled The Nature and Significance of Economics Science. Hedefined Economics as follows:

Economics is a science which studies human behaviuor as a relationship between ends and scarcemeans which have alternative uses.

In this way, Robbins has at once relieved Economics of both wealth and welfare considerations.

It is now considered a science purely of human behaviour in specific situations. Such an

economic situation is one which is marked, on the one hand, by multiple ends (wants and theirsatisfaction) and, on the other, by scarce or limited resources (money, land, water, energy, capital,etc.). This necessarily compels individuals to economize and optimize; for instance, one attempts tomaximize ones satisfaction, profits, wages, salaries, etc. and at the same time minimize the use ofones resources (expenditure, cost of production and effort). This is likely to ensure the best resultsfor all economic activities.

Yet Economics is neither the science of ends as such nor of scarcity. Resources, though scarce, arecapable of alternative uses. Land can be used for cultivation, construction, or commercial purposes.Labour can also be employed in various waysin factories, in

construction, in agriculture, etc. Capital can be used for the purchase of factory equipment, for rawmaterials, or for investing in shares and bonds, etc. Again, from among a variety of options likepurchasing a car, purchasing a house, or travelling abroad, the one which is urgent and 8


the most satisfying can be chosen. Hence, under Economics, one studies the most useful way in whichan individual or the society as a whole allocates its scarce resources.

Virtually all textbooks have definitions that are derived from this definition. Though the exact

wording differs from author to author, the standard definition is something like this: Economics is thesocial science which examines how people choose to use limited or scarce resources in attemptingto satisfy their unlimited wants.

Robbins is not without his critics. His definition has been criticised on several grounds: 1. It ignoresnormative or ethical aspects of economic phenomena. It has been pointed

out that Robbins definition, though admittedly more scientific, is colourless,

impersonal and neutral as regards ends. If Economics is to serve as an engine of social

betterment, it cannot altogether do away with normative or ethical significance. The

function of economists is not only to explain and explore but also to advocate and

condemn.

2. Robbins, it is said, has reduced Economics to mere valuation theory. But actually

Economics is much more than a study of value or resource allocation. In Economics,

we do not merely study how resources are allocated and how prices are determined.

Robbins definition merely assigns to Economics an allocative role.

3. Robbins definition does not cover Keynesian Economics. As such, it does not tell

us how the level of income and employment in a country is determined. In other

words, it does not explain fluctuations in the levels of income and employment in an

economy. This is a very serious omission, because today macro-economics forms a

very important part of the study of Economics.

4. The theory of economic growth or development has recently become a very important

branch of Economics. But Robbins definition does not cover it. The theory of

economic growth explains how an economy grows and the factors which bring about

an increase in national income and productive capacity of the economy. But Robbins

takes the resources as given and discusses only their allocation.

5. Robbins definition does not explain the problem of unemployment. For some

countries, this is an urgent problem. There is abundance of manpower rather than

scarcity of it, whereas Economics, according to Robbins, studies the problem of

scarcity.

6. Robbins definition lacks a human touch. It is very well to emphasize that

Economics is something more than a science, a science shot through with the infinite

variety of human life, calling not only for systematic thinking but for human

sympathy, imagination and in an unusual degree for the saving grace of

commonsense. But apparently, none of these is visible in his definition.

7. There is no doubt that Robbins has made Economics more abstract and complex and

hence difficult and unfruitful. This takes away its utility for the common man. Utility

of Economics lies, in a large measure, in its being a concrete and realistic field of

study.

Thus, we see that Robbins idea of Economics is not the last word on the subject. In order to have aclear idea about the nature of Economics, we must take note of some recent

developments in economic theory.


9

Modern Stage

During the last forty years or so, economic thinking has moved much further from Robbins

view. According to Robbins, Economics is concerned with the best possible use of limited

resources. But it is now supposed that Economics is much more than merely a theory of value or ofresource allocation. The credit for bringing about a revolution in economic thinking goes to the lateLord J. M. Keynes. In terms of the Keynesian point of view, Economics can be

defined as The study of the administration of scarce resources and of the determinants ofemployment and income. In other words, it studies the causes of economic fluctuations to see howeconomic stability could be promoted. Thus, besides studying the theory of value or of resourceallocation, Economics studies how the levels of income and employment in an

economy are determined.

In Benhams words, Economics is a study of the factors affecting the size, distribution

and stability of a countrys national income.

More recently, the theory of economic growth has come to occupy an important place in

the study of Economics with reference to under-developed economies. It studies how the

national income grows over the years. An economy like that of India, which is at the mercy ofmonsoons, needs economic stability besides economic growth. Thus, a study of economic

growth and economic stability forms an integral and important part of the study of Economics.

A good and adequate definition of Economics must cover them.

In short, Economics may be defined as a social science concerned with the proper use and

allocation of resources for the achievement and maintenance of growth with stability or as a socialscience concerned chiefly with the way the society chooses to employ its limited

resources, which have alternative uses, to produce goods and services for present and futureconsumption. However, beyond this there are a range of definitions, past and present, which havebeen applied first to the term political economy and then to the modern term Economics.

John Maynard Keynes once remarked that Economics is the science of thinking. Broadly

speaking, Economics has moved from the study of wealth to the study of welfare and today

to the study of trade-offs.

NATURE AND SCOPE OF MANAGERIAL ECONOMICS

Managerial Economics is a specialized discipline of management studies which deals with theapplication of economic theory and techniques to business management. Managerial Economics is theintegration of economic theory and business practices for the purpose of facilitating decision-makingand forward planning by the management. Managerial Economics also draws

together and relates ideas from various functional areas of management like production,

finance, marketing and accounting. A managerial economist has to integrate concepts and

methods from all these disciplines and functional areas, in order to understand and analyse practicalmanagerial problems.

Nature of Managerial Economics

Managerial Economics is concerned with the economic problems that the management team of

every business needs to solve. A study on the nature of Managerial Economics is relevant and 10


helpful for managerial decision-making. The nature of Managerial Economics is studied as

follows:

Microeconomics and Macroeconomics

In the 1930s, Ragnar Frisch classified Economics into two branches, viz., Microeconomics andMacroeconomics. These terms are derived from the Greek words micros and macros, which meansmall and large respectively. An economic system may be looked at as a whole or

in terms of its innumerable decision-making units such as consuming units (e.g. individual consumersand households), producing units (e.g. farms, manufacturing and mining concerns), individual factorsof production (e.g. labourers, landowners, business owners and

entrepreneurs), and individual industries (e.g. cotton textile, iron and steel, toy-making). When weanalyze the problems of the economy as a whole, we carry out a macroeconomic study. On the otherhand, an analysis of the behaviour of any particular decision-making unit, such as a firm, an industryor a consumer, constitutes Microeconomics.

Microeconomics is also called price theory and Macroeconomics is also called income theory.Price theory explains the composition or allocation of total production, whereas income theoryexplains the level of total production. These terms are explained below in some detail.

Microeconomics.

The term micro means a millionth part. In Microeconomics, a small

part or component of the whole economy is analysed. For example, we may study either an

individual consumers behaviour, or that of an individual firm, or what happens in any

particular industry. If the issue is analysis of price, in Microeconomics we study the price of aparticular product or of a particular factor of production, not the general price level in the country.Similarly, if it is a demand that we are analysing, in Microeconomics it is the demand of an individualor that of an industry that is studied, and not the aggregate demand of the entire community. Likewise,the income of an individual or an industry, and not the national income of a country, comes within thepurview of Microeconomics. In respect of employment, it is the employment situation in a firm or inan industry that is considered in Microeconomics and not the aggregate employment in the wholeeconomy.

An important feature of the micro approach is that while conducting economic analysis on

a micro basis, generally an assumption of full employment in the economy as a whole is made.

By that assumption, the economic problem is mainly of resource allocation or of price. AlfredMarshalls Principles of Economics (1890) is the first book on Microeconomics. Till recently,Economics concerned itself mainly with the theory of value and distribution, and ignored the study ofthe economic system as a whole.

Macroeconomics or Theory of Income and Employment.

In recent years, strong attention

has been given to the analysis of the economic system as a whole. The credit goes to the late Lord J.M. Keynes. His The General Theory of Employment, Interest and Money (1936) is the first book onMacroeconomics. Of course, the term Macroeconomics was first coined by Ragnar Frisch, the firstNobel Laureate economist, in 1933. In Macroeconomics we study the

aggregates and averages of the entire economy, such as national income, aggregate output, totalemployment, total investment, savings and consumption, aggregate demand, aggregate supply,MANAGERIAL ECONOMICS: THE BASICS

11

general level of prices, etc. In other words, in Macroeconomics, we study how these aggregates andaverages of the economy as a whole are determined and what causes fluctuations in them.

From theoretical reasoning and on the basis of empirical knowledge, we now know that the

old assumption of full employment is not valid. Therefore, it is very vital that we should investigatehow these aggregates of the economy are determined, and provided their

determinants are known, how to ensure the maximum level of income and employment in a

country.

Macroeconomics also deals with how an economy grows. It can be said, therefore, that

Macroeconomics examines the forest rather than the individual trees. It analyses the chiefdeterminants of economic development, and various stages and processes of economic growth.

Economic growth is a long-run problem and as such it is a post-Keynesian development, as

Keynes was pre-occupied with the short-run problem of economic fluctuations. The theory ofeconomic growth is in a greatly developed state these days. A general growth theory applies to bothdeveloped and underdeveloped economies. But special growth theories have been

propounded for accelerating the growth of underdeveloped economies.

Integration of Microeconomics and Macroeconomics.

It may be emphasised that neither of

the two approaches outlined above can alone adequately help us in analyzing the functioning of theeconomic system. What is true of the parts may not be true of the whole and what is true of the wholemay not apply to the parts. Therefore, it is very essential to integrate the two approaches, if we wishto get correct solutions to our macroeconomic problems. Take for example a period of prosperity inan economy. Even in such boom conditions, it is not

uncommon to come across examples of individual industries which may be languishing.

Likewise, in a period of deep depression, there may yet be some individual industries which enjoygreat prosperity. Now, to apply the macro approach to such individual industries would obviously bewrong; and it would be equally wrong to apply the microanalysis of these

industries to the economic system as a whole.

What is needed is a proper integration of the macro and micro approaches to such

problems. In fact, there are few macro problems which have no microelements involved and

few micro problems that are without macroaspects. It is therefore only proper to marry the twoapproaches both in analyzing the economic problems and in prescribing policy measures for tacklingthem. Ignoring one and exclusively concentrating attention on the other may often lead, not only toinadequate or wrong explanations, but also to inappropriate or even disastrous remedial measures.

Thus, according to the views of economists today, the subject matter of Economics includes pricetheory (or Microeconomics), income and employment theory (Macroeconomics) and

growth theory. Hence, broadly speaking, Economics may be described as a study of the

economic system under which men work and live. It deals with decisions regarding the

commodities to be produced and the services to be rendered in the economy, the methods to producethem most economically and distribute them properly, and also the means to provide for the growth ofthe economy. There are six distinct aspects of the two approaches that are shown in Table 1.2.

12


Table 1.2 Microeconomics and Macroeconomics

Aspects

Microeconomics

Macroeconomics

Units of the study

Individual consumers, producers,

Aggregate units such as state,

workers, traders, etc.

national or international economy.

Activities

Optimization and maximization of

Long-term growth; maintenance of

personal gains and profits.

high levels of production and

employment.

Origin

Micro activities that emerge on the

Problems of long-term growth that

demand side of the consumers

depend upon the supply of

choices.

productive resources.

Conditions

This approach is functional under static This approach is functional under

conditions and small time intervals.

dynamic conditions and complex

long-run changes.

Methods

It is concerned with small adjustments It deals with complex, dynamic

for which the application of a marginal changes inviting the use of

method is suitable.

advanced mathematical techniques.

Levels

Micro adjustments in resource

Attempts are made to find suitable

allocation are made in response to

conditions for long-term expansion

changes in relative prices of goods

in output as a whole, assuming

and services. The aggregate level of

relative prices as constant (or

income or total economic activities is significant).

considered to be constant.

This distinction between Micro- and Macroeconomics as presented above is only a matter oftheoretical convenience. The two approaches are complementary and not competitive; one

cannot consider these to be watertight compartments. Moreover, the distinction is to be

understood as relative in nature. The problems of a city municipal corporation are macro in nature ascompared to those of individual citizens, but a city unit is micro as compared to the state, and the stateunit is micro as compared to the nation. Further, the national unit can be considered micro in thecontext of the global economy. Again, all economic problems and

activities, whether micro or macro, are ultimately connected with the issues of choice andoptimization. They emerge out of and are concerned with human behaviour.

Decision-making

We have already learnt that Economics is concerned with the study of the allocation of scarceresources among competing ends. Resource allocation problems are constantly faced by

individuals, enterprises and nations. Over the years, the science of Economics has developed avariety of concepts and analytical tools to deal with such allocation problems.

The main function of a management executive in any business organization is taking

decisions regarding day-to-day business activities and establishing plans for the future based on pastdata. Some examples of the types of managerial problems that managers in different

organizational settings face every day are: what product to produce, what price to charge, where andhow to get financing, where to locate, how to advertise, what method of production to use,MANAGERIAL ECONOMICS: THE BASICS

13

whether or not to invest in new equipment, etc. In all cases the managers are faced with

alternative choices.

Decision-making thus means the process of selecting one action from two or more

alternative courses of action. Managerial decisions involve various steps. Decisions have far-reaching effects on the firm and are often not easy to make. In these circumstances, it is recommendedthat systematic efforts be made to arrive at the right decision as shown in

Fig. 1.1. The question of selection or choice arises because resources such as capital, labour, landand management are limited and can be employed in alternative ways. Once the decision is made toachieve a particular goal, plans regarding production, pricing, capital, raw materials, labour, etc. areprepared. Thus, planning goes hand in hand with decision-making.

Step 1: Establish or identify objectives

Step 2: Define problem

Step 3: Identify possible solutions

Step 4: Evaluate alternative solutions

Step 5: Select the best possible solution

Step 6: Implement the decision

Step 7: Evaluate and control

Fig. 1.1 Decision process.

Since decisions depend on the objectives of a firm, it is important to be clear about them from theoutset. If a doctor is unable to diagnose the disease, his prescriptions may not cure the patient. A

question of decision will arise only when there are alternatives; if there are no alternatives there is nodecision problem. However, in todays complex world the firm is left with a number of alternativesand also many constraints on it. A clear understanding of these needs to be obtained through athorough scanning of the environmentthe opportunities and the constraints. Evaluation requiresstrong effort. It would require gathering of relevant data and their analysis through appropriatetechniques. The next step is choosing the best among the alternatives, followed by implementation ofthe decision, which requires resources. The

managerial decision process does not end with implementation; its performance must be

monitored, so that projection errors are reduced in the future period.

The business decision-making process has lately become rather complex due to ever

growing complexity of the business world. In the older days, business units were set up and 14


managed by individuals or business families on the basis of managerial skills acquired through familytraining and own experience. But today, drastic changes have taken place in the size and nature of thebusiness. Growth of large-scale industries, growth of large varieties of industries, diversification ofindustrial products, expansion and diversification of business activities of organizations, emergenceof multinational corporations, etc. have contributed to an increase in inter-firm and internationalrivalry, competition, risk and uncertainty. In this kind of business environment, decision-makingbecomes a very complex affair. The growing complexity of

business decision-making has inevitably increased the application of economic concepts and tools ofeconomic analysis in the business field. The application of economic concepts and analytical toolsgreatly helps the business managers in assessing and predicting market

conditions and the business environment. The economic theories and analytical tools which are usedin business decision making has led to the emergence of a separate branch of study calledManagerial Economics or Business Economics.

In this information age, changes occur very fast. In the past, changes took place in years; at presentchanges take place in months and in the future we may see that changes occur in days. By the time welearn new things they may becomes obsolete. If undue delay is made in decision-making,opportunities might turn into threats. Hence, in a dynamic economy, decisions have to be made withina time constraint. Economic tools and techniques help a manager to arrive at the right decisionswithin a limited time-period.

What is Managerial Economics?

Managerial Economics (also called Business Economics), a subject first introduced by Joel Dean in1951, is essentially concerned with the economic decisions of business managers. It is a branch ofEconomics that applies microeconomic analysis to specific business decisions (i.e.

Economics applied in business decision-making). Managerial Economics may be viewed as

Economics applied to problem solving at the level of the firm. The problems ofcourse relate tochoices and allocation of resources, which are basically economic in nature and are faced bymanagers all the time. It is that branch of Economics, which serves as a link between

abstract theory and managerial practice. It is based on economic analysis for identifying problems,organizing information and evaluating alternatives. In other words, Managerial

Economics involves analysis of allocation of the resources available to a firm or a unit ofmanagement among the activities of that unit. It is thus concerned with choice or selection amongalternatives. Managerial Economics is by nature goal-oriented and prescriptive, and it aims atmaximum achievement of objectives.

Managerial Economics help managers to learn the economic principles which are relevant

to decision-making in such areas as production, personnel, marketing and finance. A clearunderstanding of economic principles will help the manager in his activities. For example, XYZ

Ltd. has limited financial, human, and physical resources. XYZ Ltd. managers seek to

maximize the financial return from these limited resources. They should apply Managerial

Economics to develop pricing and advertising strategies, design their organizations, and managepurchasing.

Managerial Economics applies economic theory and methods to business and administrativedecision-making. Managerial Economics prescribes rules for improving managerial decisions.


15

Managerial Economics also helps managers to recognize how economic forces affect

organizations and describes the economic consequences of managerial behaviour. It links

traditional Economics with the decision sciences to develop vital tools for managerial decision-making. This process is illustrated in Fig. 1.2.

Fig. 1.2 The role of Managerial Economics in managerial decision-making.

Managerial Economics has applications in both profit and non-profit sectors. For example, anadministrator of a non-profit hospital strives to provide the best medical care possible given limitedmedical staff, equipment and related resources. Using the tools and concepts of

Managerial Economics, the administrator can determine the optimal allocation of these limited

resources. In short, Managerial Economics helps managers to arrive at a set of operating rules that aidin the efficient use of scarce human and capital resources. By following these rules, businesses, non-profit organizations and government agencies are able to meet objectives

efficiently.

Thus, Managerial Economics applies the principles and methods of Economics to analyse

problems faced by the management of a business or other types of organizations and helps to findsolutions that advance the best interests of such organizations.

16


Definitions of Managerial Economics

Managerial Economics has been defined in different ways by different scholars. Some of the populardefinitions of Managerial Economics are given below:

Managerial Economics consists of the use of economic modes of thought to analyse businesssituations.

McNair and Meriam

Managerial Economics is the integration of economic theory with business practice for thepurpose of facilitating decision-making and forward planning by management.

Spencer and Siegelman

Managerial Economics is defined as price theory in the service of business executives.

Watson

Managerial Economics is viewed as a fundamental academic subject, which seeks to

understand and to analyse the problems of business decision making.

Hague

Managerial Economics is defined as the application of economic theory and methodology tobusiness administration practice.

Brigham and Pappas

Managerial Economics is the application of economic principles and methodologies to thedecision-making process within the firm or organization.

Douglas

Managerial Economics refers to the application of economic theory and the tools of analysis ofdecision science to examine how an organization can achieve its objectives most effectively.

Salvatore

Managerial Economics is the application of economic analysis to business problems; it has itsorigin in theoretical microeconomics.

Howard Davies and Pun-Lee Lam

We may, therefore, define Managerial Economics as the discipline which deals with the

application of economic theory to business management. Managerial Economics thus lies on theborderline between Economics and Business Management and serves as a bridge between the

two disciplines.

Characteristics of Managerial Economics

To understand the subject matter of Managerial Economics more clearly, it would be useful to pointout the following characteristics:

1. Managerial Economics is concerned with the study of a firm and not the entire

economy; thus it is microeconomic in character.


17

2. The contents of Managerial Economics are largely based on the Theory of the firm.

However, for the analysis of profits it takes the help of the Theory of distribution.

3. Managerial Economics is normative rather than positive in character. That is, it is

concerned with the type of decisions which the firm should make in order to prosper,

which involves value judgments and not a mere description of behaviour of the firm.

4. Managerial Economics takes the help of macro-economics to understand and adjust

to the environment in which the firm operates. This understanding helps a manager

to play a crucial role in the success of the organization.

5. Managerial Economics is goal-oriented and prescriptive. It deals with how decisions

should be made by managers to achieve organizational goals.

6. It is both conceptual and metrical because it takes the help of conceptual frameworks

to understand and analyse the decision problems as well as quantitative techniques to

measure the impact of different factors and policies.

Managerial Economics vs. Economics

There is no difference between Managerial Economics and Economics in theory; standard economictheory provides the basis for Managerial Economics. The difference is in the way economic theory isapplied. The differences between Managerial Economics and Economics are explained in Table 1.3.

Table 1.3 Managerial Economics vs. Economics

Managerial Economics

Economics

It is the study of how resources should be

It is the study of how resources are

allocated in a particular firm.

allocated in a society as a whole.

It involves application of economic principles to

It deals with the body of the principles itself.

the problems of the firm.

It is individualistic.

It is holistic.

It is microeconomic in character.

It is both macro- and microeconomic in

character.

It deals only with a firm.

It deals with a firm and its industry.

It is narrow in scope.

It is wider in scope.

It adopts and reformulates economic models

It hypothesizes economic relationships and

to suit specific conditions and serves specific

builds simplified economic models.

problem-solving processes. Thus, it modifies

and enlarges economic models.

It uses variables such as objectives of the firm,

It uses only theoretical assumptions.

multi-product

nature

of

manufacture,

constraints

on

resource

availability,

environmental aspects, legal constraints, etc.

18


Significance or Usefulness of Managerial Economics

Managerial Economics helps the manager to achieve several objectives. These are as follows: 1.Managerial Economics provides a number of tools and techniques to build models.

With the help of these models the manager handles real-life situations.

2. Managerial Economics also incorporates useful ideas from other disciplines such as

psychology, sociology, etc. if they are found relevant for decision-making.

3. Managerial Economics provides most of the concepts that are needed for the analysis

of business problems. These concepts have proved their value in solving various kinds

of managerial problems. The concepts of elasticity of demand, fixed and variable

costs, short and long run costs, opportunity costs, net present value, etc. all help in

understanding and solving problems.

4. Managerial Economics is helpful in making decisions such as: What products and

services should be produced? What inputs and production techniques should be used?

How much output should be produced and at what price should it be sold? What are

the best sizes and locations of new plants? When should equipment be replaced? How

should the available capital be allocated? How to take investment decisions? How

much should the firm advertise and how to allocate an advertisement fund between

different media?

5. Managerial Economics helps us to understand the economic behaviour of individuals.

6. Managerial Economics provides good knowledge about the cause and effect of

various economic phenomena.

Figure 1.3 illustrates that Managerial Economics also relies on economic methodology,

analytical tools, and the principles of accounting, finance, marketing, personnel, administration andproduction.

Positive vs. Normative Economics

As shown in Fig. 1.3, there are two broad approaches to economic methodology. Economics

provides us with a way of thinking, and one of the most important aspects of that way of

thinking is the distinction between positive economics and normative economics. Normative

questions involve value judgments. An example of a normative question is Should we raise theminimum wage?. Positive questions, on the other hand, are aimed at determining the

implications or consequences of an action. An example of a positive question about the

minimum wage would be Will the unemployment rate increase if the minimum wage is

raised?.

Economists have found the positive-normative distinction useful because it helps people

with very different views about what is desirable to communicate with each other. Economics equipsus to deal better with positive questions than with normative ones, because the latter involve valuejudgments. But positive questions are often crucial for understanding and

examining normative questions. For example, the desirability of raising the minimum wage (anormative issue) depends, in large measure, on whether unemployment goes up and by how

much (a positive issue).


19

Fig. 1.3 Nature of Managerial Economics.

Scope of Managerial Economics

As regards the scope of Managerial Economics, no uniform pattern has been followed by

various authors. However, the following aspects may generally fall under Managerial

Economics:

1. Demand analysis and forecasting

2. Cost and production analysis

3. Pricing decisions, policies and practices

4. Profit management

5. Capital management

6. Competition

7. Product policy, sales promotion and market strategy.

20


In recent years, there is a trend towards integration of Managerial Economics and

Operations Research. Hence techniques such as linear programming, inventory models, theory ofgames, etc. have also been regarded as part of managerial economics.

Demand Analysis and Forecasting

When a business manager decides to venture into a business, the very first thing he needs to find out isthe nature and amount of demand for the product, both at present and in the

future. A firms performance and profitability depends upon accurate estimates of demand.

The firm will prepare its production schedule on the basis of demand forecast. Demand

analysis helps to identify the factors influencing the demand for a firms product and thus helps amanager in business planning. Demand analysis and forecasting thus help him in the choice of theproduct and in planning output levels. The main topics covered under

demand analysis and forecasting are the concepts of demand, demand determinants, law of

demand, its assumptions, elasticity of demand (price, income and cross elasticity), demandforecasting, etc.

Cost and Production Analysis

In the modern world a consumer expects a good-quality product at a reasonable price from the firm. Itis possible only when a business manager has a control over the costs. An element of cost uncertaintyexists, as all the factors determining cost are not always known or controllable.

Cost control is essential for pricing policies. A business manager is confronted with the problem ofchoosing the best input-mix and technology. He can maximize his profits only if he can produce thedecided level of output at minimum possible cost. It is necessary for the manager to know therelationship between the costs and the output, both in the short run and in the long run, to position hisproducts amidst the competitive environment.

Production analysis is narrower in scope than cost analysis. Production analysis

frequently proceeds in physical terms while cost analysis proceeds in monetary terms. The maintopics covered under cost and production analysis are: cost concepts and classifications, cost-outputrelationships, economies and diseconomies of scale, production functions and

cost control.

Pricing Decisions, Policies and Practices

Once a particular quantity of output is ready for sale, the firm has to fix its price given the conditionsin the market. Pricing is a very important aspect of Managerial Economics as a firms revenueearnings largely depend on its pricing policy. A correct pricing policy makes a firm successful, whileincorrect pricing may lead to its elimination. The topics covered under this area are: pricedetermination in various market forms such as perfect market, monopoly, oligopoly, etc., pricingmethods such as differential pricing and product-line pricing, and price forecasting.


21

Profit Management

Business firms are established with the objective of making profits and it is thus the chief measure ofsuccess. For maximizing profits the firm needs to take care of pricing, cost aspects and long-rangedecisions, i.e., it has to evaluate its investment decisions and carry out the best policy of capitalbudgeting for the firm under a given set of conditions. If we know the future, profit analysis would bean easy task. However, in a world of uncertainty our expectations are not always realized, so thatprofit planning and measurement constitute a difficult area of Managerial Economics. The importantaspects covered under this area are: nature and

measurement of profit, profit policies, and techniques of profit planning like break-even analysis,cost-volume-profit analysis, etc.

Capital Management

The most complex and troublesome duty of the business manager is to decide the firms capitalinvestment. The greater the investment the more complex the decision. Capital management

implies planning, acquisition, disposition and control of capital expenditure. The main topics coveredunder this area are cost of capital, rate of return and selection of projects.

Competition

Study of markets is one of the important aspects of the work of a managerial economist. A managershould have clear knowledge of different markets existing in the environment. The environment is notconstant and goes on changing. Thus, the manager should know clearly

about perfect and imperfect markets so as to introduce the product in such markets where he canincrease the sales revenue. The main aspects are perfect market, monopoly market,

monopolistic market, oligopoly market, and price fixation under different market conditions.

Product Policy, Sales Promotion and Market Strategies

These have of late also become a part of the managerial economists responsibility. Under this head,product mix, sales production strategy, market strategies, etc. are the important areas.

RELATIONSHIP OF MANAGERIAL ECONOMICS

WITH OTHER DISCIPLINES

An important feature of Managerial Economics is its relationship with other disciplines.

Although essentially a branch of Economics, the subject draws upon a number of other

disciplines for propounding its theories and concepts for managerial decision-making.

Managerial Economics provides a link between economic theory and the decision sciences

in the analysis of managerial decision making (see Fig. 1.4).

22


Management Problems

Economic Theory

Decision Sciences

Managerial Economics

Application of economics and decision sciences

to solve management problems

Solutions to

problems faced by

managers

Fig. 1.4 Relationship of Managerial Economics to other disciplines.

Relationship with Microeconomics

It should be obvious that the roots of Managerial Economics spring from microeconomic

theory. Price theory, demand concepts and theories of market structure, to take a few examples, areelements of Microeconomics which Managerial Economics draws upon. The dependence of

the latter on microeconomic theory is very much like the dependence of medicine on biologicalsciences and of engineering or technology on physics. It is important to note that ManagerialEconomics has an applied bias and an interest in applying economic theory in order to solve real-lifeproblems of an enterprise. Mere teaching of microeconomic theory will not therefore be a substitutefor the teaching of Managerial Economics. However, a study of microeconomic theory is a pre-requisite for all students of Managerial Economics.

Relationship with Macroeconomics

Economic agents, whether they are individuals or large business enterprises and organizations, do notoperate in a vacuum. Instead, they operate within a macroeconomic environment

provided largely by the economic and other policies of the governments of the countries of theirdomicile and/or operations. Consequently, the particular macroeconomic environment the businessorganizations face represents some form of a constraint of which firms must be aware, and takecognizance of, since this economic environment underpins much of their activity. At the same time, itmust also be recognised that the policies and activities of business

organizations, in general, affect the overall economic environment, through their role in thedetermination of the circular flow of income or output.

For example, of primary concern to Managerial Economics are aspects of fiscal and

monetary policy which determine rates and levels of taxation as well as interest rates that haveMANAGERIAL ECONOMICS: THE BASICS

23

an impact on the investment and saving plans of economic agents. These plans affect growth, which inturn determines levels of income and economic activity. When it comes to forecasting sales, businessfirms have to incorporate into their models various macroeconomic variables such as disposablenational income, interest rates, inflation rates, etc. that enter the modelling exercise as predeterminedvariables. Therefore, a managerial economist must be aware of the role and significance of themacroeconomic environment and how this environment is likely to affect the plans and policies of thebusiness organization. Thus, for a proper economic interpretation of results of the quantitativeexercise, a good understanding of Macroeconomics is both desirable and necessary.

Relationship with Mathematics

Since Managerial Economics is concerned with the process of optimization, the various

quantitative methods provided by Mathematics are useful and indispensable tools for the sharperunderstanding of the subject as well as for its applications to everyday business issues. This isbecause they provide the necessary quantitative evidence to back up complementary discursivearguments in a debate. Quantitative methods help management in the provision of optimal

solutions to a number of problems, and such solutions, even when not attained in practice, arenevertheless, indicative to the management of the direction of change required.

Relationship with Management Theory and Accounting

Managerial Economics has also been influenced by the developments in management theory andaccounting. Maximization of profit has been regarded as a central concept in the theory of the firm inMicroeconomics. Organization theorists in recent years have talked about satisficing

as opposed to maximizing as an objective of the enterprise. Managerial Economics should take ofthese new concepts and changing views of enterprise goals, which may have important implicationsfor the analytical approaches and tools relevant for problem-solving.

Managerial Economics is also closely related to Accounting, which is concerned with

recording the financial operations of a business firm. Accounting information is one of the principalsources of data required by a managerial economist for decision-making. For instance, the profit andloss statement of a firm tells us how well the firm has done and the information it contains can beused by a managerial economist to throw significant light on the future course of actionwhether itshould improve or close down. The relationship between these two

subjects can be understood better when the relationship between Management Accountancy andManagerial Economics is understood. Management Accountancy tries to furnish the necessaryinformation required by the managers, while managers take the help of principles, methods andtechniques of Managerial Economics to make correct decisions. Accounting data, however, are alsoto be provided in a form so as to fit easily into the concepts and analysis of Managerial Economics.

A student of Managerial Economics should therefore be familiar with the generation,

interpretation and use of accounting data. In fact, the focus of accounting within the enterprise is fastchanging from scorekeeping to managerial decision-making. This trend has led to 24


the evolution of a new specialization termed Managerial Accounting, which has much in commonwith Managerial Economics.

Relationship with Statistics

Managerial Economics relies on Statistics in a number of ways. Statistics deals with the theory andmethods of collecting, tabulating and analysing numerical data. These are necessary

functions for the process of providing quantitative evidence for management decisions. At the heart ofstatistics lies the idea of statistical inference, by which we mean the process of inferring, from databy referring to a small part ( sample), statement relative to the whole ( population), and also providea measure of the uncertainty surrounding the inference made.

The process of sampling a small, well-stratified section of the potential consumer base to inferconsumer preferences as regards, for example, new products is of major concern to

management.

Given that in Economics in general and Managerial Economics in particular we cannot

perform controlled experiments, statistical inference provides a powerful tool of quantitative analysisand the use of probability theory becomes central to the work of a practising

managerial economist. In addition, most economic statements are conditional. For example, weexpect a particular economic variable to move (change) in a particular direction provided certainother variable(s) related to the first variable are changed. While mathematical methods can establishthe nature of the functional relationship between the variables, we are also interested in testing suchhypothesis. Thus, hypotheses testing in Managerial Economics is another area where Statistics canprovide significant help.

Relationship with Operations Research

During the Second World War and the years that followed, a great deal of inter-disciplinary researchwas undertaken in the United States and other Western countries to solve the complex operationalproblems of planning and resource allocation in defence and key industries.

Mathematicians, statisticians, engineers and scientists worked together in teams and developedmodels and analytical tools which together have since grown into a specialization known as

Operations Research. Much of the development of techniques and concepts such as linear

programming, inventory models and game theory is due to the work of operations researchers.

While economists have given considerable attention to problems involving maximization of

profits and minimization of costs, it were the operations researchers who focussed attention on theconcept of optimization. The framework of optimization has been used a great deal in ManagerialEconomics, which had originally started with the marginal analysis technique

borrowed from economic theory. Incremental or marginal reasoning is closely linked to the logicunderlying the models of Operations Research.

Similarly, Operations Research has influenced Managerial Economics through its new

concepts and models for dealing with risk and uncertainty. Though economic theory has alwaysrecognized these factors as germane to decision-making in the real world, the framework for takingthem into account in the context of actual problems has been operationalized only


25

through the recent contributions of mathematicians and statisticians. These scientists have thus done agreat deal to sharpen the tools and analytical models available to Managerial Economics.

However, it should be remembered that the practice of Operations Research requires highlyspecialized quantitative skills, whereas the reasoning underlying Managerial Economics can bemastered by managers even if their mathematical prowess is modest.

Also, various methods of Operations Research such as stock control, queues, linear

programming, transportation problems, scheduling, network analysis, theory of games and so on areof direct relevance and help to the managerial economist.

Relationship with Econometrics

Econometrics is derived from Greek and literally means measurement in economics. More

particularly, Econometrics is concerned with the application of statistical and mathematicaltechniques for the analysis of economic data. The chief role of Econometrics is the

specification, estimation and testing of economic models, and so it is used for the analysis andverification of economic models or theories. Therefore, it becomes evident that Econometrics plays acrucial role in Managerial Economics as regards, for example, the forecasting of sales, cost or anyother function we are interested in.

Clearly, for a managerial economist interested in the values of the estimated parameters of functionalrelationships used in decision-making, such as elasticities, rates of change,

multipliers, and their economic interpretation, a basic understanding of econometric methods, theirassumptions and limitations is very useful if not indispensable.

Relationship with Decision Theory

Decision theory deals with the process of formation of expectations under conditions of

uncertainty. In addition it recognises that the management may very well have a multiplicity of goalsand objectives, some of which may be conflicting. On the other hand, neo-classical economic theoryassumes conditions of certainty and perfect foresight and operates und

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