Managerial Economics PDF - MMS Mumbai University

MANAGERIA L ECONOMICS [FOR MMS MUMBAI UNIVERSITY] D. M. MITHANI, M.A., Ph.D., Professor Emeritus L.J. Institute of Management, Ahmedabad. Professor, College of Business, Norths University of Malaysia. Form...

MANAGERIA L ECONOMICS [FOR MMS MUMBAI UNIVERSITY] D. M. MITHANI, M.A., Ph.D., Professor Emeritus L.J. Institute of Management, Ahmedabad. Professor, College of Business, Norths University of Malaysia. Formerly Reader Department of Commerce, University of Mumbai, Mumbai. First Edition: 2010  MUMBAI ⌘ NEW DELHI ⌘ NAGPUR ⌘ BENGALURU ⌘ HYDERABAD ⌘ CHENNAI ⌘ PUNE ⌘ LUCKNOW ⌘ AHMEDABAD ⌘ ERNAKULAM ⌘ BHUBANESWAR ⌘ INDORE ⌘ KOLKATA © Author No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording and/or otherwise without the prior written permission of the publishers. First Edition : 2010 Published by : Mrs. Meena Pandey for Himalaya Publishing House Pvt. Ltd., “Ramdoot”, Dr. Bhalerao Marg, Girgaon, Mumbai - 400 004. 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Mobile: 09301386468 Kolkata : 108/4, Beliaghata Main Road, Near ID Hospital, Opp. SBI Bank, Kolkata - 700 010, Mobile: 09910440956 DTP by : HPH Editorial Office, Bhandup (Rajani Tambe) Printed by : Prabhat Book Binders, Mumbai Preface This book explores Managerial Economics for the understanding and application of economic analysis in the process of business decision-making by the managers. Understanding of economics as an applied science in management is crucial for the decision-makers in business tasks, such as correct pricing and marketing decisions and resource allocation as well as business forecasting and planning. The book offers an exploration of managerial economic concepts, principles and tools of analysis with illustration and cases on practical consideration as an outcome of over four decades long teaching and writing experience of the author in India and abroad. The volume is especially designed to cater to the syllabus of MANAGERIAL ECONOMICS prescribed by the Mumbai University for the MMS Course, (w.e.f. academic year 2010–2011). The book is research-based on the guidelines indicated in the syllabus. In covering the topics of the syllabus, a synthetic approach is made by filling up the gaps in the logical development of the subject for a better understanding by the Indian students. The text will be equally useful to the teaching fraternity as well. The book can also be fruitfully used by the students of management discipline in other Universities in India and abroad. The author is grateful to Dr. Shirhhalti, Director general of Oriental Institute of Management, Vashi, Prof. Timojit Roy, H.K. Institute of (HKMR) Management and Research, (Mumbai), Prof. G.H. Hamlani, and Shri Wasim Javed Khan, Managing Director of HKMR, Mumbai, Prof. Mukul Mukerjee, Oriental Institute of Management, Vashi for their valuable suggestion and interaction with the author on the subject. Mumbai, 9 March, 2010 D. M. MITHANI Syllabus (a) The Meaning, Scope and Methods of Management Economics  (b) Economics Concepts Relevant to Business, Demand and Supply, Production, Distribution, Consumption and Consumption Function, Cost, Price, Competition, Monopoly, Profit, Optimisation Margin and Average, Elasticity Micro and Macro Analysis. (c) Demand Analysis and Business Forecasting Market Structures, Factors Influencing Demand Elasticities and Demand Levels Demand Analysis for Various Products and Situations, Determinants of Demand Durable and Non Durable Goods Long Run and Short Run Demand and Autonomous Demand Industry and Firm Demand. (d) Cost and Production Analysis, Cost Concepts, Short Term and Long Term, Cost Output Relationship, Cost of Multiple Products Economies of Scale Production Functions Cost and Profit Forecasting Break-even Analysis. (e) Market Analysis, Competition, Kinds of Competitive Situations, Oligopoly and Monopoly, Measuring Concentration of Economics Power. (f) Pricing Decisions, Policies and Practices, Pricing and Output Decisions under Perfect and Imperfect Competition, Oligopoly and Monopoly, Pricing Methods, Products Line Pricing, Specific Pricing Problem, Price Dissemination, Price Forecasting. (g) Profit Management, Role of Profit in the Economy, Nature and Measurement of Profit, Profit Policies, or Profit, Maximisation, Profits and Control, Profit Planning and Control. (h) Capital Budgeting, Demand for Capital, Supply of Capital, Capital Relationing Cost of Capital Appraising of Profitability of a Project, Risk and Uncertainty, Economics and Probability Analysis. (i) Macro Economics and Business, Business Cycle and Business Policies, Economic Indication, Forecasting for Business, Input-output Analysis. Contents UNIT – 1 : THE MEANING OF MANAGERIAL ECONOMICS Chapter 1 The Meaning, Scope and Methods of Managerial Economics 3 – 23 – Meaning of Managerial Economics – The Salient Features and Significance of Managerial Economics – Managerial Economics: Normative or Positive – Scope of Managerial Economics – Scientific Method of Economic Analysis in the Managerial Decision-making – Basic Assumptions in Economic Models and Analysis – Time Perspective – Discounting Principle UNIT – 2 : ECONOMIC CONCEPTS RELEVANT TO BUSINESS Chapter 2 Economic Concepts 27 – 44 – Demand – Supply – Production – Distribution – Consumption – Consumption Function – Cost – Price – Competition – Monopoly – Profit – Margin and Average – Otimisation – Elasticity – Firm and Industry Chapter 3 Macro and Micro Analysis 45 – 53 – Micro and Macroeconomics – Distinction between Micro and Macroeconomics – The Subject-matter and the Scope of Microeconomics – Importance and Uses of Microeconomics – Limitations of Microeconomics – Importance of Macroeconomics – Limitations of Macroeconomics UNIT – 3 : DEMAND ANALYSIS AND BUSINESS FORECASTING Chapter 4 Market Structures 57 – 67 – Meaning of Market – Product and Factor Markets – Classification of Market Structures – Markets based on Time Element – Types of Market Structures formed by the Nature of Competition – Perfect Competition – Monopoly – Types of Monopoly – Imperfect Competition – Market Economy Paradigm Chapter 5 Demand Analysis 68 – 103 – Introduction – Individual Demand and Market Demand – Determinants of Demand – Demand Function – Demand Schedule – The Demand Curve – The Law of Demand – Exceptions to the Law of Demand or Exceptional Demand Curve (Upward Sloping Demand Curve) – Change in Quantity Demanded Versus Change in Demand – Reasons for Change (Increase or Decrease) in Demand – Demand Distinctions: Types of Demand – Network Externalities in Market Demand – Practical Problems Chapter 6 Elasticities and Demand Levels 104 – 141 – The Concept of Elasticity of Demand – Price Elasticity of Demand – Types of Price Elasticity – Measurement of Price Elasticity – Proof of the Geometric Method – ARC Elasticity of Demand – Factors Influencing Elasticity of Demand – Income Elasticity of Demand – Types of Income Elasticity – Applications of Income Elasticity – Cross Elasticity of Demand – Advertising or Promotional Elasticity of Demand – Practical Applications – Application Problem: A Hypothetical Case Study Chapter 7 Demand Estimation: Analysis for Various Products 142 – 168 and Situations – Estimating the Demand Function – Major Steps in Demand Estimation – Functional Forms in Estimation – Properties of Empirical Results – Demand Function Illustration/Problem – Hypothetical Cases of Demand Estimation – A Review of Select Case Studies on Demand Estimation Chapter 8 Demand Analysis in Business Forecasting 169 – 193 – The Meaning of Demand Forecasting  – The Significance of Demand Forecasting in Business – Short-term and Long-term Forecasting – General Approach to Demand Forecasting – The Sources of Data Collection for Business Forecasting – Market Survey/Studies – Statistical Method of Forecasting Demand – Consumption Level Method – Trend Projections – Criteria of a Good Forecasting Method – Sales Growth Trend Analysis – Business Forecasting Function: Some Reflections on Practical Considerations – Choosing a Forecasting Model – Business Forecasting: Summing Up UNIT – 4 : COST AND PRODUCTION ANALYSIS Chapter 9 Cost: Concepts and Cost-Output Relationship 197 – 237 – Introduction – Real Cost – Opportunity Cost or Alternative Cost – Money Cost – Accounting and Economic Costs – Fixed and Variable Costs – Types of Production Cost and their Measurement – Short-run Total Costs Schedule of a Firm – TFC, TVC and TC Curves – Short-run Per Unit Cost – Explanation of the U-shape of ATC Curve – Marginal Cost Curve (MC Curve) – The Relationship Between Marginal Cost and Average Cost – Empirical Cost Functions – Characteristics of Long-run Costs – Economies of Scale and the LAC – Technological Change and Long-run Cost – Long-run Marginal Cost Curve (LMC) – Estimation of Long-run Cost Function – Cost Elasticity – Minimum Efficient Scale – Cost Leadership Chapter 10 Economies of Scale and Scope 238 – 264 – Large-scale of Production – The Size of Firm and Industry  – Economies of Scale – Forms of Internal Economies – Forms of External Economies – Diseconomies as Limits to Large-scale Production – Scale Economies Index – X-efficiency – Managers Per Operative Ratio (MOR) – Economies of Scope – The Learning Curve – A Case Study: Costs Matter Chapter 11 Production Function 265 – 300 – Introduction – The Concept of Production Function – Time Element and Production Functions – Cobb-Douglas Production Function – Laws of Production – The Law of Diminishing Marginal Returns – The Law of Variable Proportions – The Laws of Returns to Scale: The Traditional Approach – Estimation of Production Functions – Cobb-Douglas Production Function – Measurement of AP and MP – Empirical Illustrations – Output Elasticity – Production Function through Iso-quant Curve – Properties of Iso-quant – Economic Region – Least-cost Factor Combination: Producer’s Equilibrium – Returns to Scale Explained through Iso-quants – Technical Change Chapter 12 Cost and Profit Forecasting: Break-Even Analysis 301 – 314 – The Meaning of Break-even Analysis (BEA) – The Break-even Chart – Formula Method for Determining BEP – Assumptions of Break-even Analysis – Limitations of BEA – Usefulness of BEA – Practical Problem – Cost Control – Techniques of Cost Control  – Areas of Cost Control UNIT – 5 : MARKET ANALYSIS Chapter 13 Market Analysis: Price Determination 317 – 331 – Market Economy – Price Determination Under Perfect Competition – Significance of Time Element – Market Price and Normal Price – Changes in Equilibrium Price UNIT – 6 : PRICING DECISIONS Chapter 14 Price and Output Decision Under Perfect Competition 335 – 354 – Introduction – Short-run Equilibrium of the Competitive Firm – The Nature of Equilibrium Under Cost Differences Between Firms – The Short-run Supply Curve of the Firm and Industry – The Short Period Equilibrium of the Industry – Long-run Equilibrium of the Firm – Equilibrium of the Industry in the Long-run – Long-run Equilibrium of the Firms Under Heterogeneous Conditions Chapter 15 Monopoly: Pricing and Output Decision 355 – 378 – Meaning of Monopoly – Absolute and Limited Monopoly – Measures of Monopoly Power – Sources of Monopoly Power: What Makes a Monopoly? – Monopoly Equilibrium in the Short-run: How a Monopolist Determines Price and Output – Long-run Monopoly Equilibrium – Comparison of Perfect Competition and Monopoly – Misconceptions about Monopoly Pricing and Profit Chapter 16 Monopoly: Price Discrimination 379 – 398 – Meaning of Price Discrimination – Forms of Price Discrimination – Degrees of Price Discrimination – The Ingredients for Discriminating Monopoly: Conditions Essential for Price Discrimination – When is Price Discrimination Profitable? – Profit Maximisation: Pricing and Output Equilibrium Under Discriminating Monopoly – Dumping  – Economic Effects of Price Discrimination – Social Justification of Price Discrimination Chapter 17 Monopolistic Competition Pricing under Imperfect 399 – 419 Competition – Introduction – The Concept of Monopolistic Competition – Characteristics of Monopolistic Competition – Equilibrium Output and Price Determination of a Firm Under Monopolistic Competition – Product Differentiation: Basis and Objectives – Objectives of Product Differentiation – Product Differentiation: A Facet of Non-price Competition – Quantitative Measures of Product Differentiation Chapter 18 Oligopoly 420 – 430 – Meaning of Oligopoly – Kinked Demand Curve – Kinked Demand Curve Theory of Oligopoly Prices – Pattern of Behaviour in Oligopolistic Markets – Market Share – Concentration Ratio – Game Theory and Oligopoly Chapter 19 Pricing Methods 431 – 457 – Introduction: General Philosophy – Objectives of Pricing Policy – Factors Involved in Pricing Policy – Pricing Methods – Administered Price – Major Issues of the Policy of Price Control/Administered Prices – Export Pricing – Transfer Pricing – Multi-product Pricing – Predatory Pricing – Price Matching – Skimming Pricing – Penetration Pricing – Product Line Pricing – Multiple Pricing – Loss Leader Pricing – Premium Pricing – Optimal Product Pricing – Odd/Even Pricing  – Specific Pricing Problem: Practical Aspects – Price Dissemination – Price Forecasting UNIT – 7 : PROFIT MANAGEMENT Chapter 20 Profit Management 461 – 472 – Introduction – Role of Profit in the Economy – Nature and Measurement of Profit – Nature of Profit – Sources of Profit – Risk and Uncertainty – Profit Policy: Profit Restraint – Problems in Profit Policy – Criteria for Acceptable Profit or Rate of Return on Investment – Profit Planning Chapter 21 Profit Maximisation 473 – 483 – Meaning of Profit Maximisation – The Marginal Cost-marginal Revenue Equality Approach – MC = MR Approach in Reality – An Estimation Problem UNIT – 8 : CAPITAL BUDGETING Chapter 22 Capital Budgeting 487 – 499 – Introduction – Meaning and Significance of Project Planning – The Problem and Difficulties of Project Planning – Stages of Project Planning – Investment Criteria – Decision-making Rules UNIT – 9 : MACROECONOMICS AND BUSINESS Chapter 23 Business Cycles and Business Policies 503 – 524 – Introduction – Features of Business Cycle – Phases of Business Cycle – Economic Indication – Advertising Budget Product Policy and Business Cycles – A Managerial Insight – Economic Indication and Forecasting for Business Chapter 24 Input output Analysis 525 – 532 – Introduction – Assumptions in Input-output Analysis – The Transactions Matrix  +– A General Formulation of Input-output Model Unit I The Meaning of Managerial Economics MEANING OF MANAGERIAL The Meaning, Scope and ECONOMICS Methods of Managerial 1 CHAPTER Economics 1.  In management studies, the terms ‘Business Economics’ and ‘Managerial Economics’ are often synonyms. Both the terms, however, involve ‘economics’ as a basic discipline useful for certain functional areas of business management. Economics is the study of men as they live, behave, move and think in the ordinary business of life. Economics in essence pertains to an understanding of life’s principal preoccupation. It is a religion of the day-in living for the want satisfying activity. Economics, as a social science, studies human behaviour as a relationship between numerous wants and scarce means having alternative uses. Economics is a logic of choice. It teaches the art of rational decision-making, in economising behaviour to deal with the problem of scarcity. Economics is of significant use in modern business, as decision-making is the core of business, and success in business depends on right decisions. A firm or business unit faces the problem of decision-making in the course of alternative actions, in view of the constraint set by given resources, which are relatively scarce. Managerial economics is essentially applied economics in the field of business management. It is the economics of business or managerial decisions. It pertains to all economic aspects of managerial decision making. Managerial economics, in particular, is the study of allocation of resources available to a business firm or an organisation. Business or managerial economics is fundamentally concerned with the art of economising, i.e., making rational choices to yield maximum return out of minimum resources and efforts, by making the best selection among alternative courses of action. 4 Managerial Economics Managerial economics, in the true sense, is the integration of economic principles with business management practices. The subject-matter of business economics apparently pertains to economic analysis that can be helpful in solving business problems, policy and planning. But, one cannot make good use of economic theory in business practices unless one masters the basic contents, principles and logic of economics. Managerial economics is an evolutionary science, it is a journey with continuing understanding and application of economic knowledge — theories, models, concepts and  categories in dealing with the emerging business/managerial situations and problems in a dynamic economy. Managerial economics is pragmatic. It is concerned with analytical tools and techniques of economics that are useful for decision-making in business. Managerial economics is, however, not a branch of economic theory but a separate discipline by itself, having its own selection of economic principles and methods. In essence, managerial economics rests on the edifice of economics. Knowledge of economics is certainly useful to business people. Businessmen/business managers must know the fundamentals of economics and economic theories for a meaningful analysis of business situations. Decision-making is the crucial aspect of dealing with business problems. Decision becomes essential since business problems would usually imply a basic question: What is the alternative course of action? For instance, business/managerial decisions: Should an electronic goods manufacturer cut the price of its best selling television set in response to a rival company’s launching of a new model? Should a commercial bank go for Internet banking? Should a publisher offer more trade discount in response to a new competitors’ entry into the market of educational books? Should a pharmaceutical firm undertake a promising but costly R&D programme? What tender should a construction company submit to get a road construction contract from the municipal corporation in a city? These are all economic decision-making issues in essence. A sensible economic analysis in each case is required in determining alternative course of action and making the best choice. It would be an economic choice — the rational choice towards optimisation. To understand and appreciate business decision-making, in actual practice, therefore a sound knowledge of tools of economics is warranted. A course in managerial economics thus provides an understanding of the framework and economic tools needed by managers/ businessmen as an aid to better business decision-making. Managerial Economics: An Integration of Economics, Decision Science and Business Management Managerial economics is a specialised discipline of management studies which deals with application of economic theory and techniques to business management. Managerial economics is evolved by establishing links on integration between economic theory and decision sciences (tools and methods of analysis) along with business management in theory and practice — for the optimal solution to business/managerial decision problems. This means, managerial economics pertains to the overlapping area of economics along with the tools of decision sciences such as mathematical economics, statistics and econometrics as applied to business management problems. The idea is presented in a nutshell through Figure 1.1. The Meaning, Scope and Methods of Managerial Economics 5 Traditional Economics and Tools Decision Sciences in Theory and and Practice: Decisions, Managerial Economics Techniques of Problems Business Management  Fig. 1.1: The Nature of Managerial Economics Managerial economics is confined only to a part of business management. It is primarily addressed to the analysis of economising aspects of business problems and decision-making by a business firm or an organisation. It is not directly concerned with the managerial problems and actions involving implementation, control, conflict resolution and other management strategies in day-to-day operations of the business. (Mote, et al.: 1963) Managerial economics draws heavily on traditional economics, as well as decision science in analysing the business problems and the impact of alternative courses of action on the efficient allocation of resources or optimisation. Managerial economics is however, not a branch of economic theory but a separate discipline by itself having its own selection of economic principles and methods. In essence, managerial economics rests on the edifice of economics. Knowledge of economics is certainly useful to business people. Businessmen/business managers must know the fundamentals of economics and economic theories for a meaningful analysis of business situation. Managerial economics is, by and large, the application of knowledge of economic concepts, methods and tools of analysis to the managerial/business decision-making process, involved within the firm or organisation in conducting the business or productive activity. The relation of managerial economics to economic theory is somewhat like that of medicine to biology. In short, managerial economics deals with the application of economic principles and methodologies to the decision-making process, within the firm under the given situation. It seeks to establish rules and principles to facilitate the attainment of the chosen economic goals of business management, such as minimisation of costs, maximisation of revenues and profits, and so on. It follows that certain economic theories are directly useful in business analysis and practice of decision-making as well as forward planning of management. Managerial economics deals with this kind of knowledge and principles. It is a collection of those methods/analytical techniques that have direct application to business management. In economic theory, mostly a single goal is assumed for the sake of simplicity and convenience of analysis. For example, it is assumed that a rational consumer aims at the maximisation of utility or a firm’s objective is to maximise its profit. Economic theory is thus based on ceteris paribus, i.e., given conditions with certainty of actions or events, or within the framework of axioms. 6 Managerial Economics In business decision-making, however, the real situation tends to be quite different from theoretical assumptions. Actually, there are multiple goals in running a business; there is lack of certainty due to dynamic changes; the element of uncertainty may create disappointment in the realisation of business expectations.  As a result, economic theory cannot provide clear-cut solutions to business problems. Nonetheless, economic theory does help in arriving at a better decision. But, there may be a number of obstacles and weaknesses of economic analysis in an actual decision-making exercise. There exists a wide gap between theory and actual business in practice. In economic theory, for instance, the firm — decision-maker — identifies profit maximising output by equating marginal revenue with marginal cost. But, in actual practice, this may not be possible to attain due to resource constraints. In this case, the business decision should be made with the help of linear programming for optimisation. Again, economic theory of firm assumes ‘profit maximisation’ to be the sole objective. It disregards the businessman’s ‘psychic income’ and such other aims in running a business. In practice, prices are set by the firms in view of some standard mark-up on costs, rather than following the behavioural rule of equating marginal cost with marginal revenue. Managerial economics, thus, attempts to bridge the gap between the purely analytical problems dealt with in economic theory and decisions problems faced in real business. It seeks to provide powerful tools of analysis and reasoning approaches for managerial/business policy-making. Decision-making is an art as well as science. Many managerial decisions are addressed in a routine manner. Rules of thumb or the tried-and-true decision rules are, however, invalidated by the changes in routine situations. Dynamic changes in business situations need that decisions are to be addressed in a proactive manner. In proactive decision-making, many alternatives have to be explored; conditions and assumptions have to be reviewed and structured in a perspective manner. Managerial economics offers an understanding of business and economic perspectives, jargons, tools, technique and tactics that will facilitate manager’s development as a proactive decision-maker — a decision-maker who addresses dynamic business situations in a critical, comprehensive and careful manner, right in time, using formal analytical tools and skills that are guided by the knowledge, judgement, experience and intuition. 2. THE SALIENT FEATURES AND SIGNIFICANCE OF MANAGERIAL ECONOMICS Following are the main characteristic features of Managerial Economics as a specialised discipline: The Meaning, Scope and Methods of Managerial Economics 7 It involves an application of economic theory — especially, microeconomic analysis to practical problem solving in real business life. It is essentially applied microeconomics. It is a science as well as art facilitating better managerial discipline. It explores and enhances economic mindfulness and awareness of business problems and managerial decisions. It is concerned with firm’s behaviour in optimal allocation of resources. It provides tools to help in identifying the best course among the alternatives and competing  activities in any productive sector whether private or public. Managerial economics incorporates elements of both micro and macroeconomics dealing with management problems in arriving at optimal decisions. It uses analytical tools of mathematical economics and econometrics with two main approaches to economic methodology involving ‘descriptive’ as well as ‘prescriptive’ models. Descriptive models are data based in describing and exploring economic relationships of reality in simplified abstract sense. Prescriptive models are the optimising models to guide the decision makers about the most efficient way of realising the set goal. Often, descriptive models provide a building block for developing optimising models in solving the managerial or business problems. For example, a descriptive model explains and predicts the general behaviour of price movements. It may serve as a base for constructing an optimising model for profit maximisation goal of the firm. In a prescriptive model, the set of alternative strategies towards attainment of the objective function in operation terms within specified constraints may be derived with the help of descriptive models in background. Managerial economics differs from traditional economics in one important respect that it is directly concerned in dealing with real people in real business situations. Furthermore, unlike the present trend of modern economics, which is leaning towards sophisticated theoretical, mathematical and complicated econometrics models, managerial economics is concerned more about behaviour on the practical side. Policy executives have to respond to behavioural approach of managerial economics for a better understanding of the day-to-day economy at micro and macro levels in sharpening their logic of choice. Needless to say that choice is the core of all business problems in general including economic decision-making. The choice has to be professional, efficient and effective. Managerial economics becomes more meaningful when co-ordinated with other discipline of management with a broader knowledge, techniques/methods, dogmas and theories involved — using sharp common sense in practical decision making. The significance of managerial economics is to be traced in the development of business/corporate planning and policy decisions — which are firmly based on a closely argued analysis of all relevant data, evidence and past experience, present outcomes and future expectations. Managerial economics has a pivotal place in allied business disciplines concerned into the arena of decision-making. Managerial economics as an applied economic science deals/helps in analysing the firm’s markets, industry trends and macro forces which are directly relevant to the concerned business activity. Knowledge of managerial economics is of great help in seeking maximisation of the firm’s efficiency through the analysis of its operations and their interaction with the external environment. It also guides management by interpretation of that environment in terms, which are relevant to the conduct 8 Managerial Economics of the concerned business activity and action. Managerial economics provides necessary skills in furtherance of business goals and functions. It is fundamentally concerned with the interaction between the internal operations of the business firm and the business and economic environment: such as marketing, business development, government business policies, government liaison, investment climate and finance affected by the macro-economic behaviour and policies of the government. It is truly an applied economic science — a discipline useful in pursuit of objectives as well as efficient functioning and performance of a business firm — especially, in a corporate system. Indeed, managerial economics is basically concerned with micro rather than macro area of economic analysis, which is directly relevant to the practical business-economic decision-making. Managerial economics, in short, deals directly with business realities and realisations. Managerial economics deals with a thorough analysis of key elements involved in the business decision-making. For example, if a business manager wants to enlarge his firm’s products’ share in the market, knowledge of managerial economics will help him in determining the size and dimensions of the market with a better understanding of its competitive structure. Further, the technique of economic analysis will assist him in designing the course of action as well as measuring the effectiveness of the decision arrived at. Economists, in general, are usually asked to comment on, to support or criticise, or to provide solutions for allied economic-oriented business problems in various industries, trade and commerce. Managerial economics helps the manager to understand the intricacies of the business problems which make the problem-solving easier and quicker, arrive at correct and appropriate decisions, improve the quality of such decisions, and so on. A major contribution of managerial economics to management pertains to its guidance for economising/optimisation and identification of key variables in the business decision-making process. Most managerial decisions are made under conditions of varying degrees of uncertainty about the future. To reduce this element of uncertainty, it is essential to have homework of research/investigation on the problem-solving before the action is undertaken. For example, if a businessman when decides to adopt a new variety of product in his product mix, it would pay him a rich dividend if he conducts some market research in advance to ascertain the customer needs, their likings, and the possibility of the market acceptance of the new product envisaged. The process of such business research involves some common steps such as: (i) problem definition, (ii) research design, (iii) data collection, (iv) data analysis and (v) interpretation of results. Knowledge of managerial economics coupled with management science and statistical techniques will be of great help to a manager in understanding, interpretation and evaluation of quantified variables pertaining to market and business economy. Modern business decision-making is more fact-based, evidence-based and as such has greater degree of validity and reliability. Ostensibly, knowledge of managerial economics is a boon to a manager/businessman/ entrepreneur. In these days of competition and dynamism, it is inevitable for a manager/ businessman to specialise in his business, management as well as economics of business (i.e., managerial economics) to determine and realise the competitive advantage of the firm and the concerned industry to win. Modern businessman never believes in sheer luck. He bangs on skilful management and appropriate timely economic decision-making. This art is facilitated by the science of managerial economics. The Meaning, Scope and Methods of Managerial Economics 9 Managerial economics deals with practical business problems relating to production, pricing and sale. These problems are theoretically analysed by traditional economics. For conceptual understanding and analysis of relevant business problems, we need to resort to economics theory. For further data-based analysis on practical side, we make use of tools and techniques of decision sciences such as statistics and econometrics Statistics shown how to collect, summarise and analyse data. Econometrics technique are useful in tracing empirical relationships. For example, how much to produce is a business decision. This can be arrived at through demand analysis. For this we may construct a statistical; and econometric; and econometric demand function and its estimation gives up a quantitative insight for appropriate decision. 3. MANAGERIAL ECONOMICS: NORMATIVE OR POSITIVE Economics studies economic activities of mankind without reference to their ethical significance. Economic activities may be good or bad but so long as they involve the use of limited resources to satisfy many wants, they constitute a part and parcel of economics. This raises a further question, viz., does economics study activities, as they ought to? It involves saying whether economics is a positive science, which studies things as they are. For example, Physics, Chemistry and other positive sciences do not suggest how things should work, but study things as they actually work or behave. Normative sciences study things, as they ought to. Ethics, for example, is a normative science. It tells us how we should behave. As a matter of fact, the positive sciences simply describe, while the normative sciences simply prescribe. Positive Economics explains the economic phenomenon as: What is, what was and what will be. Normative Economics prescribes what it ought to be. Whether economics is a positive science or a normative science is a controversial question. According to economists like Professors Marshall and Pigou, the ultimate object of the study of any science is to contribute to human welfare. According to these economists, economics should be a normative science. It should be able to suggest policy measure to the politicians. It should be able to prescribe guidelines for the conduct of economic activities. Economists have to be both tool makers and tool users. It means that not only economists should build up the economic theory but also, at the same time, they should provide policy measures. According to Prof. Robbins, however, economics is a positive science. Science is, after all, a search for truth and, therefore, economics should study the truth as it is and not as it ought to be. This is because when we say that this ought to be like this, we presume that our point of view is correct. When we express opinions, our own value enters into our consideration. In the study of a problem at a given point of time, not only economic considerations but also many other considerations, such as ethical, political, etc., must be considered. It is after weighing the relative importance of these various factors that a policy decision is to be taken. There are, therefore, bound to be differences in respect of policy prescription and it is, therefore, better to keep away from areas which are controversial and study the facts as they are. 10 Managerial Economics Obviously, Prof. Robbins’s point of view is not accepted by many. His critics say that the view that science is for science’s sake should be discarded, as we discard the view that art is for art’s sake. Science is, no doubt, a search for truth but it is equally important to determine which is a significant truth, i.e., significant from the point of view of the betterment of life. We must strike a balance between these two extreme views. The main function of economics, as Lord Keynes has said, is not to provide a body of settled conclusions immediately applicable in policy. It provides a method, or a technique of thinking, which enables its possessor to draw correct conclusions. It means that those who know economics can make intelligent analyses of economic problems, and point out their whys and wherefors. This might provide them some guidelines for the conduct of economic affairs. Thus, economists can give directional advice and then leave the decision taking function to the supreme bosses. The main task of an economist is not to stand in the forefront of attack (i.e., to provide policy) but to stand behind the lines, in order to provide the armoury of knowledge, i.e., to indicate the implications of the various policy measures. Managerial economics is a blending of pure or positive science with applied or normative science. It is positive when it is confined to statements about causes and effects and to functional relations of economic variables. It is normative when it involves norms and standards, mixing them with cause-effect analysis. Normative approach in managerial economics has ethical considerations and involves value judgements based on philosophical, cultural and religious positions of the community. One cannot disregard the normative functions of managerial economics, though the discipline may be treated primarily as a positive science. If business economic studies are completely detached from all normative significance, the significance of managerial economics itself will not be more than a purely formal technique of reasoning, algebra of choice. Essentially, managerial economics is a logic of rational choice and a science for the betterment of business management, which cannot and should not refrain from essential value judgements. The value judgements and normative aspect and counselling in managerial economics studies can never be dispensed with altogether. As an applied social science, managerial economics is firmly rooted in the realm of social values and problems; hence, it cannot be and should not be made a pure value free science. Managerial economics is something more than a science, a science calling not only for systematic thinking but for human sympathy, imagination and in an unusual degree for the saving grace of commonsense in business culture. Cultural values and religious sentiments of the people coin the business ethics, which governs the managerial decision-making in designing the production pattern and planning of the business in a country. Islamic culture, for instance, approves only the ‘Halal’ products prescribed in the light of Hadith and Sunnah. Similarly, the Hinduism or Buddhism followers may not approve products originating from the killings of animals. A modern multinational business firm has to abide by such norms in determining its business policy and expansion in different regions. Likewise, in entertainment business, a film producer needs to judge the social impact of the movie. So, the publishers must see that their publications should not cause damage to the social values or degrade morality. Media managers also bear similar responsibilities and so on. Furthermore, in industrial pursuit, environmental abuses need to be minimized and ecological balance has to be maintained. The Meaning, Scope and Methods of Managerial Economics 11 Managerial economists should seek to understand and examine not only what is happening in the business field; they should also seek to devise or guide in formulating and choosing alternative policies that may influence the course of business events for the betterment of the society at large. Economists Differ Often economists have appeared to have differences of opinions on the solutions to given problems and their advise to the policy-makers. They disagree on several issues and diagnosis.  This happens, because economic policy-making is a blending of positive and normative approaches. Secondly, economists may disagree on the ground of different economic theories and their axioms in analysing the working of an economy. Thirdly, economists may disagree on the incorporated variances and their significance in the economic models constructed for empirical investigations. Disagreement may be on the ground of sample size and methodology. Fourthly, economist may have disagreements on the pricing norms and suggestions. They may differ on the value judgements. Often, in the course of public policies, therefore, economists be different and argue for as against on certain measures and values. In the matter of public expenditure, for instance, there are differing views about the percentage of allocations on defence and development. Likewise, economists have no common agreement whether interest rates showed are high or low or zero for the financial sector growth and its impact on the real economic growth in the country. Same way, in trade policy their views differ on free trade and protection devices. As a result, often the policy-makers get confused by receiving conflicting devices from different ground of economists and the public policy issue tends to became controversial. For instances, the monetarists argue that the money matter the must and inflation is a monetary phenomenon. The fiscalists, on the other hand, used that money does not matter and inflation is caused by the inflationary gap when aggregate demand exceeds the aggregate supply. Hence, solution lies in the fiscal management of aggregate demand. Whereas, to supply side economists the solution implies the supply management. Nonetheless, the study of economics has its significance. Managers get a better insight about the working of the economy by learning the principles of economics, economics theories, dogmas and mode of analysis that will be of at most significance in the course of business and managerial decision-making. 4. SCOPE OF MANAGERIAL ECONOMICS Business economics, in the true sense, is the integration of economic principles with business practice. The subject-matter of business economics, as such, should pertain to economic 12 Managerial Economics analysis that can be helpful in solving business problems, policy and planning. But, one cannot make good use of economic theory in business practices unless he masters the basic contents, principles, and logic of economics. Business economics is pragmatic. It is concerned with analytical tools that are useful for decision-making in business. Managerial economics is an evolving science. It is a newly developing subject with the popularity of management studies. Hence, there is no demarcation or any uniform pattern of its subject-matter and scope.  Business economics has picked-up relevant concepts, techniques, tools and theories from micro and macroeconomics applicable to business issues and problems of decision making. Following are the core topics of managerial economics: Demand Function and Estimation Demand Elasticity Demand Forecasting Production Function and Laws Cost Analysis Pricing and Output Determination in different market structures such as perfect competition, monopoly, oligopoly and monopolistic competition Pricing Policies and Practices in Real Business Profit Planning and Management Project Planning and Management Project Planning Capital Budgeting and Management Break-even Analysis Linear Programming Game Theory Government and Business. The scope of business economics is usually restricted to the understanding of the business behaviour and problems of a firm at a micro level in the context of the prevailing business environment. The methodology of business economics involves microeconomic analysis in analysing the behaviour and problems of the business unit in particular. Microeconomic analysis is understand the business environment in the economy. Business economics is a science as well as art. Further, it is positive as well as normative science. As a positive science, it deals with empirical studies of business phenomenon such The Meaning, Scope and Methods of Managerial Economics 13 as demand cost, production, etc. As a normative science, it discusses policy objectives and business practices with a critical approach and suggest for the socially desirable course of business actions. Following are the main characteristic features of business economics as a specialised discipline: It involves on application of economics theory – especially microeconomics analysis to practical problem solving in real business life. It is essentially applied microeconomics. It  is a science and facilitating better managerial discipline. It is concerned with firm’s between in optimal allocation of resources. It provides tools to help identify the best source among the alternatives and competing activities in any productive sector whether private or public. Managerial economic incorporate elements of both micro and macroeconomics dealing with management problems in achieving at optimal decisions. It uses analytical tools at mathematical with two main approaches to economic methodology involving descriptive as well as prescriptive models. Descriptive models are data based in describing and exploring economic relationships of reality in simplified abstract sense. Prescriptive models are the optimising models to guide the decision-makers above the most efficient way of realising the set goal. Often, descriptive models provide a building block for developing optimising models in solving the managerial on business problems. For example, a descriptive model explain and predicts the general behaviour of price movement It may serve as a base for constructing an optimising model for profit maximisation goal of the firm. The set of alternative strategies towards attainment of the objective function in operation terms within specified constraints, in prescriptive model, may be derived with the help of descriptive models in background. Uses/Objectives of Managerial Economics Managerial economics is pragmatic. It is concerned with analytical tools that are useful for decision-making in business. In short, business economics essentially implies the application of economic principles and methodologies to the decision-making process within the firm under the conditions of uncertainty. Managerial economics is a selection from the tool box of economic priciples, methods and analysis applied to business management and decision-making. It follows, thus, that economic theories are very useful in business analysis and practice for decision-making and forward planning by management. Managerial economics may be useful in the following respects: It makes problem-solving easy in business; It improves the quality and preciseness of decisions; It helps in arriving at quick and appropriate decisions. 14 Managerial Economics Business economics is applicable to several areas of business and management in practice, such as production management, inventory management, marketing management, finance management, human resource and knowledge management. Production and Inventory Management  Strategic Business Management Economics: Theory and Knowledge Policy Issues Management Marketing Management Human Resources Financial Management Management Fig. 1.2: Application Areas of Managerial Economics in Business Decision-making The application of Managerial economics in business decisions, problems and allied areas of management are pinpointed in Fig. 1.2. 5. SCIENTIFIC METHOD OF ECONOMIC ANALYSIS IN THE MANAGE RIAL DECISION-MAKING Economics is an applied social science. In studying human economic behaviour in the society, it adopts a scientific approach. In understanding and examining the economic life and problem of the people, an economist behaves like a scientist because of the scientific method involved in the study. The Scientific Method The scientific method implies an analytical approach in the study of a phenomenon. The economist while studying man’s economic behaviour and the associated problem. The man’s economic behaviour on the whole pertains to the want-satisfying activity against using the available limited on scarce resources. In economic analysis, therefore observation are made first and the hypothesis is formed. Then, data are collected for testing the hypothesis. When, the hypothesis is proved and then the outcome is generalised as economic theory. Time and again, the theory is tested and evaluated by further observation and empirical investigation. Unlike, natural science, there is no laboratory experimentation. But the whole society, economy on the world at large is The Meaning, Scope and Methods of Managerial Economics 15 considered as a working lab in practice. Episodes in the economic life are analysed and economic theory is formed. Or, the existing economic theories are evaluated further in the light of new episodes occurring time-to-time in economic society. Modern economic life is dynamic and one’s behaviour governed by human mind is not certain. This keeps economics as a social science little less than perfect with permanency of the theory in its universal application.  Managerial economists tend to rely on the scientific research method in building and empirically testing business-oriented economic models. This scientific approach consists of the following steps: ⌘ Defining the problem ⌘ Formulation of the hypothesis ⌘ Abstraction for the model building ⌘ Data collection ⌘ Testing the hypothesis ⌘ Deduction based on data analysis ⌘ Evaluating the test results ⌘ Conclusion for decisions Defining the Problem The starting point of business economic investigation/research and analysis is the statement of the problem to be solved in the concerned business. The problem needs to be clearly defined by isolating the exact business phenomenon of economic interest and application. It involves framing the relevant questions to be explored in specific terms. In general, the defining of problem helps the manager/analyst in shaping the nature, course and direction of the business research. Indeed, the problem needs to be defined in view of the goals and the constraints. Out of several business goals, a specific goal is selected to determine the problem and the constraints are identified in the way of fulfilment. Constraints In reality, firms may encounter several constraints in its business operations, such as: ⌘ Availability of required inputs in required proportions. ⌘ Quality standards of labour and the productivity. Different workers have different attitude to their work and the proficiency may differ. All labour units are not alike in performance of their tasks. ⌘ Production capacity of the organisation in short and long run. ⌘ Managerial talents. 16 Managerial Economics ⌘ Government regulations. ⌘ Taxation. ⌘ Warehousing and logistic facilities. ⌘ Business capital funds. ⌘ State of technology.  ⌘ Provision of company’s hardware and software. ⌘ Quantum of information and knowledge acquisition, management and utilisation. ⌘ Corporate culture of the company. ⌘ Diversity of human resource and its mode of utilisation. Formulation of Hypothesis A hypothesis in a business enquiry is a tentative/largerly untested explanation of the behaviour, assumption about the course of behavioural tendency and discovering the cause effect relationships among the governing factors/variables of the concerned business phenomenon. In managerial economic analysis, hypothesis are formed to identify pattern of economic behaviour and discover the business variables’ economic relationship with a view to test the proposition and shed new lights on the issues and, thus, draw inferences for decision-making. Abstraction/Model Building Abstraction and model building were essential in framing up the enquiry to a manageable proportion by eliminating complexities and unnecessary or insignificant details. The process involves distillation and restrictions for choosing variables and selecting relevant informations. The investigation problem is much simplified through appropriate model building based on abstraction of reality by simplifying assumptions. In practical business studies, thus, assumptions and identifications are utilised to simplify and highlight the essential features of the events, situation and behavioural relationship for an easy investigation, analysis, inference and quick decision-making. As such, out of many goals in hand, only a few major ones or sometimes a single one is being selected at a time in a business decision-making based on scientific economic enquiry. For instance, profit maximisation is identified as a basic goal in studying a firm’s business behaviour. Similarly, in tracing the cause effect relationships among some major overriding variables, even from a practical business viewpoint, it is customary to assume that all other relevant factors which are not of any primary concern are constant in the model constructed for an enquiry. The abstract or axioms in the business economic model should, however, be reasonably representing the real world phenomena. Data Collection As per the model specification of the variables such as price, demand, sales, advertising expenditure, and so on relevant data have to be collected. Data may be time series, cross sectional or pooled. The Meaning, Scope and Methods of Managerial Economics 17 Time series data are based on the time movement and historical records. y = f(t) where y = a micro or macro economic quantity and t = time element which may be a year, quarter, month, week or day. Cross-sectional data are based on the relationship of dependent variable with other elements such as geographical place, firms, etc. Say, for instance, data on profits of different banks in a given year constitute cross-sectional data. Pooled data are the mix of time and other elements. For example, yearly profits of different banks during a certain period, say over a decade. Testing the Hypothesis The hypothesis need to be verified on empirical basis by using the relevant data. Furthermore, the significance of statistical coefficient should be determined. For further details, read Appendix 2.1. Deduction based on Data Analysis If properly formulated hypothesis indicates not only cause effect relationship, but also serves as the basis for predictions on empirical results. Predictions, forecasts or conclusions are derived from logical deductive reasoning. (Thompson and Formly, 1993, p. 5). Say, for example, if we find a significant positive correlation between advertising expenditure and sales volume of a firm, we may conclude that for further expansion of sales the firm should increase its advertising expenditure. Evaluating the Test Results When real world events confirm a hypothesis — (cause-effect relationship) — it is accepted. This, however, does not, mean that the hypothesis is proved. What it simply means is that the investigated events have failed to disprove the hypothesis. Hypothesis can only be tested; it can never be proved. The empirical results of the hypothesis researched can only be tested/ evaluated by examining its predictions in the light of experimental and observational facts (Beveridge, 1957, p. 118). A hypothesis is rejected when observed facts contradict its prediction. A hypothesis when successfully survives a number of tests, it acquires the status of a theory. Conclusion for Decisions When a hypothesis is accepted — having passed various statistical tests, it can be useful for making inferences or drawing conclusions about a business situation for decision-making. Interpretation and inference making from empirical results for the future course of action is an art and the success of decision depends on the skill of the manager or the decision maker. 18 Managerial Economics Chart 1.1 Theoretical Real Business Business World World Hypothesis: Relationships among Observations/actual behaviour the business and economic variables and concern of actions: Facts  Testing Decision-making Model Building Empirical measures: Predictions: Hypothesis Chart 1.1 outlines the scientific approach to managerial economic research/analysis in solving a business problem. It involves a bridging between theory and real business world. The significance of economic models and micro-macro analysis lies in the logical framework created by them for the decision-making process in business management. Managerial economics, thus, becomes useful as it makes the task of successful business management easier through characterisation of business behaviour with a scientific blending of economic theory and business experience in practice. As any decision tool, analysis and techniques of managerial economics, however, must be used with discretion. 6. BASIC ASSUMPTIONS IN ECONOMIC MODELS AND ANALYSIS Economists usually construct models for analysing economic behaviour and problems in view. An economic model is a set of assumptions about economic variables and their relationships concerning certain aspects of economic reality. In essence, an economic model is an abstract of economic reality. It is constructed to simplify the complexities of reality in order to comprehend the interactions of forces operating in an economy. Economic models are constructed by using logic and mathematics for deducting implications on the basis of assumptions. In short, economists develop and use theoretical models as aides to understanding economic complexities, with simplifying assumptions. Ceteris Paribus Assumption In analysing problems and business situation such as markets, demand, competition, price and cost strategies and so on, managerial economics make use of economic and The Meaning, Scope and Methods of Managerial Economics 19 econometric models as an abstraction or realty. Eventually, these model tends to be less than perfectly realistic. This is simply because, the models are constructed with a focus on particular aspect or issue of the business or managerial economic problem assuming all other things being equal the typical ceteris paribus assumptions. Ceteris paribus is always taken for granted in constructing most of economic models. In fact, laws and hypothesis of economics are always stated with the qualifying phrase: “other things being equal”, i.e., ceteris paribus assumption. Ceteris paribus is a Latin phrase meaning “all other things remaining the same” or “all relevant factors being equal or unchanged.” The term is used frequently as an axiom in the analysis of a variety of economic phenomena. For example, in price theory the analysis of a price change is carried under ceteris paribus assumption regarding the market behaviour. It is assumed, for instance, that only demand changes, supply and determinants of supply remaining unchanged. Thus, it is inferred that when demand rises, supply being constant, price rises. Economic inferences based on ceteris paribus axiom models are logically sharp, but many times irrelevant for the practice. Ceteris paribus implies static model which is unsuitable for application to a dynamic situation. In reality, we usually find dynamism. Thus, static theoretical models have least practical relevance, they are good for theoretical understanding only. A large part of micro economics based on ceteris paribus assumption suffers from such limitation. Modern economics is a more positive economics in nature, which provides “a system of generalisations that can be used to make correct predictions about the consequences of any change in circumstances.” Economics, thus, becomes an objective science when its dogmas are based on a number of explicit and implicit assumptions. Professor Friedman mentions the following three interrelated, positive roles of assumptions in an economic theory: “(a) They are often an economical mode of describing or presenting a theory; (b) they sometimes facilitate an indirect test of a hypothesis by its implications; (c) they are sometimes a convenient means of specifying the conditions under which the theory is expected to be valid.” The basic assumptions in economics may be broadly classified into three categories: psychological, structural and institutional. Psychological Assumptions Since economics is a science concerned with human behaviour, certain psychological assumptions, some of which may even be tacitly made, are basic to the inferences drawn and explanations furnished, relating to varied economic phenomena. In economic analysis, it is basically assumed that the behaviour of an economic man, whether he is a consumer or a producer or an agent of production, is normal and that he is a rational person. Thus, in every economic analysis, it is explicitly or tacitly assumed that decision-taking units in the economic system such as consumers, factors or firms, behave in a rational manner. Their behaviour is treated as rational when it is confined to some specific well-defined motivation. Thus, in various economic theories, we always find that a rational consumer is seeking maximisation of his total satisfaction in his purchases. He is, thus, assumed to behave to pursue this total 20 Managerial Economics of utility maximisation. And, we have laws of economics, like the law of equi-marginal utility, which explain how such a goal is attained by the consumer. Similarly, in analysing a firm’s behaviour, economists usually assume that the firm is rational and seeking maximisation of total profits in its business. The assumption of rationality in the behaviour of an economic entity is a psychological assumption. It also implies consistency in the choice and behaviour of the economic man concerned. It is thus assumed, for instance, that the tastes, habits and preference of the consumer remain unchanged, while examining the demand behaviour. Structural Assumptions  Economics is the study of economic activities. Economic activities are basically confined to the exploitation of productive resources: natural, human and manmade, for the satisfaction of the multiple human wants. In constructing an economic model, to study the working of a particular phenomenon or in selling an economic dogma, certain implicit assumptions about the related structural issues involved about the nature of physical structure, or the topography of a region, the climatic conditions, or the biological limitations of human resources, are to be made. These are the many implied structural assumptions in the analysis of an economic phenomenon. For instance, in studying agricultural economics, it is implicitly assumed as a fact that all lands are not capable of being used for all kinds of crops in all seasons. In industrial activity, on the other hand, it is assumed that the biological factor limits the labour supply of an individual worker. Thus, a firm cannot double the working hours of the workers in order to double its output. Workers get tired once their normal capacity is exhausted. It is a biological fact. Again, it also involves a psychological factor that workers often prefer leisure to work, once their income rises to a certain point. Institutional Assumptions Man is a socio-political animal, his behaviour is influenced by the social, political and economic institutions of the time. Thus, in analysing his economic behaviour, we have to make assumptions about the social, political and economic institutions surrounding him. Institutional assumptions are specifically related to the type of economic system and its political setting. For instance, if the behaviour is studied in a capitalist economic system, we have to assume that there is least government control and that the market mechanism has a strategic role in arriving at economic decisions. If, on the other hand, a socialist economic system is considered, the complete control of the government on economic resources, and a centralised comprehensive planning are automatically implied. Similarly, in a mixed economy, the strategic role of the public sector and the relative scope of the private sector, have to be clearly defined. Needless to say, economic dogmas and economic policies should be formulated within the constraints of the psychological, structural and institutional assumptions. Evidently, a meaningful scientific theory is based on the selection of some ‘crucial’ assumptions which are specific to understand a particular class of phenomena. Indeed, there can be more than one set of assumptions, in terms of which an economic theory may be set forth. According to Friedman, “The choice among such alternative assumptions is made on the grounds of the resulting economy, clarity and precision in presenting the hypothesis; their capacity to bring indirect evidence to bear on the validity of the hypothesis; by suggesting some of its implications The Meaning, Scope and Methods of Managerial Economics 21 that can be readily checked with observation or by bringing out its connection with other hypothesis dealing with related phenomena and similar considerations.” Above all, in modern economic analysis, it is being assumed that the pattern of regular behaviour of economic entities is reasonably stable — at least in the short-run, and it is the most fundamental feature of an operational economic proposition. 7. TIME PERSPECTIVE Economists widely used the concepts of functional time periods, short-run and long-run in their analysis. This time perspective of short and long period is also important in business decision-making. Especially, the entrepreneur or business manager has to review the long range effects on costs and revenues of decisions. “The really important problem in decision making is to maintain, the right balance between the long-run, short-run, and intermediate run perspectives.” (Haynes, Mote, Paul: 1971). Time is an important factor in business decision-making. A timely decision is always effective and rewarding, if appropriate. Usually, decisions for the future actions are based on the past observations. A foreseeable future outcome is generally the extension of the course of action and the results obtained in the relevant past period in the business trend analysis. In business decisions, in relation to time-period, thus, there are short-term and long-term perspectives. Short-term time perspectives are based on the short-run analysis of the business data and performance. Usually, from trade cycles’ point of view, seasonal fluctuations in the business are observed and decisions are carried to deal with the changing circumstance in the course of business within a short period. For instance, a banker would also find it necessary to maintain a high quantum of cash flow as liquidity to honour the demand for deposits withdrawals in the first week of every month, as people have to pay out their monthly bills and meet necessary expenses of a high order. During Diwali season, fireworks producers/ sellers have to keep a larger stock than otherwise. By and large, inventory management is based on short-term perspectives. A bus company has to manage extra tyres; a bookseller keeps high stock only before and initial month of school/college semester beginning. Guides-books are stored more in quantity when examination period, October/April is near. It involves short-term business planning to maintain business routine with the given business size. In long-run, the perception is towards growth, development and expansion. It is related to the long-run business planning for progress. In this regard, external influencing factors are also considered. For instance, when an airline assumes that business is expanding and it has increased flights due to increasing number of travellers in the years to follow on account of rising income level and economic growth rates, it has to order extra aircrafts for replacement and for additional flights, it is a long-term perspective. 22 Managerial Economics For a successful business and just-in-time strategy, a manager has to decide the time perspective of business options and actions well in advance and implement at an appropriate time. He should avoid unwise decision on time perspectives. For example, a long-run preparation of sweets by a sweet shop is obviously not a wise decision. The market demand for education when projected on a short-run basis by a university is an unwise decision. It should go for a long-term projection and long-term growth planning. 8. DISCOUNTING PRINCIPLE A present gain is valued more than a future gain. Thus, in investment decision-making, discounting of future value with the present one is very essential. The following formula is useful in this regard:  where, V= present value, A = annuity or returns expected during a year, i = current rate of interest. To illustrate the formula, suppose A = 110 and i = 10% or 1/10, we can ascertain the present value of Rs. 110 one year after as: 110 == + V= 110 AV 1.1 += 0.11 100 i)(l In business decision-making process, thus, the discounting principle may be stated as: “If a decision affects costs and revenues at future dates, it is necessary to discount those costs and revenues to present values before a valid comparison of alternatives is possible.” Case Study Decision-making — A Mini Case [Hypothetical]: Method of Managerial Economics Pioneer Automobiles projected an increasing demand for their cars in the country by 20 per cent per annum. Currently, all their 10 plants are fully in operation up to their maximum capacity. The firm intends to expand its output with an objective of earning more profits. The management has two options to choose for expanding the output: (1) Strategy one: S1: Construct two new additional plants. (2) Strategy two: S2: A rival firm, Prestige Automobiles, is in financial trouble and wishes to sell out its two plants in the vicinity of the pioneer. Buy this and modify. Decision-making Process 1. Objective: Increase in Profit (P) 2. Analysis: Work out relative cost and profit analysis in the case of these two strategies: PS1 and PS2 The Meaning, Scope and Methods of Managerial Economics 23 3. Decision Rules: When, (i) PS1 > PS2 Choose S1 (ii) PS1 = PS2 Choose S1 (iii) PS1 < PS2  Choose S2. MODEL QUESTIONS 1. What is managerial economics? 2. “Managerial economics is an integration of economic theory, decision science and business management.” Comment. 3. Discuss the salient features and significance of managerial economics. 4. Is managerial economics a positive or normative science? 5. Explain and illustrate the stages in the process of managerial decision-making. 6. Write explanatory notes on: (a) The nature of managerial economics. (b) The scope of a managerial economist. (c) Significance of managerial economics. 7. Explain the scientific method of managerial economic analysis. ⑧⑧⑧ Unit II Economic Concepts Relevant to Business 2 CHAPTER Economic Concepts  In this chapter, some fundamental economic concepts relevant to business have been discussed. 1. DEMAND Ordinarily, by demand is meant the desire or want for something. In economics, however, demand means much more than that. The economics meaning of demand refers the effective demand, i.e., the amount the buyers are willing to purchase at a given price and over a given period of time. From managerial economic’s point of view, thus, the concept of demand may be looked upon as follows: 1. Demand is the Desire or Want Backed up by Money. Demand means effective desire or want for a commodity, which is backed up by the ability (i.e., money or purchasing power) and willingness to pay for it. Obviously, to a businessman, a buyer’s wish for the product without possessing money to buy it or unwillingness to pay a given price for it will not constitute a demand for it. For instance, a pauper’s wish for a Maruti car will not constitute its potential market demand, as he has no ability to pay for it. Likewise, a miser’s desire for the same, how rich he may be, will not become an effective demand when he is unlikely to spend the money for the fulfilment of that desire. In short: Demand = Desire + Ability to pay (i.e., Money or Purchasing Power) + Will to spend 2. Demand is Always Related to Price and Time. Demand is not an absolute term. It is a relative concept. Demand for a commodity should always have a reference to price and time. For instance, an economist would say that the demand for grapes by a household, at a price of Rs. 40 per kg, is 10 kilograms per week. 28 Managerial Economics Economists always mention the amount of demand for a commodity with reference to a particular price and specific time period, such as per day, per week, per month or per year. ‘They are not concerned over with a single isolated purchase, but with a continuous flow of purchase.’ In economics studies, therefore, demand is expressed ‘as so much per period of time — one million oranges per day, say, or seven million oranges per week, or 365 million per year’ (Ibid., p. 47).  We may, thus, define demand as follows: Definition of Demand. The demand for a product refers to the amount of it which will be bought per unit of time at a particular price. 3. Demand may be Viewed Ex-Ante or Ex-Post. Demand for a commodity may be viewed as ex-ante, i.e., intended demand or ex-post, i.e., what is already purchased. The former denotes potential demand, while the latter refers to the actual amount purchased. 2. SUPPLY In economics, supply during a given period of time means the quantities of goods which are offered for sale at particular prices. Thus, the supply of a commodity may be defined as the amount of that commodity which the sellers (or producers) are able and willing to offer for sale at a particular price during a certain period of time. Supply is a relative term. It is always referred to in relation to price and time. A statement of supply without reference to price and time conveys no economic sense. For instance, a statement such as ‘the supply of milk is 500 litres’ is meaningless in economic analysis. One must say, ‘the supply at such and such a price and during a specific period.’ Hence, the above statement becomes meaningful if it is said ‘at the price of Rs. 20 per litre, a dairy farm’s daily supply of milk is 500 litres.’ Here, both price and time are referred to with the quantity of milk supplied. Secondly, supply is what the seller is able and willing to offer for sale. The ability of a seller to supply a commodity, however, depends on the stock available with him. Thus, stock is the determinant of supply. Similarly, another determining factor is the will of the seller. A seller’s willingness to supply a commodity, however, depends on the difference between the reservation price and the prevailing market price or the price which is offered by the buyer for that commodity. If the ruling market price is greater than the seller’s reservation price, he (the seller) is willing to sell more. But at a price below the reservation price, the seller refuses to sell. In short, supply always means supply at a given price. At different prices, the supply may be different. Normally, the higher the price, the greater the supply and vice versa. 3. PRODUCTION Production is an outcome of economic activity. Its purpose is the satisfaction of wants – collective or individual. Production is meant for changing the form or arrangement of matter by man, in order to create further utility and make it more useful for satisfying human wants. Consumption is not possible without production. Economic Concepts 29 Production means the process of transforming the factors of production such as land, labour and capital into goods and services. It is the process by which the input of factors of production results in the output economic goods. Production eventually means creation of utilities such as form utility, place utility and time utility. It implies creation of additional utilities by changing form, place and time. production by changing form: Manufacturing activities lead to the creation of form utility. For example, changing of cotton into cloth or of wood into furniture is the production by creating form utility. Production by changing place: Activities relating to the change of place of commodities, i.e., bringing apples from Simla to Bombay, is also regarded as production, as there is creation of place utility. Production by changing time: Supplying the goods at a time when they are needed most is the production by creating time utility. Traders, for instance, keep stocks of goods for sale at a proper time to satisfy the buyers’ needs when the demand rises considerably. Preserving fruits in cold storages and supplying them during off season, is production by creating time utility. The utility of stored grain and grass increases during the pre-monsoon period and in the event of a famine or scarcity. This is also production. As a matter of fact, creation of place utility and time utility may be described as “distributive services” or “exchange activities.” Thus, production includes transportation, trading and commerce, together with industry and agriculture. Therefore, all productive economic activities are the process of production of material goods. Non-material goods resulting from direct services of doctors, lawyers, teachers, dancers, musicians, actors, etc., are also regarded as production. According to J.R. Hicks, ‘any activity towards the satisfaction of other people’s wants through exchange’ is production. Value (in use) of the commodity produced is also increased because its utility has increased. Hence, production is also the creation of values. Features of Production The concept of production would be still clearer, if we notice the following features of economic production or productive activity. 1. Wider Term: “Production” is a wider term which relates to both goods and services produced in different sectors of the economy – agriculture, mining and quarrying, manufacturing, trading, transport and communication, banking and other professional services like those of doctors, lawyers, teachers, etc. 2. Creation of Value: Production implies creation of economic goods having exchange values. Production process, thus, results in the creation of value, measurable in terms of money (i.e., price). 3. Transformation of Resources: ”Production” refers to transformation of productive resources (inputs) into marketable goods and services (outputs). The term “inputs” or “productive resources” means factors of production. Thus, production is the result of combined efforts of the various factors of production – land, labour, capital and enterprise. 30 Managerial Economics 4. Complete Process: Production is the complete process in the creation of economic goods to satisfy consumers’ wants. Thus, production implies all processes necessary, say, from manufacturing to marketing, to bring goods into the hands of the consumers. 5. Flow over a Period of Time: Production is a flow concept. Thus, productive activity is measured as a rate of output per unit of time period, e.g., 1000 TV sets produced per month by an electronic firm. Firm as a Producing Unit The firm is a producing unit. It is a business unit which undertakes production activity. The firm buys and coordinates the services of productive factors such as land, labour and capital along with its organisation for producing a commodity and sells it in the market to the households. The firm is controlled by the entrepreneur who undertakes major decisions such as: What to produce Where to produce How and how much to produce Whom to sell and at what price The firm hires factors of production and pays them remuneration to compensate for their productive services. In short, the firm organises the business and bears risks. Thus, a firm, i.e., the entrepreneur or a businessman as the owner/controller of the firm earns profits as the reward. Firm owns/organises a plant. It may be a factor/plant as a production plant containing shed, machineries, equipments etc. A plant is a place arrangement for a production process. Whereas firm is a decision-making unit. 4. DISTRIBUTION In a modern economy, the production of goods and services is a joint operation. All groups of factors of production, viz., land, labour, capital, and enterprise, are combined together in productive activity. Productive activity is thus the result of the joint efforts of these four factors of production which work collectively to produce wealth. These factors need to be paid or rewarded for their services for producing wealth, and hence the problem of distribution follows. Distribution thus refers to the sharing of the wealth that is produced among the different factors of production. The wealth that is produced by the people is distributed in the following forms: (i) rent as share of land, (ii) wages as remuneration for labour, (iii) interest as return on capital, and (iv) profit as reward of enterprise. Distribution thus implies the division of national income amongst the different classes: landlords, labourers, capitalists and entrepreneurs. It is through distribution of production that different individuals in the community receive their income. Economic Concepts 31 Thus, distribution is an economical method by which the real wealth, collectively produced by the agents of production, is divided or distributed among them. Functional Distribution vs. Personal Distribution In economics, the term ‘distribution’ has at least two connotations: (i) functional distribution, and (ii) personal distribution. Functional distribution refers to the distinct share of national income received by the people, as agents of production per unit of time, as reward for the unique functions rendered by them through their productive services. These shares are commonly described as wages, rent, interest, and profits. Briefly, thus, functional distribution relates to the share of the factors of production in the form of rent, wages, interest and profits in the aggregate production. It is a macro concept. Personal distribution, on the other hand, is a micro concept. It refers to a given amount of wealth and income received by individuals in society through their economic efforts, i.e., individual’s personal earnings of income through various sources. The concept of equality and inequality of income distribution and social justice is basically concerned with the personal distribution of income. Taxation measures are designed to influence personal distribution of income and wealth in a community. The theory of distribution deals with functional distribution and not with personal distribution of income. It seeks to explain the principles governing the determination of factor rewards — rent, wages, interest and profits — i.e., how prices of the factors of production are set. Needless to say, rent is the price of land. Wage is the price of labour. Interest is the price of capital, and profit of enterprise. The theory of distribution thus states how the product is functionally distributed among the cooperating factors in the process of production. The theory of distribution does not explain what is the income of each and every individual in the community, and why it is so much. It just explains how labour, as a whole, or as a class, as a factor of production, would receive its share of national income, and as also the other factors of production. 5. CONSUMPTION Consumption is the action of consumer for using the satisfaction of given wants. Consumption, however, does not imply the using up or the destruction of goods. In the consumption process, there is destruction of utility. Its end result is the satisfaction of want. In the consumption of perishable goods, however, with the destruction of utility, the good is also used up or literally consumed. It vanishes or disappears in the process of consumption, e.g., when we drink milk or tea, eat banana or biscuits, they are also destroyed together with the destruction of utility for satisfying our thirst or hunger. Whereas in the case of durable goods, though their utility is destroyed, goods remain in existence. The depreciation of such goods is slow, so the same goods go on satisfying our wants again and again. Their utility remains till they become old and deteriorate or break down. Thus, a car in use does not disappear and if well maintained may not even deteriorate perceptibly. But in the real consumption process, we definitely exhaust its utility, though gradually, by using its services in a steady flow over its life time. 32 Managerial Economics Further, wealth and not capital is consumed by the consumers for satisfying wants, e.g., when we travel by a railway, we directly consume railway’s services and not the rail-carriage or engine. Engine or train compartment is just a capital for facilitating railway services. At the most, this is regarded as indirect consumption. Briefly, thus, consumption is the using up of utility, directly or indirectly, when we come to satisfy our wants. Importance of Consumption 1. Consumption is the beginning and end of economic activity. Wants are satisfied through the consumption of goods. And, wants are the starting point of economic activity. Thus, the desire for consumption comes before production. Producers produce goods because there is want, there is consumption. And every economic effort results in the production of goods and services. This production is ultimately consumed for the satisfaction of wants. 2. Production and consumption are associated with each other. Without production, consumption is not possible; without consumption, production is useless. 3. In a market-oriented economy, consumption behaviour of the consumer and their demand pattern determine the mode of production. Household as a Consuming Unit In a market economy, households and firms are the major economic entity. Micro economic theory deals with their behaviour in particular. The household refers to a basic consuming unit. A household may be defined as an individual or a group of individuals in a family under one roof who undertake decisions regarding consumption for the satisfaction of their numerous wants. In macroeconomics, thus, a household is a consumer. It seeks to describe consumer behaviour in demand theory. The behaviour of household is important because it constitutes demand for a commodity. The market demand is composed by the aggregate of individual demand. A Consumer is sovereign in a market economy. He chooses his wants and buys goods accordingly to satisfy them. Consumer’s preference is thus very important in determining the pattern of demand as well as the forms of production in a market. Since a consumer has many wants against his limited income, he has to make a rational choice. Scale of Preference Scale of preference means the arrangement of wants and the relative preference of goods in accordance with the degree of intensity or urgency of different wants. We have to arrange our wants according to our scale of preference because our means to satisfy our wants are limited. It is because our wants are of varying importance and that they can be arranged on our scale of preference so that choice is possible. A man will give the highest order of priority Economic Concepts 33 of preference to some wants and put other wants in a descending order of preference. This ordering of wants is called the scale of preference. Every consumer has his unique scale of preference. It is obvious that the scale of preference will differ from individual to individual, from time to time and from place to place. Today, we might prefer to coffee and after some time, we might prefer coffee to tea.  Human beings may be conscious or unconscious, rational or irrational, consistent or inconsistent in preparing a scale of preference. 6. CONSUMPTION FUNCTION Consumpt