2 Overview of Important Terms and Concepts in Managerial Economics

Dr. Savita

 

1. Learning Outcome:

 

After having studied this module, one may be able:

 

1. To know the various concepts of Managerial economics.

2. To understand how these concepts are fundamental to business analysis and decision-making.

3. To understand how these concepts are helpful to improve Managerial decision-making.

 

2. Introduction

 

In due course of business, managers often encountered the various situations where they require taking rational decision to ensure the smooth functioning of the organization. At the same moment taking right decision at the right time is difficult task. Failure to do so may lead to a sudden fall of business enterprise. Therefore, to arrive at the right decision one can make use of Economic theories, concepts, and analytical tools.

 

3. Basic Tools in Managerial Economics or principles of Managerial Economics or Fundamental Concepts of Managerial Economics:

 

Managerial Economics employs some well known tools of analysis. These tools are given below in detail:

  • Principle of Opportunity cost
  • Principle of Incremental cost and revenue
  • Principle of Time perspective
  • Principle of Equi-marginal satisfaction and Productivity
  • Principle of Discounting
  • Principle of Risk and uncertainty
  • Principle of Optimisation

 

  1. Opportunity Cost:

 

While taking decision in relation to any business activity we have to take into consideration various alternatives. In Managerial economics, the opportunity cost is useful in decision involving a choice between different alternative courses of action. The opportunity cost of any decision is the sacrifice of the next best alternative course of action available to any firm. If we don’t have to make any sacrifice then the opportunity cost is zero. Opportunity cost, therefore represent the benefits or revenue foregone by pursuing one course of action rather than another.

 

 

The concept of opportunity cost implies following things:

 

1. The calculation of opportunity cost involves the measurement of sacrifices made termed as the cost of sacrificed alternatives.

2.Sacrifices may be monetary or real.

3.The opportunity cost may also be interpreted as the cost of alternative which we have to forego.

Further W.W.Haynes has clarified the meaning of the concept of opportunity cost with the help of following examples:

 

The opportunity cost of the funds tied up in one’s own business is the interest (or profits corrected for differences in risk) that could be earned on those funds in other ventures.The opportunity cost of the effort one puts into his own business is the salary he could earn in other occupations (with a correction for the relative ‘phychic income’ in the two occupations).The opportunity cost of using a machine that is useless for any other purpose is nil. Since its use requires no sacrifice of other opportunities.From the above examples it is clear that opportunity cost requires the measurement of sacrifice. If there is no sacrifice involved by a decision, there will be no opportunity cost. Though the opportunity cost is not recorded in the books of accounts. It is an important consideration in business decisions.

 

The importance of opportunity cost is as follows:

 

a) It helps in determining the relative prices of goods.

b) It helps in determining normal remuneration to factors of production.

c) It helps in proper allocation of resources.

 

Thus we can say opportunity cost is the cost of next best alternative use. Following are the various examples that illustrate the concept of Opportunity cost:

 

The opportunity cost of the capital employed in the business is the interest that could be earned on that capital which may be deposited in the bank.

 

The opportunity cost of the time any person devotes to his own business is the salary he could earn by being employed elsewhere.

 

The opportunity cost of using a machinery to produce any product is the earnings foregone which may be possible from the production of other products.

 

An Ice cream making firm producing vanilla flavour ice cream can also make pineapple flavour Ice Cream; in this case the opportunity cost of making vanilla is the amount of the pineapple ice cream given up.

 

The opportunity cost of holding Rs.10000/- as cash in hand for one year is the 8% rate of interest, which would have been earned had the money been kept as fixed deposit in a bank.

 

Therefore, we can say that opportunity cost of anything is the next best alternative that could be manufactured by the same factors and by the same amount of expenditure. Thus opportunity costs must be considered by the managers before taking any decision for business.

  1. Incremental cost and revenue principle:

 

Incremental concept is another important concept. Incremental concept is in close relation to the marginal costs and marginal revenues. Incremental concept implies measuring the changes in total cost and total revenue due to change in the decision of the firm in relation to changes in techniques of production, prices of products, investments, source of raw material etc.

 

The two basic components of incremental reasoning are:

 

a) Incremental cost

b) Incremental revenue.

 

(a) Incremental Cost may be defined as the change in total cost as a result of a particular decision. In simple words Incremental cost is the differential cost that must be incurred if a decision is taken and that need not be incurred if the same is not executed. It is a change in total cost due to a change in the level of the activity. Incremental cost may be either fixed cost or variable cost. This is because a business decision may require purchase of extra labour and raw materials to be used for implementing the decision.

 

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In any case, a business decision may need additional capital equipment on which extra cost has to be incurred. Let us further clear the concept of incremental cost. If some factors in a firm are lying idle and have no alternative use, and if a particular decision involves the use of these idle factors, then for calculation of incremental cost, the costs incurred on these factors in the past must not be included for a particular decision being presently considered since opportunity cost of these idle resources at present is zero, they are not relevant from the economic point of view to be included in the incremental cost. There are three types of incremental cost:

 

Opportunity Cost: Opportunity cost or alternate cost is the cost that has been forgone. It is a well known fact that a person can not satisfy all his wants. When he satisfies one want he is to sacrifice the other wants, the sacrifice is the opportunity or alternative cost. The concept of opportunity cost is very important in economic analysis, particularly, in case of those factors which are scarce in the economy. A significant fact is that relative prices of goods tend to show their opportunity cost. It is opportunity cost of a factor which provides the chance of substituted one factor for the other factor.

 

Current Period Explicit Cost: Explicit costs include the payment which is made by the producer to the factors other than his own factors. Explicit costs are mostly in the nature of contractual payments made by the employer to the owners of those factors whose services are hired by him for production. Current period explicit costs include costs incurred on direct labour engaged, on purchase of new materials, certain type of variable overhead costs such as an electricity consumption required to implement the decision can be easily calculated.

 

Future Costs: Not only the current costs associated with a given decision to be considered but also the likely future costs any kind resulting from a given decision. It may however be noted that to the extent these costs can be foreknown their expected present value is estimated and included in the incremental cost of the decision.

 

(b) Incremental Revenue: Incremental revenue is the change in total revenue resulting from the implementation of a particular decision. Increase in total revenue caused by deciding about a relatively large change in output, say by 15%, introduction of a new product line or a new technology or launching advertisement campaign expenditure is called incremental revenue.

 

The incremental principle implies that a decision is profitable only if:

 

It increases revenue more than costs It reduces costs more than revenues.

 

It decreases some costs to a greater extent than it increases other costs It increases some revenues more than it decreases other revenue

 

For example: In Fire Fighting industry in order to cut the metal sheets for making fire brigades gas cutting machines were used if a firm decides to go for CNC sheet cutting, the additional revenue it earns will be termed ‘incremental revenue’ and the extra cost of setting up CNC sheet cutter facilities will be termed incremental cost. Therefore, as stated earlier if the incremental revenue is more than incremental cost resulting from a particular decision it is acceptable and regarded as profitable.

 

Further it can be illustrated as:

 

Suppose a new order is estimated to bring additional revenue of Rs. 7,000. The costs are estimated as under:

 

Material cost Rs.2, 000/-

Labour Cost Rs.3, 500/-

Overhead Cost Rs. 2, 500/-

Selling Cost Rs.1, 000/-

—————–

Total cost Rs.9, 000/-
—————–

 

As per the incremental principle the decision seems to be unprofitable.

 

Although the concept is widely followed by the Progressive concerns but it has a short run approach and can only be used by the firms having idle production capacity.

 

Contribution analysis

 

Associated with the concept of incremental cost and incremental revenue is the concept of contribution. It can be stated as the difference between the incremental revenue and the incremental cost associated with that particular decision. This principle tells us that every factor of production makes its own contribution to productivity for the firm and that this contribution changes as the volume of output is changed. It is useful technique for taking a decision on:

 

Either accept the project or not,

Either introduce a new project or not, Either accept a fresh order or not,

Either add to an additional plant or not, Either make or to buy a product etc.

In order to use the contribution analysis for a business decision, one must know the incremental cost and incremental revenue.

 

  1. Time perspective:

 

The concept of time element was introduced by Marshall. Time perspective principle highlights that manager should give appropriate importance to short term and long term effects of his decisions before arriving any decisions. In simple words, the decision of a business firm should be taken only after considering the short-run and long-run effects of decisions on costs and revenues. In managerial economics, the decisions and analysis are classified into short and long period. While taking decision manager establishes balance between short run and long run.

 

 

In short period firm can alter its level of production by changing only variable factor. However, in long run firm can alter its level of production by changing variable as well as fixed factors of production because of sufficient time availability.

 

In short run the average cost of the firm may be either more or less than its average revenue. In the long period, the average cost is equal to average revenue. Many a times manager take decision by taking into consideration short term factors but may have long term effects, which make it more or less profitable than what it appears to manager at first instance. The business decision-maker must assess and determine the time perspective well in advance and make decisions accordingly. Determination of time perspective is of great significance especially where projections are involved.

 

4.    The Equi-marginal Principle:

 

Another important principle of economics is Equi-Marginal principle. It is also called principle of equi-marginal satisfaction and productivity. Originally the concept is used in relation to consumption. The Equi marginal principle states that a consumer will be in equilibrium when the marginal utilities of various commodities consumed by him are equal. This principle is also known as principle of maximum satisfaction. The law of equi-marginal principle has been applied to the allocation of scarce resources among their alternative uses with a view to maximizing profit in case a firm carries out more than one business activity. According to this principle, an input should be allocated in such a manner that the value added by the last unit of the input is the same in all uses. Hence, this principle provides a basis for maximum exploitation of all the productive resources of a firm so that the profitability of the firm may be maximised.

 

The Equi-marginal principle can be applied only where

(i) Firms have limited funds available for investment

(ii) Resources have alternative uses

(iii) The investment in various alternative uses is subject to diminishing marginal productivity or returns.

Let us consider a case in which the firm is involved in four activities i.e. activity W, activity X, activity Y, activity Z. All these activities require the services of labour. The firm can increase any one of the activities by employing more labour, but only at the cost of other activities. In this case, the firm allocates labour for each of the activity in such a manner that the value of the marginal product is equal in all activities.

 

VMPw = VMPx = VMPy = VMPz

Where ‘L’ indicates labour and W,X,Y,Z represent the activities, that is, the value of the marginal product of labour employed in a is equal to the value of the marginal product of the labour employed in X, and so on.

If the firm funds that the value of the marginal product is greater in one activity than another, the firm must realize the fact that an optimum has not been achieved.

The equi-marginal principle can be applied in different areas of management:

a) It is used in budgeting. The objective is to allocate resources where they are most productive. It can be used for eliminating waste in useless activities. The management can accept investments with high rates of return so as to ensure optimum allocation of capital resources.

 

b) The equi-marginal principle can also be applied in multiple product pricing. A multi product firm will reach equilibrium when the marginal revenue obtained from a product is equal to that of another product or products.

 

c) The Equi-marginal principle may also be applied in allocating research expenditures.

 

5. Discounting Principle:

 

It is a fundamental principle of economics that the worth of a rupee receivable tomorrow is lesser than that of a rupee available today. As it is mentioned in the time perspective principles, if the decision affect the cost and revenue in the long run, therefore all costs and revenue must be discounted to the present values before valid comparison of alternatives is possible because people generally consider a rupee tomorrow to be worth less than a rupee today. This is also implied by the common saying that a bird in hand is worth than two in the bush. Anybody will prefer Rs. 1000 today to Rs. 1000 next year. There are two main reasons for this:

 

(1) The future is uncertain

(2) There is risk factor involved in the future.

 

Discounting can be defined as a process used to transform future rupees into an equivalent number of present rupees. This is so because a rupee tomorrow to be worth less than a rupee today. Money actually has time value. For example, Rs. 5000 invested at 10% will be equivalent to Rs.5500 next year. Hence, the timing of receipt of an amount should be duly taken into consideration in the solution of a particular problem relating to investment.

  1. Principle of Risk and Uncertainty:

 

As we know future is uncertain. Whatever the investment are made today will yield return in future. Change occurring in the economy on account of change in government policy, change in business cycle and also on account of change in the structure of economy.

 

 

Uncertainty and risk are correlated. Since managers cannot foresee the changes in the future, decisions are taken may proved to be risky because of uncertainty in regard to production, market prices, strategies of rival firms.

 

Also changes in the external economy are dynamic and beyond the control of the firm, the outcome is risk and therefore returns cannot be estimated with certainty. One of the well accepted principle is that profitability and risk are closely related. It is very likely that the project which seems to be profitable ay also increase the perceived risk of an undertaking. This will certainly effect the decision of firm regarding acceptance of project. The manager will not accept any investment proposal which seems to be more risky and less profitable. Therefore it is very necessary to take into consideration risk factor in the light of uncertain factors

  1. Principle of Optimization:

 

This is yet another important concept used in managerial economics. Optimisation principle aims at selecting an alternative whose cost is least or ensures highest returns under the given constraints, by maximizing desired factors and minimizing undesirable factors. Maximisation implies  aiming  to  achieve  the  highest  or  maximum  outcome  without  regard  to  cost  or expense. Managerial economics often aims at optimizing a given objective. The objective may  be  maximization  of  profit  or  minimization  of  time  or  minimization  of  cost.  The important    techniques    for    optimization    include    marginal    analysis,    calculus,      linear programming etc. In computer simulation of business problems optimization is achieved generally by employing linear programming technique of operations research.

  1. Summary

 

Managerial Economics has offered a number of concepts and principles which helps in improving decision making process of any business concern and therefore suggesting the answers to the practical problems faced by managers in their day routine. This module presents some major concepts and their use in business decision making. It explains opportunity cost and decision rule. The scarcity and the alternative uses of the resources give rise to the concept of opportunity cost. This concept can be applied to all other kind of resources involved in business decisions, particularly where there at least two alternative options involving cost and benefits. Marginality concept assumes special significance where maximisation or minimisation problem is involved. The use of incremental concept in business decisions is called incremental reasoning. The incremental reasoning is used in accepting or rejecting a business proposition or option. The law of equi-marginal principal was over time applied by business managers to allocate of resources between their alternative uses with a view to maximising profit in case a firm carries out more than one business activity.

 

References