National Institute of Business Management

Chennai - 020

THIRD SEMESTER MBA

Subject : Managerial Economics

1.What is Managerial Economics ? Explain.

Ans:- Definition and Meaning of Managerial Economics:
 
Managerial economics, used synonymously with business economics. It is a branch of
economics that deals with the application of microeconomic analysis to decision-making
techniques of businesses and management units. It acts as the via media between economic
theory and pragmatic economics. Managerial economics bridges the gap between "theory and
practice". Managerial economics can be defines as:
 
According to Spencer and Siegelman:
 
“The integration of economic theory with business practice for the purpose of facilitating
decision-making and forward planning by management”.
 
According to McGutgan and Moyer:
 
“Managerial economics is the application of economic theory and methodology to decision-
making problems faced by both public and private institutions”.
 
Managerial economics studies the application of the principles, techniques and concepts of
economics to managerial problems of business and industrial enterprises. The
term is used interchangeably with micro economics, macro economics, monetary economics.
 
Characteristics of Managerial Economics:
 
(i) It studies the problems and principles of an individual business firm or an individual industry.
It aids the management in forecasting and evaluating the trends of the market.
 
(ii) It is concerned with varied corrective measures that a management undertakes under various
circumstances. It deals with goal determination, goal development and achievement of these
goals. Future planning, policy making, decision making and optimal utilization of available
resources, come under the banner of managerial economics.
 
(iii)  Managerial economics is pragmatic. In pure microeconomic theory, analysis is performed,
based on certain exceptions, which are far from reality. However, in managerial economics,
managerial issues are resolved daily and difficult issues of economic theory are kept at bay.
 
(iv) Managerial economics employs economic concepts and principles, which are known as the
theory of Firm or 'Economics of the Firm'. Thus, its scope is narrower than that of pure economic
theory.
 
(v) Managerial economics incorporates certain aspects of macroeconomic theory. These are
essential to comprehending the circumstances and environments that envelop the working
conditions of an individual firm or an industry. Knowledge of macroeconomic issues such as
business cycles, taxation policies, industrial policy of the government, price and distribution
policies, wage policies and antimonopoly policies and so on, is integral to the successful
functioning of a business enterprise.
 
(vi) Managerial economics aims at supporting the management in taking corrective decisions and
charting plans and policies for future.
 
(vii) Science is a system of rules and principles engendered for attaining given ends. Scientific
methods have been credited as the optimal path to achieving one's goals. Managerial economics
has been is also called a scientific art because it helps the management in the best and efficient
utilization of scarce economic resources. It considers production costs, demand, price, profit, risk
etc. It assists the management in singling out the most feasible alternative. Managerial
economics facilitates good and result oriented decisions under conditions of uncertainty.
 
(viii) Managerial economics is a normative and applied discipline. It suggests the application of
economic principles with regard to policy formulation, decision-making and future planning. It
not only describes the goals of an organization but also prescribes the means of achieving these
goals.
 
Scope of Managerial Economics:
 
The scope of managerial economics includes following subjects:
 
(i) Theory of Demand
 
(ii) Theory of Production
 
(iii) Theory of Exchange or Price Theory
 
(iv) Theory of Profit
 
(v) Theory of Capital and Investment
 
Importance of Managerial Economics:
 
Business and industrial enterprises aim at earning maximum proceeds. In order to achieve this
objective, a managerial executive has to take recourse in decision making, which is the process
of selecting a specified course of action from a number of alternatives. A sound decision requires
fair knowledge of the aspects of economic theory and the tools of economic analysis, which are
directly involved in the process of decision-making. Since managerial economics is concerned
with such aspects and tools of analysis, it is pertinent to the decision making process.
 
Spencer and Siegelman have described the importance of managerial economics in a business
and industrial enterprise as follows:
 
(i) Accommodating traditional theoretical concepts to the actual business behavior and
conditions: Managerial economics amalgamates tools, techniques, models and theories of
traditional economics with actual business practices and with the environment in which a firm
has to operate. According to Edwin Mansfield, “Managerial Economics attempts to bridge the
gap between purely analytical problems that intrigue many economic theories and the problems
of policies that management must face”.
 
(ii) Estimating economic relationships: Managerial economics estimates economic
relationships between different business factors such as income, elasticity of demand, cost
volume, profit analysis etc.
 
(iii) Predicting relevant economic quantities: Managerial economics assists the management in
predicting various economic quantities such as cost, profit, demand,
capital, production, price etc. As a business manager has to function in an environment of
uncertainty, it is imperative to anticipate the future working environment in terms of the said
quantities.
 
(iv) Understanding significant external forces: The management has to identify all the
important factors that influence a firm. These factors can broadly be divided into two categories.
Managerial economics plays an important role by assisting management in understanding these
factors.
 
(a) External factors: A firm cannot exercise any control over these factors. The plans, policies
and programs of the firm should be formulated in the light of these factors. Significant external
factors impinging on the decision making process of a firm are economic system of the country,
business cycles, fluctuations in national income and national production, industrial policy of the
government, trade and fiscal policy of the government, taxation policy, licensing policy, trends
in foreign trade of the country, general industrial relation in the country and so on.
 
(b) Internal factors: These factors fall under the control of a firm. These factors are associated
with business operation. Knowledge of these factors aids the management in making sound
business decisions.
 
(v) Basis of business policies: Managerial economics is the founding principle of business
policies. Business policies are prepared based on studies and findings of managerial economics,
which cautions the management against potential upheavals in national as well as international
economy. Thus, managerial economics is helpful to the management in its decision-making
process.

2. Explain the approaches to Consumer Demand Analysis.

Ans:- The branch of economics devoted to the study of consumer behavior, especially as it
applies to decisions related to purchasing goods and services through markets. Consumer
demand theory is largely centered on the study and analysis of the utility generated from the
satisfaction of wants and needs. The key principle of consumer demand theory is the law of
diminishing marginal utility, which offers an explanation for the law of demand and the negative
slope of the demand curve.
Consumer demand theory provides insight into an understanding market demand and forms a
cornerstone of modern microeconomics. In particular, this theory analyzes consumer behavior,
especially market purchases, based on the satisfaction of wants and needs (that is, utility)
generated from the consumption of a good.

A basic version of this theory, primarily taught in introductory courses, involves the analysis of
total and marginal utility, especially the role played by the law of diminishing marginal returns.
A more sophisticated version of the theory, more commonly found at the intermediate course
level and above, relies on the analysis of indifference curves and relative utility, with a key role
play by decreasing marginal rate of substitution. Both versions provide insight into the law of
demand and the negative slope of the demand curve.

Doing Demand
Demand, the willingness and ability to purchase a range of quantities at a range of prices, is one
half of the market. The law of demand, which gives rise to a negatively-sloped demand curve, is
an essential principle underlying market analysis. Modern microeconomic theory, among other
topics, is concerned with understanding and explaining the law of demand.

Insight into this law can be found with consumer demand theory. The explanation is relatively
simple--on the surface. Consumers purchase goods that satisfy wants and needs, that is, generate
utility. Those goods that generate more utility are more valuable to consumers and thus buyers
are willing to pay a higher price. The key to the law of demand is that the utility generated
declines as the quantity consumed increases. As such, the demand price that buyers are willing to
pay decreases as the quantity demanded increases.

A Little History
The notion that market demand depends on the satisfaction of wants and needs has been an
essential part of the economic analysis of markets since at least the time of Adam Smith.
However, three scholars working in progression from the late 1700s to the late 1800s gave the
development of consumer demand theory a large, formal boost.

Jeremy Bentham: The first major advance in the development of consumer demand theory was
provided by Jeremy Bentham in the late 1700s. Bentham coined the term "utility" in reference to
the satisfaction of wants and needs. He also developed the notion that people are motivated by
the desire to maximize utility. Bentham firmly believed that utility was a measurable,
quantifiable characteristic of a person, much like height or weight.

John Stuart Mill: The theoretical work developed by Bentham was extended and popularized
by John Stuart Mill, whose father James Mill was a contemporary and close friend of Bentham.
The elder Mill introduced the younger Mill to the thoughts and teachings of Bentham at an early
age. John Stuart Mill expanded and promoted these consumer demand principles in a number of
publications, including his book, Principles of Political Economic, which was the dominate
economics textbook for several decades.

William Stanley Jevons: A major improvement in consumer demand theory was provided by
William Stanley Jevons with the notion of marginal utility. Jevons also developed the rule of
consumer equilibrium, stating that consumers purchase goods such that the ratio of marginal
utilities is equal to the ratio of prices. Along the way, Jevons helped to transform consumer
demand theory (as well as microeconomics in general) into a rigorous mathematical science.

Utility analysis
Utility Analysis
A basic formulation of consumer demand theory involves an analysis of
the total utility and marginal utility derived from the consumption of a
good. The focal point of utility analysis is usually a table of the total and
marginal utility generated by consuming different quantities of a good, such as the one displayed
in the exhibit to the right.

This analysis is based on the presumption that the amount of utility generated from the
consumption of a good can be explicitly measured. The standard measurement unit is "utils."

This particular set of numbers illustrates the total and marginal utility generated by riding a roller
coaster at the local amusement park. The key bits of information presented in this table are:

First, the far left column presents the number of rides on the roller coaster, which is the quantity
of the good consumed. It increases from 0 hours to 8 rides.

Second, the middle column indicates the total utility, or the cumulatively amount of utility,
obtained from the rides. For example, taking 3 roller coaster rides generates 27 utils of total
utility. Most notably, total utility generally increases with the number of rides. However, it does
reach a maximum for the 6 rides, then declines.

Third, the far right column shows marginal utility, or the amount of additional utility derived
from each extra ride. For example, because 2 rides generates a total utility of 20 utils and 3 rides
generates a total utility of 27 utils, the amount of extra utility generated by taking the third ride
on the roller coaster is 7 utils.

Fourth, marginal utility in the far right column declines with additional rides on the roller
coaster. This reflects the law of diminishing marginal utility, the key economic principle
underlying utility analysis.

The Law of Diminishing Marginal Utility

The law of diminishing marginal utility states that marginal utility, or the extra utility obtained
from consuming a good, decreases as the quantity consumed increases. In essence, each
additional good consumed is less satisfying than the previous one. This law is particularly
important for insight into market demand and the law of demand.

If each additional unit of a good is less satisfying, then a buyer is willing to pay less. As such, the
demand price declines. This inverse law of demand relation between demand price and quantity
demanded is a direct implication of the law of diminishing marginal utility.
 Indifference Curve Analysis

Indifference Curves
A more advanced form of consumer demand
theory involves the analysis of indifference curves.
An indifference curve, such as the one labeled U in
the exhibit to the right, presents all combinations
of two goods that provide the same amount of
utility. Hence a consumer is "indifferent" between
consuming any combination of the two goods
anywhere on the curve.

Indifference curve analysis relies on a relative

ranking of preferences between two goods rather
than the absolute measurement of utility (utils) derived from the consumption of a particular
good.

Key bits of insight obtained from this diagram are:

First, the indifferent curve representing equal utility obtained from any consumption combination
of the two goods (time at the beach and time at an amusement park) is represented by U.

Second, the consumer is faced with an income or budget constraint, I, which shows the
alternative combinations of the two goods that the buyer can purchase given a specific amount of
income and existing prices.

Third, the negative slope of the budget constraint reflects the tradeoff between the consumers
ability to purchase the two goods. Purchasing more of one good necessarily means the consumer
must purchase less of the other.

Fourth, the negative slope and convex shape of the indifference curve reflects the tradeoff
between the consumers willingness to purchase the two goods. In particular, the convex shape
reflects the decreasing marginal rate of substitution between the two goods.

Decreasing Marginal Rate of Substitution

The decreasing marginal rate of substitution means that a consumer is willing to give up
increasingly smaller quantities of one good in order to obtain more of another good. The reason
is that as more of a good is consumed it becomes relatively less satisfying.
A decreasing marginal rate of substitution generalizes the law of diminishing marginal utility.
However, rather than stating that the incremental satisfaction declines absolutely, it states that
incremental satisfaction declines relative to that obtained from other goods.

Moreover, like the law of diminishing marginal utility, the decreasing marginal rate of
substitution used in indifference curve analysis provides insight into market demand and the law
of demand. If a good generates less relative satisfaction, then a buyer is wiling to pay a relatively
lower price, which also explains the inverse law of demand relation between demand price and
quantity demanded.

Applying the Theory

Consumer demand theory is primarily directed toward an understanding of market demand and
the law of demand. However, it provides a great deal of insight into all sorts of human behavior
and activities. A short list includes:

Labor Supply: Insight into the quantity of labor that workers are willing to supply at different
wages can be obtained with consumer demand theory by analyzing the tradeoff between labor
and leisure activities.

Household Production: In a similar manner, insight into the amount of work performed around
the house, without explicit compensation, be analyzed using consumer demand theory.

Crime: The choice between committing a crime and not committing a crime can also be
investigated using consumer demand theory, with the "price" paid for criminal activities based
on the probability of being caught and punished.

Voting: The amount of time and effort devoted to voting in elections has also been subjected to
analysis using consumer demand theory.

A complete list of areas that have been or can be analyzed and better understood using consumer
demand theory is limited only by the choices people make and the types of activities they pursue.
In essence, consumer demand theory can be applied to virtually any form of human behavior that
involves a tradeoff and a choice.