CHAPTER 1

INTRODUCTION TO MANAGERIAL ECONOMICS

Learning Objectives

 To define of Economics;
 To differentiate Microeconomics vs. Macroeconomics;
 To identify the fundamental concepts of economics;
 To define of Managerial Economics;
 To discuss the Nature of Managerial Economics;
 To identify the scope of Managerial Economics;
 To discuss the relationship with other disciplines; and
 To determine role of managerial economist in business.

STIMULATING LEARNING

In this chapter, important terms sets as a guide to understand further managerial

economics will be presented. To understand further the concept of managerial
economics, it is better to go through previous discussion in economics and define and
understand its basic and related terms.

INCULCATING CONCEPTS

Introduction to Managerial Economics

Economics is the science that deals with the management of scarce resources in
demand. It is also described as a scientific study on how individuals and the society
generally make choices (Fajardo, 1977). Specifically, it studies problems on using
available economic resources as efficiently as possible so as to attain the maximum
fulfilment of society’s unlimited demand for goods and services. As Slavin (2005) puts
it, economics is simply scarcity and choice.

Economics is a study of human activity both at individual and national level. Any activity
involved in efforts aimed at earning money and spending this money to satisfy our
wants such as food, clothing, shelter, and others are called “Economic activities”.
It was only during the eighteenth century that Adam Smith, the Father of Economics,
defined economics as the study of nature and uses of national wealth’.
Definition:
Dr. Alfred Marshall, one of the greatest economists of the nineteenth century, writes
“Economics is a study of man’s actions in the ordinary business of life: it enquires how
he gets his income and how he uses it”.
Prof. Lionel Robbins defined Economics as “the science, which studies human behavior
as a relationship between ends and scarce means which have alternative uses”.
Efficiency and effectiveness is necessary in the study of managerial economics.
Efficiency refers to productivity and proper allocation of economic resources and
effectiveness means attainment of goals and objectives. With every decision making
of firms in terms of resources change or production process, the concept of opportunity
is present. Opportunity cost in the definition refers to the foregone value of the next
best alternative. It is the value of what is given up when one makes a choice.
Production on the other hand is an economic activity that combines its factors from land,
labor, and capital to entrepreneurs. Land, refers to all-natural resources, which are
given by, and found in nature, and therefore, not manmade. Labor is any form of
human effort exerted in the production of goods and services. Capital refers to man-
made goods used in the production of other goods and services.

As a whole, entrepreneurship pertains to the skills, talent, and risk-taking behaviour

needed in building, operating, and expanding a business. Entrepreneurs decide what
combinations of land, labor, and capital are to be used in the production process.
Entrepreneurship is an economic resource that is remunerated in the form of profit.

MICROECONOMICS
 The study of an individual consumer or a firm is called microeconomics.
 Micro means ‘one millionth’.
 Microeconomics deals with behavior and problem.s of single individual and of
micro organization.
 It is concerned with the application of the concepts such as price theory, Law of
Demand and theories of market structure and so on.

MACROECONOMICS
 The study of ‘aggregate’ or total level of economic activity in a country is called
macroeconomics.
 It studies the flow of economics resources or factors of production (such as land,
labor, capital, organization and technology) from the resource owner to the
business firms and then from the business firms to the households.
 It is concerned with the level of employment in the economy.
 It discusses aggregate consumption, aggregate investment, price level, and
payment, theories of employment, and so on.
FUNDAMENTAL CONCEPTS OF ECONOMICS
1. Opportunity Cost: The benefit of the next best alternative which had been
sacrificed due to the choice of the best alternative is known as opportunity cost of
the best alternative. It tells us the gain from the proposed use of input.

2. Incremental Reasoning: It’s the most important concept in economics.

Incremental principle is applied to business decisions which involves a large
increase in total cost & total revenue. Incremental cost is defined as change in
total cost as a result of change in the level of output. Incremental revenue is
change in total revenue resulting from change in the level of output. It tells us
gain arising from the change in activity.

3. The Discounting Principle: Discounting factor determines the present value of

future inflow of cash. It is based on the fundamental fact that a peso now is worth
more than a peso earned a year after.

4. Time Perspective: Aim of the firm is to make profit in the long run. There is a
difference between long & short run. In short run all of the inputs(called fixed
inputs) cannot be altered, while in the long run all the inputs can be changed(i.e.
there are no fixed inputs). A decision should take into account both the short run
& long run effects on revenues & costs to maintain a right balance b/w short &
long run perspectives.

5. Risk & Uncertainty: In real world, uncertainty influences the estimation of costs &
revenues & hence the decision of the firm. Since future conditions are not
perfectly predictable, there is always a sense of risk & uncertainty about outcome
of decisions. When a firm is operating in a market along with other firms there is
generally an element of uncertainty regarding the actions & reactions of the
competitors. Other uncertain factors can be shifts in consumers choices,
changes in government policies, national and international political scenario.

MANAGERIAL ECONOMICS
Managerial Economics refers to the firm’s decision making process. It could be also
interpreted as “Economics of Management” or “Industrial economics“ or “Business
economics”.
According to Spencer: “Managerial economics is the integration of economic theory with
business practice for purpose of facilitating decision making and forward planning by
management”. It means management of limited funds available in most economical
way. It deals with basic problems of the economy i.e. what, how & for whom to
produce.

Nature of managerial Economics

1. Close to microeconomics: Managerial economics is concerned with finding the
solutions for different managerial problems of a particular firm. Thus, it is more close to
microeconomics.
2. Operates against the backdrop of macroeconomics: The macroeconomics conditions
of the economy are also seen as limiting factors for the firm to operate. In other words,
the managerial economist has to be aware of the limits set by the macroeconomics
conditions such as government industrial policy, inflation and so on.
3. Normative statements: A normative statement usually includes or implies the words
‘ought’ or ‘should’. They reflect people’s moral attitudes and are expressions of what a
team of people ought to do.
•Such statement are based on value judgments and express views of what is
‘good’ or ‘bad’, ‘right’ or ‘ wrong’.
•One problem with normative statements is that they cannot to verify by looking
at the facts, because they mostly deal with the future. Disagreements about such
statements are usually settled by voting on them.
4. Prescriptive actions:
•Prescriptive action is goal oriented.
•Given a problem and the objectives of the firm, it suggests the course of action
from the available alternatives for optimal solution.
•It also explains whether the concept can be applied in a given context on not.
For instance, the fact that variable costs are marginal costs can be used to judge the
feasibility of an export order.
5. Applied in nature:
• ‘Models’ are built to reflect the real life complex business situations and these
models are of immense help to managers for decision-making.
• The different areas where models are extensively used include inventory
control, optimization, project management etc.
• In managerial economics, we also employ case study methods to
conceptualize the problem, identify that alternative and determine the best course of
action.
6. Offers scope to evaluate each alternative:
 • Managerial economics provides an opportunity to evaluate each alternative in
terms of its costs and revenue.
• The managerial economist can decide which is the better alternative to
maximize the profits for the firm.

7. Interdisciplinary:
• The contents, tools and techniques of managerial economics are drawn from
different subjects such as economics, management, mathematics, statistics,
accountancy, psychology, organizational behavior, sociology and etc.

Scope of Managerial Economics

Managerial economics refers to its area of study. Managerial economics, Provides
management with a strategic planning tool that can be used to get a clear perspective of
the way the business world works and what can be done to maintain profitability in an
ever-changing environment.
Managerial economics is primarily concerned with the application of economic principles
and theories to five types of resource decisions made by all types of business
organizations.
a. The selection of product or service to be produced.
b. The choice of production methods and resource combinations.
c. The determination of the best price and quantity combination
d. Promotional strategy and activities.
e. The selection of the location from which to produce and sell goods or service to
consumer

The scope of managerial economics covers two areas of decision making

• Operational or Internal issues
• Environmental or External issues
A. OPERATIONAL ISSUES:
Operational issues refer to those, which are within the business organization and they
are under the control of the management. Those are:
1. Demand Analyses and Forecasting
Demand analysis also highlights for factors, which influence the demand for a
product. This helps to manipulate demand. Thus demand analysis studies not only
the price elasticity but also income elasticity, cross elasticity as well as the influence
of advertising expenditure with the advent of computers.
Demand forecasting has become an increasingly important function of
managerial economics. A firm can survive only if it is able to the demand for its
 product at the right time, within the right quantity. Understanding the basic concepts
of demand is essential for demand forecasting.

2. Pricing and competitive strategy

Pricing decisions have been always within the preview of managerial economics.
Price theory helps to explain how prices are determined under different types of
market conditions.
Competitions analysis includes the anticipation of the response of competitions
the firm’s pricing, advertising and marketing strategies. Product line pricing and
price forecasting occupy an important place here.

3. Production and cost analysis

 Production analysis is in physical terms.
 While the cost analysis is in monetary terms cost concepts and classifications,
cost-output relationships, economies and diseconomies of scale and production
functions are some of the points constituting cost and production analysis.

4. Resource Allocation
 Managerial Economics is the traditional economic theory that is concerned with
the problem of optimum allocation of scarce resources.
 Marginal analysis is applied to the problem of determining the level of output,
which maximizes profit.
 In this respect linear programming techniques has been used to solve
optimization problems. In fact lines programming is one of the most practical and
powerful managerial decision making tools currently available.

5. Profit analysis
 Profit making is the major goal of firms. There are several constraints here an
account of competition from other products, changing input prices and changing
business environment hence in spite of careful planning, there is always certain
risk involved.
 Managerial economics deals with techniques of averting of minimizing risks.
Profit theory guides in the measurement and management of profit, in calculating
the pure return on capital, besides future profit planning.
6. Capital or investment analyses:
 Capital is the foundation of business. Lack of capital may result in small size of
operations. Availability of capital from various sources like equity capital,
institutional finance etc. may help to undertake large-scale operations.
 Hence efficient allocation and management of capital is one of the most
important tasks of the managers.
 The major issues related to capital analysis are:
1.The choice of investment project
2.Evaluation of the efficiency of capital
 3.Most efficient allocation of capital.
Knowledge of capital theory can help much in taking investment decisions. This
involves, capital budgeting, feasibility studies, analysis of cost of capital, etc.

7. Strategic planning
 Strategic planning provides a long-term goals and objectives and selects the
strategies to achieve the same. The perspective of strategic planning is
global.
 Strategic planning has given rise to be new area of study called corporate
economics.
B. Environmental or External Issues: They refer to general economic, social and
political atmosphere within which the firm operates. A study of economic environment
should include:
The type of economic system in the country.
a. The general trends in production, employment, income, prices, saving and
investment;
b. Trends in the working of financial institutions like banks, financial corporations,
insurance companies c. Magnitude and trends in foreign trade;
d. Trends in labour and capital markets;
e. Government’s economic policies viz. industrial policy monetary policy, fiscal policy,
price policy etc.
 The social environment refers to social structure as well as social organization
like trade unions, consumer’s co-operative etc.
 The Political environment refers to the nature of state activity, chiefly states’
attitude towards private business, political stability etc.
 The environmental issues highlight the social objective of a firm i.e.; the firm
owes a responsibility to the society. Private gains of the firm alone cannot be the
goal.

Relationship with Other Disciplines

1. Statistics & Economics: Statistical techniques are very useful for collecting,
processing & analyzing business data, testing & validity of economic laws before they
can be applied to business. Statistical techniques like regression analysis, forecasting is
used in economics.
2. Operation Research & Economics: OR is an activity carried out by specialist within
the firm to help the manager to do his job of solving decision problems. OR is also
concerned with model building but economic models are more general & confined to
broad decision making.
3. Accounting & Economics: Accounting data & statements reflect financial position, net
loss or net profit earned by a company. For decision-making a manager should be
familiar with generation, interpretation & use of A/c data.
4. Mathematics & Economics: Managers have to deal with quantitative concepts like
demand, cost, prices & wages. So knowledge of mathematical concepts is important to
take decisions.
5. Computers & Economics: Today each person is dependent on computers. Managers
depends on computer for decision making. Through computer data is presented in
organized manner which facilitates decision making.

Role of Managerial Economist in Business

1. Specific Decisions: There are several specific decisions that managers might have to
take like: Production scheduling, demand forecasting, market research, security
management analysis, economic analysis of the industry, advice on trade, pricing
decisions.
2. General Tasks: It includes understanding external factors & suggesting the firm
which policy is to be used. External factors include- economic condition of the
economy, demand for the product, market conditions of raw materials, input cost of
the firm affected by outside forces.