Managerial Economics is both conceptual and metrical. Before the substantive decision problems which fall within the purview of managerial economics are discussed, it is useful to identify and understand some of the basic concepts underlying the subject.
Economic theory provides a number of concepts and analytical tools which can be of considerable and immense help to a manager in taking many decisions and business planning. This is not to say that economics has all the solutions. In fact, actual problem solving in business has found that there exists a wide disparity between economic theory of the firm and actual observed practice.
Therefore, it would be useful to examine the basic tools of managerial economics and the nature and extent of gap between the economic theory of the firm and the managerial theory of the firm. The contribution of economics to managerial economics lies in certain principles which are basic to managerial economics. There are six basic principles of managerial economics. They are:
- The Incremental Concept
- The Concept of Time Perspective
- The Opportunity Cost Concept
- The Discounting Concept
- The Equi-marginal Concept
- Risk and Uncertainty
- The Incremental Concept:
The incremental concept is probably the most important concept in economics and is certainly the most frequently used in Managerial Economics. Incremental concept is closely related to the marginal cost and marginal revenues of economic theory.
The two major concepts in this analysis are incremental cost and incremental revenue. Incremental cost denotes change in total cost, whereas incremental revenue means change in total revenue resulting from a decision of the firm.
The incremental principle may be stated as follows:
A decision is clearly a profitable one if
(i) It increases revenue more than costs.
(ii) It decreases some cost to a greater extent than it increases others.
(iii) It increases some revenues more than it decreases others.
(iv) It reduces costs more than revenues.
Some businessmen hold the view that to make an overall profit, they must make a profit on every job. The result is that they refuse orders that do not cover full costs plus a provision of profit. This will lead to rejection of an order which prevents short run profit. A simple problem will illustrate this point. Suppose a new order is estimated to bring in an additional revenue of Rs. 10,000. The costs are estimated as under:
Labour Rs. 3,000
Materials Rs. 4,000
Overhead charges Rs. 3,600
Selling and administrative expenses Rs. 1,400
Full Cost Rs.12, 000
The order appears to be unprofitable. For it results in a loss of Rs. 2,000. However, suppose there is idle capacity which can be utilised to execute this order. If order adds only Rs. 1,000 to overhead charges, and Rs. 2000 by way of labour cost because some of the idle workers already on the pay roll will be deployed without added pay and no extra selling and administrative costs, then the actual incremental cost is as follows:
Labour Rs. 2,000
Materials’ Rs. 4,000
Overhead charges Rs. 1,000
Total Incremental Cost Rs. 7,000
Thus there is a profit of Rs. 3,000. The order can be accepted on the basis of incremental reasoning. Incremental reasoning does not mean that the firm should accept all orders at prices which cover merely their incremental costs.
The concept is mainly used by the progressive concerns. Even though it is a widely followed concept, it has certain limitations:
(a) The concept cannot be generalised because observed behaviour of the firm is always variable.
(b) The concept can be applied only when there is excess capacity in the concern.
(c) The concept is applicable only during the short period.
- Concept of Time Perspective:
The time perspective concept states that the decision maker must give due consideration both to the short run and long run effects of his decisions. He must give due emphasis to the various time periods. It was Marshall who introduced time element in economic theory.
The economic concepts of the long run and the short run have become part of everyday language. Managerial economists are also concerned with the short run and long run effects of decisions on revenues as well as costs. The main problem in decision making is to establish the right balance between long run and short run.
In the short period, the firm can change its output without changing its size. In the long period, the firm can change its output by changing its size. In the short period, the output of the industry is fixed because the firms cannot change their size of operation and they can vary only variable factors. In the long period, the output of the industry is likely to be more because the firms have enough time to increase their sizes and also use both variable and fixed factors.
In the short period, the average cost of a firm may be either more or less than its average revenue. In the long period, the average cost of the firm will be equal to its average revenue. A decision may be made on the basis of short run considerations, but may as time elapses have long run repercussions which make it more or less profitable than it at first appeared.
The firm which ignores the short run and long run considerations will meet with failure can be explained with the help of the following illustration. Suppose, a firm having a temporary idle capacity, received an order for 10,000 units of its product. The customer is willing to pay only Rs. 4.00 per unit or Rs. 40,000 for the whole lot but no more.
The short run incremental cost (ignoring the fixed cost) is only Rs. 3.00. Therefore, the contribution to overhead and profit is Rs. 1.00 per unit (or Rs. 10, 000 for the lot). If the firm executes this order, it will have to face the following repercussion in the long run:
(a) It may not be able to take up business with higher contributions in the long run.
(b) The other customers may also demand a similar low price.
(c) The image of the firm may be spoilt in the business community.
(d) The long run effects of pricing below full cost may be more than offset any short run gain.
Haynes, Mote and Paul refer to the example of a printing company which never quotes prices below full cost due to the following reasons:
(1) The management realized that the long run repercussions of pricing below full cost would more than offset any short run gain.
(2) Reduction in rates for some customers will bring undesirable effect on customer goodwill. Therefore, the managerial economist should take into account both the short run and long run effects as revenues and costs, giving appropriate weight to most relevant time periods.
- The Opportunity Cost Concept:
Both micro and macro economics make abundant use of the fundamental concept of opportunity cost. In everyday life, we apply the notion of opportunity cost even if we are unable to articulate its significance. In Managerial Economics, the opportunity cost concept is useful in decision involving a choice between different alternative courses of action.
Resources are scarce, we cannot produce all the commodities. For the production of one commodity, we have to forego the production of another commodity. We cannot have everything we want. We are, therefore, forced to make a choice.
Opportunity cost of a decision is the sacrifice of alternatives required by that decision. Sacrifice of alternatives is involved when carrying out a decision requires using a resource that is limited in supply with the firm. Opportunity cost, therefore, represents the benefits or revenue forgone by pursuing one course of action rather than another.
The concept of opportunity cost implies three things:
- The calculation of opportunity cost involves the measurement of sacrifices.
- Sacrifices may be monetary or real.
- The opportunity cost is termed as the cost of sacrificed alternatives.
Opportunity cost is just a notional idea which does not appear in the books of account of the company. If resource has no alternative use, then its opportunity cost is nil.
In managerial decision making, the concept of opportunity cost occupies an important place. The economic significance of opportunity cost is as follows:
- It helps in determining relative prices of different goods.
- It helps in determining normal remuneration to a factor of production.
- It helps in proper allocation of factor resources.
- Equi-Marginal Concept:
One of the widest known principles of economics is the equi-marginal principle. The principle states that an input should be allocated so that value added by the last unit is the same in all cases. This generalisation is popularly called the equi-marginal.
Let us assume a case in which the firm has 100 unit of labour at its disposal. And the firm is involved in five activities viz., А, В, C, D and E. The firm can increase any one of these activities by employing more labour but only at the cost i.e., sacrifice of other activities.
An optimum allocation cannot be achieved if the value of the marginal product is greater in one activity than in another. It would be, therefore, profitable to shift labour from low marginal value activity to high marginal value activity, thus increasing the total value of all products taken together.
If, for example, the value of the marginal product of labour in activity A is Rs. 50 while that in activity В is Rs. 70 then it is possible and profitable to shift labour from activity A to activity B. The optimum is reached when the values of the marginal product is equal to all activities. This can be expressed symbolically as follows:
VMPLA = VMPLB = VMPLC = VMPLD = VMPLE
Where VMP = Value of Marginal Product.
L = Labour
ABCDE = Activities i.e., 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 В and so on. The equimarginal principle is an extremely practical notion.
It is behind any rational budgetary procedure. The principle is also applied in investment decisions and allocation of research expenditures. For a consumer, this concept implies that money may be allocated over various commodities such that marginal utility derived from the use of each commodity is the same. Similarly, for a producer this concept implies that resources be allocated in such a manner that the marginal product of the inputs is the same in all uses.
- Discounting Concept:
This concept is an extension of the concept of time perspective. Since future is unknown and incalculable, there is lot of risk and uncertainty in future. Everyone knows that a rupee today is worth more than a rupee will be two years from now. This appears similar to the saying that “a bird in hand is more worth than two in the bush.” This judgment is made not on account of the uncertainty surrounding the future or the risk of inflation.
It is simply that in the intervening period a sum of money can earn a return which is ruled out if the same sum is available only at the end of the period. In technical parlance, it is said that the present value of one rupee available at the end of two years is the present value of one rupee available today. The mathematical technique for adjusting for the time value of money and computing present value is called ‘discounting’.
The following example would make this point clear. Suppose, you are offered a choice of Rs. 1,000 today or Rs. 1,000 next year. Naturally, you will select Rs. 1,000 today. That is true because future is uncertain. Let us assume you can earn 10 per cent interest during a year.
You may say that I would be indifferent between Rs. 1,000 today and Rs. 1,100 next year i.e., Rs. 1,100 has the present worth of Rs. 1,000. Therefore, for making a decision in regard to any investment which will yield a return over a period of time, it is advisable to find out its ‘net present worth’. Unless these returns are discounted and the present value of returns calculated, it is not possible to judge whether or not the cost of undertaking the investment today is worth.
The concept of discounting is found most useful in managerial economics in decision problems pertaining to investment planning or capital budgeting.
The formula of computing the present value is given below:
V = A/1+i
V = Present value
A = Amount invested Rs. 100
i = Rate of interest 5 per cent
V = 100/1+.05 = 100/1.05 =Rs. 95.24
Similarly, the present value of Rs. 100 which will be discounted at the end of 2 years: A 2 years V = A/ (1+i) 2
For n years V = A/ (1+i) n
- Risk and Uncertainty:
Managerial decisions are actions of today which bear fruits in future which is unforeseen. Future is uncertain and involves risk. The uncertainty is due to unpredictable changes in the business cycle, structure of the economy and government policies.
This means that the management must assume the risk of making decisions for their institution in uncertain and unknown economic conditions in the future. Firms may be uncertain about production, market prices, strategies of rivals, etc. Under uncertainty, the consequences of an action are not known immediately for certain.
Economic theory generally assumes that the firm has perfect knowledge of its costs and demand relationships and of its environment. Uncertainty is not allowed to affect the decisions. Uncertainty arises because producers simply cannot foresee the dynamic changes in the economy and hence, cost and revenue data of their firms with reasonable accuracy.
Also dynamic changes are external to the firm, they are beyond the control of the firm. The result is that the risks from unexpected changes in a firm’s cost and revenue data cannot be estimated and therefore the risks from such changes cannot be insured. But products must attempt to predict the future cost and revenue data of their firms and determine the output and price policies.
The managerial economists have tried to take account of uncertainty with the help of subjective probability. The probabilistic treatment of uncertainty requires formulation of definite subjective expectations about cost, revenue and the environment. The probabilities of future events are influenced by the time horizon, the risk attitude and the rate of change of the environment.