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CHAPTER 1

DEFINITION OF ECONOMICS:

PRELUDE:

Economics is a social science; a classified body of knowledge concerning human relationships clustered about

mans effort to earn a living.conomics is quite an old discipline. That is why Prof.Samuelson remarks that

Economics is the Oldest of the arts, newest of the sciences, indeed the Queen of the social sciences.

The origin of the subject could be traced to the works of the Greek philosopher, Aristotle who confines the study

of economics to household management and acquiring and making proper use of wealth. It is important to note

that the word Economics has been derived from the Greek words Oikos (a house) and nemine (to manage).

Thus economics means managing a household with limited funds. Adam Smiths magnum opus book An

enquiry into the nature and causes of wealth of Nations published in the year 1776, laid a strong foundation for

the growth of economics. So Adam Smith is rightly called as the Father of Economics. Although there is a

plethora of definitions, there is no concord among economists about a precise definition.

1. DEFINITION OF ECONOMICS:

The Various definitions can be classified broadly into three categories:

1. A science of wealth

2. A science of material welfare and

3. A science of scarcity

1.1 A SCIENCE OF WEALTH:

Adam smith, J.B.say, F.A. Walker and other economists of the 18 th and 19 th centuries have defined economics as

that part of knowledge which relates to wealth. Adam smith considered that the main aim of all economic

activities is to amass as much wealth as possible. It is, therefore, necessary to analyse how wealth is produced

and consumed. Most classical economists supported the Smithian definition of economics.

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1.3.1 HUMAN WANTS ARE UNLIMITED

Ends refer to human wants which are unlimited but the resources available to satisfy them are unlimited.

1.3.2SCARCITY OF MEANS

The resources(time or money or both) at the disposal of a person to satisfy his wants are limited. If things are

available in abundance just like free goods, the economic problem will not arise. But as Prof.Meyers says,

Alladins lamps exist only in Arabian fairy tales.

1.3.3ALTERNATIVE USES

Economic resources are scarce, but they can be put to alternayive uses. If we choose one thing, we must give up

others.

1.3.4THE ECONOMIC PROBLEM

When the means at the disposal of a person are limited and the resources can be put to several uses, and when

want s can be graded on the basis of intensity, human behavior necessarily takes the form of choice.

Recently, Prof.Samuelson has given a definition based on Growth aspects which is known as the Growth

Definition.

MANAGERIAL ECONOMICS

MEANING

Managerial economics lies on the borderline of management and economics.It is a hybrid of the two disciplines

and is primarilyan applied branch of knowledge.The development of the science of managerial economics is of

recent origin. After the Second World War and particularly after 1950, with rapid expansion of international

trade, the Business Managers faced numerous delicate problems. As Professor Ansoff says, since the early

1950s confronted with the growing variability and unpredictability of the business environment, business

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managers have become increasingly concerned with rational and foresightful ways of adjusting to an exploiting

environmental change.

There was a gap between economic theory and the correct procedure they have to employ to problems. The

problems of the business world attracted the attention of academicians and gave rise to a special treatment of

business problems. As a result managerial economics came into being.

2. DEFINITION OF MANAGERIAL ECONOMICS

Managerial economics has meant different things to different people. In simple terms managerial economic

means the application of economic theory to the problems of management.

Prof. Spencer and Siegelman defined managerial economics as the integration of economic theory with

business practice for the purpose of facilitating decision making and forward planning by the management.

It is clear from this definition that the problems of management are two fold. They are (i) decision making (ii)

forward planning. Decision making is a process of selecting a particular course of action from among a number

of alternative options. Forward planning means preparing plans for the future. Forward planning and decision

making goes hand in hand.

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We may define managerial economics as application of economic theory and decision science tools to problem

of managerial decision.

The following chart will make the concept clear.

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3. DISTINCTION BETWEEN ECONOMICS AND MANAGERIAL ECONOMICS

Economics has both micro and macro analysis. The roots of managerial economics spring from micro

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economic theory.

Economics is both positive and normative in character. Managerial economics is basically normative in

character.Economics mainly deals with the theoretical aspects of

the firm.

Managerial economics is concerned with practical

problems of the firm.

Micro economics, as part of economics deals with

individual and firms.

Managerial economics deals with firms and not with

individuals.

Economics studies principles underlying wage, rent,

interest and profit.

Managerial economics studies mainly the principles of

profit only.

Economics deals only with economic aspects of the

problem.

Managerial economics deals with both the economic

and non-economic aspects of the problem.

The scope of economics is wide. The scope of managerial economics is narrow.

4. SCOPE OF MANAGERIAL ECONOMICS

4.1 DEMAND ANALYSIS AND FORECASTING

It analyses the various types of demand which enable the manager to arrive at a reasonable estimate of the

demand for the products of his firm. When the current demand is estimated, the next logical step is to ascertain

the future demand for his products. The main areas cover under demand analysis is demand determinants

demand distinctions and demand forecasting.

4.1.1 COST AND PRODUCTION FUNCTION

Cost and production analysis is vital for the efficient allocation of scare resources. This analysis is also useful for

profit planning, project planning, cost control and pricing of products. While cost analysis is done in monetary

terms, production analysis is done in physical units. The major areas cover under cost and production analysis

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are cost concepts, and classification, cost output relationships, economies and diseconomies of scale and cost

control.

4.1.2 PRICING DECISIONS, POLICIES AND PRACTICES

Pricing is an important area in managerial economics. While fixing the price of a commodity, a complete

knowledge of the price system is essential. The success or failure of a firm mainly depends upon its accurate

price decisions. Pricing policy has considerable significance for the management only when there is a

considerable degree of imperfection in the market. The main areas covered are price determination in various

market structures, pricing methods and price forecasting.

4.1.3 PROFIT MANAGEMENT

Profit is the life blood of any organization. An element of uncertainty exists about profit due to variations in cost

and revenues. If knowledge about the future were perfect, profit analysis would be much easier. The important

areas covered are profit planning, profit management, profit forecast and profit measurement.

4.1.4 CAPITAL MANAGEMENT

Capital management means planning and control of capital expenditure. Capital measurement is done through

capital budgeting. Cost of capital, rate of return and selection of project are the important areas covered under

the capital management.

4.1.5 DECISION MAKING

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It is the process of selecting a particular course of action from among a number of alternatives. In arriving at a

decision, the alternative courses of action available have to be weighted for acceptance or rejection. Operational

research have developed many techniques which are frequently used in managerial economics for this purpose.

5. NATURE OF MANAGERIAL ECONOMICS

5.1 SPECIAL BRANCH OF ECONOMICS

Managerial economics is a special branch of economics bridging the gap between theory and practice.The

relation of managerial economics to economic theory is much like that of engineering to physics or of medicine

to biology or bacteriology.

5.1.1. MICRO ECONOMIC IN CHARACTER

Managerial economics draws heavily on the propositions of micro economic theory. For eg., demand concepts

and theories of market structure are elements of micro economics which managerial economics uses. The other

concepts widely used are (i) elasticity of demand ,(ii) marginal cost,(iii) marginal revenue,(iv) opportunity cost

etc. But some of these concepts however provide only the necessary logical base and have to be modified in

actual practice to suit special circumstances.

5.1.2 RELATED TO MACRO ECONOMICS ALSO

Though, basically managerial economics is micro economics in nature, it uses macro economics forecasting. A

proper understanding of the functioning of the economic system is of immense importance to the managerial

economist in framing suitable policies. Concepts like business cycles, national income accounting etc are widely

used in managerial economics.

5.1.3PRAGMATIC

Managerial economics is pragmatic and essentially an applied branch of knowledge. In economic theory many

abstract issues are analyzed on the basis of assumptions which are highly unrealistic. Managerial economics,

avoids difficult abstract issues. It is mainly concerned with analytical tools that are useful to firms.

5.1.4ELECTIVE IN NATURE

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Managerial economics is integrative or elective in nature. It combines and synthesizes ideas and methods from

various functional fields of business administration like accounting, production management, marketing and

finance. Thus it is multi-disciplinary in dimension.

5.1.5NORMATIVE

Managerial economics is prescriptive in character. It recommends what should be done under various alternative

conditions. Managerial economists are generally preoccupied with the optimum allocation of resources among

completing ends wit h a view to obtaining the maximum benefit according to pre-determined criteria. To achieve

these objectives, they do not assume that all other things would remain equal,but try to introduce policies whichif implemented would achieve the desired results. Thus managerial economics is both light giving and a fruit-

bearing one.

Managerial economics and other disciplines

Managerial economics is closely related to other disciplines and frequently impinges upon their fields.

Managerial economics and economics

Micro economics is also known as partial equilibrium analysis deals with the problem of individuals, firms and

industries and is the main source of inspiration to managerial economics. Concepts like elasticity, marginal

revenue, marginal cost, and models, like price leadership, kinked demand curve and price discrimination are

made use of in managerial economics spring from micro economic theory.

Macro economics aids managerial economics in the area of forecasting. The aggregates of the economics system

such as Gross National Product, General Price Index and level of employment serve as a useful guide for

devising relevant business policies.

Managerial economics and Statistics

Statistics provides many tools to Managerial economics. It is highly useful in demand forecasting. A correct

estimate of demand is vital for the management in framing a suitable inventory policy. Statistical tools like

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averages, dispersion, correlation, regression, time series etc are extensively applied in various managerial

aspects.

Managerial economics and Mathematics

Operations research is the application of mathematical techniques in solving business theory, input-output

analysis, queuing and simulation are some of the techniques developed by operational researchers. These

techniques are applied in Managerial economics.

Managerial economics and Accounting

Managerial economics is also related to accounting. For example, the profit and loss statement of a firm will

furnish necessary information to the manager to identify the specific areas of loss and arrive at suitable

decisions. It is very much useful in cost control.

Managerial economics and decision making

The theory of decision making too, has a significant place in managerial economics. It deals with the selection of

a particular course of action among the various alternatives. In order to choose a particular course of action,

many factors are taken into accounts. Sociological and psychological factors are considered and weighted

against economic factor in arriving at a decision.

7. ROLE OF A MANAGERIAL ECONOMIST IN BUSINESS

A managerial economist has a significant role to play in business by assisting the managements in their

successful decision making and forward planning goals. The factors which influence the business over a period

may lie within the firm or outside the firm. In general, these factors can be divided into two categories. (1)

External and (2) Internal

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The external factors lie outside the control of the management because they are external to the firm and are said

to constitute the business environment. The internal factors lie within the scope and operations of a firm and

hence within the control of the management and they are known as business operations.

EXTERNAL FACTORS

The function of a managerial economist is to analyze the environmental factors and recommend suitable

policies. The following are the important external factors affecting the firm.

General Economic Conditions

The most important external factor is the general economic conditions of the economy such as business cycles,

competitive conditions of the market, size and the rate of growth of the national income, the regional pattern of

income distribution, influence of globalization on the domestic economy etc. it is the duty of the managerial

economist to gather and analyze information with regard to these changes, and advise the management regarding

their likely effects on the operations of the firm and recommend suitable ways to pursue the organizational

goals.

Nature of Demand

The second important external factor relates to the nature of demand for the product. Since purchasing power is

an important variable influencing demand, the managerial economist has to study the purchasing power trend in

general an din the region concerned in particular. Moreover, it is his function to observe whether fashions, tastes

and preferences undergo any change and whether it is likely to have an impact on the demand for the product.

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Input Cost

The third external factor influencing the firm is the input cost of the firm. The managerial economist has to

advise the management on labour market conditions i.e., the cost of labour in different occupations. He also

studies the money market conditions, the changing scenario in governmentscredit policy and possible ways of

achieving the least-cost combination of factors and so on.

Marketing

Buying of raw materials and selling of finished goods are two important aspects of marketing. The managerial

economist has to study the markets from where the firm is buying its raw materials and selling its finishedgoods. The understanding helps him to evolve and frame a suitable price policy for the firm.

Market share

Market share refers to the share of a firm in the industry for a particular product. Expansion of market share is a

good symptom of growth. Therefore, the managerial economist has to examine the opportunities and strategies

which help in the expansion of the firms share in the regional and international markets.

Economic policies

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Last, but not the least, the managerial economist must keep in touch with the governments monetary policy,

fiscal policy, industrial policy, budgetary policy trends

etc. to advice the management.

INTERNAL FACTORS

A managerial economist can also be helpful to the management in making decisions relating to the internaloperations of the firm. The analysis of cost structure, and forecasting of demand are very essential. Moreover, it

is his responsibility to bring about a synthesis of policies relating to production, investment, inventories and

price.

SPECIFIC FUCTIONS

It involves

I. Sales forecasting

II. Industrial market research

III. Economic analysis of competing companies

IV. Pricing problems of industry

V. Capital projects

VI. Production programmes

VII. Security management analysisVIII. Advice on trade and public relations

IX. Advice on primary commodities

X. Advice on foreign exchange management

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XI. Economic analysis of agriculture

XII. Analysis on underdeveloped countries

XIII. Environmental forecasting etc.

APPLICATION OF THE THEORIES OF ECONOMICS IN BUSINESS DECISIONS

The following are the main theories in economics that help the firm in decision-making process.

THEORY OF DEMAND

Demand theory explains the consumers behavior. The theory helps to understand the behavior of

consumers when the determinants of demand such as income, taste and fashion, prices of substitutes, etc

change. A knowledge of demand theory is vital in the choice of commodities for production.

THEORY OF PRODUCTION

The BASIC function of a firm is to produce goods and services and sell them in the market. Production

requires employment of various factors of production. The factors are substitute among themselves to a

certain extend. To maximize production and profit, it is necessary to achieve the least-cost combination

of factors. Production theory is of immense use in determining the size of the firm, the size of the total

output and the optimum factor combination.

THEORY OF PRICE

Price theory explains price determination under various different market structures like perfect

competition, monopoly, oligopoly, etc. It is also useful to determine the optimal advertisement budget

that is necessary to maximize sales.

THEORY OF PROFIT

Profit making is the basic objective of business concerns. But, making a satisfactory level of profit is not

always certain, due to the presence of risk and uncertainty in business operations. Some of the factors

which influence profit are (i) nature of demand for the product (ii) prices of the inputs in the factor market

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and (iii) the degree of competition in the factor market . An element of risk is always there, even if

business activities are systematically planned .Therefore, minimising risks is of paramount importance to

safeguard the welfare of the firms. Profit theory guides in the measurement of profit and in estimating a

reasonable return on the capital employed.

THEORY OF CAPITAL AND INVESTMENT

Capital like all other inputs, is scare and an expensive factor. Rational utilisation of scarce resources is

one of the important tasks of the managers. The major issues related to capital are (i) assessing the

efficiency of capital (ii) choice of investment projects(iii) the most efficiency allocation of capital

.Knowledge of capital theory can contribute a great deal in investment decisions ,choice of projects,

maintaining capital intact ,capital budgeting etc.

MACRO ECONOMIC THEORIES

Though managerial economics is basically micro in nature, macro theories are altogether irrelevant for

decision making at the firm level. This is because, the macroeconomic environment, which includes the

behaviour of national aggregates such as priced level , national income , unemployment, poverty and,microeconomic policy aspects, such as economic policy aspects, such as economic policy ,industrial

policy subsidies ,administered prices and controls licensing policy ,etc affect firms decisions.

XIV.

CHAPTER 2

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OBJECTIVES OF BUSINESS FIRMS

INTRODUCTION

The sole and only objective in the traditional theory of the firm has been profit maximization.this objective

occupied the centre stage of economictheories till 1939 when R.L. Hall and C.J. Hitch with the help of their empirical studies,challenged both the profit maximization and the marginalistic behavioural rules.

THE FIRM AND ITS OBJECTIVES

A firm is a technical unit in which commodities are produed for sale to other economic units like

individuals,households,firms and government bodies.

MAXIMISATION OF PROFIT

The traditional economic theory assumed profit maximization as the sole objective of the firm.Under perfect

competition, the price of a commodity is determined by the forces of demand and supplay.Since the firm is one

among the many firms.,its action has no perceptibleinfluence on price and supply.The firm is a price taker and a

quantity adjuster.That is ,by accepting the market price the firm can sell any amount of product it likes.The

difference between the total revenue and total cost is the economic measure of profit.It is the residue that is left

after payment to all factors of production have been made.

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SALES MAXIMISATION

Baumols theory of sales maximisation is an alternative theory of a firms behaviour.The hypothesis rests on the

separation of ownership and management found in firms.Being a consultant to a number of firms in America ,he

points out that most managers seek to maximize their sales revenue rather than profits.He argue that the

managers in oligopolistic markets must earn a minimum level of profits to keep the share holders satisfied and

only after that ,they may pursue other things.In simple terms Baumols sales maximization hypothesis suggests

that the maximization of sales revenue subject to a profit constraint may be a more likely goal of large businees

firms than the mere assumption of profit maximization.

SECURITY OF PROFIT

According to prof:Rothchild the main aim of a firm is not profit maximization ,but a steady flow of profit for a

long time.In other words, it is interested in getting secure profits for a long period of time rather than profitmaximization.

Rothchild argues that the objectives of profit maximisation is valid only under conditions of perfect competition

or monopolistic competition,where there are a large number of firms.This is true under true monopoly also.In

these forms of market, problem of security does not arise.For the pure monopolist ,security against competition

is ensured by virtue of his monopoly power.And for a small competitor the security question is a very urgent

one;the market conditions have such an overwhelming force that he alone cannot do anything to safeguard his

position.Maximisation of profits is therefore a legitimate generalization about their behaviou of an entrepreneur

in such cases.

But Rothchild points out that in the field of duopoly and oligopoly this assumption is no longer valid.Under

oligopoly,a firm is not motivated by profit maximization.It is engaged in a constant struggle to achieve and

maintain a secure poition in the market,like a military strategit.

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MAXIMISATION OF SATISFACTION

Prof;Scitovsky favours satisfaction maximization in the place of profit maximization.According of Scitovsky

the satisfaction of an entrepreneur does not depend only upon the material goods in the form of comforts and

necessaries obtained by him out of the profits due to his entrepreneurial activity.It includes the leisure or what

Hicks calls aquiet life also as an essential ingredient of individual welfare.

Scitovskyargues that an entrepreneur would profits only.if his choice between more income and more leisure is

independent of his income.If an entrepreneur works more,less time will be available to him for leisure therefore

the satisfaction and keep his effortsand output below the level of obtaining maximum profits.

UTILITY MAXIMISATION

Oliver E.Williamson has developed the managerial utility hypothesis,managers seek to maximize their own

utility function,subject to a minimum leval of profit.A minimum leval of profit is necessary to satisfy the

shareholders or to keep the managers position unchanged. The utility of the self seeking managers depends

upon three factors.1)no.of persons working as subordinates,known as staff ,2)perquisites enjoyed by managers

and,3)discretionary powers to sanction investment project.Thus the hypothesis states that a long as a firm

earnsprofit which meet the minimum requirements of the owners,managers seek to maximize their own utility

functions.

.

SATISFICING

Prof Herbert Simon has developed a theory which emphasizes that the objective of a firm is not profit

maximization but satisficing.According to Simon,the firms may prefer the quite life and may be satisfied in

achieving a certain minimum level of profits,a certain share of the market or certain leval of sales.

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GROWTH MAXIMISATION

According to Marris the main goal of a firm is the balanced rate of growth of the firm.It means the maximization

of the rate of growth of demand for the products of the firm and the rate of growth of its capital supply.By

maximizing these variables,managers maximize their own utility functions and also the owners utility functions.

OTHER POSSIBLE OBJECTIVES

Papandreou says that organizational objectives grow out of an interaction among the various participants in the

organization.this interaction produses a general preference function.

Cooper argues that business attempt to maintain liquidity sufficients to assure the firms financial position,

3. DECISION MAKING

Decision-making is the process of selecting a particular course of action from among the various alternativesavailable.

Most of the economic theories are based on perfect knowledge which implies certainty. In real life, a firmmay experience uncertainty regarding market trends, reaction of competitors, and of government policies. Infact, most decisions have to be made under varying degrees of risk and uncertainty. Risk refers to a situationwhere there is more than one possible outcome to a decision and the probability of each specific outcome isknown or can be estimated. Uncertainty is the case where there is more than one possible outcome to a decisionand the probability of each specific outcome occurring is not known. The ability of an efficient manager lies intaking a correct decision when the information and time available are limited.

The following chart depicts the process of decision-making.

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Now the question is how to take a decision. Since the knowledge of the future uncertain the managements haveto make decisions daily and also formulate plans for the future. There are various ways in which decisions can

be made, ranging from off the cuff guess work to fully informed conclusions combined with good judgement.Mainly there are five fundamental concepts that are used in decision making viz.,

i. Incremental concept

ii. The concept of time perspective

iii. The discounting principle

iv. The concept of opportunity cost and

v. The principle of equi-marginalism

4. FUNDEMENTAL CONCEPTS USED IN MANAGERIAL

ECONOMICS

Five fundamental concepts that are basic in study of managerial economics are as follows:

1. The incremental concept

Alternativecourses of Action

Selection of aparticular Action

Execution of Action

Result of Action

Action A

Action B

Action C

Decision A chosenplan of

Full realization of objective

Partial realizationof objective

Non-realization of objective

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2. The concept of Time perspective

3. The Discounting principle

4. The concept of opportunity cost5. The principle of equi-marginalism

4.1. The Incremental Concept

Incremental concept is closely related to the marginal revenues and marginal cost of economic theory.Incremental reasoning involves estimates of the impact of decision alternatives on costs and revenues, stressingthe changes in total costs and total revenue that result from changes in price, products, procedures, investments,

or whatever may be at stake in the investment decision.

The two basic concepts involved in this analysis are incremental cost and incremental revenue.Incremental cost is the change in total cost consequent upon a decision. Likewise incremental revenue is thechange in total revenue due to decision.

The decision criterion according to this concept is Accept a particular decision if it increases the revenuemore than it increases the cost, as assessed from the managerial point of view.

Other variants of this principle are: if:

i. It decreases some costs to a greater extent than it increases others

ii. It increases some revenues more than it decreases others: and

iii. It reduces costs more than revenues

4.2. Implications of Incremental Reasoning

Incremental reasoning is significant, for some business hold an erroneous view that to make an overall profitthey must make a profit on every job. The result is that they often refuse orders that do not cover

20

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Full cost (labor, materials and overhead) plus some provision for profit. But incremental reasoning shows thatthis rule may be inconsistent with profit maximization in the short run. It can be seen from the followingillustration that a refusal to accept business below full cost means a rejection of a possibility of adding more torevenue than to cost.

Illustration

Suppose a new order is estimated to bring in Rs. 20,000 by way of additional revenue. The cost as estimated bythe companys accountant is as follows:

Labor.Rs. 6,000

Material...Rs. 8,000

Overhead (allocated at 120% of labor cost) .Rs. 7,200

Selling and administrative expenses

(allocated at 20% of labor and material costs)..Rs. 2,800

-------------------------

Full Cost Rs. 24,000--------------------------

The order appears to be unprofitable, because, if it is accepted it will result in a loss of Rs. 4,000. But supposethat there exists an idle capacity with this order could met. Further suppose the order adds only Rs. 2000 tooverheads (the incremental overhead is limited to the added use of heat, power and light, the added wear and tear to the machinery, the added costs of supervision etc). The order does not require any selling and administrativecosts, as the only requirement is the acceptance of the order. In addition, only a part of the labor cost isincremental because some of the idle workers already on the pay roll will be employed without any additional

pay

The incremental cost of accepting the above order may be as follows:

Overheads.Rs. 2,000

MaterialsRs. 8,000

Labor Rs. 4,000

----------------------------------

Total incremental cost Rs. 14,000

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Therefore, contrary to the accountants estimate of a loss of Rs. 4,000 the order will result in an addition of Rs.6,000 as profit. The application of the incremental principle maximizes short run profit, but not long-run profit.

21

4.3. The Concept of Time Perspective

Economists make a distinction between short-run and long-run with a precision that is often missed in ordinarydiscussions. This distinction is not based on the duration of time but on the ability of the business firms tochange the use of the different inputs such as raw material, labor, management, plant and equipment etc.

If firms can change the ratio in which every input is used, the period is referred to as the long run. On theother hand, if firms can change the use of a few inputs but not all, the period is referred to as the short run.

In real life this type of dichotomy between long-run and short-run perspectives breaks down. In manydecisions as the time perspective is extended more and more items of costs become variable. Revenue items also

are likely to change as the time perspective moves out farther. The crucial problem in decision-making is tomaintain the right balance between the short run and long run and intermediate run considerations, but may astime passes, have long run repercussions that make it more of less profitable than it seemed at first. Thefollowing illustration may make the matter clear.

Consider a firm with some temporary idle capacity. An order for 10,000 units comes to the managementsattentions. The prospective consumer is willing to pay Rs. 4 per unit or Rs. 40,000 for the whole lot. The shortrun incremental cost (which ignores the fixed cost) is only Rs. 3 . Therefore, the contribution to overhead and

profit is Re.1 per unit (or Rs. 10,000 for the whole lot). In spite of this favorable position, before accepting thisorder, the management must take into consideration the following long run repercussion viz.,

1. Firstly, if the management commits itself to a series of repeat orders at the same price the managementmay be forced to consider the question of expansion of capacity when the so called fixed costs may also

become variable.

2. Secondly, the acceptance of an order at a lower price might tarnish the image of the company.

3. Thirdly, some of the present customers may feel that they had been treated unfairly and may opt to resortto firms which follow ethical pricing.

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The above considerations lead us to following conclusion. A decision should take in to account the short run andlong run effect on revenue and cost, customer reaction and companys image etc, giving appropriate weight tothe most relevant time periods.

The Discounting Principle

Money has a time value. A certain sum of money, say Rs 1000 to be received today is worth more than Rs

1000 to be received in future. But how much is it worth depends upon two factors which are, (1) The timeinterval (2) The time pattern

The proverb A bird in the hand is worth two in the bush is applicable to this concept. Suppose a personis offered a choice whether to receive Rs 1000 today or Rs 1000 next year. Naturally he will choose the firstoffer for two reasons.

First, the amount can be invested and made to earn interest. Second, a lot of risk and uncertainty is involved inrecovering the amount in future. Considering these, business firms always prefer receiving a given amount thatday itself to receiving the same amount in future.

Investment in business leads to an accrual of benefits over a period of time. The computation of the present value of an amount due in future or stream of earnings likely to accrue in future, involves discounting of time.

Suppose we have Rs.2,000 at our disposal. We can invest this amount in a bank, say at an interest rate, rof 10%. After one year, we could withdraw from the bank both the original deposit and the accumulated interest;this would be our future receipt in year one, or R 1.

That is, R 1= Rs2000 + (0.1)2000 =Rs 2200

Generally R 1=PV +r(PV) = PV(1+r)

Where PV = present value

Alternatively if we do not withdraw the money but leave it on deposit for a further period of one year,

then at the end of the second year we could withdraw the following.

R 2 = R 1 +r(R1) = R 1(1+r) = PV(1+r) 2

In this manner, R at the end of year n

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R n = PV(1+r) n

This process is called compounding. The above compound interest formula tells us about the magnitude of a future receipt if we already know its present value and the interest rate.

The reverse procedure, where the future receipt and the interest are known, and the present value can befound out. It is known as discounting.

The discounting formula can be stated as:

PV =R n(1+r) n

This gives us the PV of a sum of money to be received n years hence, at a given discount rate of r. When a

stream of future receipts is expected, to accrue at annual intervals, then the PV of a stream is the sum of the PVsof each receipt. That is

R1/(1+r) + R2/(1+r) 2+ R3/(1+r) 3..................+ Rn/(1+r) n

Suppose a firm is going to receive Rs 20000 per year for the next three years at a rate of 10% from its fixeddeposit. Then

PV= 20000/(1+0.10) + 20000/(1+0.10) 2+20000/(1+0.10) 3

= 20000/1.10 + 20000/1.21 + 20000/1.301

= 18180.2 + 16529 + 15026.2 = Rs 49735.4

The Concept of Opportunity Cost

The concept of opportunity cost lies at the heart of all managerial decisions. The opportunity cost of anything isthe alternative that has been forgone. This implies that one commodity can be produced only at the cost of foregoing production of the other.

Smith has observed, if the hunter can bag a deer or a beaver in the course of a single day, the cost of a deer is a beaver and the cost of a beaver is a deer.

In managerial economics, opportunity costs are the costs of displaced alternatives. They represent onlysacrificed alternatives. According to Haynes, Mote and Paul.

1. The opportunity cost of funds tied up in ones own business is the interest that could be earned on thosefunds in other ventures.

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3. What are the objectives of a business firm

4. State the incremental concept and explain its importance.

5. Briefly explain the 5 principles which are basic to the entire gamut of managerial economics.

6. What is opportunity cost? How is it calculated?

7. Show that the principle of Equi-Marginalism is the extension of the condition of equilibrium of aconsumer.

8. Write short notes on

a. Discounting principle

b. Marginalism

c. Steps in decision-making

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