Chapter 1Basic Concepts and

Principles

:- Ved Prakash panda

Lecture plan Objectives What is Economics? Basic Assumptions Types of Economic Analysis Managerial Economics Managerial Decisions Economic Principles Relevant to Managerial Decisions Production Possibilities Curve Managerial Economics and Functions of Management Relationship with Other Disciplines Summary

Objectives

To introduce key economic concepts like scarcity, rationality, equilibrium, time perspective and opportunity cost.

To explain the basic difference between microeconomics and macroeconomics.

To help the reader analyze how decisions are made about what, how and for whom to produce.

To define managerial economics and demonstrate its importance in managerial decision making.

To discuss the scope of managerial economics and its relationship with various other disciplines and functional areas.

What is Economics? Discusses how a society tries to solve the human

problems of unlimited wants and scarce resources. Scientific study of the choices made by individuals and

societies with regard to the alternative uses of scarce resources employed to satisfy wants.

Theoretical aspect and an applied science in its practical aspects.

Not an exact science; An “art” as well A social science Deals with the society as a whole and human behaviour in

particular Studies the production, distribution, and consumption of

goods and services. A science in its methodology, and art in its application.

Basic Assumptions

Ceteris Paribus Latin phrase “With other things (being) the same” or “all other things

being equal”. Rationality

Consumers maximize utility subject to given money income.

Producers maximize profit subject to given resources or minimize cost subject to target return.

Types of Economic Analysis

Micro and Macro Microeconomics (“micro” meaning small): study of

the behaviour of small economic units An individual consumer, a seller/ a producer/ a

firm, or a product. Focus on basic theories of supply and demand in

individual markets Macroeconomics (“macro” meaning large):

study of aggregates. Industry as a unit, and not the firm. Focus on aggregate demand and aggregate

supply, national income, employment, inflation, etc.

Types of Economic Analysis

Positive and Normative Positive economics: “what is” in economic matters

Establishes a cause and effect relationship between variables.

Analyzes problems on the basis of facts. Normative economics: “what ought to be” in

economic matters. Concerned with questions involving value judgments. Incorporates value judgments about what the economy

should be like.

Short Run and Long Run Short run: Time period not enough for consumers and

producers to adjust completely to any new situation. Some inputs are fixed and others are variable

Long run: Time period long enough for consumers and producers to adjust to any new situation.

All inputs are variable Decisions to adjust capacity, to introduce a larger

plant or continue with the existing one, to change product lines.

Types of Economic Analysiscontd..

Types of Economic Analysis

Partial and General Equilibrium Partial equilibrium analysis: Related to micro analysis

Studies the outcome of any policy action in a single market only.

Equilibrium of one firm or few firms and not necessarily the industry or economy.

General equilibrium: explains economic phenomena in an economy as a whole.

State in which all the industries in an economy are in equilibrium.

State of full employment

Managerial Economics

Application of economic theory and the tools of analysis of decision science to examine how an organisation can achieve its objectives most effectively

Study of allocation of the limited resources available to a firm or other unit of management among the various possible activities of that unit

Applies economic theory and methods to business and administrative decision-making

Application of economic principles and methodologies to the decision-making process within the firm or organization

Micro as well as Macro Applied microeconomics: demand analysis, cost and

production analysis, pricing and output decisions Macroeconomic: national income, inflation and stages of

recession and expansion Normative Bias

Prescriptive: States what firms should do in order to reach certain objectives.

Decides on whether or not the probable outcome of a managerial decision is desirable.

Decisions Resulting in Partial Equilibrium Decisions taken by any firm would relate to the equilibrium of

that particular firm. Deals with partial equilibrium analysis

Managerial Economics Contd…

Economic Principles Relevant to Managerial Decisions Concept of scarcity

Unlimited human wants Limited resources available to satisfy such wants Best possible use of resources to get:

maximum satisfaction (from the point of view of consumers) or maximum output (from the point of view of producers or firms)

Concept of opportunity cost Opportunity cost is the benefit forgone from the alternative

that is not selected. Highlights the capacity of one resource to satisfy multitude of

wants Helps in making rational choices in all aspects of business,

since resources are scarce and wants are unlimited

Concept of margin or increment Marginality: a unit increase in cost or revenue or

utility. Marginal cost: change in Total Cost due to a unit change in

output. Marginal revenue: change in Total Revenue due to a unit

change in sales. Marginal utility: change in Total Utility due to a unit change

in consumption. Incremental: applied when the changes are in bulk,

say 10% increase in sales.

Economic Principles Relevant to Managerial Decisions Contd…

Economic Principles Relevant to Managerial Decisions Discounting Principle

Time value of money : Value of money depreciates with time

A rupee in hand today is worth more than a rupee received tomorrow.

Outflow and inflow of money and resources at different points of time

PVF =

where PVF = Present Value of Fund, n = period (year, etc.) R = rate of discount

nr)1(1

Production Possibilities Curve

Shows the different combinations of the quantities of two goods that can be produced (or consumed) in an economy at any point of time.

Depicts the trade off between any two items produced (or consumed).

Highlights the concepts of scarcity and opportunity cost Indicates the opportunity cost of increasing one item's production

(or consumption) in terms of the units of the other forgone Slope of the curve in absolute terms

Assumptions The economy is operating at full employment. Factors of production are fixed in supply; they can however be

reallocated among different uses. Technology remains the same.

Food

Clothing

FQ

CQ

Q

FP

CP

P

O

Figure 1.3: PPC for the Society

Production Possibilities Curve Contd…

Productively Inefficient Area

Technically Infeasible Area

All points on the PPC (like P and Q) are points of maximum productive efficiency.

In the figure, OFp of food and OCp of clothing can be produced at Point P and OFQ of food and OCQ respectively at point Q, when production is run efficiently.

All points inside the frontier are feasible but productively inefficient.

All points to the right of (or above) the curve are technically impossible (or cannot be sustained for long).

A move from P to Q indicates an increase in the units of clothing produced and vice versa.

It also implies a decrease in the units of food produced. This decrease in the units of food is the opportunity cost of producing more clothing.

Production Possibilities Curve Contd…

Managerial Economics and Functions of Management All functional areas have to find the most

efficient way of allocating scarce organizational resources

Managerial economics: Facilitates the process of evaluating

relationships between functional areas Helps in making rational decisions across

managerial functions.

Managerial Economics and Functions of Management

Financial Management From where to collect resources

Equity Debt

How to allocate resources How much profit to be retained/distributed

Human Resource Management Recruitment Wage and Salary Training and development Retirement

Contd…

Managerial Economics and Functions of Management Marketing Management

Which product For whom What price How to sell

Operations Management Which technology Inputs Processing

Information System Management Communication channels Use of information Technology

Relationship Other Disciplines Economic Theory

MicroeconomicsTheory of firm Theory of consumer behaviour (demand)Production and cost theory (supply)Market structure and competition Price theoryMacroeconomicsNational income and output Business cycleInflation

Quantitative AnalysisNumeric and algebraic analysisOptimizationDiscounting and time value of money techniquesStatistical estimation and forecastingGame theory

Managerial Economics

Solutions to Managerial Decision MakingQuantity and quality of product Price of productMarketing ManagementFinancial ManagementHuman Resource ManagementResearch and Development

Summary• Economics studies the choices made by individuals and societies in

regard to the alternative uses of scarce resources which are employed to satisfy unlimited wants.

• Microeconomics is the study of the behaviour of individual economic units, such as an individual consumer, a seller, a producer, a firm, or a product.

• Macroeconomics deals with the study of aggregates, the economy as a whole.

• Ceteris paribus is a Latin phrase, literally translated as “with other things (being) the same”.

• The assumption of rationality means that consumers and firms measure and compare the costs and benefits of a decision before going ahead for that decision.

• Partial equilibrium analysis studies the outcome of any policy action in a single market only, while general equilibrium analysis seeks to explain economic phenomena in an economy as a whole.

• Opportunity cost is the benefit forgone from the alternative that is not selected.

Summary• Concept of Time value of money tells that Value of money

depreciates with time.• Concept of Marginal/increment tells about impact of

unit/proportionate change in cost/revenue on decision making.• Managerial economics is a means to finding the most efficient way

of allocating scarce organizational resources and reaching stated objectives. It is micro as well as macro in nature; it has a normative bias, and deals with partial equilibrium.

• Production Possibilities Curve (PPC) is a graph that shows the different combinations of the quantities of two goods that can be produced (or consumed) in an economy, subject to the limited availability of resources.

• The knowledge of managerial economics helps to understand the interrelationships among the various functional units of any firm (namely production, marketing, HR, finance, IT and legal)

• Decision sciences provide the tools and techniques of analysis used in managerial economics, in particular numerical and algebraic analysis, optimization, statistical estimation and forecasting.