Hu 300 Engg Economics

NATIONAL INSTITUTE OF TECHNOLOGY KARNATAKA, SURATHKALDEPARTMENT OF HUMANITIES, SOCIAL SCIENCES AND MANAGEMENT

V/VI SEMESTER B. Tech. [COMMON]

HU –300 ENGINEERING ECONOMICS 3-0-0: 3

Unit – 1

INTRODUCTION:

“Economic science is primarily concerned with the processes of mobilising,

allocating, and utilising resources for the purpose of promoting human development and

welfare.” In these processes, it is more important to uphold truth and humanitarianism

than to apply-sophisticated theories, models and techniques backed by mathematical

logic, econometric methodology and computer software.

Economics as a branch of knowledge is concerned with the study of the allocation

of scarce resources among competing ends. Problems of resource allocation are

constantly faced by individuals, enterprises and nations. Over the years, the science of

economics has developed a variety of concepts and analytical tools to deal with such

allocation problems. The necessity for economising arises from the fact that we have

limited productive resources such as land, raw materials, skilled manpower, capital

equipment’s, and technology at our disposal. Because these resources are found in limited

quantity, the goods they can produce are also limited. Therefore, resources need to be

used and managed most efficiently and economically. Efficient and economic use of

resources is not an easy task. It is achieved over time, and is a function of many physical,

financial, engineering, human and institutional factors.

Economics contributes a great deal towards the performance of managerial duties

and responsibilities. All other things remaining the same, managers with working

knowledge of economics, can perform their functions more efficiently than those without

it. The emphasis here is on the maximization of the objective and limitedness of the

resources. Resources at the disposal of a person /firm /nation, be it finances, men or

Course Instructor Dr. K. B. Kiran 1Email:[email protected]

material, are by all means limited. Therefore, the basic task of the management is to

optimise the use of the resource.

In performing his functions, a manager has to take a number of decisions in

confirmity with the goals of the firm. Many of the decisions are taken under the condition

of uncertainty and therefore involve risk. Uncertainty and risk arise mainly due to

uncertain behavior of the market forces, i.e., the demand and supply, changing business

environment, govt. policy, external influence on the domestic market and social and

political changes in the country. However, the degree of uncertainty and risk can be

greatly reduced if market conditions could be predicted with a high degree of reliability.

Taking appropriate business decisions requires a clear understanding of the

technical and environmental conditions under which decisions are to be taken.

Application of economic theories to explain and analyse the technical conditions and the

economic environment in which a business undertaking operates contributes a good deal

to the rational decision-making. Economic theories have therefore gained a wide

application to the analysis of practical problems of business. Therefore, a working

knowledge of economics, not necessarily a formal degree, is essential requirement for the

managers. Moreover the modern engineering graduate is increasingly finding himself in

positions in which his responsibility is extended to include economic factors.

Nowadays, the economic environment of most manufacturing enterprises is

drastically changing. The economy of scale is being replaced by an economy of scope.

Customisation, i.e., product adaptation to specific customer requirements, is driving the

demand. Globalisation, i.e., the necessity to be present on worldwide markets, implies a

timely deployment strategy in terms of product manufacturing and distribution,

sometimes forcing strategic alliance with partner companies. Fierce competition with

emerging countries forces industrialised countries to produce at lower cost, with higher

quality and in shorter delays. Finally, the consequence of widespread automation and the

need to gain on productivity are pushing manufacturing enterprises to lean their

management and manufacturing operations, therefore employing less and less people.


Thus, with the growing complexity of business environment, the usefulness of

economic theory as a tool of analysis and its contribution to the process of decision-

making has been widely recognised. Possibly, because modern business problems are so

complex that decision maker’s personal experience, insight, intuition, foresight and

judgement alone are no longer adequate to find out an appropriate solution to the

complex business problems. The application of economic tools and logic to the business

problems helps in arriving at an optimum solution to the problem.

Economic life is an enormously complicated hive of activity, with people buying,

selling bargaining, investing, persuading and threatening. The ultimate purpose of

economic science is to understand this complex undertaking.

Every subject deals with a particular field of knowledge. For example, Natural

Sciences deal with man’s physical environment. But Economics, as a social science,

studies man as a member of the organised society. What is the behaviour of most of the

people in a society when they buy goods in the market? Obviously, the group behaviour

is that more people would buy at low prices and less people would buy at high prices.

This group reaction in buying is known as the law of demand.

Engineering is not a science but is an application of science. It is an art composed

of the skill and ingenuity in adapting knowledge to the uses of humanity. To the engineer,

knowledge is not an end in itself but is the raw material from which he fashions

structures, systems, and process. Engineering involves the determination of the

combination of material forces, and human factors that will yield a desired result.

Engineering activities are rarely carried out for the satisfaction that may be derived from

them directly. With few exceptions, their use is confined to satisfying human wants.

The technological and social environment is which we live continue to change at a

rapid rate. In recent decades, advances in science and engineering have made space travel

possible, revolutionized communication, transformed our transportation systems,

revolutionized the practice of medicine, and miniaturized electronic circuits so that a

computer can be placed on a semiconductor chip. The list of such achievements seems

almost endless.


The Accreditation Board for Engineering and Technology (USA) states that

engineering “is the profession in which a knowledge of the mathematical and natural

sciences gained by study, experience, and practice is applied with judgement to develop

ways to utilize, economically, the materials and forces of nature for the benefit of

mankind.” In this definition the economic aspects of engineering are emphasized as well

as the physical aspects. Clearly, it is essential that the economic part of engineering

practice be accomplished well.

Engineering Economy involves the systematic evaluation of the economic merits

of proposed solutions to engineering problems. To be economically acceptable (i.e.,

affordable), solutions to engineering problems must demonstrate a positive balance of

long-term benefits over long-term costs, and they must also:

Promote the well-being and survival of an organization,

Embody creative and innovative technology and ideas,

Permit identification and scrutiny of their estimated outcomes, and

Translate profitability to the “bottom line” through a valid and acceptable measure of

merit.

Engineering activities of analysis and design are not an end in themselves but are a

means for satisfying human wants. Thus, engineering has two aspects. One aspect

concerns itself with the materials and forces of nature; the other is concerned with the

needs of mankind. Because we live in a resource-constrained world, engineering must be

closely associated with economics. It has become absolutely essential that engineering

proposals be evaluated in terms of worth and cost before they are undertaken. Therefore,

we can say that the essential prerequisite of successful engineering application is

economic feasibility.

Engineers are confronted with two important interconnected environments, the

physical and the economic. Their success in altering the physical environment to produce

goods and services depends upon knowledge of physical laws. However, the worth of

these products and services lies in their utility measured in economic terms.


Want satisfaction in the economic environment and engineering proposals in the

physical environment are linked by the production or the construction process. Figure: 1

illustrates the relationship between the engineering proposals, production or construction,

and want satisfaction:

THE TOTAL ENVIRONMENT

Physical environment Economic environment

Engineering proposals Production / Construction Want satisfaction

Figure: 1 The Engineering Environment

The usual function of engineering is to manipulate the elements of one

environment, the physical, to create utility in a second environment, the economic.

However, engineers some times have a tendency to disregard economic feasibility and

are often appalled in practice by the necessity for meeting situations in which action must

be based on estimates and judgement. Yet the modern engineering graduate is

increasingly finding himself in positions in which his responsibility is extended to include

economic factors.

Engineers can readily extend their inherent ability of analysis to become proficient

in the analysis of the economic aspects of engineering application. The large percentage

of engineers who will eventually be engaged in managerial activities will find such

proficiency of necessity.

An engineering economy study is accomplished using a structured procedure and

mathematical modeling techniques. The economic results are then used in a decision

situation that involves two or more alternatives and normally includes other engineering

knowledge and input.

Engineering Economic Analysis Procedure Engineering Design Process

Step Activity 1. Problem recognition, definition, 1. Problem/need definition.


and evaluation.

2. Development of the feasible alternatives. 2. Problem/need formulation and evaluation.

3. Development of the cash flows for each 3. Synthesis of possible alternative. solutions (alternatives).

4. Selection of a criterion (or criteria). 4. Analysis, optimization, and evaluation.

5. Analysis and comparison of the alternatives. 5. Specification of preferred alternative.

6. Selection of the preferred alternative. 6. Communication.

7. Performance monitoring and post- evaluation of results.

Economic Development and its Impact on Science, Engineering Technology and Society (Environment):

Growth in real percapita income has more generally been accepted as an index of

economic development of a country. As Dan Usher puts it, “to economists, journalists,

historians, politicians and the general public, the rate of economic growth is a summary

measures of all favourable developments in the country.” We are pleased when economic

growth occurs and displeased when it does not.

Development is not the same thing as economic growth. Economic development is

synonymous with a general rise in standard of living; and increase in the percapita

income may not accomplish it. A continuous rise in the real percapita income may be

indicative of the “growth” of an economy, but not of its development. Growth means

more output. Development implies not only more output but also different kinds of output

than were previously produced as well as changes in the technical and institutional

arrangements by which output is produced and distributed


Economic development is the function of several determinants, which can

conveniently be classified into two categories, viz., Economic factors and scientific

factors.

Economic Development

Economic factors Scientific factors

(a) Natural resources (a) The propensity to develop

Fundamental Sciences

(b) Capital formation (b) The propensity to apply Science to economic ends.

(c) Capital output ratio (c) The propensity to accept Innovations.

(d) Technological progress (d) The propensity to seek material advance.

(e) Size of market. (e) The propensity to consume.

(f) Human Resources

Besides, the various political and social factors also condition the rate of economic

development.

In short, economic development is the result of concerted efforts of both economic

and scientific factors. However, the mere presence of one or more or all of these factors

may not ensure that the economy will be in a position to generate forces that bring about

a fast economic development. Some further factors may also be required that may work

as a catalyst for growth. This function can well be performed by the state (Government).


Recent empirical studies of the developed countries suggest that technological

progress has been a major source of economic growth. Only a minor part of the total

increases in output over a long period, in these empirical studies, has been attributed to

increased physical inputs, such as labour and capital; the greater part of the increase has

been due to ‘Technological Progress’ or ‘human factors’, such as education, research and

development etc., which are responsible for the increase in the productivity of the

physical factors.

Economic development and development of Science, Engineering Technology and

Society (environment) are interdependent. Science is the foundation upon which the

engineer builds toward the advancement of mankind. With the continued development of

Science and the widespread application of engineering, the standard of living may by

expected to improve and further increase the demand for those things that contribute to

people’s love for the comfortable and beautiful.

Rate of economic development to a large extent is conditioned by technological

progress. Technological progress implies the application of improved technical know-

how in the production activity. This depends upon the advancement of fundamental and

applied sciences, resulting in scientific inventions. When an invention is adopted, it

becomes an innovation. Innovations result in an improvement in technology, which

increases productivity. In Samuelson’s language, a High – Invention nation will grow at

a faster rate than a ‘High – Investment Nation’.

For technological progress to take place, three conditions are necessary:

(a) Technological progress requires large capital investments in research as well as in

industries.

(b) It needs entrepreneurs who have the ability to understand the possibilities of using

scientific inventions for commercial purposes.

(c) There must be expanding market for products.


All these conditions are fulfilled in a developed economy; hence the rate of

technological progress is very fast in these countries. In an economically backward

country, these conditions do not obtain, and, hence the technological progress is retarded.

MACRO-ECONOMICS AND MICRO-ECONOMICS:

One useful distinction that economic theorists make is between macro and

microeconomics.

The micro-economic analysis deals with the theory of the firm, and the behaviour

and problems of individuals and of micro-organizations. In other words micro-economics

is a study of the small individual units of the economic system in detail. According to

Prof. Boulding, “Micro-economics is the study of individuals firms, households,

individual prices, wages, and particular industries”.

On the other hand macro-economics is concerned with the behaviour of the

economy as a whole, and the theories about its operation. In the words of Prof. Boulding,

“Macro-economics deals not with individual quantities as such, but with the aggregates

of those quantities – not with individual prices but with price level, not with individual

outputs, but with the national output”.

Thus, the study of the level and determination of National Income, employment

and general prices and the analysis of aggregate consumption and balance of payments

belong to macro-economics.

However, in actuality micro and macro-economics are interdependent. In fact,

neither macro-economic nor micro-economic analysis alone can adequately explain the

working of the economic system. This is because what is true of an individual unit of the

economy may not be true of the economy as a whole, and what is true of the economy as

a whole may not be true of an individual unit of the economy. For instance, saving by an

individual is good but not by, the nation as a whole. Similarly, the general price level in

the economy might have remained constant over a specified period, but the prices of

some specific units might have fluctuated violently during the same period. To quote


Prof. Paul A Samuelson, “……… you are less than half educated if you understand the

one while being ignorant of the other”. So both the approaches are necessary for a

perfect study of economics.

MICRO-ECONOMICS IN MANAGERIAL DECISION MAKING:

The roots of Managerial economics spring from micro-economic theory. In the

case of managerial economics, micro economics helps in studying what is going on

within the firm, how best to use the available scarce resources between various activities

of the firm, how to be technically as well as economically efficient, etc.

Some of the popular micro-economic concepts are the elasticity of demand,

marginal cost, the short and long run economies, and diseconomies of scale, opportunity

cost, present value and market structures. Managerial economics also uses some of the

well-accepted models in price theory. Such as the model for monopoly price, kinked

demand model, the model of price discrimination and the behavioural and managerial

models.

The dependence of Managerial Economics on Micro-economic theory is very

much like the dependence of engineering or technology on physics. It has an interest in

applying economic theory in order to solve real life problems of enterprises.

MACRO-ECONOMICS IN MANAGERIAL DECISION MAKING:

Macro–economics is very useful in managerial decision making. Managerial

economics takes the help of macro-economics to understand the external conditions

which are relevant to the business. For instance macro-economic policies like industrial

policy, tax policy, exim policy, etc. of the government. Since these, conditions are

beyond the firm’s control it has to adjust itself to the changes in these conditions to

survive and grow.

Macro-economics helps managerial-economics in national income forecasting. It

is an important aid to business conditions analysis, which in turn could be a valuable

input for forecasting the demand for specific product groups. Assumptions and estimates


of demand are essential data for most of the allocation decisions managerial economics is

concerned with.

Thus, the system of logic that managerial economics (managerial decision making)

uses come from this heritage of economic theory.

Operational Issues and Microeconomics

Operational problems are basically of internal nature. They include all those

problems, which arise within the business organization, and fall within the purview and

control of the management. Some of the basic internal issues are: (i) choice of

commodity, i.e., what to produce; (ii) choice of size of the firm, i.e., how much to

produce; (iii) choice of technology, i.e., choosing the factor-combination; (iv) choice of

price, i.e., how to price the commodity; (v) how to promote sales; (vi) how to face price

competition; (vii) how to expand the investment; (viii) how to manage profit and capital;

(ix) how to manage inventory, i.e., stock of both finished goods and raw materials. These

problems may also figure in forward planning. All these questions and alike confronted

by the managers of a business enterprise are related to various economic theories. The

branches of economic theories which deal with most of these questions are following:

Theory of demand: Demand theory explains the consumer’s behaviour. It answers the

question: why do consumers buy a commodity? How do they decide on the quantity of a

commodity to be purchased? When do they stop consuming a commodity? How do the

consumers behave when price of the commodity, their income, and taste and fashions,

etc., change? The knowledge of demand theory can, therefore, be helpful in choice of

commodities for production.

Theory of production: Production theory, also called “Theory of Firm,” explains how

average and marginal costs vary when production is increased; under what conditions

costs increase or decrease; how total output increases when units of one factor (input) are

increased keeping other factors constant, or when all factors are simultaneously

increased; to what extent one factor (say, labour) can substitute another, (say, capital),

how optimum size of output is achieved. Production theory thus helps in determining the


size of the firm, size of the total output and the factor proportion, i.e., the amount of

capital and labour to be employed.

Theory of exchange or price theory: Price theory explains how prices are determined

under different market conditions; when price discrimination is desirable, feasible and

profitable; to what extent advertisement can be helpful in expanding the sale in a

competitive market. Price theory, thus, can be helpful in determining price policy of the

firm. Price and production theories together, in fact, help in determining optimum size of

the firm.

Theory of profit: Profit making is the most common objective of the business

undertakings. But, making a satisfactory profit is not always guaranteed because a firm

has to carry out its activities under conditions of uncertainty in regard to: (I) demand for

the product, (ii) input prices in the factor market, (iii) nature and degree of competition in

the product market, and hence (iv) price behaviour under changing conditions in the

product market, etc. therefore, an element of risk is always there even if most efficient

techniques are used for predicting future and even if business activities are meticulously

planned. The firms are therefore supposed to safeguard their interest and avert, as far as

possible, the possibilities of risk or minimize it. Profit theory guides in the measurement

and management of profit, in making allowances for risk premium, in calculating the

pure return on capital and pure profit and also in future profit planning.

Theory of capital and investment: Capital like all other inputs is a scarce and an

expensive factor. Capital is the foundation of a business. Its efficient allocation and

management is one of the most important tasks of the managers. The major issues related

to capital are: (I) choice of investment project, (ii) assessing the efficiency of capital, and

(iii) most efficient allocation of capital. Knowledge of capital theory can contribute a

great deal in investment-decisions, choice of projects, maintaining capital intact, capital

budgeting, etc.

Business Environment and Macroeconomics

Environmental issues pertain to the general business environment in which a

business operates. They are related to the overall economic, social and political


atmosphere of the country. The factors which constitute economic environment may be

mentioned as: (i) the type of economic system of the country, (ii) general trends in

production, employment, income, prices, saving and investment, etc., (iii) structure of

end trends in the working of financial institutions, e.g., banks, financial corporations,

insurance companies, etc., (iv) magnitude of and trends in foreign trade, (v) trends in

labour and capital markets, (vi) government’s economic policies, e.g., industrial policy,

monetary policy, fiscal policy, price policy, etc., (vii) social factors like value systems of

the society, property rights, customs and habits, (viii) social organisations like trade

unions, consumers cooperatives and producers union, (ix) social structure and class

character of the various social groups. Political environment is constituted of such factors

as political system-democratic, authoritarian, socialist, or otherwise, State’s attitude

towards private business, size and working of the public sector, and political stability.

It is far beyond the powers of a single business firm, howsoever large it may be, to

determine and guide the course of economic, social and political factors of the nation,

although all the firms together or at least giant business houses may jointly influence the

eco-political atmosphere of the country.

The environmental factors have a far-reaching bearing upon the functioning and

performance of the firms. Therefore, business decision-makers have to take into account

the changing economic, political and social conditions in the country and give due

consideration to the environmental factors in the process of decision-making. This is

essential because business decisions taken in isolation of environmental factors may not

only prove fatal, but may also lead to heavy losses. For instance, a decision to expand the

business beyond the paid –up capital permissible under Monopoly and Restrictive Trade

Practices Act (MRTP Act) will amount to inviting legal shackle and hammer; a decision

to employ a highly sophisticated, labour-saving technology ignoring the prevalence of

mass open unemployment-an economic factor- may prove to be self-defeating; a decision

to expand the business on a large scale, in a society having a low per capita income and

hence a low purchasing power stagnated over a long period may lead to wastage of

resources. The managers of a firm are therefore supposed to be fully aware of the


economic, social and political conditions prevailing in the country while taking decisions

on the wider issues of the business.

Managerial economics is however, concerned with only economic environment,

particularly with those economic factors, which form the business climate. The study of

political and social factors falls out of the purview of managerial economics. It should,

however, be borne in mind that economic, social and political behaviour of the people are

interdependent and interactive. For example growth of monopolistic tendency in the

industrial sector of India led to the enactment of Monopoly and Restrictive Trade

Practices Act (1961) which restricts the proliferation of large business houses. Similarly,

various industrial policy resolutions formulated until 1990 in the light of socio-political

ideology of the government restricted the scope and area of private business. Besides,

government’s continuous effort to transfer the resources from the private to the public

sector with a view to setting up a ‘socialist pattern of society’ has restrained the

expansion of private business in India. Some of the major areas in which politics

influences economics are concentration of economic power, growth of monopoly, state of

technology, existence of mass poverty and open unemployment, foreign trade, taxation

policy, labour relations, distribution system of essential goods etc.

Macroeconomic Issues

The major macro-economic or environmental issues, which figure in the business

decision-making, particularly in regard to forward planning, may be described under

three categories.

Firstly, there are issues that are related to the trends in macro variables, e.g., the

general trend in the economic activities of the country, investment climate, trends in

output and employment, and price trends. These factors not only determine the prospects

of private business, but also greatly influence the functioning of individual firms.

Therefore, a firm planning to set up a new unit or to expand its existing size would like to

ask itself what is the general trend in the economy. What would be the consumption

pattern of the society? Will it be profitable to expand the business? Answer to these

questions and alike are sought through the macroeconomic studies.


Secondly, an economy is also affected by its trade relations with other countries,

more so the sectors or firms dealing in exports and imports. Fluctuations in the

international market, exchange rate, and inflows and outflows of capital in an open

economy have a serious bearing on its economic environment and, thereby, on the

functioning of its business undertakings. The managers of a firm would, therefore, be

interested in knowing the trends in international trade, prices, exchange rates, and

prospects in the international market. Answers to such problems are obtained through the

study of international trade and international monetary mechanism.

Lastly, the government policies designed to control and regulate the economic

activities of the people affect the functioning of the individual business undertakings.

Besides, firms’ activities as producer and their attempt to maximize their private gains or

profits leads to considerable social costs, in terms of environmental pollution, congestion

in the cities, creation of slums, etc. Such social costs not only bring firm’ interest in

conflict with that of the society, but also impose a social responsibility on the firms. The

government policies and its various regulative measures are designed, by and large, to

minimize such conflicts. The managers therefore should be fully aware of the aspirations

of the people and give such factors a due consideration in their decisions. The economic

concepts and tools of analysis help in determining such costs and benefits.

Thus, economic theories, both micro and macro, have wide application to the

business decision-making. Some of the major theories which are widely applied to

business analysis have been mentioned above. But it should always be borne in mind that

economic theories, models and tools of analysis do not offer readymade answers to the

practical problems of individual firms. They provide only logic and methods to find out

answers, not the answers as such. It depends on the managers’ own understanding,

experience and intelligence and training as to how to use the tools of economic analysis

to find a correct answer to the practical problems of business.

Briefly speaking, microeconomic theories including theory of demand, theory of

production, theory of price determination, theory of profit and capital budgeting, and

macroeconomic theories including theory of national income, theory of economic growth


and fluctuations, international trade and monetary mechanism, and the study of state

policies and their repercussions on the private business activities constitute, by and large,

the scope of managerial economics. This should however not mean that only these

economic theories form the subject matter of managerial economics. Nor the knowledge

of these theories wholly fulfills the requirement of economic logic in decision-making.

An overall study of economics and a wider understanding of economic behaviour of the

society, individuals, firms, and state would always be desirable and more helpful.

Managerial Economics and Economic Theory:Economics traditionally is divided into microeconomics and macroeconomics.

Microeconomics deals with the theory of individual choice; that is, decisions made by a

particular consuming unit, such as an individual, or a producing unit, such as a business

firm. Macroeconomics focuses on the overall economy and general economic

equilibrium conditions. Managerial economists draw on both of these branches of

economics during the decision-making process. Although a firm’s managers can do little

to affect the aggregate economy, their decisions should be consistent with the current

economic outlook.

The types of decisions made by managers usually involve questions of resource

allocation within the organisation in both the short and long run. In the short run, a

manager may be interested in estimating demand and cost relationships to make decisions

about the price to charge for a product and the quantity of output to produce. The areas

of microeconomics dealing with demand theory and with the theory of cost and

production are obviously useful in making decisions on such matters. Macroeconomic

theory also enters into decision making when a manager attempts to forecast future

demand based on forces influencing the overall economy.

In the long run, decisions must be made about expanding or contracting

production and distribution facilities, developing and marketing new products, and

possibly acquiring other firms. Basically, these decisions require the organisation to

make capital expenditures; that is, expenditure made in the current period that are

expected to yield returns in future periods. Economists have developed a theory of


capital budgeting that can be used in deciding whether to undertake specific capital

expenditures.

MANAGERIAL ECONOMICS

Managerial economics refers to those aspects of economic theory and applications,

which are directly relevant to the practice of management and the decision-making

processes within the enterprises. Managerial economics may be viewed as economics

applied to problem solving at the level of the firm. The problems relate to choices and

allocation of resources, which are basically economic in nature and are faced by

managers all the time.

Managerial economics may be defined as the study of economic theories, logic

and methodology, which are generally applied to seek solution to the practical problems

of business. It is the integration of economic theory with business practice for the purpose

of facilitating decision-making and forward planning by management. Decision-making

is essentially a process of selecting the best out of alternative opportunities open to the

firm. And forward planning means establishing plans for the future.

In a sense managerial economics provides a link between economic theory and

business management for managerial decision making.

Application of economic theories to the problems of business not only guide’s

assists and streamlines the process of decision-making but also contributes a good deal to

the validity of decisions.

The scope of managerial economics comprehends all those economic concepts,

theories and tools of analysis, which can be used to analyse the business environment and

to find out solution to practical business problems.

Managerial economics can be viewed as an application of that part of

microeconomics that focuses on such topics as risk, demand, production, cost, pricing,

and market structure. Understanding these principles will help to develop a rational


decision-making perspective and will sharpen the analytical framework that the executive

must bring to bear on managerial decisions.

Individuals and firms interact in both the product and the factor markets. Prices of

outputs and inputs are determined in these markets and guide the decisions of all market

participants. The firm is an entity that organizes factors of production in order to produce

goods and services to meet the demands of consumers and other firms. In a market

system, the interplay of individuals and firms is not subject to central control. The prices

of both products and factors of production guide this interaction. Within firms, however,

activity is directed by managers. Central control within the firm is advantageous because

transactions and information costs are reduced. The size of the firm is limited because

transaction costs within the firm will rise as the firm grows and because management

skill is limited.

It is assumed that the goal of the firm is to maximize the value of the firm or the

present value of all future profits, defined as revenue less all costs, explicit and implicit.

Opportunity costs such as the remuneration and interests that owner and managers have

forgone on their labor and capital must be included as costs. Failure to account for these

implicit costs may result in an inefficient allocation of resources. The objective of profit

maximization is subject to legal, moral, contractual, financial, and technological

constraints. Some economists argue that the firm’s objective is a “satisfactory” level of

profit rather than maximum profit.

Profit plays two primary roles in the free-market system. First, it acts as a signal to

producers to increase or decrease the rate of output or to enter or leave an industry.

Second, profit is a reward for entrepreneurial activity, including risk taking and

innovation. In a competitive industry, economic profits tend to be transitory. The

achievement of high profits by a firm usually results in other firms increasing their output

of that product, thus reducing price and profit. Firms that have monopoly power may be

able to earn above-normal profits over a longer period; such profit does not play a

socially useful role in the economy.


A primary role of economics in management is in making optimizing decisions

where constraints apply. In general, managerial economics will help managers to ensure

that resources are allocated efficiently within the firm and that the firm makes appropriate

reactions to changes in the economic environment.

With extremely hard work, a creative mind, and a willingness to take risks, Gates

has demonstrated how the market rewards the successful entrepreneur. He was able to

produce what consumers wanted at a price they were willing to pay; the result was that

both he and they are better off! . This is the essence of the free-market economic system.

Managerial economics is concerned with resource-allocation, strategic, and

tactical decisions that are made by analysts, managers, and consultants in the private,

public, and not-for-profit sectors of the economy. Managerial economic techniques seek

to achieve the objectives of the organization in the most efficient manner, while

considering both explicit and implicit constraints on achieving the objective(s).

The major emphasis is to provide the analytical tools and managerial insights

essential to the analysis and solution of those problems that have significant economic

consequences, both for the firm and society at large. Effective decision-making requires

an understanding of the limitations imposed on the decision-maker by the business

environment.


ECONOMIC ANALYSIS AND DECISIONS

1. Demand Analysis and Forecasting2. Production and Cost Analysis3. Pricing Analysis4. Capital Expenditure Analysis

ECONOMIC, POLITICAL, AND SOCIAL ENVIRONMENT1. Business Conditions (Trends, Cycles,

and Seasonal Effects)2. Factor Market Conditions (Capital,

Labour, Land and Raw Materials)3. Competitors’ Responses4. External, Legal, and Regulatory

Constraints5. Organizational (Internal) Constraints

Cash Flows Risk

Firm Value(Shareholders’ Wealth)

Managerial economics is the application of microeconomic theory and

methodology to decision-making theory and methodology to decision-making problems

faced by private, public, and not-for-profit institutions. Managerial economics assists

decision makers (managers) in efficiently allocating scarce resources, planning corporate

strategy, and executing effective tactics.

Managerial economics deals with the application of microeconomic reasoning to

real world decision-making problems faced by private, public, and not-for-profit

institutions. The field of managerial economics has experienced rapid growth over the

past three decades. This growth reflects a realization that analysts, directors, and senior

managers can use economic theory to make decisions consistent with the goals of the

organisation. Managerial economics extracts from microeconomic theory those concepts

and techniques that enable the decision maker to select strategic direction, to allocate

efficiently the resources of the organisation, and to respond effectively to tactical issues.

The tools of managerial economics can be applied by managers in profit-seeking

firms and in the public and not-for-profit sectors of the economy. Because managers in

all types of enterprises face a common set of problems. Managerial problems generally

follow this form:

To identity the alternative means of achieving given objective(s), and then to

select the alternative that accomplishes the objective(s) in the most resource efficient

manner, taking into account the constraints and the likely actions and reactions of

interdependent rival decision makers.

The Decision-Making Model:

The ability to make good decisions is the key to successful managerial

performance. Managers of profit-seeking firms are faced with a wide range of important

decisions in the areas of pricing, product choice, cost control, advertising, capital

investments, and dividend policy, to name but a few. Managers in the not-for-profit and


the public sectors are faced with a similarly wide range of decisions. For example, the

dean of your school must decide how to allocate funds among such competing needs as

travel, phone services, and secretarial support. Longer-range decisions must be made

about new facilities, new programs, the purchase or lease of a new computer, and the

decision to establish an executive training center. Public sector managers face such

decisions as the need for a “Stealth” bomber, the capacity planning for public transit

systems, the enforcement of antitrust laws, the economic viability of passive restraint

devices in automobiles, and alternatives to reduce energy consumption.

Decision making in each of these areas shares several common elements. First, the

decision maker must establish or identify the objectives of the organisation. The failure

to identify organisational objectives correctly can result in the complete rejection of an

otherwise well-conceived and well-implemented plan. Later sections of this chapter deal

with the issue of organisation objectives.

Next, the decision make must identify the problem requiring a solution. For

example, the manager of a brewing plant in Milwaukee may note that the plant’s profit

margin on sales has been decreasing. This could be caused by pricing errors, labor force

problems, or the use of outdated production equipment. Once the source or sources of

the problem are identified, the manager can move to an examination of potential

solutions. If the problem is the use of technologically inefficient equipment, two possible

solutions are (1) updating and replacing the plant’s equipment or (2) building a

completely new plant. The choice between these alternatives depends on the relative

costs and benefits, as well as other organisational and social constraints that may make

one alternative preferable to another. For example, the decision to build a new brewery

in a suburban area may not be politically desirable if it means a major inner-city facility

must be closed.

The final step in the process, after all alternatives have been identified and

evaluated and the best alternative has been chose, is the implementation of the decision.

This phase often requires constant monitoring to ensure that results are as expected. If


they are not, corrective action needs to be taken when possible. This five-step decision-

making process is illustrated in Figure.

BUSINESS DECISIONS AND ECONOMIC ANALYSIS

Business decision-making is essentially a process of selecting the best out of alternative

opportunities open to the firm. The process of decision-making comprises four main

phases:

1. determining and defining the objective;

2. collection of information regarding economic, social, political and technological

environment and foreseeing the necessity and occasion for decision;


Establish and/ or identify objectives

Define the problem

Identify possible alternative solutions

Consider societal constraints

Evaluate alternative and select the best

Consider organisational and input constraints

Implement and monitor the decision

3. “inventing, developing and analysing possible courses of action”, and

4. ‘Selecting a particular course of action’, from the available alternatives.

It is in this process of decision-making that the management of a company has to apply

economic theories as a tool of analysis.

Economic theories state the functional relationship between two or more economic

variables, under certain given conditions. Application of relevant economic theories to

the problems of business facilitates decision-making in three ways.

Firstly, it offers clarity of various economic concepts (i.e., cost, price, demand,

etc.) used in business analysis.

Secondly, it helps in ascertaining the relevant variable and specifying the relevant

data.

Thirdly, since economic theories state general relationship between two or more

economic events, they provide consistency in analysis, which helps in arriving at right

conclusions. Thus, application of economic theories to the problems of business not only

guides, assists and streamlines the process of decision-making but also contributes a good

deal to the validity of decisions.

Nobel prize-winning economist Herbert Simon identifies the primary activities in

decision-making:

1. Finding occasions for making decisions.

2. Identifying possible courses of action.

3. Evaluating the revenues and costs associated with each course of action.

4. Choosing that one course that best meets the goal or objective of the firm (i.e., that

maximizes the value of the firm).

Thus the primary role of managerial economics is in evaluating the implications of

alternative courses of action and choosing the best or optimal course of action from

among those several alternatives.

Decision-making in this context implies the need for optimizing behavior. The

marketing vice-president strives to maximize sales revenue, the production manager


attempts to minimize cost or maximize production, and the division president’s goal is to

maximize profit. These management targets are constrained by other parameters relating

to that decision. For example, production costs might be minimized by producing

nothing, but this would be inconsistent with the firm’s goal of profit maximization. A

more typical goal for the production manager would be to minimize cost subject to

producing a specified output rate, while the objective of the marketing vice-president

would be to maximize sales subject to a given advertising budget.

The essence of efficient and rational management is constrained optimization.

Virtually all choices and decisions are subject to limitations, and this is where the tools of

managerial economics are most useful. The manager who can achieve the most despite

those constraints will be rewarded with the high salary, stock options, and the other

perquisites usually associated with success.

OBJECTIVES OF THE FIRM

The function of management is the efficient direction of a business organisation.

Management always faces the problems of scarcity and choice. Rational choice could be

made only if the objectives of the firm are clearly and unambiguously defined.

In modern society a firm invariably pursues multiple objectives even though one

or some of them may receive priority over others. It is a common experience to find firms

wishing to pursue every plausible goal, which one can propose to it. They wish to

maximize profits, while at the same time minimize costs, maximize sales, satisfying

consumers and so on. Unfortunately, it is not possible to fulfill all the attractive sounding

but mutually incompatible goals at the same time.

In conventional economics, however, no attention was given to these factors in the

context of the firm. Instead, the sole objective was assumed to be the maximization of

profits. The entire analytical apparatus of economics was evolved to aid the achievement

of this objective. As a result, the central concept in managerial economics continues to be

profit maximization.


** Profit maximization ---- The rational firms pursue the objective of profit maximization

subject to the technical and market constraints. There are two kinds of profit

maximization; the short-run profit maximization and long-run profit maximization. Short-

run gains are often sacrificed for the sake of long-run growth and survival.

** Minimization of cost;

** Sales maximization;

** Increasing the market share;

** Efficient inventory management;

** Quality management;

** Establishing a brand name and earning business reputation.

** Promotion of the long -run welfare of the firm;

** Stabilisation of prices and margins;

** Satisfying goal—consumers, community, investors, tax officials etc.,

** Achieving a satisfactory rate of growth;

** Marketing management,

** Developing R&D infrastructure;

** Employees welfare;

** Meeting Environmental concerns,

** Development of human resources,. And so on.

Thus, a firm invariably pursues multiple objectives even though one or some of

them may receive priority over others.

Objectives of Business

1. Organic Objectives. To try for survival, and then to gain prestige and win recognition

from the society and thus try to grow.

2. Economic Objectives. To earn as much profit as possible.

3. Social Objectives. Business must fulfill its obligations to society, by way of supply of

quality goods, avoidance of profiteering and antisocial practices, and providing

employment.


4. Human Objectives. These are (a) fair deal to employees, (b) development of human

resources, (c) participation, and (d) job satisfaction.

5. National Objectives. These are (a) ensuring social justice, (b) development of small

enterprises, (c) production according to national priorities, (d) self-sufficiency and

export development and (e) development of skill of personnel.

TECHNICAL (PHYSICAL) AND ECONOMIC EFFICIENCY

Both individuals and organizations possess limited resources. This makes it

necessary to produce the greatest output for a given input-that is, to operate at high

efficiency. Thus, the search is not merely for a good opportunity for the employment of

limited resources, but for the best opportunity.

People are continually seeking to satisfy their wants. They give up certain utilities

in order to gain others that they value more. This is essentially an economic process, in

which the objective is the maximization of economic efficiency.

Engineering is primarily a producer activity that comes into being to satisfy human

wants. Its objective is to get the greatest end result per unit of resource expenditure.

Efficiency of a system is generally defined as the rate of its output to input. This is

essentially a physical process in which the objective is the maximization of physical

efficiency, which may be stated as

Technical Efficiency (physical) = Output Input

If interpreted broadly enough, physical efficiency is a measure of the success of

engineering activity in the physical environment. However, the engineer must be

concerned with two levels of efficiency. On the first level is physical efficiency expressed

as outputs divided by inputs of such physical units as Btu’s, kilowatts, and foot-pounds.

When such physical units are involved, efficiency will always be less than unity, or less

than 100%.


On the second level are economic efficiencies. These are expressed in terms of

economic units of output divided by economic units of input, each expressed in terms of a

medium of exchange such as money. Economic efficiency may be stated as

Efficiency (economic) = Worth Cost

It is well known that physical efficiencies over 100% are not possible. However,

economic efficiencies can exceed 100% and must do so for economic ventures to be

successful.

Physical efficiency is related to economic efficiency. For example, a power plant

may be profitable in economic terms even though its physical efficiency in converting

units of energy in coal to electrical energy may be relatively low. As an example, in the

conversion of energy in a certain plant, assume that the physical efficiency is only 36%.

Assuming that output Btu’s in the form of electrical energy have an economic worth of

Re. 14.65 per million and that input Btu’s in the form of coal have an economic cost of

Re. 1.80 per million, then

Efficiency (economic) = Btu output x worth of electricity Btu input x cost of coal = 0.36 x Re. 14.65 = 293%

Re. 1.80Since physical processes are of necessity carried out at efficiencies less than 100%

and economic ventures are feasible only if they attain efficiencies greater than 100%, it is

clear that in feasible economic ventures the economic worth per unit of physical output

must always be greater than the economic cost per unit of physical input. Consequently,

economic efficiency must depend more upon the worth and cost per unit of physical

outputs and inputs than upon physical efficiency. Physical efficiency is always

significant, but only to the extent that it contributes to economic efficiency.

In the final evaluation of most ventures, even those in which engineering play a

leading role, economic efficiencies must take precedence over physical efficiencies. This

is because the function of engineering is to create utility in the economic environment by

altering elements of the physical environment.


Economic efficiency (%) = Output x 100 = Worth x100 Input Cost ‘Worth’ is the annual revenue generated by way of operating the business and

‘cost’ is the total annual expenses incurred in carrying out the business. For the survival

and growth of any business the economic efficiency should be more than 100%.

Economic efficiency is also called ‘productivity’. There are several ways of

improving productivity.

Increased output for the same input.

Decreased input for the same output.

By a proportionate increase in the output which is more than the proportionate

increase in the input

By a proportionate decrease in the input which is more than the proportionate

decrease in the output

Through simultaneous increase in the output with decrease in the input.


Hu 300 Engg Economics

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