Basics of Managerial EconomicsA study of Choice

What is Economics?

Essence best captured by Lionel Robbins in 1932 as “the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses."

It is all about allocating scarce resources between competing demands.

How individuals and societies use limited resources to satisfy unlimited wants.

Is Economics a Science? YES ,..because it uses scientific methods to explain and study

social behaviour.

Economics sets up hypotheses-- a reasonable proposition about the workings of the world which may or may not be true.

Then uses Data to validate or verify hypotheses. Statistical methods are used to analyse the data.

Ceteris Paribus Assumption:In order to test an hypothesis we need to keep constant other factors that may affect it. Other things are called ceteris paribus factors.

Why is Economics a science? Many economic theories are abstractly

represented with graphs. A picture or graph can be less confusing than words.

Equations. Graphs are two-dimensional pictures of mathematical equations.

Equations can represent relationships between three or more things, like:

Y = 3 + 2X - 4Z

Fundamental Economic Problem:

What are resources?

Resource payments

Economic Resource Resource payment

land rent

labor wages

capital interest

entrepreneurial ability profit

The Problem

Wants and needs are relative - my burning want might be very different from the wants of someone like the boy in the image above. Resources are not evenly distributed

Fundamental Principles Choice --- arises because all resources have

alternative uses and thus an opportunity cost. Limited resources ,their alternative use and infinite human wants give rise to economic problem.

Why is Scarcity so important? Scarcity dictates that we must answer the three

basic questions of allocation which are:

Q1 ) What goods and services will be produced with society's resources?

-capital goods -consumer goods -public goods

Q2) How will society's resources be used to produce the goods and services?

- land intensive- labour intensive-capital intensive

Q 3) For whom? Who receives the goods and services produced with society's resources?- Income distribution

How to decide or make a choice as to what use the resource can be put to use ? Economists use a tool called:

Opportunity Cost – the quantity of other goods that must be sacrificed to obtain another unit of a good.

Monetizing opportunity costs is clearly valuable, because it gives a means of comparison. This cost does not involve actual payment.

The opportunity cost of any alternative is defined as the cost of not selecting the "next-best" alternative.

Who are the main decision making units?

Food for thought Did Bill Gates and Tiger Woods

consider opportunity costs while making their career decisions?

They are the world’s most famous college drop-outs.

Opportunity cost of what?

Concepts in Decision Making Explicit versus Implicit cost:

Total economic cost= sum of implicit and explicit cost.

Accounting Profit versus Economic Profit of a business unit:

Managerial Economics concerns with Economic Profits:

Explicit Vs Implicit costsOpportunity Cost of an additional year in PG educationExplicit Cost Implicit CostTuition fees Rs 200000 Foregone

SalaryRs 200000

Books Rs 20000Entertainment Rs 20000Total Rs 240000 Rs 200000Total opportunity Cost

Total Explicit cost + Total Implicit Cost = Rs 440000

Accounting Vs Economic Profit: Ratna’s Food Delivery : Revenue Rs 200000Explicit Cost -Rs 60000Depreciation -Rs 5000Tax -Rs 4200Accounting Profit Rs 130800Implicit CostInterest loss @ 9% p.a. - Rs 18000Salary foregone - Rs 300000Economic Profit - Rs 187200

Where does resources allocation take place? Through Markets. Market is where

individual choices interact. So, Economics studies markets.

The medium of interaction is very often the Price.

Concepts of economics in Decision Making 2. Marginal Analysis:

Most Economic decisions are “either-or” decisions or “how much” decisions.

Either –Or Decisions: buy a car or not Run your own business or work for someone else

How much decisions : How many miles do you go before an oil change in your

car? How many workers to hire in your company?

Marginal Analysis: Marginal analysis is used to analyse “how much”

decisions.

Involves comparing the benefit of doing a little more of an activity (marginal benefit) to the cost of doing a little bit more of that same activity ( marginal cost).

Marginal Benefit vs Marginal Cost.

All economic decisions happen at the margin.

Net benefit: Note this Individuals are not expected to

maximize benefit; nor are they expected to minimize costs.

Individuals are assumed to attempt to maximize the level of net benefit (total benefit minus total cost) from any activity in which they are engaged.

Marginal analysis MB > MC expand the activity MB < MC contract the activity optimal level of activity: MB = MC

(Net benefit is maximized at this point)

Example: Patty delivers pizza using her own car, and she is

paid according to how many pizzas she delivers. The accompanying table shows Patty’s total benefit and total cost when she works a specific number of hours. Calculate the optimal number of hours Patty should work.

Quantity of hours worked

Total Benefit ( RS)

Total Cost ( Rs)

0 0 01 30 102 55 213 75 344 90 505 100 70

Two types of Economic analyses:Normative and Positive Economics Positive economics has an obvious Cause – Benefit

Analysis. A hike in the prices of luxury items will cause a definite drop in demand. Positive Economics is backed by theory. Its is a statement of fact.

Normative economics offers prescriptions based on value judgements : eg, a tax should be imposed on cigarettes to discourage smoking. Should property tax be imposed to build a local park?

Two Main Branches :Micro and Macro Economics Microeconomics studies how individuals, firms and

households make decisions to allocate limited resources , typically in markets where goods or services are being bought and sold.

Macroeconomics gives us a birds’ eye view of the functioning of the whole economy specially National Income, Output, Unemployment, Inflation , Monetary and Fiscal policy.

Managerial Economics Is the link between microeconomic theory and business

practice. Applies economics tools and techniques to business and

administrative decision making.

Essentially a study of competitive markets, market power and imperfect markets.

Scope of Managerial economics: what will we study?

Demand analysis and forecasting: Demand analysis helps in analyzing the various types of demand which enables the manager to arrive at reasonable estimates of demand for product of his company. Managers not only assess current demand but also assess future demand.

Production function: Conversion of inputs into outputs . With limited resources managers have to make the alternative uses of this limited resource.

Cost analysis: Cost analysis is helpful in understanding the cost of a

particular product. It takes into account all the costs incurred while producing a particular product.

Scope of Managerial Economics Pricing system: Here pricing refers to the

pricing of a product .

Macro Economics : understanding how the wheels of the economy work.

1) Describe some of the opportunity costs when you decide to do the following:

A) attend university instead of taking a job. B) watch a movie instead of studying for an exam C) Ride the bus instead of driving a car

Review Questions:

Review Questions: 2) Indicate whether each of the following is a

topic of microeconomics or macroeconomics:

The impact of higher oil prices on the production of steel The increased demand in the last 15 years for exotic dietary

supplements The surge in aggregate economic activity that hit much of

Asia late in the early 2000s The sharp increases in the price of gold in India between

2003 and 2013. The impact of preservation of wilderness areas on the

logging industry and on the price of lumber

Review Questions : Karma and Don run a furniture-refinishing business from their home.

Which of the following represent an explicit cost of the business and which represent an implicit cost?

a. Supplies such as paint stripper, varnish, polish, sandpaper, and so on

b. Basement space that has been converted into a workroom

c. Wages paid to a part-time helper

d. A van that they inherited and use only for transporting furniture

e. The job at a larger furniture restorer that Karma gave up in order to run the business

Applying opportunity cost: CASE 1 A leading charity is working

in a country that has been hit by a severe earthquake. It knows that there are a wide range of competing needs of the population in the area: food; clothing; shelter; medicine; counselling; education; clearing up, and reconstruction of houses and amenities

Applying Opportunity Cost It only has a limited amount of funds, far

less than would be required to satisfy all these requirements. It has to make some tough choices but tries to rationalise those choices by placing a value on the importance in terms of the benefits to the widest number of people from the allocation of its scarce resources (in other words, spending its money).

The Decision It decides to focus on the erection of

tents and provision of medicine as its main priorities. The monetary cost of this decision might be Rs 15 million but the opportunity cost would be expressed as the food that is not being provided for the displaced population, or the clothing, reconstruction and clearance that would have to be sacrificed.