Notes Managerial Economics
Notes Managerial Economics
Theoretical Foundation of Managerial analytical tools to help us understand and analyze such
problems. Managerial Economics may be taken as economics
Economics Topics: applied to problems of choice of alternatives of economic
nature and allocation of the resources by the firms. In other
» MEANING AND NATURE OF MANAGERIAL ECONOMICS
words, managerial economics involves analysis of allocation
» SIGNIFICANCE OF MANAGEERIAL ECONOMICS
of the resources available to a firm or a unit of management
» SCOPE OF MANAGERIAL ECONOMICS among the activities of that unit. It is thus concerned with
» ROLE OF A MANAGERIAL ECONOMIST IN BUSINESS choice or selection among alternatives.
» MODEL OF PROFIT MAXIMIZATION OR THE THEORY OF
FIRM Definition of Managerial Economics
» MANAGERIAL THEORIES OF THE FIRM
» MORE ECONOMICS TOPICS Some of the popular definitions of managerial economics are:
Economics as a science is concerned with the problem of “A fundamental academic subject which seeks to understand
allocation of scarce resources among competing ends. These and to analyse the problems of business decision-
problems of allocation are on a regular basis confronted by making.”____ Hague.
individuals, households, firms as well as economies.
Economics provide us with a number of concepts and As is evident, there are different projections of the subject
matter on managerial economics by different authorities, but
the following features seem common to these viewpoints. 4. Takes the help of macro-economics to understand and
adjust to the environment in which the firm operates.
1. Concerned with decision-making of economic nature. We know that the decisions of the firm are made almost
This implies that managerial economics deals with always within the broad framework of economic environment
identification of economic choices and allocation. within which firm operates, known as micro-economic
conditions. With regards to these conditions, we may stress
2. Micro-economic in character, where the unit of study is a these points.
firm. It concentrates on the study of the firm and not on the
working of the economy. i) The economy in which the business operates is
The chief source of concepts and analytical tools predominantly a free enterprise economy using price and
for managerial economics is micro-economic theory, also market.
known as price theory, some of the popular micro- economic
concepts are the elasticity of demand, marginal cost, the ii) The present-day economy is the one undergoing rapid
long-run economies and diseconomies of scale, opportunity technological and economic changes.
cost, present value and market structures. Managerial
economics also uses some of the well-accepted models in iii) The intervention of government in economic affairs has
price theory, such as model for monopoly price, kinked increased in recent times and there is no likelihood that this
demand model, the model of price discrimination and the intervention will stop in future.
behavioral and managerial models.
These external conditions are beyond the control of the firm,
3. Concerned with normative micro-economics, where the hence the firm needs to adjust itself to the changes in these
economist says what he thinks should happen rather than conditions to survive and grow. This sort of a management is
what does happen to the firm. called a progressive management.
When applies that the decisions of the firm are made almost
always within the broad framework of economic environment 5. Goal-oriented and prescriptive
within which thee firm operates, known as maco-economic It deals with how decisions should be mad e by managers to
conditions. With regards to these conditions, we may stress achieve the organizational goals. Knowledge of managerial
these points. economics helps in making wise choices—as managrs
continue to face the problem of scarcity of resources and 1. Managerial Economics a number of tools and techniques
making suitable choices to allocate them appropriately in to enable a Manager to become a more competent model
order to achieve organizational goals. builder. With the help of these models, the Manager can
capture the essential relationships that represent the real
6. Pragmatic situation while eliminating the relatively less important
Managerial Economics concentrate on making economics details.
theory more application- oriented. It is concerned with those
analytical tools which are useful in improving decision- 2. Managerial Economics provides most of the concepts that
making. are needed for the analysis of business problems. Concepts
like elasticity of demand, fixed and various costs, short and
7. Both ‘conceptual’ and ‘Metrical’ long-run costs, opportunity costs.net present value etc. help
An intelligent application of quantitative techniques to in understand and solving a decision problem.
business presupposes considered judgement and hard and
careful thinking about the nature of the particular problem to 3. Managerial Economics helps in making decisions such as:
be solved. Managerial Economics provides necessary
conceptual tools to achieve this. Moreover, it helps the *What should be the product mix?
decision makers by providing measurement of various *Which is the production technique and the input-mix that is
economic entities and their relationships. This material least costly?
dimension of managerial economics is complementary to its *What should be the level of output and price for the
conceptual framework. product?
*How to take investment decisions?
*How much should a firm advertise and how to allocate the
SIGNIFICANCE OF MANAGERIAL ECONOMICS advertisement fund between different Media?
2. Demand Analysis and Demand Forecasting: The very first 8. Product Policy, Sales Promotion and Market Strategy: An
thing to find out in a new business venture is the nature and intelligent market management also helps the firm to grow.
amount of demand for the product, both at present and in Market management includes product competition like
future, Demand analysis and forecasting therefore help in the advertising, product design etc.
choice of the product and in planning the output levels.
The managerial economics, taking the help of economics
3. Production and Cost: Once the output is decided, the concepts and relationships, tries to find out which course is
manager then needs to choose the best input-mix and the likely to be the best for the firm under a given set of
technology. He will maximize his profits only if he produces th conditions.
desired level of output at the minimum possible cost.
*Managerial Economics and Traditional Economics:
4. Competition: Competition is one of the essential a *Managerial Economics and Operation Research:
*Managerial Economics and Statistics: organizations goals.
*Managerial Economics and the Theory of Decision-Making:
ii. Empirical evidence shows that the stock earnings and *Advertisement is a major instrument of sales revenue
salaries of the top management are correlated more closely maximization I,e. because advertisement will shift the
with sales than with profits. demand curve to the right.
iii. Increasing sales revenue over a period of time gives *Price of the product is assumed to be given and the firm has
prestige to the top management, but profits are enjoyed only to decide on its output.
by the shareholders.
The sales maximization model is explained with the help of
iv. Growing sales means higher salaries and better perquisites. the following figure:
Hence sales revenue maximization results in a healthy
personnel policy.
There are two main versions of the cases where managers in NORMATIVE APPROACH: Is prescriptive approach in that it
the modern large corporations are asked to influence the attempts to prescribe what ought to be done.
goals of the firm and not go along wholly pursuing the goals
of the owners. ASPIRATION LEVEL: Demands of the different groups of the
organization-coalition, competing for the given resources of
(c) Growth Maximization Models the firm, take the form of aspiration levels.
Growth of the firm is obviously the cornerstone of corporate EXPENSE PREFERENCE: Certain discretionary expenditures
strategy, Rate of growth and potential of growth are generally that provide satisfaction to managers, like discretionary
used as yardsticks to measure corporate success. Growth of a power of investing in projects, which may enhance his status
firm must be financed either from retained earnings or from and esteem.
market borrowing or both.
FIXED COSTS: That cannot be eliminated in short run.
Marshall, Taussig, Robertson and Bober have defined profits
MANAGERIAL SLACK: The company fund which the manager in a broad sense. Hansen defined profits as ‘the residual
is allowed to spend for his own ends, like entertainment payment, what is left to the producer’s income after all other
expense, staff car, Luxurious office. payments have been met’’. Similarly, Drucker said, “the
surplus of current income over past cost is profit.”
NON-PECUNIARY ASPECTS: Relate to physical inputs, and
other variable (i.e. non-financial variables). DYNAMIC STATE: The economic state where the future is
likely to be different from the present, but this change is
OPTIMAL DECISION: Enables the decision-maker (firm)to unpredictable.
attain its desired objective most closely.
GROSS PROFIT: The difference between receipts and payment
OLIGOPOLISTIC MARKET STRUCTURE: Market with large over a time period.
number of buyers but a small number of sellers; where some
of the sellers dominate the market, Further, action of each INFLATION ACCOUNTING: To judge the impact of changing
firm in oligopoly affects the other sellers in the market, which prices on the profitability and financial health of the firm.
invites reaction from rivals in term of price cuts, changes in
quality, advertising, new product line etc. INNOVATION: All those measures taken by an entrepreneur
which reduce cost or enhance demand (i.e., finding new
SATISFYING BEHAVIOUR: When the goal of the firm is not to products, sale-territories, technology, etc.).
maximize but only to satisfy a goal/ goals. The owners/
shareholders, according to this concept, are satisfied with NET PROFIT: Profit net of implicit cost.
adequate return and growth since they really cannot judge
when profits are maximized. NORMAL PROFIT: The minimum expected return to keep an
entrepreneur in his present business.
PROFITS: Profits may considered a reward for making
innovations ,a reward for accepting risks and uncertainties MONOPOLY PROFIT: Profit that arises due to disequilibrium
and the result of imperfections in the market structure. and imperfection in the market. The term profits is also used
_____Henry Grayson for monopoly profits. An entrepreneur earns monopoly
profits not because he performs any entrepreneurial activity, OPPORTUNITY COST: Represents the benefits or revenue
but because he has a certain degree of monopoly power in forgone by pursuing one course of action rather than another.
the product market. His monopoly profits are in direct
proportion to the extent of his monopoly power. Monopoly MARGINAL PRODUCTIVITY: Output that results from one
profits exist because of disequilibirum and imperfect additional unit of a factor of production(such as a labour hour
competition. They tend to persist because the economy can or a machine hour),all other factors remaining constant,
rarely adjust instantaneously to changes in cost and demand Whereas the marginal cost indicates the added cost incurred
conditions. And so long as the monopoly power exists with in producing an additional unit of output, marginal product
the producer he keeps on earning 'monopoly profits'. indicates the added output accruing to an additional input.
Since marginal product is measured in physical units
RISK: Those unpredictable changes that can be insured produced, it is also called marginal physical product.
against.
PERFECT COMPETITION: A market structure in which (a) the
UNCERTAINTY: Those unpredictable changes that cannot be firms take market price as given ,since an individual firm
insured against. produces only a small fraction of total industry output; (b) the
product of all firms is a interferences with the activities of
WINDFALL PROFITS: Profits due to changes in the general buyers and seller; and (e) there is perfect knowledge and
price level in the market. These profits arise due to changes in mobility.
the general price level in the market. If the producers and
traders buy their inputs and raw materail when prices are low DEFINITIONS OF THE MARKET: A market is a body of persons
and sell their output when, due to some unforseen external in such commercial relations that ach can easily acquaint
factors, the prices have abruptly gone up, then the profits himself with the rates at which certain kinds of exchanges of
resulting there from called 'windfall profits'. it must be noted goods or services are from time to time made by the others.
that these windfall profits just happen to come in the way of
these producers and traders; they never planned their The word market has been generalized so as to mean
business operations for earning them. These come anybody of persons who are in intimate business relations
unexpectedly and cannot therefore be treated as a reward for and carry on extensive transactions in any commodity.
any specific activity of the entrepreneur. __Jevons
Market is any area over which buyers and sellers are in close implies a market structure, where there is a single seller. In
touch with one another, either directly or through dealers, economic theory, monopoly is characterized by sole producer
that the price obtainable in one part of the market affects the selling a distinct product for which there are no close
prices paid in other parts.__ Benham. substitutes and there are strong barriers to entry. This sole
producer (may be known as monopolist) controls the entire
EQUILIBRIUM PRICE: The price at which the quantity supply of the market. Thus, the supply curve of the firm and
demanded by consumers of a product is equal to the quantity the industry will be one and the same.
supplied by sellers of a product.
NORMAL PROFIT: The rate of profit just sufficient under
FREE ENTRY: The absence of barriers to entry into a market. conditions of free entry, to keep firms from leaving a given
In a market characterized by free entry, greater than normal industry in the run.
profit serves the function of drawing new firms into the
industry. PERFECT COMPETION: A market structure in which (a) the
firms take market price as given, since an individual firm
MARKET STRUCTURE: The number and relative sizes of produces only a small fraction of total industry output; (b) the
buyers and sellers in a particulars market, the nature of product of all firms is homogeneous;(c) there is freedom of
product and the degree of ease of entry of firms into the entry into and exit from the industry; (d) there are no
market determine the market structure. For example, in interferences with the activities of buyers and seller; and (e)
perfect competition, large number of buyers and sellers are there is perfect knowledge and mobility. Perfect competition
competing with each other for buying and selling a has an edge over other realistic and complicated market
homogenous good, while free entry and exit is permitted. forms, as it is relatively simple to handle. This kind of idealistic
market structure provides a yardstick or a standard against
MONOPOLY: A market structure characterized by the which other more realistic market forms can be compared,
existence of only one firm in the industry. For a firm to retain evaluated and understood better.
monopoly control there must be complete barriers to entry
into the industry. Monopoly is a market form, which has PRICE TAKERS: Firms that cannot influence the market price.
always attracted the attention of economists. This word has It refers to firms in perfect competitive markets.
come from Greek words, monos(single), polein (selling),
which mean alone to sell. Therefore, in literary terms, it PRICE DISTRIBUTION: Charging different prices for the same
product from consumers in different markets segments states, not companies. also called trust.
(based on the price elasticity of demand in each market
segment). DUOPOLY: A market form in which there are large number of
buyers but only two sellers with mutual interdependence.
PROFT-MAXIMIZING RULE: Produce up to the point where Two firms in the industry · Strong control over price.· Uses
marginal revenue is equal to marginal cost; and at higher Non price competition to compete· Very strong Barriers to
output levels marginal revenue is less than marginal cost. entryNote. a pure dupoly very rarly occurs in real life the
more common is two dominate firms who hold majority of
SHUTDOWN POINT: The point at which the firm must the market share.
consider stopping its production activity because the short
run loss remains the same (that is, equal to total fixed cost) KINKED DEMAND CURVE: A graphical representation of a
whether the firm produces or not. In a perfectly competitive situation wherein rival firms do not follow the price increase
situation this point is found at the lowest point of a firm’s of a firm but follow its price cuts. Such a demand curve is
average variable cost curve. more elastic for prices above the going market price and less
elastic for prices below the going price.
CARTEL: A group of firms that have joined together to make
arrangements on pricing and market strategy. Cartel MONOPOLISTIC COMPETITION: A market structure
agreement is an agreement of companies or sections of characterized by the existence of many firms in the industry,
companies having common interests to form an association or where each seller attempts to differentiate its product from
a cartel. Such agreements are designed by companies to its rivals, so that he has some control over price. Monopolistic
prevent extreme or unfair competition and allocate markets, competition pertains to a market situation where there is a
and to promote the interchange of knowledge resulting from relatively large number of small producers or suppliers selling
scientific and technical research, exchange of patent rights, similar but not identical products. Monopolistic competition
and standardization of products.A group of companies or is a market structure characterized by many firms selling
countries which collectively attempt to affect market prices by products that are similar but not identical, so firms compete
controlling production and marketing. Illegal in the United on other factors besides price. Monopolistic competition is
States and the European Union. Very few major cartels exist; sometimes referred to as imperfect competition, because the
the most prominent example is OPEC, a cartel which can not market structure is between pure monopoly and pure
be considered illegal because it is made up of sovereign competition.
a price that subsequently determines what other firms in the
OLIGOPOLY: A market structure characterized by the industry will charge for their products (known as followers).
existence of a few dominant firms in an industry (each
recognizing their mutual interdependence) having substantial PRODUCT DIFFERENTIATION: A wide variety of activities,
barriers to entry. An oligopoly is a market dominated by a few such as design changes and advertising that rival firms
large suppliers. The degree of market concentration is very employ to attract customers by distinguishing their product
high (i.e. a large % of the market is taken up by the leading from competitors’ products
firms). Firms within an oligopoly produce branded products
(advertising and marketing is an important feature of
competition within such markets) and there are also barriers
to entry.The term oligopoly is derived from two Greek words: Theory of Competition and Models of
‘oligi’ means few and ‘polein’ means to sell. Oligopoly is a
market structure in which there are only a few sellers (but Markets and Economics Topics:
more than two) of the homogeneous or differentiated
» INTRODUCTION
products. So, oligopoly lies in between monopolistic
» CONCEPT OF MARKET
competition and monopoly.Oligopoly refers to a market
» WHAT IS A FIRM
situation in which there are a few firms selling homogeneous
or differentiated products. Oligopoly is, sometimes, also » TRADE CYCLES - MEANING AND CHARACTERISTICS
known as ‘competition among the few’ as there are few INTRODUCTION TO THEORY OF FIRM
sellers in the market and every seller influences and is
influenced by the behaviour of other firms. important
characteristic of an oligopoly is interdependence between The theory of demand provides an explanation of the
firms. This means that each firm must take into account the consumer’s behavior in order to reduce the demand for a
likely reactions of other firms in the market when making commodity. Similarly, the theory of firm explains the goals
pricing and investment decisions. This creates uncertainty in and objectives of a firm with a view to determine the supply
such markets - which economists seek to model through the of a commodity. The theory of demand (through behavior of
use of game theory. consumer) and the theory of firm (through the behaviour of
firm) together enable us to ascertain the price and output of
PRICE LEADERSHIP: It occurs when a firm in an oligopoly sets a commodity or service by the free interplay of the forces of
demand and supply in the market in the absence of market bids and offers, using bargaining and haggling. The term
intervention. The nature of the demand curve and the price- ‘potential’ here implies that if the prevailing price of the
output business decisions depend upon the type of the commodity happens to be higher or lower than the one at
market in which the commodity is produced and sold. The which some transactors plan to deal, those buyers or sellers
market type along with its size, the behavior of markets and in the two cases respectively are eliminated from the market.
transactors therein help in making the analytical evaluation of Thus, market determines who buyers and sellers are, what
operational efficiency of business firms. The behavior of the the price will be and what quantities will be brought and
transactors is read in terms of the ‘market strategy and sold. Market is actually the essence of business. All business
tactics’ chosen by them in a given market environment so as decisions relating to price , output, product style,
to survive and grow their market share. There is a good deal advertisement ,investment, etc. are taken in the light of
of market dependence. The market behaviour of one may actual as well as potential competition by new entrants.`
condition that of other. Non-market environment also affects
market behaviour, through Government regulation, NATURE OF COMPETITION
consumer’s forum, traders’ guild, manufacture’ association,
etc. Competition has different meanings. The term always
denotes the presence in a specific market of two or more
seller and two or more buyers of a definite commodity, each
CONCEPT OF MARKET seller acting independently of every other seller and each
buyer independently of every other
buyer. Competition implies freedom in economic life. It has
In common parlance, the term ‘markets ‘means a particular been considered as a healthy sign in consumption,
place or locality, where goods are bought and sold. We often production, distribution and exchange . The presence and the
speak of the Mumbai market, the New York market, the Rani pressure of competitive market forces in the modern business
Bagh market and so on. In economics, however, this term is units force the producers to produce as efficiency as possible.
used in a broader sense. If reefers to a complex set of Those who are inefficient and not able to cover up their
activities by which actual and potential buyers as well as minimum cost of production will automatically leave the
sellers with each other and the price as well as the output are market. The more perfect the competition, the more perfect
determined. In the process of determining the terms at which the market will be.
the exchange would take place, they may make all sorts of
PERFECT COMPETITION • Perfect Mobility of Factors of Production.
• Perfect Knowledge.
• Absence of Transportation and Selling Costs.
In economic theory, perfect competition has a meaning
diametrically opposite to the everyday use of this term as PURE COMPETITION VERSUS PERFECT COMPETETION
synonymous to rivalry. The perfect competition means
complete freedom in economic life and absence of rivalry
among firms. It prevails, when all the conditions given here Some economists, notably E.H. Chamberlin and F.H. Knight
are simultaneously present in the market. However, most of make distinction between pure competition and perfect
these stringent conditions are unlikely to be present in the competition. According to Chamberlin, “Pure competition is
real world. The real world consists of various imperfections unallowed by monopolyelments.it is much simpler and less
and monopolistic tendencies. The market is rarely perfect in exclusive concept than perfect competition for the letter may
the actual sense. This suggests that perfect competition is a be interpreted to involve perfect in many other respects than
purely theoretical market from, which is never observed in in the absence of monopoly e.g. perfect mobility or perfect
reality. However, the stock market is close approximation knowledge or such other perfection as the particulars theorist
of perfect competition. Here, any particular stock is finds convenient or useful to him.”
homogenous, there is no information cost (information is
readily available through published prices), free entry and exit Usually, the term pure competition and perfect
conditions for the transactors having insignificant control on competition and perfect competition are used
price. interchangeably, since in both the cases sellers as well as
buyers are price takers with no control over the prevailing
The following features serve as a necessary set of market price, Further, the demand and supply curves of the
assumptions or conditions underlying the model of perfect firms as well as industry are similar in either situations.
competition.
MONOPOLY
(i) MR=MC
(ii) MC rises to intersect the horizontal MR line.
In common terms, National Income means the total value of >> Only final goods and services are included and the
goods and services produced annually in a country. intermediary goods and services are left.
In other words, National Income is the total amount of >> Money sent by Indian citizens working aboard are also
income accruing to a country from economic activities in a added.
year‘s time.
GROSS NATIONAL INCOME = Money Value of total goods and
National Income helps us to know the economic progress services + Income from abroad
achieved and to make comparative study.
INCOME METHOD
Simon Kuznets defines it as ―The net output of commodities
and services flowing during the year from the country‘s >> The net income payments received by all citizens of a
country in a particular year are added up. CONCEPTS OF NATIONAL INCOME
>> Income details are obtained from Income Tax Dept. (High GROSS DOMESTIC PRODUCT (GDP)
Income) and Wages Bills. (Workers) GROSS NATIONAL PRODCUT (GNP)
NATIONAL DOMESTIC PRODUCT (NDP)
>> Income by way of net wages, net rents, net interest, net NET NATIONAL PRODUCT (NNP)
profits are added together but incomes received in form of PERSONAL INCOME
transfer payments are exempted. PER CAPITA INCOME
PERSONAL DISPOSABLE INCOME
GROSS NATIONAL INCOME = Rent + Wages + Interest + Profit
+ Income from abroad LIMITATIONS IN MEASURING NATIONAL INCOME