ME-KMBN102-Unit-1 - Complete Typed Notes
ME-KMBN102-Unit-1 - Complete Typed Notes
UNIT 01
Name of Faculty: Saira Banoo Warsia
Name of Department: Management Studies
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- Edwin Mansfield
Resources be it finance, men or material are all limited so the basic task of the
management is to optimize the use of the resources.
Baumol, has pointed out three main contributions of economic theory to business
economics.
(i) Economic theories can contribute in building analytical models which help to
recognize the structure of managerial problems, eliminate the minor details
which might obstruct decision making and help to concentrate on the main
issue.
(ii) Economic theories enhance the analytical capabilities of the business analyst.
(iii) They offer clarity to various concepts used in business analysis which helps
managers to avoid conceptual pitfalls.
Business decision making is essentially a process of selecting the best out of the
alternative opportunities open to the firm. The process of decision making comprises
4 main phases:
(i) Determining and defining the objectives to be achieved.
(ii) Collection and analysis of information regarding economic, social, political and
technological environment and foreseeing the necessity and occasion for decision.
Today a personal business sense and experience alone is not sufficient to run
businesses. Businessmen need to be updated on market conditions and business
environment.
(i.e., Cost, Price, Demand, so for example the concept ‘cost’ includes ‘Total’,
‘Average’, ‘Marginal’, ‘Fixed’, ‘Variable’, Actual cost. So when you study economics it
is clarified which cost concepts are relevant.
(ii) It helps in ascertaining the relevant variables and specifying the relevant
data.
1. Profit Decision
2. Demand Decision
Profit depends on the sales volume and revenue earned. Sales and revenue in turn
are dependent on the nature of individual and market demand.
So the management not only has to decide the current demand for its product but
also has to estimate the future demand. Topics studied here are:
3. Production Decision
Demand and supply are related to each other and so demand decisions are
followed by production decisions.
Once a firm estimates the demand for the product then it needs to take the
following decisions before the production takes place:
All these issues are addressed through an analysis of production function of the
firm.
These issues can be addressed through an analysis of market structure that is the
form of competition which a firm faces.
5. Investment Decision
The decisions taken here involve:
(i) How much to invest?
(ii) What should be the rate of investment?
(iii) What should be the proposition of new investment and replacement
investment?
Such decisions can only be taken through proper analysis of Marginal efficiency of
capital (rate of return) and Cost of Capital (rate of investment).
Micro Economics:
Description: Microeconomic study deals with what choices people make, what
factors influence their choices and how their decisions affect the goods markets by
affecting the price, the supply and demand.
Therefore, the study of individuals like a single firm, single customer, single producer
etc.is classified as microeconomics.
Macro Economics:
Definition: Macroeconomics is the branch of economics that studies the behavior and
performance of an economy as a whole. It focuses on the aggregate changes in the
economy such as unemployment, growth rate, gross domestic product and inflation.
Reference:
https://economictimes.indiatimes.com/definition/microeconomics
Traditional Economics has both micro and macro aspects whereas Managerial
Economics is essentially micro in character. Traditional Economics deals mainly with
the theoretical aspect only whereas Managerial Economics deals with the practical
aspect.
Opportunity cost is related to the alternative uses of scarce resources. Both natural
and man-made resources are scare and also have alternative uses. This scarcity and
alternative uses of available resources gives rise to the concept of opportunity cost.
The opportunity cost of anything is the next best alternative that could be produced
by the same factors of production consisting of same amount of money.
For example,
A firm has Rs.10 lakh at its disposal and there are three alternatives available before
the firm:
The opportunity cost of availing an opportunity is the expected income forgone from
the second best opportunity of using the resources.
The concept of opportunity cost is useful in all types of business decisions where
there are at least 2 alternative options involving cost and benefits.
2. Marginal Principle
If it is possible one should pick up the level at which the marginal benefit
equals the marginal cost.
For example, the total cost of flying a plane from London to New York will be several
thousand Pounds. However, with a plane 50% full, the cost of carrying one extra
passenger is quite low. Therefore, the marginal cost of carrying the 102nd passenger
is very low compared to the total overall cost.
3. Incremental Principle
For example, a firm is producing 5000 units of a commodity and the cost incurred on
producing these 5000 units is Rs.10,000/-. But the firm wants to increase the
production to 6000 units for which the costs will rise to Rs.14,000/-.
The incremental cost then is Rs.4000, that is 14000 – 10000, for producing 1000
additional units.
This refers to that period of time wherein some input factors are kept fixed while
others are variable, therefore, the supply is relatively inelastic.
This is defined as that period of time when all input factors are variable. In this period
supply can accordingly be adjusted as per the prevailing market conditions.
A business decision should take into account both the short run and long run effects
on revenues and costs so as to be able maintain a right balance between long-run
and short run perspectives.
5. Discounting Principle
This fundamental principle of economics states that the worth of Re.1 which will be
received tomorrow is less than the worth of Re.1 received today. This is called Time
value of Money.
For example, If we have the option of taking 10000/- today or 10000/- one year
later, we would naturally prefer to take this amount today. This is because of two
reasons:
There is another way of illustrating the discounting principle. One may ask how much
money today would be equivalent to Rs. 100 a year from now.
If the rate of interest is 5% the present value of Rs. 100 to be received after
one year is:
100
𝑃𝑉 =
1+𝑖
𝟏𝟎𝟎
= 𝟏+ .𝟎𝟓
=95.24
i = rate of interest
As a cross check one may multiply the PV of Rs. 95.24 by 1.05 to determine how
much money will have accumulated during the year at 5%. The answer is Rs. 95.24 x
1.05 = Rs.100. In other words, Rs. 95.24 plus the interest on it will accumulate to an
amount exactly equal to Rs. 100.
An individual who can earn 5% on his (or her) money should be indifferent between
receiving Rs. 95.24 today and Rs. 100 after one year. So the present value of Rs. 100
is Rs. 95.24.
In general, the present value of a sum to be received at any future date can
be found out by using the following formula:
i = rate of interest
If the receipts are made available over a number of years, the formula becomes:
Check this link for Time Value of Money PPT: Pearson Education9
https://slideplayer.com/slide/1507347/
The equi-marginal principle is related with the law of Equi-marginal utility which
states that a utility maximising consumer distributes his expenditure in such a
manner between various goods and services he uses, that the marginal utility derived
from each unit of expenditure on various goods and services is the same.
The equi marginal principle can be applied only in cases where firms have limited
resources and these resources have alternative uses.
The Equi-marginal Principle in Economics (Managerial Economics) states that different
courses of action should be pursued up to the point where all the courses give equal
marginal benefit per unit of cost. It claims that a rational decision-maker would
certainly allocate or her resources in a fashion that the ratio of marginal returns and
marginal costs of various uses of a provided resource or of various resources in a
given use is the same.
For instance, a consumer looking for optimum utility (satisfaction) from his
consumption basket, will allocate his consumption budget on services and products
such that,
In the same manner, a manufacturer in search of maximum profit would use the
technique of production (input-mix.) which will ensure:
You can easily observe that if the above equation is not satisfied, the decision makers
could increase his utility/profit by shuffling the resources/input e.g. if
MU1/MC1>MU2/MC2 the customer would certainly add to his utility by purchasing
more of item one and less of item two.
The firm can increase any one of these activities by employing more labour but only
greater in one activity than in another. It would be, therefore, profitable to shift
labour from low marginal value activity to high marginal value activity, thus
while that in activity В is Rs. 70 then it is possible and profitable to shift labour from
activity A to activity B. The optimum is reached when the values of the marginal
L = Labour
ABCDE = Activities
i.e., the value of the marginal product of labour employed in A is equal to the value of
the marginal product of the labour employed in В and so on. The equimarginal
concept implies that money may be allocated over various commodities such that
marginal utility derived from the use of each commodity is the same. Similarly, for a
producer this concept implies that resources be allocated in such a manner that the
https://www.yourarticlelibrary.com/managerial-economics/managerial-economics-6-
basic-principles-of-managerial-economics-explained/28361
Utility Analysis
The consumer demands a commodity because they derive or expect to derive UTILITY
from that commodity. The expected utility from a commodity is the basis of demand
for it.
Utility though is a common term, it has a specific meaning and use in the analysis of
consumer behaviour.
MEANING OF UTILITY
• Commodity Angle
• Consumer’s Angle
CHARACTERISTICS OF UTILITY
1. Utility is subjective.
3. Utility is variable.
4. Utility is different from usefulness.
On the other hand, from a consumer’s point of view, utility is a post consumption
phenomenon as one derives satisfaction from a commodity only when one consumes
or uses it. Utility in the sense of satisfaction is a ‘subjective’ or ‘relative’ concept
because:
1. A commodity may not be useful for all. Eg. Cigarettes do not have any utility for
non-smokers and meat has no utility for strict vegetarians.
2. Utility of a commodity varies from person to person and from time to time.
3. A commodity need not have the same utility for the same consumer at different
points of time, at different levels of consumption and at different moods of a
consumer.
In consumer analysis, only the subjective concept of utility is used. Now let us study
some concepts used in utility analysis.
(i) Total Utility
Assuming that utility is measurable and additive, total utility may be defined as the
sum of the utilities derived by a consumer from the various units of goods and
services he/she consumes.
The law of Diminishing Marginal Utility states that as the quantity consumed of a
commodity increases, the utility derived from each successive unit decreases,
consumption of all other commodities remaining the same.
In simple words, when a person consumes more and more units of a commodity per
unit of time for example, Ice-cream, keeping the consumption of all other
commodities constant, the utility which he derives from the successive units of
consumption goes on diminishing.
This law applies to all types of consumer goods, durable and non-durable sooner or
later.
The law can be illustrated numerically and graphically.
Total utility is increasing but at a diminishing rate. The total utility increases from 20
to 50 and then starts decreasing. When we look at the graph we can see that
Marginal Utility curve is a downward sloping curve which shows that marginal utility
goes on decreasing as consumption increases.
At 5 units, the TU reaches its maximum level, and the MU becomes 0. This is the
point of saturation. Beyond this point MU is negative and TU begins to decline.
The downward sloping MU curve illustrates the Law of Diminishing Marginal Utility.
4. The mental condition of the consumer must remain normal during the period of
consumption.
Cardinal Approach
This approach says utility is measurable in monetary units (i.e., the amount of
money) a consumer is prepared to pay for another unit of a commodity.
This approach is based on two assumptions:
(i) Axiom of diminishing marginal utility
(ii) The total utility of a ‘basket of goods’ depends on the quantities of
individual commodities. If there are ‘n’ commodities in the bundle with
quantities 𝐪𝟏 , 𝐪𝟐 , 𝐪𝟑 ….𝐪𝐧 , the total utility is:
U= f (𝐪𝟏 , 𝐪𝟐 , 𝐪𝟑 ….𝐪𝐧 )
The theory states that the condition for the equilibrium of the consumer is the
equality of the ratios of MU of the individual commodities to their prices, i.e.,
𝑴𝑼𝒙 𝑴𝑼𝒚 𝑴𝑼𝒏
= =….=
𝑷𝒙 𝑷𝒚 𝑷𝒏
The utility derived from spending an additional unit of money must be the same for all
the commodities. If the consumer derives greater utility from one commodity, he can
increase his level of satisfaction by spending more on that commodity and less on the
others until the above equilibrium condition is fulfilled.
Adam Smith wrote about his famous diamond – water paradox but was not able to
solve as the concept of Marginal utility and tools of demand and supply were not
known to him.
According to Smith, there was nothing more important than water, but it has no
price, while diamond is hardly of any value to us and still dictates a high price.
And because the marginal utility of water is low, the price at which the market supply
of water will come to the market has to be low.
Now diamonds are not essential to life like water but consumers possess few so the
marginal utility of diamond is high so they are willing to pay high prices for diamonds.
FROM SUPPLY SIDE
The marginal cost that is the additional cost of producing one more unit of output of
water is low because additional amount of water can be produced easily.
Ordinal Utility
This approach says utility is not measurable. Utility is an ordinal magnitude. (The
consumer needn’t know in specific units the utility of various commodities to make his
choice. It is sufficient if he is able to rank the various ‘basket of goods’ according to
the satisfaction that each bundle gives him. He must be able to determine his order of
preference among different bundles of goods.)
The ordinal approach employs the device of indifference curves for the purpose of
determination of consumer equilibrium.
With the market prices of commodities and the money income to be spent on them,
we can locate the attainable combinations of commodities. These can be plotted in
the form a straight line, called the Budget Line.
12
8
Apples 5
3 IC
2
O 1 2 3 4 5 X
Biscuits
This schedule shows that a household gets equal satisfaction from all the five
combinations A,B,C,D and E.
At combination ‘A’, the household has 1 unit of biscuit and 12 units of apples. At
combination ‘B’ the household has 2 units of biscuits and 8 units of apples. In order to
have one more unit of biscuit he has to sacrifice some amount of apples that is 4
units in this case in such a way that there is no change in the level of satisfaction
from each combination.
This is what is also termed as Marginal rate of Substitution. The amount of apples
the household substitutes to consume additional units of biscuits is the marginal rate
of substitution for the household. So at combination ‘B’ the marginal rate of
substitution is 1:4, at ‘C’ 1:3 and so on.
Indifference Map
An indifference map is a group or set of indifference curves each one of which
represents a given level of satisfaction.
Good Y 𝑰𝑪𝟒
𝐼𝐶3
𝐼𝐶2
𝐼𝐶1
O X
Good X
The figure above shows an indifference map consisting of various indifference curves
𝑰𝑪𝟏 , 𝑰𝑪𝟐 , 𝑰𝑪𝟑 and 𝑰𝑪𝟒 and each of these curves represent a different level of
satisfaction.
The more the distance of the curve from the origin, the higher is the level of
satisfaction.
Marginal Rate of Substitution
Marginal rate of substitution (MRS) is the rate at which the consumer is willing to
substitute one good for another without changing the level of satisfaction. The MRS of
Y for X is (𝑴𝑹𝑺𝒚𝒙 ) and is defined as the amount of Y, the consumer is willing to give
up to get one additional unit of X so that the same level of satisfaction is maintained.
Budget Line
Suppose the consumer has Rs.200 to spend on food and clothing. The
price of food is Rs.20 per unit and the price of clothing is Rs.40 per unit,
so we get the above combinations of both the commodities.
These combinations represent the maximum amount that can be
purchased with an expenditure of Rs.200 and at the given prices the
same can be plotted graphically.
Y
5 A
4 B G
C A combination like G is not
attainable as it lies outside
Clothing 3
the Budget space.
2 H D
A combination like H is
1 attainable as money E
income is not spent
completely F
X
0 2 4 6 8 10
Food
BUDGET LINE