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Economics Managerial Economics This document is authorized for internal use only at IBS Campuses Batch of 2013-2015, Semester-I. No part of this publication may
be reproduced, stored in a retrieved system, used in a spreadsheet, or transmitted in any form or by any means - electronic,
mechanical, photocopying or otherwise. Transmission, copying or posting on web are violation of intellectual property rights. C HAPTER 1 Introduction to Managerial Economics S ECTION 1 Introduction to Managerial Economics Video 1.1.1: Introduction to
Economics by Prof Dennis
Meyers Economics is the study of how economic
agents, individually and collectively,
make choices regarding the use of
scarce resources that can often be put to
different uses, in order to satisfy wants
which are of relatively higher priority
from among the unlimited wants they
face. It is the study of how entities try to
make the best possible use of the limited
resources they have.
Economic analysis, like any other
scientific analysis, can be either positive
or normative. The analysis is positive
when it describes how things are and
how things will be. It is normative when
the focus is on how things ought to be.
Positive economics explains economic
phenomena according to their causes
and effects. It says nothing about what is
right or wrong; it is not concerned with
moral judgments. On the other hand,
normative economics involves making value judgments. There is a desired end
which is deemed to be subjectively
better than the alternatives and
normative economics is about using the
right means to reach that desired end. A
positive statement is based on facts. A
normative statement involves ethical
Economics can be broadly divided into
microeconomics and macroeconomics.
Microeconomics is the study of how
individual economic units, be it an
individual agent or household or firm,
tries to optimize when faced with
resource scarcity. Microeconomics
studies economic decision-making from
the perspective of households and firms;
it focuses on the conduct of individual
consumption and production units within
a particular market structure. The broad
framework of microeconomics revolves
around the allocation of resources, 3 Video 1.1.2: Micro Vs Macro Economics
production and distribution of goods and services and
consumption. Broadly, microeconomics deals with the
consumer behavior, theory of demand and supply, theory of
firm, pricing and market structure, and theory of distribution.
Microeconomics deals with consumption and production, and
uses notions of surplus to explain a sense of economic wellbeing. Change in these measures are used to understand the
overall implications of economic policies on the welfare of the
people. Much of welfare economics is based on price theory
as microeconomics also deals with how to minimize
inefficiencies in allocation and production. When economic
efficiency is improved, wastage of scarce resources is
minimized, which has significant effects on improving
economic welfare. Keynote 1.1.1: Differences Between Micro & Macro Economics Macroeconomics deals with the overall performance of the
economic system; it focuses on issues such as unemployment, inflation, economic growth and other problems, which
affect the economy as a whole. It deals with aggregates and
the overall economic environment. The framework of macroeconomics broadly covers sustained economic growth, price
stability, growth and development, balance of payment, etc. Managenomics rial Eco- Managerial economics is the application of economic theory
and decision science tools and techniques to the problems of
4 managerial decision-making. While microeconomics provides
theoretical framework and tools that help optimally utilize the
firm’s resources, macroeconomics plays an important role by
providing an understanding of the economic environment in
which managerial decision-making takes place. To that extent,
one can say that managerial economics is the application of
microeconomic theory by practicing managers in running their
business and developing it.
According to Dominic Salvatore, "Managerial Economics is
the application of economic theory and the tools of analysis of
decision science to examine how an organization can achieve
its aim or objectives most efficiently.”
Spencer and Siegelman define Managerial Economics as
"The integration of economic theory with business practice for
t h e
Keynote 1.1.2: Dimension of Managerial Economics
b y management"
Managerial Economics is a discipline which integrates
economic theory, decision science and fundamental areas of
business administration. Managerial Economics thus serves
as a bridge between economics and business management.
Theories are important for any science. Theories provide a
framework for explaining reality and making predictions.
There are several economic theories. Consumption Theory
and the Theory of the Firm are two of the most important
components of microeconomic theory.
A model is an abstraction or simplification of the real world,
based on economic theory. A model with its assumptions is
often analogous to the control experiments that are done in
the basic sciences. These models may be explained in words,
or with numerical tables, graphs or algebra.
Models often make use of assumptions. Most microeconomic
theories assume that economic agents are rational and other
factors, not in consideration, remain unchanged (“Ceterius
paribus”). Such assumptions often may not hold true.
However, if the model retains its predictive capacity, the
invalidity of assumptions are not a matter of concern. Even in
basic sciences, by definition, control factors in laboratory
experiments may not remain the same outside the laboratory
environment, but this does not make the experiment irrelevant
in any fashion.
The science of economics renders a technical help to the
manager in making optimal and rational economic decisions
particularly in situation involving risk and uncertainty.
5 Nature and the Scope
Managerial economics helps the consumers and managers of
a firm in reaching various managerial decisions such as
decisions on buying different combinations of goods and
services, what products and services to be produced,
producing a level of output by using different combinations of
inputs and techniques of production, how much output to be
produced and at what price output to be sold, etc. It also
helps the managers in taking marketing decision, cost
decisions, advertisement decisions, budgetary decisions and
investment decisions. Managerial economics deals in detail
with the below-mentioned managerial decision problems
faced by consumers and firms.
Thus managerial economics is the application of economic
analysis in evaluating decisions having economic content and
intent. Some of the business decisions which have economic
content are as follows:
Profit maximization is assumed to be the most principal
objective of any business firm. In reality, a firm may not aim
for maximizing profit, but they do have a profit policy. The
entrepreneur constantly examines the profit position of the
company so as to take the corrective timely measures in an
advance. Hence the decision concerning the level of profit
and reinvestment of profit are relevant and in turn influences
the business greatly. For instance, Managerial economics explains rules for selecting the profit maximizing output for
firms in all types of market structure - perfectly competitive
market, monopoly, monopolistic competitive market, oligopoly
Profits are functionally related to the volume of sales and the
revenue earned thereby. Demand for the firm’s goods or
services and revenues in turn depend on the nature of
individual and market demand. Demand decision of the firm
needs to take into account the nature and dynamics of
demand for its goods or services and accordingly arrange the
factor inputs to organize the production in efficient manner. As
such, demand decisions which can be evaluated through an
analysis of consumer behavior are crucial. Managerial
economics helps an organization to understand how changes
in price and income affect demand for their products and
helps to take appropriate production decisions.
Analysis of demand decisions is naturally followed by that of
production decisions. Production function is a statement of
technological relation between input and output. Any decision
concerning output has, therefore, a natural bearing on the
decisions concerning input. The business firm, whether it
produces goods or services, has to decide about factor
combinations and factor proportions. The choice of
techniques of production, use of economies of scale and
scope, and least cost combination constitutes the dimension
of production decision. For an examination of such decisions,
6 production analysis must be combined with loss analysis.
Firms have to decide how much of each input to be used in
producing its output given the resource constraint.
Profit decision depends on two attributes, i.e., cost of
production and revenue received from the sale of the product.
It can be further inferred from the cost of production attribute
that at what price and in what quantity are the productive
factors obtained from the factor market. From the second
attribute we can infer the meaning that at what price and what
quantity are the products sold in the commodity markets?
Answers to such questions are possible through an analysis
of the market structure, i.e., the form of competition which the
business firm faces in the commodity and factor market. Thus Managerial economics is the application of economic
theory and decision science tools and techniques to the
problems of managerial decision-making. It helps the firm in
reaching various managerial decisions such as profit
decisions, demand decisions, production decisions, priceoutput decisions, marketing decisions and investment
decisions for achieving optimal solutions.
The next chapter will throw light on the theory of demand and
Positive and Normative Economics
Macro and Micro Economics Investment decisions
The investment decision is also part of the production and
capital budgeting decision of the firm. If the firm is operating
for the long haul, the firm’s capital needs to be arranged at the
least cost so as to enjoy the financial economies of scale.
The various types of economic decisions taken by a business
enterprise can be evaluated only through an extensive use of
various types of economic analysis. Thus the scope of
managerial economics tends to be wide. The main objective
of managerial economics is the analysis of business decision
of a firm with the help of microeconomic concepts, tools and
techniques. 7 R EVIEW 1.1
Question 1 of 4
Who among the following supplies the various factors
of production? A. Households
D. Government Check Answer 8 S ECTION 2 Scarcity and Choice Video 1.2.1: Scarcity & Choice Scarcity is what necessitates making
choices. Problems of choice arise at all
levels - at the individual level, at the
household level, at the firm level and at
the overall economy level. The challenge
is to make choices that maximize the
level of satisfaction, with the available
The allocation of scarce resources
between competing requirements is the
main economic problem in any society.
The individual also faces similar problems
of choice as multiple wants have to be
satisfied with a limited amount of money.
To e n s u r e e ff i c i e n t a l l o c a t i o n o f
resources, microeconomics advocates a
free-market economy where demand and
supply determine the allocation of
resources. If demand is high for a
particular product, and supply is less than the demand, its price will increase.
Producers in a market economy will
automatically produce more of the
product, to reap the profits from the
higher price. Consequently, supply
increases and prices drop till the point
where there is neither shortage nor
surplus in the market. Thus in a free
market economy, there is no agency or
intermediary planning or controlling the
market or fixing the price. Instead,
consumers and producers make their
choices based on the market forces of
demand and supply.
In market economies, both consumers
and producers face trade-offs; trade-offs
between consuming more and saving
more or between earning more money
and having more leisure. 9 It is important to remember that, in reality, markets may be
competitive or non-competitive. Most benefits of market
economy are benefits derived from competition. Since not all
markets are equally competitive, the degree of economic
efficiency which exists in various markets are likely to differ.
The opportunity cost of using a resource is the benefit that
one could have got had the resource been put to its next best
possible alternative use. The opportunity cost is an important
concept; by making a choice to produce one type of good, the
next best alternative good cannot be produced. For the
consumer, deciding to spend a certain amount of money on a
particular good is also about deciding not to spend that
amount on another good which satisfies some want. It should
be obvious that if scarcity was not there, opportunity cost
would hardly matter.
Consumers typically make their decisions based on two
considerations - budget constraints and personal preferences.
A budget constraint is the difficulty a person faces when he
tries to satisfy his unlimited wants with a limited income. Since
the budget constraint is a function of income and price, one
can say that any purchase decision is based on income,
price, and personal tastes and preferences.
A consumer can have a choice of alternative products with a
limited income if he can find a person with whom he can
exchange goods or services. By means of such exchanges,
he can increase his level of satisfaction. Such exchanges are also possible for producers. Although
two producers may both be capable of producing two
products, each can also choose to produce the one product in
which she has a comparative advantage over the other and
exchange products. Fundamental Economic Problems
All societies face three fundamental economic problems
which arise out of scarcity. These are questions about choices
related to the use of scarce economic resources. They are:
What to produce?
At the societal level, scarcity of land, labor and capital implies
that all the wants in the economy cannot be satisfied. Since
all wants cannot be satisfied, society must determine which
wants are more important at a given point in time. Accordingly,
they have to choose which goods and services are to be
produced with the limited resources available.
How to produce?
This is about choosing the combination of resources and the
quantity of each resource to be used to produce a certain
quantity and quality of output. From a societal perspective,
the best combination is one which fully employs the available
resources to produce the maximum output. Depending on the
resources available, techniques of production may be labor
intensive or capital intensive. 10 For whom to produce?
This refers to the distribution of goods and services between
different sections of the population. Scarce resources are to
be used appropriately to cater to the needs of all income
These three questions are indeed interrelated. A society,
which decides to produce more of highly sophisticated
aircrafts and less of cycles, is also deciding to use more of
capital and less of labor. In turn, since aircraft mechanics are
likely to belong to a much higher income group than, say,
cycle mechanics, the decision to produce more aircrafts has
direct implications on the distribution question as well. Economic Systems
How these fundamental questions are answered will depend
on the extent of government control on the economy. Based
on the role of the government in addressing these questions,
there are three broad types of economic systems in the world
- the market economy, the command economy and the mixed
In a market economy, the freedom of individuals as
consumers and suppliers of resources, allows market forces
to determine the allocation of scarce resources through the
price mechanism. Based on market demand and supply,
consumers are free to buy goods and services of their choice
and producers allocate their resources based on the demand. Decisions made by producers and consumers are influenced
greatly by price. Any increase in the price of a product without
a corresponding increase in cost increases profit; as a result,
producers allocate more resources to that particular product.
On the other hand, if consumers do not like to buy a product,
supply would exceed demand and price would fall, resulting in
a lower profit or even a loss to the producers.
Thus price plays a major role in a market economy. The role
of the government is negligible: consumers choose the goods
they want and producers allocate their resources based on
the market demand for different products. The United States
of America is an example of a market economy.
In the US, firms decide the type and quantity of goods to be
made in response to consumer demand. An increase in the
price of one good encourages producers to switch resources
to the production of that item. Consumers decide the type and
quantity of goods to be bought; a decrease in the price of one
good encourages consumers to switch to buying that item.
In a command economy, answers to the three fundamental
questions are decided by the government. So, what to
produce, how to produce and for whom to produce are all
decided by the people in power. The role of the government is
all pervasive here, while consumer and producer choice is
very limited. In this system, efficiency can be achieved only
when demand is accurately forecasted and resources
allocated accordingly. The former USSR was an example of a
command economy. The government had complete control
11 over the economy and consumers were just the price takers.
The government set output targets and allocated the
necessary resources. The biggest challenge for a command
economy is the massive requirement of real-time economic
data, far beyond the technological and infrastructural
capabilities of any government anywhere today.
A mixed economy is an economic system, which combines
the features of a free market economy and a command
economy. While consumers and producers enjoy freedom and
choice, the government usually sets limits to such freedom.
Government controls price
fluctuations beyond a range,
while interfering in the
economy in order to achieve
a few set national goals.
Mixed economies often have
some unregulated sectors
and some highly regulated
sectors. Governments in
mixed economies generally
attempt to plan the course of their countries’ development and
use cost-benefit analyses to answer the fundamental
economic problems of what, how and for whom to produce. In
principle, decisions or projects affecting the economy as a
whole are taken or accepted only when the social benefits
from the decision of project are greater than the social costs.
Theoretically, a cost benefit analysis helps to assess the full
costs and benefits to society arising from a particular decision
or project, but sometimes in practice, the cost of collecting and processing the massive amount of information required
results in lags and inefficiencies.
In a mixed economy, often the government organizes the
provision of certain goods and services such as education
and health care, which are considered essential. Production Possibility Curve The production possibility curve (PPC) helps us understand
the problem of scarcity better, by showing what can be
produced with given re...
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- Fall '19