ME Version 1.pdf - Managerial Economics Managerial Economics This document is authorized for internal use only at IBS Campuses Batch of 2013-2015

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Unformatted text preview: Managerial 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 values. 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 purpose of facilitating Keynote 1.1.2: Dimension of Managerial Economics decision making and forward planning 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 Decision: 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 market, etc. Demand Decisions 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. 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. Price-Output Decisions 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 supply. References 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 B. Firms C. Industry 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 resources. 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. Opportunity Cost 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 groups. 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 economy. Market Economy 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. Command Economy 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. Mixed Economy 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 Video 1.2.2:Economic fluctuations beyond a range, Systems 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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