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Economics For
1.4
Business Decisions
Module – 1 Introduction (8 hours)
Introduction to Managerial Economics; The roles of the firm and
the House hold Decision Making in the Household - Consumer
Choice. Theory of Demand; its Determination, Estimation and
Forecasting. Economic principles relevant to managerial decision
making. Opportunity cost, production possibility curve, concept
of increments and margin, discounting principle, Theory of
business firm.
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Meaning - Economics
Economics refers to choices or decisions made by
Individuals, Businesses, and Governments regarding
the production, distribution, and consumption of
goods & services.
It also studies their Resource Allocation for the same
during Scarcity.
In short, it is a branch of Social Science dealing with the
interaction of People with value.
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Scarcity
• Scarcity implies the limited availability of resources, such as
Land, Capital, Machinery & Labor
• Economics examines effective resource utilization for the
production of commodities. Also, it investigates the role of
government incentives and policies in increasing production and
trade efficiency
• It is Based on how people, entities and nations interact to find ways
to meet increasing demands with scarce resources, it could be Micro
and Macroeconomics
Definition
Dr. Alfred Marshall, one of the Greatest Economists
of the 19th century, writes
“Economics is a study of man’s actions in the
ordinary business of life: it enquires how he
gets his income and how he uses it”.
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Types of Economies
•Controlled or Centrally planned Economy
•Free or Market Economy
•Mixed Economy
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• It refers to the economy in which the economic activities relating to
production, consumption, investment, or exchange are controlled by the
Government or some central authority. In such economies, the
Degree of Control is Very High. Countries like China, Russia and
North Korea.
Cont…
Free or Market Economy
• It refers to the economy in which the economic activities relating
to production, consumption, investment or exchange are
controlled by the market forces such as demand and
supply.
• The degree of control by the Government or any
authority is very low.
• The countries like USA and UK have such economies.
Cont…
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Mixed Economy
• It refers to the economy in which the economic activities relating to
production, consumption, investment or exchange are governed by the
market forces such as demand and supply and controlled by
the Government.
• The degree of control by the
Government or any authority
is Moderate (neither very
high nor very low)
• India is the biggest example
for such an economy.
Business Decisions
• Businesses need to make crucial decisions on a day-to-day basis.
These decisions can be about an investment opportunity,
• A new product,
• A new competitor, or
• A company’s direction.
• For such important decisions, businesses need to rely on
experts. These experts come from the background of
Managerial Economics. They are the experts who provide
monetary value to the different opportunities and then
urge the company to proceed.
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Microeconomics
•The study of an individual consumer or a firm is called
microeconomics.
•Microeconomics deals with behavior and problems of
single individual and of micro organization.
•It is concerned with the application of the concepts such as
price theory, Law of Demand and theories of market structure
and so on.
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Macroeconomics
• The study of ‘aggregate’ or total level of economic activity in a
country is called macroeconomics.
• It studies the flow of economics resources or factors of production
(such as land, labor, capital, organization and technology) from the
resource owner to the business firms and then from the business firms
to the households.
• It is concerned with the level of employment in the economy.
• It discusses aggregate consumption, aggregate investment, price level,
and payment, theories of employment, and so on.
Managerial Economics
• Managerial Economics can be defined as amalgamation
(combination or mix) of economic theory with business practices so as
to ease decision-making and future planning by management.
• Managerial Economics assists the managers of a firm in a rational
solution of obstacles faced in the firm’s activities.
• It makes use of economic theory and concepts.
• It helps in formulating logical managerial decisions.
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• Managerial Economics is a science dealing with
effective use of scarce resources.
• It guides the managers in taking decisions relating to the
firm’s customers, competitors, suppliers as well as relating
to the internal functioning of a firm.
• It makes use of statistical and analytical tools to assess
economic theories in solving practical business problems.
• Study of Managerial Economics helps in enhancement of
analytical skills, assists in rational configuration as well as solution of
problems.
• While Micro Economics is the study of decisions made regarding
the allocation of resources and prices of goods and services.
• Macro Economics is the field of economics that studies the
behavior of the economy as a whole (i.e. entire Industries and
Economies).
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• Managerial Economics is associated with the economic theory which
constitutes “Theory of Firm”.
• Theory of firm states that the primary aim of the firm is to maximize
wealth.
• Decision making in managerial economics generally involves
• Establishment of firm’s objectives
• Identification of problems involved in achievement of those objectives
• Development of various alternative solutions
• Selection of best alternative and
• Finally implementation of the decision.
Difference Between Managerial Economics
and Economics
Basis of
Managerial Economics Economics
Difference
It is the study of proper allocation of resources in a It is the study of allocation of resources in a society
Meaning
particular firm as a whole.
Presence of The proper application of economic principles to the
The body of the principles are being dealt itself.
Principle problems of the firm.
Nature It is individualistic. It is comprehensive.
Type of
It is micro-economic in character. It is both macro and micro-economic in character.
Economics
Deals in It deals only with a firm. It deals with a firm and its Industry.
Scope It is narrow in scope. It is wider in scope.
The modification and enlargement of models is done by
adopting and revaluating of economics models to match It speculates economic relationships and builds
Type of Work
specific conditions and to help in the process of problem- simplified economic models.
solving.
Variables such objectives of the firm, multi-product nature
Factors Used of manufacture, constraints on resource availability, Theoretical assumptions are used.
environmental aspects, legal constraints, etc., are utilized.
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Household
Concept of Household
• Households are the main sector for the consumption of an economy.
• The primary economic function of households is to supply domestic firms with needed
factors of production - land, human capital, real capital and enterprise. The factors are
supplied by factor owners in return for a reward.
• Land is supplied by landowners,
• Human capital by labour,
• Real capital by capital owners (capitalists) and
• Enterprise is provided by entrepreneurs
• Entrepreneurs combine the other three factors, and bear the risks associated with production.
• It purchases all the final goods and services produced by the firms from the markets
directly. Hence, they supply different factor services to the economy and on the other
hand they create demand for the final goods and services from the market.
Role of the Household in Economy
The roles and importance of households for building an economy are
immense. Some of the performances of household are described
below:
• Act as a Producer
• Act as a Consumer
• Act as a Tax-Payer
• Act as a Professional
• Act as a Saver
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Act as a Producer
• There are several families in India who are the owners of several small
production units.
• These households act as entrepreneurs or producers of different goods and
services.
• They form the enterprises which are basically semi-corporate in nature.
Act as a Consumer
• The households are the final consumers of goods and services produced by
the firms.
• They create demand in the market and according to their tastes and
preferences.
• The firms produced and supplied goods in the market, as per their
demand.
• Therefore, households determine the production line of a country.
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Act as a Tax-Payer
• Households are the main sources of the government tax-revenue.
• They are the main tax-payer.
• A household pays
• Income tax
• Wealth tax
• Estate duty
• Gift tax, etc, as direct taxes to the state.
• Similarly, a household pays several indirect taxes to the government like
• GST, customs duty, etc.
• All these tax revenues are collected for the welfare and
development of the economy.
Act as a Professional
• All types of professional services like Doctor, Teacher, Lawyer, Engineer., etc.,
come from households.
• Their activities are very much required for the country to enhance economic
development.
• These professional services increase the living standard of the people.
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Act as a Saver Income
• After consumption is saving.
• Hence households earn income after giving several services to the economy.
• The portion of their income left after the consumption, is saved in the
banks or financial institutions.
• These savings are considered as one of the main source of capital
formation in India.
Economic Principles Relevant to
Managerial Decision Making
Opportunity Cost
Concept of Incremental
Principle
Principle
Concept of Marginal
Concept of Discounting
Principle
Principle
Concept of Time
Concept of Equi-Marginal
Perspective Principle
Principle
Concept of Scarcity
Principle of Risk and
Principle
Uncertainty
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Opportunity Cost Principle
• The interest earned on the funds that had been employed in other
ventures is the opportunity cost of the funds employed in one’s own
business.
• The time given by an entrepreneur to himself is the opportunity cost of
time.
• The opportunity cost of holding Rs.1,000/- as cash for one year is 8%
rate of interest, if the person has invested the money in mutual funds.
Therefore the determination of sacrifices is known as opportunity
cost. Opportunity cost will be zero, if there are no sacrifices.
Concept of Incremental Principle
• Incremental cost and Revenue : The changes in a particular
decision like price, product, procedure, investment, etc. which results into
the change in total cost and revenue of a product.
A decision is profitable if, the following factors:
• The increase in revenue is more than the increase in cost.
• The increment in other costs is comparatively less than the reduction in some of the cost.
• The fall in other resources is comparatively less than the rise in some of the resources.
The basic motive of every businessman is to earn profit. It clearly states
that higher the risk more is the profit.
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Concept of Marginal Principle
• If the resources are scarce then the manager has to be very careful
about the full utilization of each and every additional unit of
resources (inputs).
• Example: a consumer is willing to pay $5 for an ice cream, so the marginal benefit
of consuming the ice cream is $5. However, the consumer may be substantially less
willing to purchase additional ice cream at that price – only a $2 expenditure will
tempt the person to buy another one.
Example: A store-owner keep his shop open one
hour longer?
• You must compare the marginal benefit with the
marginal cost
• Benefit = the extra bonus that results from the small
change
• Cost = the additional costs associated with the small
change
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Difference between Marginal and
Incremental Concept
Basis of
Marginal Concept Incremental Concept
Difference
Marginal concept focuses on the function
Incremental concept considers more than
of single variable or it considers
Meaning one independent variable. It is multi-variable
independent variable.
function.
Example: Revenue depends upon Output.
Nature It is more specific in nature. It is general in nature.
Interrelation
All marginal concepts are some how All incremental concepts are not essentially
between each
incremental concepts. marginal.
other
Expressed in It is expressed in terms of unit change. It is expressed in terms of bulk change.
Concept of Discounting Principle
• The origin of this principle is the valuation of the money received at
different point of time.
• Various transactions which involve making or receiving cash
payments at numerous future dates uses the discounting principle.
• Example: When a buyer takes home loan from any bank then he promise to make
monthly payments for twenty years. When a person injured in an automobile accident
then he accepts a settlement of Rs.4,000/- per month as compensation for the
damage from the insurance company for the life time.
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• The concept of time value of money explains that the money which is received
at different future dates will not be same today.
• After one year the value of Rs.1,000/- is not equal to Rs.1,000/-, but
less than that. But it is required to know that how much money today is
equal to 1,000/- of one year hence. The rate of interest is required to find
out this.
• So, we will discount 1,000 at that rate of interest to ascertain the value
of 1,000 one year hence or two years hence.
• This discounting principle is:
FV=PV (1+r) n
Concept of Time Perspective Principle
• A business firm should take any decision only after considering the effects of
decisions on costs and revenues in short-run and long-run.
• It is required that the proper balance should be maintained between the
short-run and long- run effects. Hence, it is very important to give proper
consideration to the time perspective.
• For example, ABC is a firm engaged in continuous production of X
commodities (long run). In the production process, it is having daily an ideal
time (free time) for few hours. In that ideal time, firm can take an order for
manufacturing other similar goods instead of wasting time.
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Concept of Equi-Marginal Principle
• According to this principle, an input should be allocated in a way that the
value added by the last unit is the same in all cases. This
generalization is called the equi - marginal principle.
• Let us consider that a firm is involved in three activities such as A, B and
C activity. All the activities require the services of labour and the firm should
allocate the available labour in such a way that the value of Marginal
Product of labour is equal in all the three activities.
VMPLa = VMPLb= VMPLc
Where,
• VMP = Value of Marginal Product
• L = Labour
• a, b, c = 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 b and so on.
• For example: if in activity 'A', the value of marginal product of labour is 30 while
that in activity 'B', it is 40. Hence, it is profitable to shift labour from activity 'A' to
activity 'B', thereby expanding activity 'B' and reducing activity 'A'. When the value of
marginal product is equal in all the activities then the optimum condition will be
achieved.
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Concept of Scarcity Principle
• 'Excess demand' of any commodity or service is referred to as scarcity.
• If demand (requirement) for anything exceeds its supply (availability) then it is
called scarce.
• Amount of demand in relation to supply determines the scarcity and hence it is
called relative concept. The scarcity requires managerial attention because it lies at
the root of any problem.
For example:
• Scarcity of jobs is known as unemployment.
• Scarcity of goods is known as inflation.
• Unsold stock of inventory is essentially the scarcity of buyers.
• Under-utilised capacity at the plant level may be primarily due to scarcity of power or other
supporting facilities.
Principle of Risk and Uncertainty
• The risk and uncertainty are the important conditions which are faced by the managers
at the time of taking various kinds of decisions. The businessmen for taking better
decision should understand these conditions properly.
• Risk
• Risk refers to the possibility of the amount of uncertainty in the business. In other words, the
reduction in the number of possible outcome to various alternative course of action is termed as
risk.
• Uncertainty
• It refers to a situation where the various alternatives are present and among that the specific
outcome is determined. The possibilities of happening and non-happening of the resultant outcome
cannot be predicted.
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Production Possibility Curve
•A production possibilities curve measures the
maximum output of two goods using a fixed
amount of input.
•The input is any combination of the four Factors of
Production: natural resources (including land), labor,
capital goods, and entrepreneurship.
• In Economics, the production possibilities curve is a visualization
that demonstrates the most efficient production of a pair of goods.
Each point on the curve shows how much of each good will be
produced when resources shift to making more of one good and less of
another.
• The production possibilities curve measures the trade-off
between producing one good versus another.
• Alternate name:Transformation curve
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Assumptions
• Only two specific goods, namely, ‘X’ (consumer goods) and ‘Y’ (capital
goods), are widely produced in an economy in different proportions.
• The same combination of resources can be used for producing either
one or both of the goods and can be freely shifted between them.
• The supply of resources is fixed but can be reallocated to produce
both goods but within feasible limits.
• All resources and available technology in the economy is optimally
allocated and used.
• The time duration is short.
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• By describing this trade-off, the curve
demonstrates the concept of
opportunity cost. Making more of one
good will cost society the opportunity
of making more of the other good.
Sl.
Chance Oranges Apples Total
No.
1 A 0 1,40,000 1,40,000
2 B 20,000 1,20,000 1,40,000
3 C 35,000 85,000 1,20,000
4 D 40,000 0 40,000
Inside the curve. Inefficient use of
5 E
resources.
Outside the curve. Impossible with
6 F
current resources.
How the Production Possibilities Curve
Affects the Economy
• The curve does not tell decision-makers how much of each
good the economy should produce; it only tells them how
much of each good they must give up if they are to
produce more of the other good.
• It is up to them to decide where the sweet spot is.
• In a market economy, the law of demand determines how much
of each good to produce. In a command economy, planners decide
the most efficient point on the curve. They are likely to consider how
best to use labor so there is full employment.
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Theory / Objectives of Business
Firm
Profit Maximization
Sales Maximization
Wealth Maximization
Managerial utility Maximization
Satisfactory level of profits
Economic theory of the firm
Cyert and March’s Behaviour
Other theory / Objectives of a
Theory
firm
Sales Maximization
• It is achieved when a
business sells as much of a
product or service as possible
without making a loss,
meaning the average revenue
of a product or service is the
same as its average cost to
produce it.
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Profit maximization
• Profit maximization is a process in business firms to undergo and to
ensure the best output and price levels are achieved in order to maximize its
returns.
• In business, profit maximization is a good at the same time it can be a bad
• For example, lower-quality materials and labour are used or if the business decides
to raise the prices for executing projects
Topics Profit Maximization Wealth Maximization
Wealth maximization means maximizing
Profit maximization means
Definition the net present value or a wealth of a course
maximizing the profit of the firm.
of action to shareholders.
Subject Matter To increase profit volume. To increase wealth, not profit.
Risk The risk would not be considered. The risk would be considered.
TimeValue Time value is not considered. Time value is considered.
Inflation Inflation would not be evaluated. Inflation would be evaluated.
Welfare Social welfare is not considered. Social welfare is considered.
Keeps interested Only the owners. All the interested parties
Indicator It indicates increasing EPS. It indicates an increasing share price.
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Utility maximization
Is a strategic scheme whereby individuals and companies seek to achieve the
highest level of satisfaction from their economic decisions.
For example:
When a company's resources are limited, management will implement a
plan of purchasing goods or services that provides the maximum benefit.
Economic theory of the firm
• There are two views of the firm:
• Neoclassical theory
• Firm is a calculating entity, that makes decisions to
• Buys inputs,
• Making output and
• Selling for profit or loss
• Property rights theory
• Firm is a collection of contracts between owners of resources, who wish
to combine some portion of their resources, for some period, for some
purpose.
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Cyert and March’s Behaviour Theory
• According to Cyert and March, modern business firm are group of
individuals who are engaged in the decision-making process relating
to its internal structure whose interests may conflict with each
other.
• They proposed that real firms aim at satisficing rather than
maximizing their results. I.e., some groups may settle for "good
enough" achievements rather than striving for the best possible outcome.
Maximum Growth Rate
Economic
Objectives
Desire for Liquidity
Survival
Other theory /
Objectives of Building-up Public
a firm Confidence for the product
Non-Economic Welfare
Objectives
Sound Business Practices
Progressive Management
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References:
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