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Chapter -1 Introduction to Economics As an MBA student you need to study Managerial Economics which is concerned with decision making

by managers. As you all are aware that the main job of managers is decision making only. Before making a decision one has to take into accounts so many things. And here comes the importance of managerial economics. Meaning of Economics: Economics can be called as social science dealing with economics problem and mans economic behavior. It deals with economic behavior of man in society in respect of consumption, production; distribution etc. economics can be called as an unending science. There are almost as many definitions of economy as there are economists. We know that definition of subject is to be expected but at this stage it is more useful to set out few examples of the sort of issues which concerns professional economists. Example: For e.g. most of us want to lead an exciting life i.e. life full of excitements, adventures etc. but unluckily we do not always have the resources necessary to do everything we want to do. Therefore choices have to be made or in the words of economists individuals have to decide----how to allocate scarce resources in the most effective ways. For this a body of economic principles and concepts has been developed to explain how people and also business react in this situation. Economics provide optimum utilization of scarce resources to achieve the desired result. It provides the basis for decision making. Economics can be studied under two heads: 1) Micro Economics 2) Macro Economics Micro Economics: It has been defined as that branch where the unit of study is an individual, firm or household. It studies how individual make their choices about what to produce, how to produce, and for whom to produce, and what price to charge. It is also known as the price theory is the main source of concepts and analytical tools for managerial decision making.

Various micro-economic concepts such as demand, supply, elasticity of demand and supply, marginal cost, various market forms, etc. are of great significance to managerial economics. Macro Economics: Its not only individuals and forms who are faced with having to make choices. Governments face many such problems. For e.g. How much to spend on health How much to spend on services How much should go in to providing social security benefits. This is the same type of problem facing all of us in our daily lives but in different scales. It studies the economics as a whole. It is aggregative in character and takes the entire economic as a unit of study. Macro economics helps in the area of forecasting. It includes National Income, aggregate consumption, investments, employment etc. Meaning of managerial economics: It is another branch in the science of economics. Sometimes it is interchangeably used with business economics. Managerial economic is concerned with decision making at the level of firm. It has been described as an economics applied to decision making. It is viewed as a special branch of economics bridging the gap between pure economic theory and managerial practices. It is defined as application of economic theory and methodology to decision making process by the management of the business firms. In it economic theories and concepts are used to solve practical business problem. It lies on the borderline of economic and management. It helps in decision making under uncertainty and improves effectiveness of the organization. The basic purpose of managerial economic is to show how economic analysis can be used in formulating business plans. Definitions of managerial economics: In the words of Mc Nair and Merriam, Managerial Economics consists of use of economic modes of thought to analyze business situation. According to Spencer and Seigelmanit is defined as the integration of economic theory with business practice for the purpose of facilitating decision making and forward planning by the management. Economic provides optimum utilization of scarce resource to achieve the desired result. MEs purpose is to show how economic analysis can be used formulating business planning.

Management Decision Problems

Economic Concepts Managerial Economics

Decision Science

Optimal Solution to Managerial Decision Problems Managerial Economics bridges the gap between purely analytical problems dealt within economic theory and decision problems faced in real business and thus helps out in making rational choices to yield maximum return out of minimum efforts and resources by making the best selection among alternative course of action. How does managerial economics differ from regular economics? There is no difference in the theory; standard economic theory provides the basis for managerial economics. The difference is in the way the economic theory is applied.

Economics in its broadest sense means what economists do. They provide solutions to various economic problems (inflation, unemployment etc). The one main root cause of all economic problems is SCARCITY and managerial economics is the use of economic analysis to make business decisions involving the best use of organizations scarce resources.

Unlimited Wants

Limited resources or means

Scarcity

What to produce?

How to produce?

For whom to produce

Human wants are virtually unlimited and insatiable and economic resources to satisfy them are limited which give rise to choices between what to produce, how to produce and for whom to produce. MANAGERIAL ECONOMICS = Economics + Decision Science + Management Business

Managerial economics has evolved by establishing link on integration between economic theory and decision sciences along with business management in the theory and practice for the optimal solution to business decision problems. It deals with the application of economic principles and methodologies to the decision making process within the firm, under the given situation. Chief Characteristics Managerial Economics is micro economic in character: This is because the unit of study is a firm; it is the problem of a business firm which is studied and it does not deal with the entire economy as a unit of study. Managerial Economics largely uses economic concepts and principles: Economics largely uses economic concepts and principles. Managerial

Managerial Economics is pragmatic: It avoids difficult abstract issues of economic theory but involves complications ignored in economic theory to face the overall situations in which the decisions are made. Managerial Economics belongs to normative rather than positive economics: Positive economics derives useful theories with testable propositions about what is and normative economics provides the basis for value judgment on economic outcomes, what should be. In other words it is prescriptive rather then descriptive. It is known as the normative micro economics of the firm. Macro Economics is also useful to managerial economics: Macro economics provides an intelligent understanding of the environment in which the business unit must operate. This understanding enables a business executive to adjust in the best possible manner with external forces over which he has no control but which play a crucial role in the well being of his concern.

Nature and Scope of Managerial Economics

Scope of Managerial Economics: Well scope is something which tells us how far a particular subject will go. As far as Managerial Economic is concerned it is very wide in scope. It takes into account almost all the problems and areas of manager and the firm. ME deals with Demand analysis, Forecasting, Production function, Cost analysis, Inventory Management, Advertising, Pricing System, Resource allocation etc. Following aspects are to be taken into account while knowing the scope of ME: 1. Demand analysis and forecasting: Unless and until knowing the demand for a product how can we think of producing that product. Therefore demand analysis is something which is necessary for the production function to happen. Demand analysis helps in analyzing the various types of demand which enables the manager to arrive at reasonable estimates of demand for product of his company. Managers not only assess the current demand but he has to take into account the future demand also. 2. Production function: Conversion of inputs into outputs is known as production function. With limited resources we have to make the alternative uses of this limited resource. Factor of production called as inputs is combined in a particular way to get the maximum output. When the price of input rises the firm is forced to work out a combination of inputs to ensure the least cost combination. 3. Cost analysis: Cost analysis is helpful in understanding the cost of a particular product. It takes into account all the costs incurred while producing a particular product. Under cost analysis we will take into account determinants of costs, method of estimating costs, the relationship between cost and output, the forecast of the cost, profit, these terms are very vital to any firm or business. 4. Inventory Management: What do you mean by the term inventory? Well the actual meaning of the term inventory is stock. It refers to stock of raw materials which a firm keeps. Now here the question arises how much of the inventory is ideal stock. Both the high inventory and low inventory is not good for the firm. Managerial economics will use such methods as ABC Analysis, simple simulation exercises, and some mathematical models, to minimize inventory cost. It also helps in inventory controlling. 5. Advertising: Advertising is a promotional activity. In advertising while the copy, illustrations, etc., are the responsibility of those who get it ready for the press, the problem of cost, the methods of determining the total advertisement costs and budget, the measuring of the economic effects of advertising ---- are the problems of the manager. Theres a vast difference between producing a product and marketing it. It is through advertising only that the message about the product should reach the consumer before he thinks to buy it. Advertising forms the integral part of decision making and forward planning.

6. Pricing system: Here pricing refers to the pricing of a product. As you all know that pricing system as a concept was developed by economics and it is widely used in managerial economics. Pricing is also one of the central functions of an enterprise. While pricing commodity the cost of production has to be taken into account, but a complete knowledge of the price system is quite essential to determine the price. It is also important to understand how product has to be priced under different kinds of competition, for different markets. Pricing = cost plus pricing and the policies of the enterprise Now it is clear that the price system touches the several aspects of managerial economics and helps managers to take valid and profitable decisions. 7. Resource allocation: Resources are allocated according to the needs only to achieve the level of optimization. As we all know that we have scarce resources, and unlimited needs. We have to make the alternate use of the available resources. For the allocation of the resources various advanced tools such as linear programming are used to arrive at the best course of action.

NATURE OF MANAGERIAL ECONOMICS Managerial economics aims at providing help in decision making by firms. It is heavily dependent on microeconomic theory. The various concepts of micro economics used frequently in managerial economics Elasticity of demand Marginal cost Marginal revenue Market structures and their significance in pricing policies. Macro economy is used to identify the level of demand at some future point in time, based on the relationship between the level of national income and the demand for a particular product. It is the level of national income only that the level of various products depends. In managerial economics macro economics indicates the relationship between (a) the magnitude of investment and the level of national income, (b) the level of national income and the level of employment, (c) the level of consumption and the level of national income. In managerial economics emphasis is laid on those prepositions which are likely to be useful to management.

Functions & Responsibilities of a Managerial Economist A further idea of the role managerial economists can play, can be had from thefollowing specific functions performed by them as revealed by a survey pertainingto Britain conducted by K.J.W. Alexander and Alexander G. Kemp: 1. Sales forecasting 2. Industrial market research. 3. Economic analysis of competing companies. 4. Pricing problems of industry. 5. Capital projects. 6. Production programs. 7. Security/investment analysis and forecasts. 8. Advice on trade and public relations. 9. Advice on primary commodities. 10. Advice on foreign exchange. 11. Economic analysis of agriculture. 12. Analysis of underdeveloped economics. 13. Environmental forecasting. The managerial economist has to gather economic data, analyze all pertinent information about the business environment and prepare position papers on issues facing the firm and the industry. In the case of industries prone to rapid technological advances, he may have to make a continuous assessment of the impact of changing technology. He may have to evaluate the capital budget in the light of short and long-range financial, profit and market potentialities. Very often, he may have to prepare speeches for the corporate executives. It is thus clear that in practice managerial economists perform many and varied functions. However, of these, marketing functions, i.e., sales forecasting and industrial market research, has been the most important. For this purpose, they may compile statistical records of the sales performance of their own business and those relating to their rivals, carry our analysis of these records and report on trends in demand, their market shares, and the relative efficiency of their retail outlets. Thus while carrying out their functions; they may have to undertake detailed statistical analysis. There are, of course, differences in the relative importance of the various functions performed from firm to firm and in the degree of sophistication of the methods used in carrying them out. But there is no doubt that the job of a managerial economist requires alertness and the ability to work under pressure. Economic Intelligence Besides these functions involving sophisticated analysis, managerial economist may also provide general intelligence service supplying management with economic information of

general interest such as competitors prices and products, tax rates, tariff rates, etc. In fact, a good deal of published material is already available and it would be useful for a firm to have someone who understands it. The managerial economist can do the job with competence. Main Responsibilities of a Managerial Economist Let us now examine have can the Managerial Economist best serve the management. He can serve the management best when he recognizes and adhere to his responsibilities towards the management. The main responsibilities of a managerial economist are the following: Responsibilities 1. To make reasonable profits on capital employed: He must have strong conviction that profits are essential and his main obligation is to assist the management in earning reasonable profits on capital invested by the firm. He should always help the management to enhance the capacity of the firm to earn profits. If he fails to discharge this responsibility then his academic knowledge, experience, expertise and business skill will be of no use to the firm. 2. Successful forecasts: It is necessary for the managerial economist to make successful forecasts by making in-depth study of internal and external factors that may have influence over the profitability or the working of the firm. He must aim at lessening if not fully eliminating the risk involved in uncertainties. It is his major responsibility to alert management at the earliest possible time in case he discovers an error in his forecast, so that the management can make necessary changes and adjustment in the policies and programmes of the firm. A managerial economist is supposed to forecast the trends in the activities of importance to the firm such as sales, profit, demand, costs, competition, etc. He must inform the management about the trend turning point of business activities of the firm. He must be willing to make considered and fairly positive statement about occurring economic development. 3. Knowledge of sources of economic informations: A managerial economist should establish and maintain close contacts with specialists and data sources in order to collect quickly the relevant and valuable information in the field. For this purpose he should develop personal relation with those having specialized knowledge of the field. He should also join professional associations and take active part in their activities. His success depends on how quickly he gathers additional informations to serve best the interest of the firm. Contacting the source of economic information and experts a managerial economist is responsible for providing all the relevant economic information to the management so the plans of the organization be chalked out after taking into consideration. So he should maintain the

contact with all possible sources from where he can collect the information relevant for firm. For this purpose, he should join professional associations and take active part in them. In fact, one of the best means of determining the caliber of a managerial economist is to evaluate his ability to obtain information quickly by personal contacts rather than by lengthy research from either readily available or obscure reference sources.

4. His Status in the Firm: A managerial economist must earn full status in the business team because only then he can be really helpful to the management in formulating successful business policies. He should be ready and even offer himself to take up special assignments. He is to win continuing support for his professional ideas by performing his functions efficiently in an atmosphere where his resources and advice are widely sought and used. He should express his ideas and suggestions in simple and understandable language with minimum use of technical words, while communicating with his management executives. It is clear from the above discussion that managerial economists perform many and varied functions. He must be able to earn full status on the business team. He should be ready and even offer himself to take up special assignments, be that in study teams, committees or special projects. For, a managerial economist can only function effectively in an atmosphere where his success or failure can be traced not only to his basic ability, training and experience, but also to his personality and capacity to win continuing support for himself and his professional ideas. While intellectually he must be in tune with industrys thinking the wider national perspective should not be absents from his advice to top management. However, of these, marketing function, i.e. sales forecasting and industrial market research has been the most important. For carrying out their functions, they may have to undertake detailed statistical analysis. Thus, managerial economists help the management a lot in discharging its function of making decisions and formulating forward plans. Managerial economist must see that his responsibilities and functions are successfully discharged. He can give the firm a profitable growth and his presence should be an effective solution to the complex problems of the management.

Demand refers to the quantities of goods that consumers are willing and able to purchase at various prices during a given period of time. For your demand to be meaningful in the marketplace you must be able to make a purchase; that is, you must have enough money to make the purchase. There are, no doubt, many items for which you have a willingness to purchase, but you may not have an effective demand for them because you dont have the money to actually make the purchase. For example, you might like to have a 3600-square-foot resort in Mussorie, an equally large beach house in Goa, and a private jet to travel between these places on weekends and between semesters. But it is likely that you have a budget constraint that prevents you from having these items. For demand to be effective, a consumer must also be willing to make the purchase. There are many products that you could afford (that is, you have the ability to buy them), but for which you may not be willing to spend your income. Each of us has a unique perspective on our own personal satisfaction and the things that may enhance that satisfaction. The important point is that if you do not expect the consumption of something to bring you added satisfaction, you will not be willing to purchase that good or service. Therefore, you do not have a demand for such things despite the fact that you might be able to afford them. n we discuss demand, we are always referring to purchases made during a given period of time. For example, you might have a weekly demand for soft drinks. If you are willing and able to buy four soft drinks at a price of Rs 5.00 each, your demand is four soft drinks a week. But your demand for shoes may be better described on a yearly basis so that, at an average price of Rs. 800.00 a pair, you might buy three pairs of shoes per year. The important point here is that when we refer to a persons demand for a product, we usually mean the demand over some appropriate time period, not necessarily over the rest of the persons life. Think about the last time you spent money. It could have been spent on a car, a computer, a new tennis racquet, or a ticket to a movie, among literally thousands of other things. No matter what you purchased, you decided to buy something because it would please you. You are not forced to make purchases. You do so because you expect them to increase your personal satisfaction. If these things give us satisfaction, we say that they have value to us. Used in this way, value implies value in use. Air has a value in use, because we benefit from breathing air. But air is free. If air has value to us, why is it free? We certainly would be willing to pay for air rather than do without it. But air is available in such abundance that we treat it as a free good. We also get satisfaction from using petrol. Petrol has value in use. But unlike air, we must pay for the petrol we use. That is, petrol has value in exchange as well as value in use. We are willing to exchange something-usually money-for the use of some petrol. Why air free, but petrol is is costly? One important reason is that petrol is scarce, whereas air is abundant. This should start making you think about the role that scarcity plays in the economy. But be careful as you do so. Just because something is scarce does not necessarily mean it will have value in exchange. Another reason that something may not have value in

exchange is because it has no value in use. That is, people just do not get any satisfaction from possessing or using it.

THE DEMAND FUNCTION


The demand function sets out the variables, which are believed to have an influence on the demand for a particular product. The demand for different products may be determined by a range of factors, which are not always the same for each of them. The presentation in this section is of a generic demand function which includes some of the most common variables that affect demand. For any individual product, however, some of these may not apply. Thus, any attempt by the firm to predict demand for a product on the basis of the demand function will require some initial knowledge, or at least informed guesswork, about the likely influences on it. The demand function can be written as: Qd = f (Po, Pc, Ps, Yd, T, A, CR, R, E, N, 0) The first three variables in the function relate to price. They are the own price of the product (Po), the price of complements (Pc) and the price of substitutes (Ps) respectively. In the case of the own price of a good, the expected relationship would be, the higher the price the lower the demand, and the lower the price the higher the demand. This is the law of demand which is explained in greater detail in the next section. In the case of complements, if the price of complementary goods increases, we would expect demand to fall both for it and for the good that it is complementary to. This is the case as fewer people would now wish to buy either good given that the complementary good is now more expensive and this has the effect of reducing demand for the other well as well. In contrast, if the price of a substitute good rises, then demand for the good that it is a substitute for would be expected to rise as people switched to buying the latter rather than its more expensive substitute. Complements and substitutes are also explained in detail later on. The fourth variable in the demand function, Yd stands for disposable income, that is, the amount of money available to people to spend. The greater the level of disposable income, the more people can afford to buy and hence the higher the level of demand for most products will be. This assumes of course that they are normal goods, purchases of which increase with rising levels of income, as opposed to inferior goods that are purchased less frequently as income rises. The use of disposable income rather than just income is justified on the grounds that people do not have total control over their gross incomes. There will, for example, be deductions to be made in the form of taxes. Thus the level of disposable income can change over time, for example changes in tax rates. The effect of changes in disposable income on the demand for individual products will of course be determined by the ways in which it is spent. This is where the fifth variable, tastes (T), needs to be taken into account. Over a period of time, tastes may change significantly, but this may incorporate a wide range of factors. For example, in case of food, greater availability of alternatives may have a significant effect in changing the national diet. Thus, in India for

instance, the demand for bajra has fallen over the past 10 years as people have switched to eating rice and wheat instead. Social pressures may also act to alter tastes and hence demand. For example, tobacco companies have been forced to seek new markets as smoking has become less socially acceptable in the USA and Western Europe, thus reducing demand in these areas. Changes in technology may also have an impact. For example, as the demand for colour televisions increased, the demand for black and white televisions fell as tastes changed and the latter were deemed to be inferior goods. Thus there are a number of ways in which tastes may change over time. The next set of variables, the A variable, relates to levels of advertising, representing the level of own product advertising, the advertising of substitutes and the advertising of complements respectively. The relationships here are as follows. In general, the higher the level of own advertising for a good, the higher demand for that good would be expected, other things being constant. Likewise, the higher the level of advertising of a complementary good, the higher the demand for it and the good(s) which it is complementary to will be, given their symbiotic relationship. Conversely, however, the higher the level of advertising of a substitute good, the lower the demand for the good for which it is an alternative and people buy more heavily promoted good. The overall effect of advertising will depend on the extent to which each of these forms of advertising is used at any given point of time as they may, at least in part, cancel each other out. This is something the firm will also need to know in order to determine its optimal advertising strategy. The variables CR and R are also related. The former represents the availability of credit while the latter represents the rate of interest that is the price of credit. These variables will be most important for purchases of consumer durable goods, for example cars. Someones ability to buy a car will depend on his or her ability to raise money to pay for it. This means that the easier credit is to obtain, the more likely they are to be able to make the purchase. At the same time credit must be affordable, that is the rate of interest must be such that they have the money to pay. These two

THE DETERMINANTS OF DEMAND Many forces influence our decisions regarding the bundle of goods and services we choose to purchase. It is important for managers to understand these forces as fully as possible in order to make and implement decisions that enhance their firms long-term health. It is probably impossible to know about all such forces, let alone be able to identify and measure them sufficiently to incorporate them into a managers decision framework. However, a small subset of these forces is particularly important and nearly universally applicable. As stated above, the overall level of demand is determined by consumers incomes, their attitudes or feelings about

products, the prices of related goods, their expectations, and by the number of consumers in the market. These are often referred to as the determinants of demand. Determinants of demand are the factors that determine how much will be purchased at each price. As these determinants change over time, the overall level of demand may change. More or less of a product may be purchased at any price because of changes in these factors.

Such changes are shown by a shift of the entire demand curve. If the demand curve shifts to the right, we say that there has been an increase in demand. This is shown as a move from the original demand D1 D1 to the higher demand D2 D2 in the below figure. The original demand curve can be thought of as being the market demand curve for soft drinks. At a price of Rs. 15.00, given the initial level of demand, consumers would purchase 6,000 soft drinks. If demand increases to the higher demand, consumers would purchase 13,000 soft drinks rather than the 6,000 along the original demand curve. A decrease in demand can be illustrated by a shift of the whole demand curve to the left. In Figure 2-3, this is represented by a move from the original demand D1 D1 to the lower demand D2 D2. At the price of Rs. 13 initially 8,000 soft drinks are purchased, while following the decrease in demand only 7,000 soft drinks are bought. It is important to see that these changes in demand are different from the changes in quantity demanded. We discussed how changes in price cause a change in quantity demanded. As price changes, people buy more or less along a given demand curve. Movement from A* to B* in Figure 4.1 shows the change in quantity demanded as price changes. It is not a shift in the whole demand curve, such as that shown in Figure 4.3a and 4.3b. When the whole demand curves changes, there is a change in demand. Some of the variables that cause a change in

demand are changing incomes, changing tastes of consumers, changes in other prices, changes in consumer expectations, and changes in the number of consumers in the market etc. These variables that cause a change in demand are also known as shifter variables.