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UNIT- 1
General Foundations of Managerial Economics

Introduction to Economics

Economics is a social science. Its basic function is to study how people-individual, households,
firms and nations- maximize their gains from their limited resources and opportunities. It
studies human behaviour in relation to optimizing allocation of available resources to achieve
the given ends/goals.
The word Economics is derived from the Greek Word Oikonomia which means household
management.

Definitions of Economics
Economics is an ever growing science. Thus it is very difficult to define economics properly. It
is very clear from the words of the following scholars.
Mrs. Barbara Wootten, wherever six economists gathered, there will arise seven opinions
about economics.
J.M.Keynes, Political economy is said to be strangled itself with definitions.
Prof. Jacob Viner, Economics is what economists do.
From the words of above scholars it is clear that the branch of knowledge economics is
blessed with large number of definitions.
The basic definitions of economics can be classified under 4 heads.
a). Wealth Definition b). Welfare Definition c). Scarcity Definition d).Growth Definition
1. Wealth Definition (Prof. Adam Smith, University of Glasgow, Scotland)
The first economist to attempt a scientific definition of economics was Adam Smith, the
Father of Economics. In his famous book An Enquiry in to the Nature and Causes of Wealth of
Nations published in 1776, Adam Smith defined economics as a science of wealth.
The Wealth definition of economics has been severely criticised because it assumed wealth as
an end of human activities. Smiths definition has a tendency to make people selfish as the
welfare aspects of human life were neglected.
2. Welfare Definition (Prof. Alfred Marshall, University of Cambridge)
Prof. Alfred Marshall in his famous book Principles of Economics (1890) defined economics as
a study of mankind in the ordinary business of life; it examines that part of individual and
social action which is most closely connected with the attainment and the use of material
requisites of well-being.
Prof. Lionel Robbins and others criticised this definition on the ground that welfare is
subjective and so it cannot be measured or compared.
3. Scarcity Definition (Prof. Lionel Robbins, University of London)
Prof. Lionel Robbins in his book The Nature and Significance of Economic Science (1932)
gave a new definition to economics. This definition is known as the scarcity definition. Robbins
defined economics in the following lines,
Economics is a science which studies human behaviour as a relationship between ends and
scarce means which have alternative uses.
This definition is base on the following fundamental propositions
a) Human wants are unlimited
b) Means/ resources are limited
c) Resources have alternative uses.

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4. Growth Definition (Prof. P.A. Samuelson, Massachusetts Institute of Technology)


According to Prof. P. A. Samuelson economics is the study of how men and society choose
with or without the use of money, to employ scarce productive resources, which could have
alternative uses, to produce various commodities over time and distribute them for
consumption now and in the future among various people and group of society.

Nature of Economics
In order to understand the nature of economics we have to indicate the following,
a) Whether economics is a science or an art?
b) If economics is a science, whether it is a positive science or a normative science?
1. Whether economics is a science or an art?
i) Economics as a Science
The systematized body of knowledge regarding a subject is commonly defined as a science. A
science is not a mere collection of facts but indicates a relationship between cause and effect.
Economics is considered as a full-fledged science. Like any other science economics has its
own generalisations, theories or laws of economics which traces out a cause and effect
relationship between two or more phenomena.
ii) Economics as an Art
The practical application of scientific techniques is the Art of Economics.
Economics is a science in its methodology and an art in its application.
It is considered as newest of sciences and oldest of arts and the
Queen of all the social sciences.
2. Whether economics is a positive science or a normative science?
i) Economics as a Positive Science
A positive science is a body of systematized knowledge concerning what is. As per the
nineteenth century experts, economics is a positive science. Positive economics is free from
value judgment i.e, it describes observed facts without saying whether they are good or bad
Examples of positive statements are given below.
1. An additional tax on goods will raise its price.
2. A rise in the price of a commodity will reduce its demand.
ii) Normative Economics
A normative science is a body of systematized knowledge concerning what ought to be.
Normative economics or welfare economics is the study of what ought to be or how the
economic problems should be solved.
Examples of normative statements are given below.
1. The distribution of National Income in India should be more equal.
2. The level of government expenditure should be reduced.
In short, economics is both a positive and normative science

Scope of Economics
The scope of economics means the area or boundary of the study of economics. There are
different views regarding the scope of economics. According to Prof. A.C. Pigou, economics is
a positive science of what is. It is not a normative science of what ought to be. Prof. Viner
states that economics is what economists do.
The scope of economics include the following
1. The subject matter of economics
2. Specialized branches of economics
1. The subject matter of economics
The subject matter of economics is divided in to two.

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a) Micro economics
b) Macro economics.
Micro Economics and Macro Economics
The term micro and macro were coined by Prof. Ragnar Frisch of Oslo University (Norway)
in 1933. The term micro has been derived from the Greek word mikros which means small.
Micro economics is the study of the behaviour of individual economic unit. It is also called
Price theory. It studies economic activities concerning an individual consumer, a firm or an
industry and the study of individual income, the determination of product price, factor price
etc.
Macro economics is the study of the economy as a whole. The term macro has been derived
from the Greek word makros which means large. It studies aggregate facts like national
income, total expenditure, total investment, level of employment, total production, general
price level etc. It is also called the theory of income and employment.
Micro economics

Macro economics

1.Studies only part of the economy


2. Bases on partial equilibrium analysis
3. Takes the assumption, other things
remains the same
4. Use deductive method (General to
Particular)
5. provide worms eye view of the
economy
6. It is also known as price theory
7. Study of individual units

1.Studies the economy as a whole


2.Bases on general equilibrium analysis
3.Doesnot taken this assumption
4.Use inductive method (Particular to
General)
5.provide birds eye view of the economy
6. Known as theory of income and
employment
7. Study of aggregates

2. Specialized branches of economics


In addition to micro economics and macro economics, many specialized branches of
economics have come up over time as a result of growing need for intensive and extensive
study of certain aspects of micro economics and macro economics. Some of the major
specialized fields of economic studies are listed below with a brief description of their subject
matter.
1. Economics of development deals with the factors that determine economic development
and growth of a country, the cause of underdevelopment, unemployment and poverty in
less developed countries and suggests policy measures to achieve a sustainable high
growth rate of economy and employment.
2. International economics studies the cause and consequences of international trade in
goods and services, international flow of capital, international monetary and financial
institutions, balance of payment, and international payment system.
3. Public economics examines economic role of the government, sources of government
revenue, governments fiscal policy, effects of taxation and public expenditure, causes and
consequences of budgetary deficits etc.
4. Monetary economics studies the monetary affairs of the country including demand for and
supply of money, working of the money market, credit and financial system, and
management of the monetary sector.
5. Labour economics examines the problems faced by labour as an economic class and
problems associated with labour organizations, labour productivity and wages, exploitation
of labour etc.
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6. Econometrics is the study of statistical and mathematical techniques applied to economic


data with a view to testing a hypothesis, to quantify the relationship and to measure the
effects of economic policies.
7. History of economic thoughts is the study of evolution and development thoughts and
ideas, their background, their logic etc.
8. Industrial economics is concerned with the development and working of financial
institutions
9. Environmental economics: examines how industrial growth affects, rather destroys,
natural environment of the country and how world industrial growth affects the global
business environment and causes global warming, and affects climatic conditions.
10. Managerial Economics

Managerial Economics
Managerial economics studies how economic theories, concepts and tools of analysis can be
applied to business decision making and to understand the business environment of the
country. It is nothing but the application of economics to the real business activities, so as to
get the desired business result.

Definitions of Managerial Economics


Mc Gutgan and Moyer: Managerial economics is the application of economic theory and
methodology to decision-making problems faced by both public and private institutions.
Spencer and Siegelman: Managerial economics is the integration of economic theory with
business practice for the purpose of facilitating decision-making and forward planning by
management.
McNair and Meriam: Managerial economics consists of the use of economic modes of
thought to analyse business situations.

Nature / Characteristics of Managerial Economics


In a world of competition in the market there exist thousands of rivals; due to this a
businessman or an entrepreneur plans his strategies so as to take control over the market.
The following points constitute the nature of managerial economics.
1. It is a Micro economic analysis: It studies the problems and principles of an individual
business firm or an individual industry. It aids the management in forecasting and evaluating
the trends of the market.
2. Normative economics: It is concerned with varied corrective measures that a management
undertakes under various circumstances. It deals with goal determination, goal development
and achievement of these goals. Future planning, policy-making, decision-making and optimal
utilisation of available resources, come under the banner of managerial economics.
3. Pragmatic: Managerial economics is pragmatic (practical in outlook). In pure microeconomic theory, analysis is performed, based on certain exceptions, which are far from
reality. However, in managerial economics, managerial issues are resolved daily and difficult
issues of economic theory are kept at bay.
4. Uses theory of firm: Managerial economics employs economic concepts and principles,
which are known as the theory of Firm or 'Economics of the Firm'. Thus, its scope is narrower
than that of pure economic theory.
5. Takes the help of macro economics: Managerial economics incorporates certain aspects of
macroeconomic theory. These are essential to comprehending the circumstances and
environments that envelop the working conditions of an individual firm or an industry.
Knowledge of macroeconomic issues such as business cycles, taxation policies, industrial
policy of the government, price and distribution policies, wage policies and antimonopoly
policies and so on, is integral to the successful functioning of a business enterprise.
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6. Aims at helping the management: Managerial economics aims at supporting the


management in taking corrective decisions and charting plans and policies for future.
7. A scientific art: Managerial economics has been also called as a scientific art because it
helps the management in the best and efficient utilisation of scarce economic resources. It
considers production costs, demand, price, profit, risk etc. It assists the management in
singling out the most feasible alternative. Managerial economics facilitates good and result
oriented decisions under conditions of uncertainty.

Scope of Managerial Economics


The scope of managerial economics includes following subjects:
1. Theory of demand
2. Theory of production
3. Theory of exchange or price theory
4. Theory of profit
5. Theory of capital and investment
6. Environmental issues
1. Theory of Demand: According to Spencer and Siegelman, A business firm is an economic
organisation which transforms productivity sources into goods that are to be sold in a
market. It includes
a. Demand analysis: Analysis of demand is undertaken to forecast demand, which is a
fundamental component in managerial decision-making.
b. Demand theory: Demand theory relates to the study of consumer behaviour.
2. Theory of Production: Production and cost analysis is central for the unhampered
functioning of the production process and for project planning. Production is an economic
activity that makes goods available for consumption. Production is also defined as a sum of all
economic activities besides consumption. It is the process of creating goods or services by
utilising various available resources.
3. Theory of Exchange or Price Theory: Pricing is an important area in managerial economics.
The accuracy of pricing decisions is vital in shaping the success of an enterprise.
4. Theory of profit: Every business and industrial enterprise aims at maximising profit. Profit is
the difference between total revenue and total economic cost. Profitability of an organisation
is greatly influenced by the following factors:
Demand of the product
Prices of the factors of production
Nature and degree of competition in the market
Price behaviour under changing conditions
5. Theory of Capital and Investment: Capital is the building block of a business. Like other
factors of production, it is also scarce and expensive. It should be allocated in most efficient
manner.
6. Environmental issues: Managerial economics also encompasses some aspects of
macroeconomics. These relate to social and political environment in which a business and
industrial firm has to operate.

Importance of Managerial Economics in Business


Emergence of managerial economics as a separate course of management studies can be
attributed to at least three factors.
1. Growing complexity of the business decision making process due to changing market
conditions.
Growing complexity of business decision is mainly due to changes in business environment
That means:
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growth of large scale industries


growth of large variety of industries
diversification of industrial products
expansion and diversification of business activities of corporate firms
growth of MNCs
Mergers and takeovers
2. Increasing use of economic logic, concepts and tools in the process of business decision
making.
The growing complexity of business decision making has inevitably increased the application
of economic concepts, theories and tools of economic analysis. The reason is that making an
appropriate business decision requires
A clear understanding of market conditions
The nature and degree of competition
Market fundamentals
Business environment
3. Rapid increase in the demand for professionally trained managerial power.
Consequently economic theories and analytical tools, which are widely used in business
decision making have crystallized in to a separate branch of management studies, called
managerial economics or business economics.

Why do Managers Need to Know Economics?


Economics is the study of logic, tools and technique of making optimum use of the available
resources to achieve the given ends. It provides analytical tools and techniques that managers
need to achieve the goals.
The contribution of economics towards the performance of managerial duties and
responsibilities is of prime importance.
Just as biology contributes to medical profession and physics to engineering, economics
contributes to the managerial profession.
All other professional qualifications being the same, managers with a working knowledge
of economics can perform their functions more efficiently than those without it.
Managers are responsible for achieving the objective of the firm to the maximum possible
extent with the limited resources placed at their disposal
In the absence of unlimited resources, it is the responsibility of the management to
optimise the use of these resources.
How Economics Contribute to Managerial Function?
Economics provides analytical tools and techniques that managers need to achieve the
goal of the organization they manage.
Many business decisions are taken under conditions of uncertainty and risk. The degree of
uncertainty and risk can be greatly reduced if market conditions are predicted with a high
degree of reliability. Economics offers models, tools and techniques to predict the future
course of market conditions and business prospects.
Contributions of Economic Theory to Business Economics
According to Baumol, there are three main contributions of economic theory to business
economics.
1. Building analytical models, which help to recognize the structure of managerial problems,
eliminate the minor details that might obstruct decision making, and help to concentrate on
the main issue

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2. Economic theory comprises a founding pillar of business analysis- a set of analytical


methods, which may not be applied directly to specific business problems, but they do
enhance the analytical capabilities of the business analyst.
3. Economic theories offer clarity to the various concepts used in business analysis, which
enables the manager to swerve from conceptual pitfalls.
Therefore, a working knowledge of economics, not necessarily a formal degree is essential for
managers.

Application of Economics to Business Decision Making


Business decision-making is essentially a process of selecting the best out of alternative
opportunities open to the firm.
The process of decision making comprises four main phases
a) Determining and defining the objectives to be achieved
b) Collection and analysis of business related data and information regarding social,
political and technological environment
c) Inventing, developing and analysing possible courses of action
d) Selecting a particular course of action from the available alternatives
For instance, suppose a firm plans to launch a new product for which close substitutes are
available in the market. One method of deciding whether or not to launch the product is to
obtain the services of business consultants or to seek expert opinion. If the matter has to be
decided by the managers of the firm themselves, the two areas which they will need to
investigate and analyse thoroughly are:
a) Production related issues, and
b) Sales prospects and problems.
It is in this area of decision making that economic theories and tools of economic analysis
contribute a great deal.
Application of relevant economic theories to the problem of business facilitates decisionmaking in the following ways.
First, it gives a clear understanding of various economic concepts used in business analysis
Second, it helps in ascertaining the relevant variables and specifying the relevant data
Third, application of economic theory provides consistency to business analysis and helps in
arriving at the right decisions.

Managerial Economist: Role and Responsibilities


A managerial economist can play a very important role by assisting the management in using
the increasingly specialised skills and sophisticated techniques, required to solve the difficult
problems of successful decision-making and forward planning. In business concerns, the
importance of the managerial economist is therefore recognised a lot today. In advanced
countries like the USA, large companies employ one or more economists. In our country too,
big industrial houses have understood the need for managerial economists. Such business
firms like the Tata, DCM and Hindustan Lever employ economists. A managerial economist
can contribute to decision-making in business in specific terms.
A managerial economist with good knowledge of economic principles is able to obtain and
analyse information necessary for profitable decision making. His main functions are
1. Production scheduling
6. Investment appraisal
2. Sales forecasting
7. Security management analysis
3. Market research
8. Advise on foreign exchange management
4. Economic analysis of competing companies 9. Environmental forecasting.
5. Pricing problems of industries

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The Central Problems of an Economy


Economics is the branch of social science which studies the human wants and their
satisfaction. Human wants are unlimited and resources to satisfy these wants are limited. The
problem of allocating the scarce resources to satisfy the infinite wants is the central economic
problem.
In economics, the term scarcity means that wants are greater than resources. The resources
in an economy refers to the factors of production ie, land, labour, capital and organization.
Since the supply of these factors of production is limited, the goods and services produced by
these resources are also limited. Since the supply of resources and goods and services are
scarce, there arouses the need for choice. The producers have to decide how factors of
production shall be employed and the consumers have to decide which of their wants are to
be satisfied.
Since there is the problem of scarcity of productive resources in every economy, it has to take
certain basic decisions regarding the production and distribution of goods and services in the
economy. These decision making process is otherwise called as the central problems of an
economy.
The central problems faced by any country are the following.
1. What to Produce? What to produce refers to what goods and services and in how much
quantities are to be produced by the economy. The millions of people living in a country
require many goods and services. But due to the scarcity of resources, the economy is not
capable of producing all these goods and services. Increase in the production of one
commodity will limits the production of other commodities.
2. How to Produce? How to produce refers to the method/technique of production.
Techniques /methods/choice of production
There are mainly two methods used in production;
a) Labour intensive method and
b) Capital intensive method.
Method of production in which more labour and less capital are used is called labour intensive
method and method of production in which more capital and less labour are used is called
capital intensive method. Labour intensive method is suitable for developing countries and
capital intensive method is suitable for developed countries.
E.g.; Cloth can be produced on hand looms or power looms. If hand looms are used, relatively
more labour and less capital is employed. In the case of power looms, more capital and less
labour is required.
3. For whom to Produce? For whom to produce refers how the total output is divided among
consumers. Since goods and services produced are limited, all wants of the people cannot be
satisfied by a country.
4. How to achieve Economic Growth? The attainment of rapid economic growth is another
basic economic problem. Economic growth refers to an increase in the real per capita income
of a country. Rapid economic growth can be attained by fuller utilization of the available
resources.
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