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Fundamentals concepts of Economics or Basic Economic Concepts There are six major fundamental economic concepts which are

used explicitly or implicitly, consciously or unconsciously, deliberately or otherwise in business decisions. They are: 1. Opportunity Cost and Decision Rule: the concept of opportunity cost is related to the alternative uses of scarce resources. Resources either natural or manmade are scarce. They are scarce in relation to demand for them to satisfy the ever growing human needs. Resources though scarce, have alternative uses. The scarcity and alternative uses of the resources give rise to the concept of opportunity cost. Thus, it refers to sacrificing the next best alternative in order to attain the first best alternative. The above explanation can be supported by the following example: a. If a firm has Rs.100 million at its disposal and the firm finds 3 risk-free alternative uses of fund available to it. They are: i. Expansion of the size of the firm Rs.20milloin ii. Setting up a new production unit Rs.18million iii. Buying shares in another firm Rs.16million b. All the other things being the same the rational decision for the firm would be to invest in the first alternative. This implies that the manager would have to sacrifice the annual return of Rs.18million from the 2nd best alternative. Rs 18millionis called an annual opportunity cost of an annual income of Rs.20million. c. The difference between actual earning and its opportunity cost is called economic gain or economic profit. 2. Marginal Principle and Decision Rule: The concept of marginal value is widely used in economic analysis like consumer analysis, marginal cost in production analysis and marginal revenue in pricing theory. The term marginal refers to change (increase or decrease) in total quantity or value due to one unit change in its determinant. This is mainly utilized when the problem is associated with maximization or minimization of a firms profit, etc. for example: a. The total cost of production of a commodity depends on the number of units produced, for a given factor prices. In this case, marginal cost, MC can be defined as the change in the total cost as a result of producing one additional unit of a commodity. Thus, MC can be worked out as

Marginal cost, MC= TCn - TCn-1


Where, TCn=total cost of producing n units and

TCn-1=total cost of producing n-1 units.


Alternatively, marginal revenue depends on the total number of units at some point of time. So MR can be defined as the change

in TR due to the sale of one additional unit of product. Therefore,

Marginal Revenue= TR n-TRn-1


Where, TRn=total revenue from the sale of n units TRn-1=total revenue from sale the sale of n-1 units. If TC and TR are given in the form of a function then MC and MR can be obtained by taking the first derivative of TC and TR. But these values obtained are different when compared to the value when taken in units instead of functions. Decision Rule: The question before any firm is how much to produce so as to maximize the profit? The quantity produced should be such that MR>MC. The necessary condition for profit maximizing output is that MC must be equal to MR. i.e. profit is maximum when MR=MC. In simple words, the profit of a firm is maximized at that level of output where the cost of producing one additional unit equals the revenue from the sale of that unit of output. MC involves only variable cost. 3. Incremental Principle and Decision Rule: It is similar to the concept of marginal value but, with a difference. Marginal principle can be applied only where MC & MR can be calculated precisely, but it is difficult to estimate MC & MR for the firms as mostly business firms produce and sell their products in bulk and not in terms of units unless it is the case of production and sale of such large unit goods as airplanes, ships, large, buildings, turbines etc. where production and sale activities are carried out on bulk basis and where both fixed & variable costs are subject to change, business managers use the incremental principles in their business decisions. The incremental principle is applied to business decisions which involve bulk production and a large increase in total cost and total revenue. Such an increase in total cost and total revenue is called incremental cost and incremental revenue respectively related to incremental output. a. For example, if a firm decides to increase production by adding a new plant to the existing capacity, then this increases the firms total cost of production from say, Rs100million to Rs. 115million. Then, difference between 100million & 115million is called as incremental cost. IC involves both fixed and variable cost. b. There are three major components in IC, they are i. Present explicit costs: consists both fixed and variable costs ii. Opportunity costs: refers to expected income in foregone from the next best use of the resources involved in the present decision.

iii. Future costs: include depreciation and advertising costs if the product does not sell as well as expected c. On the other hand incremental revenue is the increase in the total revenue resulting from a business decision. 4. Contribution Analysis and Decision Rule: This concept is associated with the concept of incremental cost and incremental revenue. Contribution of a business decision can be defined as a difference between the incremental revenue and the incremental cost associated with that particular decision. It is a useful technique for taking decisions on: a. Whether or not to accept a project b. Whether or not to introduce a new product c. Whether or not to accept a fresh order d. Whether or not to add an additional plant e. Whether to make or buy etc. For the use of contribution analysis for a business decision, it is important to know what the incremental cost is and what the relevant incremental revenue is. It is important to know what is included and what is not included in the incremental cost and incremental revenue. The relevant ICs that are taken into account in the contribution analysis include the following: i. Present explicit costs: i.e. all current expenses. a. Explicit variable costs include: i. Direct labor costs ii. Direct material costs iii. Direct variable overheads b. Fixed costs i. New additional equipment ii. New additional personnel Opportunity costs Future incremental costs

ii. iii.

Irrelevant costs are: Committed costs: which have already been committed by a firm and which cannot be changed w.r.t any business decision. ii. Sunk costs: the costs which have already been made on purchase of assets and non-recoverable advance payments. 5. The Equi-Marginal Principle: This principle was originally associated with consumption theory and the law is called law of equimarginal utility. The law of equimarginal utility principle was over time applied by business managers to allocation of resources between their alternative uses with a view to maximizing the profit in case of a firm carries out more than one business activity. The i.

principle suggests that available resources (i/ps) should be so allocated between the alternative options that the marginal productivity gains from the various activities are equalized. Suppose a firm has a total capital of 100million with it and it wants to allocate the capital b/w 3 alternatives. For example, a firm has a 100millon capital and can allocate them in the following ways: Units of Expenditure (Rs.10million) First Second Third Fourth Fifth Marginal productivity(MP) Project A 501 452 357 2010 10 Project B 403 305 208 10 0 Project C 354 306 209 15 12

Where 1, 2, 3 indicate the order of the unit of expenditure on Projects A, B, & C. The firm has used four units of finance for project A, and three units each projects B & C. that is Rs.40million on project A and Rs. 30million each on projects B and C. this pattern of investment maximizes the firms productivity gains. No other pattern of investment will ensure this objective. The equimarginal principle now suggests that a profit (gain) maximizing firm allocates its resources in a proportion such that

MPA=MPB=MPC=..=MPn
Always the change should be the same for all the projects. 6. Time Perspective In Business Decision: A business decisions are taken with a certain time perspective. The time perspective refers to the duration of time period extending from the relevant past and foreseeable future taken in view while taking a business decision. Relevant past means, it is the period of past experience and trends which are relevant for business decisions with long run implications. All business decisions may not have same perspective, some have short run outcome or pay-off and therefore involve short run perspective. Example: manufacturing of Diwali crackers. There are some other decisions which have long run implication i.e. investment in plant, building, machinery, land, spending on labor welfare activities, expansion of the scale of production, introduction of new product, advertisement, bribing a government officer and investment abroad. The business decision makers must assess and determine the perspective of business propositions well in advance and make decisions accordingly.