Managerial Economics 2

CONCEPTSCONCEPTS

The FirmThe Firm

Controlled by Entrepreneur – who decidesControlled by Entrepreneur – who decides

What to produce?What to produce?

Where to produce?Where to produce?

How to produce?How to produce?

How much to produce?How much to produce?

Whom to sell?Whom to sell?

At what price?At what price?

Risk taking earns profit as Risk taking earns profit as rewardsrewards

The firm organises all factors of productionThe firm organises all factors of production Plant (Place of production)Plant (Place of production) Labour – pays wages for servicesLabour – pays wages for services Own funds – borroed funds (pays interest)Own funds – borroed funds (pays interest) Manages the entire operation includingManages the entire operation including Stocking, distribution, selling andStocking, distribution, selling and

recovery of sales proceeds.recovery of sales proceeds.

Firm and IndustryFirm and Industry Firm is an individual productive unit.Firm is an individual productive unit. Industry is a set of all such firms engaged Industry is a set of all such firms engaged

in identical productive activity.in identical productive activity. Homogenours products – steel, cement.Homogenours products – steel, cement. Same type of products – textile cloth.Same type of products – textile cloth. Common raw materials – clay used for Common raw materials – clay used for

pottery, crockery.pottery, crockery. Similar processes : engineering, transport.Similar processes : engineering, transport. Similar trade and services: banking – Similar trade and services: banking –

public, private, cooperative.public, private, cooperative.

PlantPlant

A Plant is a Technical Unit to be used in a broad A Plant is a Technical Unit to be used in a broad sense to include Farms, Offices, Shops, sense to include Farms, Offices, Shops, Stores, Warehouses, Workshops, Factories, Stores, Warehouses, Workshops, Factories, etc.etc.

A Plant enjoys autonomy within the broad A Plant enjoys autonomy within the broad framework laid down by the firm, and tkes framework laid down by the firm, and tkes decisions on technical aspects.decisions on technical aspects.

A Plant is a body of persons who work to A Plant is a body of persons who work to specified timings and at a given place.specified timings and at a given place.

A Plant is controlled by a single firm.A Plant is controlled by a single firm.A Plant produces products having similar A Plant produces products having similar

technology. technology.

FirmFirm

A firm can own more than one plant.A firm can own more than one plant. Has unified control over all plants.Has unified control over all plants. The firm organises resources and organizes The firm organises resources and organizes

their efficient use.their efficient use. A firm can be subsidiary of another firm.A firm can be subsidiary of another firm. A firm is a separate legal entity – can sue A firm is a separate legal entity – can sue

and be sued, whereas the plant is not.and be sued, whereas the plant is not. Lon-term motive of the firm is to produce for Lon-term motive of the firm is to produce for

profits, while in the short-run it may be to profits, while in the short-run it may be to maximise sales, corner market, have steady maximise sales, corner market, have steady income, business reputation, prestige etc.income, business reputation, prestige etc.

IndustryIndustry

An industry is a group of firms. There has An industry is a group of firms. There has to be some common factor among all the to be some common factor among all the firms that make up the industry.firms that make up the industry.

Supply side : raw material usedSupply side : raw material used production techniqueproduction technique Demand Side : Similarity among the Demand Side : Similarity among the

products produced. products produced. All the firms producing All the firms producing

substitute products can be substitute products can be grouped under one grouped under one industry.industry.

Economic ConceptsEconomic Concepts

1.Opportunity Cost1.Opportunity Cost

2. Equi-marginal principle2. Equi-marginal principle

3. Incremental principle3. Incremental principle

4. Time perspective; and 4. Time perspective; and

5. Discounting Principle5. Discounting Principle

Opportunity CostOpportunity Cost

When own capital is invested, the interest the When own capital is invested, the interest the entrepreneur would have earned had he entrepreneur would have earned had he invested elsewhere is to be taken into account.invested elsewhere is to be taken into account.

Similarly, time and effort devoted in organising the Similarly, time and effort devoted in organising the businesss will have to be valued.businesss will have to be valued.

If the business does not produce adequate profits If the business does not produce adequate profits in the long run compared to the sacrifice made, in the long run compared to the sacrifice made, he will have to take a decision to shut down or he will have to take a decision to shut down or reorganize the business for better profits.reorganize the business for better profits.

Equimarginal principleEquimarginal principle

This is very significant in resource This is very significant in resource allocation. allocation.

Resources are allocated in such a way Resources are allocated in such a way that optimum efficiency is reached. that optimum efficiency is reached.

This can be done by ensuring that the This can be done by ensuring that the Value of Marginal Product is the same Value of Marginal Product is the same in all the activities of the firm.in all the activities of the firm.

Incremental ConceptIncremental Concept

Incremental Revenue should be more Incremental Revenue should be more than incremental cost.than incremental cost.

This formula should be applied to This formula should be applied to alternative decisions.alternative decisions.

Time PerspectiveTime Perspective

The really important problem in The really important problem in decision making is to maintain the decision making is to maintain the right balance between long-run, right balance between long-run, short-run and intermediate-run short-run and intermediate-run perspectives.perspectives.

Discounting PrincipleDiscounting Principle

In this principle, the present gain is valued In this principle, the present gain is valued more than future gain.more than future gain.

If V = present value, A = annuity or returns If V = present value, A = annuity or returns expected during a year, I = current rate expected during a year, I = current rate of interest, applying the formulaof interest, applying the formula

V = V = A = A = 110 110 = = 100100 (1 + i ) 1+0.1(1 + i ) 1+0.1

Thus for comparison only Rs.100 is to be Thus for comparison only Rs.100 is to be taken not 110.taken not 110.

The scientific approach ofThe scientific approach ofBuilding an Economic ModelBuilding an Economic Model

1. Defining the Problem1. Defining the Problem 2. Formulation of Hypothesis2. Formulation of Hypothesis 3. Abstraction/Model Building3. Abstraction/Model Building 4. Data Collection4. Data Collection 5. Testing the Hypothesis5. Testing the Hypothesis 6. Deduction6. Deduction 7. Evaluating the Test Result7. Evaluating the Test Result 8. Conclusion8. Conclusion

Defining the problemDefining the problem

A. statement of the problem to be A. statement of the problem to be solved.solved.

B. Define correctly the problem by B. Define correctly the problem by framing appropriate questions.framing appropriate questions.

C. Arrive at the nature, course and C. Arrive at the nature, course and direction of the business research to direction of the business research to be undertaken.be undertaken.

Formulation of HypothesisFormulation of Hypothesis

Hypothesis is a tentative untested Hypothesis is a tentative untested behaviour or assumption about the course behaviour or assumption about the course of behavioural tendency and to discover of behavioural tendency and to discover the cause and effect relationships.the cause and effect relationships.

In managerial economics, hypotheses are In managerial economics, hypotheses are formed to identify pattern of economic formed to identify pattern of economic behaviour and discover business variables’behaviour and discover business variables’relationship in order to test the proposition relationship in order to test the proposition and arrive at a decision.and arrive at a decision.

Abstraction /Model BuildingAbstraction /Model Building

Choose and select only relevant Choose and select only relevant information.information.

Assumptions and identificatioins are Assumptions and identificatioins are utilised to simplify and highlight essential utilised to simplify and highlight essential features of the events.features of the events.

Based on scientific enquiry, out of many Based on scientific enquiry, out of many choices only few or even one is chosen.choices only few or even one is chosen.

In cause effect relationship, all other In cause effect relationship, all other factors which are unimportant for our factors which are unimportant for our study, are assumed to be constant.study, are assumed to be constant.

The abstract should represent the real The abstract should represent the real world phenomena.world phenomena.

Data CollectionData Collection

Relevant data have to be collected Relevant data have to be collected as per the model specifications of the as per the model specifications of the variables such as price, demand, variables such as price, demand, sales, advertising expenditure &c.sales, advertising expenditure &c.

These data may be a) time series These data may be a) time series data b)Cross sectional data or c) data b)Cross sectional data or c) Pooled data.Pooled data.

Testing the hypothesisTesting the hypothesis

Hypothesis is to be tested with the help of Hypothesis is to be tested with the help of data collected by adopting the following data collected by adopting the following major steps:major steps:

1. We first set up a hypothesis or assumption. 1. We first set up a hypothesis or assumption. Formulation of null hypothesis – HoFormulation of null hypothesis – Ho

2. Specify, alternates, H1, H2.2. Specify, alternates, H1, H2. 3. Accept Ho - null hypothesis if it is true 3. Accept Ho - null hypothesis if it is true

based on evidence (supporting data).based on evidence (supporting data). 4. Reject Ho – if not supported by evidence.4. Reject Ho – if not supported by evidence.

DeductionDeduction

Assuming that the hypothesis is accepted as Assuming that the hypothesis is accepted as it, not only, indicates cause effect it, not only, indicates cause effect relationship, but also serves as the basis of relationship, but also serves as the basis of predictions.predictions.

Predictions, forecasts are obtained by Predictions, forecasts are obtained by deductive reasoning.deductive reasoning.

Example: Increase in ad. Expenditure, Example: Increase in ad. Expenditure, resulted in improved sales. It is deduced that resulted in improved sales. It is deduced that the firm can increase expenditure on the firm can increase expenditure on advertisements.advertisements.

Evaluating the Test ResultEvaluating the Test Result

When real world events confirm a When real world events confirm a hypothesis, it is accepted. Acceptance is hypothesis, it is accepted. Acceptance is not proving. It needs to be tested, to find not proving. It needs to be tested, to find out whether the predictions are correct.out whether the predictions are correct.

If observed facts contradict the If observed facts contradict the predictions, the hypothesis is rejected.predictions, the hypothesis is rejected.

But But if it successfully survives a number of if it successfully survives a number of tests, it is accepted as a theory.tests, it is accepted as a theory.

ConclusionConclusion

An accepted hypothesis can form the An accepted hypothesis can form the basis for decision making.basis for decision making.

Interpretation and arriving at Interpretation and arriving at inferences from empirical resultsinferences from empirical results for for taking decision about the future taking decision about the future course of action, will call for course of action, will call for the skill the skill of the manager.of the manager.

Empirical = Based on observation of Empirical = Based on observation of facts and experiments and not based facts and experiments and not based on theory.on theory.

Basic assumptions in Economic Basic assumptions in Economic ModelsModels

1. Ceteris Paribus assumption1. Ceteris Paribus assumption 2. Psychological assumption about rational 2. Psychological assumption about rational

behaviour of man.behaviour of man. 3. Structural assumptions such as all land is not 3. Structural assumptions such as all land is not

tillable or production cannot be doubled by tillable or production cannot be doubled by doubling the working hours of the worker.doubling the working hours of the worker.

4. Institutional Assumptions:4. Institutional Assumptions: Capitalist economic system – free market Capitalist economic system – free market

economy.economy. Socialistic system – Govt. control on economic Socialistic system – Govt. control on economic

resources.resources. Mixed economy – Strategic role of Public sector and Mixed economy – Strategic role of Public sector and

relative scope of private sector.relative scope of private sector.

Equilibrium in Economic Equilibrium in Economic analysisanalysis

Equilibrium implies absence of Equilibrium implies absence of change in the behavioural change in the behavioural movement.movement.

Equilibrium is the best possible stage Equilibrium is the best possible stage under existing circumstances, and under existing circumstances, and there is no need for change, so long there is no need for change, so long as circumstances remain the same.as circumstances remain the same.

Partial EquilibriumPartial Equilibrium

Partial equilibrium is based on only Partial equilibrium is based on only restricted range of data – equilibrium restricted range of data – equilibrium price of a single commodity, price of a single commodity, assuming all other things to be assuming all other things to be equal.equal.

Major advantages of Partial Major advantages of Partial EquilibriumEquilibrium

1.1. It is simple.It is simple.2.2. It is useful for prediction purposes.It is useful for prediction purposes.3.3. It can be applied to solve micro-economic It can be applied to solve micro-economic

problems.problems.4.4. It is a stepping stone to analyse general It is a stepping stone to analyse general

equilibrium of the economy.equilibrium of the economy.5.5. It is useful in reviewing market mechanism in a It is useful in reviewing market mechanism in a

free enterprise economy.free enterprise economy.6.6. It is useful to understand rational human It is useful to understand rational human

behaviour for maximising satisfaction.behaviour for maximising satisfaction.7.7. It analyses firm’s profit maximisation behaviour.It analyses firm’s profit maximisation behaviour.

Limitations of Partial equilibrium Limitations of Partial equilibrium analysis:analysis:

1. It can deal with one economic entity only.1. It can deal with one economic entity only. 2. It is not applicable for the entire economy.2. It is not applicable for the entire economy. 3. It is based on ceteris paribus.3. It is based on ceteris paribus. 4. Its unrealistic assumptions, makes it 4. Its unrealistic assumptions, makes it

unsuitable for application to world unsuitable for application to world phenomenon.phenomenon.

5. Its analysis is incomplete as only primary 5. Its analysis is incomplete as only primary and not secondary effects are studied.and not secondary effects are studied.

6. Its segregation of individual behaviour 6. Its segregation of individual behaviour from the rest of the economy is unrealistic.from the rest of the economy is unrealistic.

General EquilibriumGeneral Equilibrium

An economy is in general equilibrium when all An economy is in general equilibrium when all consumers, all firms, all factors of production, all consumers, all firms, all factors of production, all industries, all markets are in equilibrium industries, all markets are in equilibrium simultaneously.simultaneously.

Two sets of conditions are to be fulfilled to attain Two sets of conditions are to be fulfilled to attain general equilibrium:-general equilibrium:-

1. A subjective condition : Each individual economic 1. A subjective condition : Each individual economic entity is attaining its maximisation goals.entity is attaining its maximisation goals.

2. An Objective condition: Each market (commodity 2. An Objective condition: Each market (commodity as well as factor) is in equilibrium with demand as well as factor) is in equilibrium with demand equal to supply.equal to supply.

Usefulness of General Equilibrium Usefulness of General Equilibrium analysis:analysis:

1.1. It explains the structure, mechanism and operating It explains the structure, mechanism and operating forces and working of the entire economic system.forces and working of the entire economic system.

2.2. It analysses inter-sectoral changes and their It analysses inter-sectoral changes and their impact.impact.

3.3. It explains the complexities of commodity and It explains the complexities of commodity and factor markets and their inter-relationship.factor markets and their inter-relationship.

4.4. It examines functions of prices and price structure It examines functions of prices and price structure in the economy.in the economy.

5.5. It is useful in planning process by providing It is useful in planning process by providing conceptual basis for input-output analysis.conceptual basis for input-output analysis.

6.6. It is useful in public poilicy formulation.It is useful in public poilicy formulation.7.7. It is used in modern welfare economics and It is used in modern welfare economics and

monetary theory.monetary theory.

Limitations of General Equilibrium Limitations of General Equilibrium analysis.analysis.

1. It is essentially static in its 1. It is essentially static in its approach.approach.

2. It is unrealistic in its assumptions 2. It is unrealistic in its assumptions such as perfect competition.such as perfect competition.

3. It analysis is complicated involving 3. It analysis is complicated involving series of simultaneous equations.series of simultaneous equations.

4. It ignores leads and lags and 4. It ignores leads and lags and considers only instant happenings, considers only instant happenings, which is not realistic.which is not realistic.