BUSINESS ECONOMICS. (Common to All Branches) As per New Syllabus of Leading Universities AIR WALK PUBLICATIONS

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1 BUSINESS ECONOMICS (Common to All Branches) As per New Syllabus of Leading Universities Mrs. Parameshwari Ramachandran, B.Com., M.B.A Dr. Bhuvaneswari Gowthaman, M.B.A., Ph.D., Professor & Research Head, Ms. Y. Aysha Fathima, M.B.A Assistant Professor Faculty of Administration, Sathyabama University, Chennai AIR WALK PUBLICATIONS (Near All India Radio) 80, Karneeshwarar Koil Street Mylapore, Chennai Ph.: , aishram2006@gmail.com, airwalk800@gmail.com

2 First Edition: June 2016 ISBN: ISBN :

3 BUSINESS ECONOMICS Course Plan Unit I II Topics Hours Percentage Allotted Marks Nature of Economics 6 15% Definitions of Economics and their limitations, Economic Problems (2 Hrs.), Economic Systems, meaning of Business or Managerial Economics (2 Hrs.) and its role and relevance in managerial decision making in an industrial setting (2 Hrs). Demand and Supply Analysis 6 15% Demand Curve, Demand function (2 Hrs.), Elasticity of demand and its estimation (2 Hrs.), Supply curve, equilibrium price and price mechanism (2 Hrs). FIRST INTERNAL EXAM III Production Economics Economies of Scale and Diseconomies of Scale (1 Hr.), Production and Cost Functions. Factors of Production (2 Hrs.), Law of Diminishing marginal Productivity. Construction and analysis of Break Even Charts (3 Hrs.) 6 15%

4 IV V VI Market Structure and Price-Output Decisions Price and output determination under Perfect Competition, Monopoly and Monopolistic Competition (3 Hrs.). Collusion and Cartel, Nash Equilibrium (3 Hrs.). 6 15% SECOND INTERNAL EXAM Money, National Income and 9 20% Taxation Money, Emerging Bit Coin concept, Quantity Theory of Money, Interest Rate Management (2 Hrs), Open Market Operations by RBI, Selective Credit Controls, SLR, CRR (2 Hrs), Definition & Measurement of National Income, methods, sectors of economy (3 Hrs), inflation, deflation, trade cycles- Value- Added Tax (2 Hrs). Investment Decisions and 9 20% Balance Sheet Analysis Capital Budgeting, Investment Analysis NPV, IRR, Profitability Index, ARR, Payback Period (3 Hrs), Depreciation, Time value of money. Business Forecasting Elementary techniques (2 Hrs). Balance sheet preparation principles and interpretation (4 Hrs) END SEMESTER EXAM

5 Contents 1 Contents 1. Nature of Economics 1.1 Introduction Definition of Economics Uses of economy Macro economics and Micro economics Importance of Economics Positive Economics Normative Economics Economics limitations Economic Growth Factors of economic growth The Role of Natural Resources Human Capital Investment in Capital Goods The Role of Entrepreneurship Economic Problems Problem of allocation of resources The problem of all economic efficiency The problem of full-employment of resources The problem of economic growth Economic Systems Planned Economies Market Economies Mixed Economy Business Economics (or) Managerial Economics Definition of Business Or Managerial Economics Nature of Managerial Economics

6 2 Business Economics Scope of Managerial Economics Role of Managerial Economics in Business Development Business Economics Decision Making in An Industrial Setting (i) Production Decisions (ii) Inventory Decision (iii) Cost Decisions (iv) Marketing Decisions (v) Investment Decision (vi) Personnel Decision Case Study Plant Location Plant locational decisions Economic Optimisation Technical Efficiency Economic Efficiency Determinants of Economic efficiency External forces affecting economic efficiency How to measure Technical efficiency How to measure economic efficiency Efficiency and Decision - Making Process Demand and Supply Analysis 2.1 Introduction Meaning of Demand Demand Curve Characteristics of Law of Demand Elasticity of Demand Types of Elasticity of Demand Income Elasticity Types of Income elasticity

7 Contents Cross Elasticity of Demand (e c ) Advertisement and demand - Functions of Advertisement Uses of Price elasticity of demand Factors determining the Price Elasticity of Demand (or) Factors influencing demand Demand Forecasting Types of demand forecasting Forecasting methods Demand forecasting for new products Criteria for a Good Forecasting method Supply Supply Schedule Law of supply Supply Curve Determinants of Supply or Factors influencing supply Elasticity of Supply Production Economics 3.1 Economies of Scale Internal Economies of Scale Types of Internal Economies of Scale External Economies of Scale Diseconomies of Scale Production Analysis Production Function Cost And Supply Analysis Actual cost Opportunity Cost Incremental Costs (or) Differential Costs.. 3.9

8 4 Business Economics Sunk cost Marginal Cost Average Cost: (AC) or Unit cost Fixed Cost And Variable Cost Fixed Costs Variable cost Semi-Variable Cost Short - run costs Long-run costs Shut down cost Abandonment Cost Cost - Output Relationship The cost-output relationship in Short-run Average fixed cost (AFC) and output Average variable cost (AVC) and output: Average total cost (AC) and output Average total cost (AC) Advantages of LAC Curves Cost Functions Factors of Production The Law of Diminishing Marginal Productivity Break Even Analysis (BEA) Significance of BEA Concept of Break Even Point Construction And Analysis of Break Even Charts Graphical Method Analytical method Contribution: (S-V) Profit volume ratio (or) Simply P/V ratio Applications of Break Even Analysis Limitations

9 Contents 5 4. Market Structure and Price-output Decisions 4.1 Price And Output Determination Price Price fixation Factors influencing price fixation Pricing Policy (Price Mechanism) Objectives of pricing policy Factors influencing Pricing Policies Competition Types of Competition Perfect Competition Imperfect Competition Different types of competition in tabular form Difference between Monopoly and Perfect Competition Difference between Monopoly and Monopolistic competition Difference between Perfect and Monopolistic competition Price And Output Determination Under Perfect Competition Equilibrium price Pricing policy (Price mechanism) under monopoly Pricing policy (Price mechanism) under Oligopoly competition Pricing policy (Price mechanism) under Monopolistic Competition Other Factors Influencing Pricing Policies Pricing Methods Cost plus pricing (or) Full cost pricing:

10 6 Business Economics 2. Marginal cost pricing Going - rate pricing Customary pricing Mark-up Pricing and Mark down pricing Cartel Vs Collusion Cartel Collusion The difference Between a Cartel and Collusion Game Theory The Prisoner s Dilemma The Nash Equilibrium Money, National Income and Taxation 5.1 Money Properties or Characteristics of Money Origins of Money Functions of Money Money supply High powered money Types of Banks Emerging Bit Coin Concept Quantitative Theory of Money Instruments of Monetary Policy Interest Rate Management Open Market Operations by RBI Variable reserve ratio Statutory Liquidity Ratio (SLR) Selective Credit Control Electronic Money ecash National Income

11 Contents Uses of measuring National Income (or) Uses of Gross National product Definition of GNP Measurement of National Income and Product Accounts Problems in Estimating National Income Inflation Consumer Price Index CPI Three levels of inflation Effects of inflation Causes of Inflation Control of Inflation Different Types of Inflation Deflation Disinflation Trade Cycle Introduction Definition Features of Trade Cycle Phases of Trade Cycles Causes of Business Cycle Types of Trade Cycle Value Added Tax Definition Features of Value Added Tax in India Need for VAT Advantages of Value Added Tax (VAT) Disadvantages of Value Added Tax (VAT) Principles Governing Value Added Tax Calculation of VAT Differentiation between Sales Tax And VAT 5.68

12 8 Business Economics VAT Implementation in Various State of India Investment Decisions and Balance Sheet Analysis 6.1 Capital Budgeting Importance of Capital Budgeting Factors (criteria) influencing capital expenditure decisions Investment Analysis The Nature and Types of Investment Decisions Operating Cost Methods of Project Evaluation Payback Period Accouting or average rate of return (arr) method Discounted cash flow-techniques Net Present Value (NPV) method Profitability Index (PI) Internal Rate of Return (IRR) Method Compare and Contrast NPV and IRR methods Time Value of Money Depreciation Business Forecasting Techniques of Forecasting Accounting Basic Accounting Terms Balance Sheet

13 Chapter 1 NATURE OF ECONOMICS Nature of Economics Definitions of Economics and their limitations, Economic Problems, Economic Systems, meaning of Business or Managerial Economics and its role and relevance in managerial decision making in an industrial setting 1.1 INTRODUCTION Economics is the science, which studies human behaviour when he is struggling to satisfy his needs by using available sources. Economic problem arises when there is a scarcity of sources. Then the people try to use the alternative sources to satisfy their needs. Normally, the income of a person is limited but his desire is unlimited. He earns Rs 20,000 per month, but he wants to buy a car of cost Rs 4,00,000/-. In this situation, he has to adopt some criterion to fulfill his desire from his limited income. He can utilize an attractive car loan scheme or he can borrow money from somebody. Similarly, for an Engineer (Engineering economist) who wants to be an Entrepreneur, the resources like land, raw materials, labour, capital etc., are scarce. To overcome this difficulty, he has to take decisions about production, marketing and distribution. The following are the important issues on which the engineer (engineering economist) has to take decisions. 1. What commodities should be produced? 2. What is the quantity of production or output level? 3. What is the technology to be adopted?

14 1.2 Business Economics Where should the goods be produced? 5. What should be the size of the factory? 6. What price should he charge? 7. What wages he should pay? 8. How much should he allot for advertisement? 9. How much should he borrow from the bank? 10. What is his own investment? 1.2 DEFINITION OF ECONOMICS 1. Economics is the study of activities involved in the production and exchange of goods. 2. Economics analyses the trends in prices, output and unemployment. 3. Economics studies how people choose to use scarce or limited productive resources like land, labour, equipment and technical knowledge to produce various goods and to distribute these goods to various members of the society for their consumption. 4. Economics is the study of money, banking capital and wealth. 5. Economics helps to know why nations export some goods and import others and analyses the effects of putting economic barriers at national level. By seeing all different types of definitions, we can conclude as follows. Economics is the study of how the people use scarce resources to produce valuable commodities and distribute them among different groups.

15 Nature of Economics Uses of economy 1. Economics knowledge serves us in managing our personal lives. 2. It makes us understand the society. 3. It gives the design of better economic policies. 4. Learning about the stock market and interest rates may help people manage their own finances better. 5. Knowledge about price theory and antitrust policy may improve the skill of lawyer. 6. Awareness of determinants of cost and revenue will make the managers take better business decisions. 7. The engineer, doctor, investor and farmer should understand about accounting and regulation to make the highest profit from their business. 8. Some study economics because they hope to make money. 9. Some study economics because of the fact that they will be illiterate if they cannot understand the laws of supply and demand. 10. Some study economics to learn how budget deficits and inflation will affect their future. Some study economics to pass in examination. 11. As a voter, one should know what are budget deficit, taxes and foreign trade. 12. As a head of a family, one should know economics to decide how much to spend and how much to save. 13. Economics is used to solve business problems and household problems. 14. It helps us understand the causes of poverty. 15. It uses to understand the essential national issues.

16 1.4 Business Economics Macro economics and Micro economics Macroeconomics studies the functioning of the economy as a whole. It analyses the following: 1. Determination of national income and output. 2. Overall inflation 3. Unemployment rates 4. Total money supply 5. Investigating why some nations flourish while others stagnate. Microeconomics analyses the behaviour of individual components like industries, firms and household. It analyses the following. 1. How individual prices are set? 2. Behaviour of labour union. 3. Taxes on people, work and its effects. 4. Savings. 5. Investigating why some people are fabulously rich while others are begging in street Importance of Economics 1. If you want to buy a car, you should know which car would give more kilometers per litre of fuel. People buy a small Car as it is economical. When you want to buy a motorbike, you will go for Hero Honda since it is giving 90 km/litre of petrol. Even though Yamaha engine is very good, middle class people buy only Hero Honda for economical mileage. 2. When you search a house for rent, you will not select the house in the main bazaar. Because, you have to give more rent for a house located in main business

17 Nature of Economics 1.5 area. So you should know the economical condition of the street in which you find house for rent. 3. When you go for foreign countries, you will not go to Africa or Malaysia or Pakistan or Srilanka. Because our country is economically better than the above countries. You would normally go to U.S or Dubai for earning money. People go for these countries to earn much and become economically sound. Therefore, it is essential to know the economical conditions of the country. 4. When you are giving loan to someone, you should know the economical condition of the person to whom you give loan. If you give loan to everyone randomly, oneday, you will come to a position to ask loan from others. Bank gives loan to customers by knowing their economical conditions, ie whether they have the capabality to repay or not. 5. Person earning Rs 30,000/- per month, will be given Bank loan of Rs 9,00,000/- (ie 30 times of his salary) for constructing house. In this case, the person will repay (principal + interest) Rs 10,000/- per month towards house loan and remaining Rs 20,000/-will be used for monthly expenditure including food and clothes. For Bank and other similar Govt. Sectors, knowing the economical conditions of the customers is very much important Positive Economics It describes facts and behaviour in economy as follows: 1. What percent of teenagers are unemployed? 2. How many people earn less than 12,000/- per month?

18 1.6 Business Economics 3. What will be the effect of higher cigarette taxes on the number of smokers? Normative Economics It involves ethics and value judgements. 1. Should the government introduce free noon meal scheme for poor children studying in corporation school? 2. Should the government companies (or) private sector provide extra jobs for unemployed teenagers? 3. Should the budget deficit be reduced by higher taxes or lower spending? 4. How to help poor people? 5. How to prevent inflation? 6. How much the nation should spend for defense? The above questions should be answered by politicians with economic knowledge. That is why Economists are counselors to presidents and prime ministers Economics limitations Economics is a social science that examines how people produce, distribute, and consume goods and services. 1. Economics is based on human behavior, which is irrational and unpredictable. Hence it is difficult to predict market performance accurately. 2. It is not easy to conclude how certain policies will affect different sectors and economies. 3. There are many variables influencing the market conditions. It is impossible to recreate all market conditions or be certain of predictions based on how markets have behaved in the past under similar circumstances. The markets are simply too large, too

19 Nature of Economics 1.7 intertwined and too influenced by human behavior which is dependent on many variables. 4. Economics involves recommendations about how things should be and what types of policies the government should implement in order to improve the economy. Different economists derive completely different conclusions about what kind of regulations and controls should be applied to various markets and exactly what outcomes will result. While they can use data and other facts to support their arguments, they is no guarantee that they are right. 5. The field of economics cannot provide concrete conclusions, it is susceptible to criticism from a variety of sources. Politicians often use economics to argue for certain policy changes that support their own agendas. They present their beliefs and hypotheses to the public as irrefutable facts when, in actuality, there is no way to verify the validity of their ideas except to put them into practice and evaluate the results. 1.3 ECONOMIC GROWTH If productive capacity grows, an economy can produce progressively more goods, which raises the standard of living. The increase in productive capacity of an economy is called economic growth. There are various factors affecting economic growth. How is Economic Growth Measured? Economic growth in a country is measured by the country s Gross Domestic Product (GDP) in one year

20 1.8 Business Economics GDP = the total amount of final goods and services produced in one year within a country Gross Domestic Product - GDP is the total value of all the goods and services produced in that country in one year Tells how rich or poor a country is Shows if the country s economy is getting better or worse Raising the GDP of a country can improve the country s standard of living Standard of Living means the quality of life of the people within a country The higher a country s GDP, the better quality of life standard of living increases In order for a country to have an increasing GDP, it must invest in human capital through education & training, and it must produce goods that have value to be sold within the country or exported Factors of economic growth There are four factors that determine a country s Gross Domestic Product for the year: Natural Resources Human Capital Capital Goods Entrepreneurship 1. The Role of Natural Resources Gifts of Nature - Important to countries: Without them, countries must import the resources they need

21 Nature of Economics 1.9 (costly) Countries that have a lot of natural resources are able to use them to produce goods & services cheaper than a country that has to import natural resources If a country has many natural resources, it can also trade them with other countries and make money for the economy 2. Human Capital It is the value that humans bring to the marketplace Nations that invest in the health, education, and training of their people will have a more valuable workforce. Human capital includes education, training, skills, and healthcare of the workers and the value that they bring to the country s economy Examples: computer/reading/writing/math skills, talents in music/sports/acting, ability to follow directions, ability to serve as group leader & cooperate with group members A country s literacy rate impacts human capital the percent of the population over 15 that can read/write. How does Human Capital Influence Economic Growth? Nations that invest in the health, education, & training of their people will have a more valuable workforce that produces more goods & services. People that have training are more likely to contribute to technological advances, which leads to finding better uses of natural resources & producing more goods.

22 1.10 Business Economics 3. Investment in Capital Goods To increase GDP, countries must also invest in capital goods: All of the factories, machines, technologies, buildings, and property needed by businesses to operate Examples: tools, equipment, factories, technology, computers, machinery, etc. The more capital goods a country has, the more goods & services they are able to produce ie the more money they can make! 4. The Role of Entrepreneurship People who take the risk to start and operate a business are called entrepreneurs. These people risk their own money and time because they believe their business ideas will make a profit. Entrepreneurs must organize their businesses well, for them to be successful. They bring together natural, human, and capital resources to produce foods or services to be provided by their businesses. How does Entrepreneurship Influence Economic Growth? Entrepreneurship creates jobs and lessens unemployment Encourages people to take risks, and in doing so, they create better healthcare, education, & welfare programs. The more entrepreneurs a country has, the higher the country s GDP will be.

23 Nature of Economics ECONOMIC PROBLEMS All societies face the economic problem, which is the problem of how to make the best use of limited, or scarce, resources. The economic problem exists because, although the needs and wants of people are endless, the resources available to satisfy needs and wants are limited. Limited Scarce Resources Production Unlimited wants and Needs Fig:1.1 The Economic Problem is to Match Limited Resources to Unlimited Wants and Needs Limited resources Resources are limited in two essential ways: 1. Limited in physical quantity, as in the case of land, which has a finite quantity. 2. Limited in use, as in the case of labour and machinery, which can only be used for one purpose at any one time. Three questions arise from this: What to produce? What and how much will you produce? This question lies with selecting the type of supply and the quantity of the supply, focusing on efficiency. e.g. What should I produce more; laptops or tablets?

24 1.12 Business Economics How to produce? How do you produce this? This question deals with the assets and procedures used while making the product, also focusing on efficiency. e.g. Should I hire more workers, or do I invest in more machinery? For whom to produce? To whom and how will you distribute the goods? and For whom will you produce this for? arises from this question. This question deals with distributing goods that have been produced, focusing on efficiency and equity. e.g. Do I give more dividends to stock holders, or do I increase workers wages? The economic problem can be divided into 4 different parts, which are given below Problem of allocation of resources The problem of allocation of resources arises due to the scarcity of resources, and refers to the question of which wants should be satisfied and which should be left unsatisfied. In other words, we should finalize what to produce and how much to produce. More production of a good implies more resources required for the production of that good, and resources are scarce. These two facts together mean that, if a society decides to increase production of some good, it has to withdraw some resources from the production of other goods. In other words, more production of a desired commodity can be made possible only by reducing the quantity of resources used in the production of other goods.

25 Nature of Economics 1.13 The problem of allocation deals with the question of whether to produce capital goods or consumer goods. If the community decides to produce capital goods, resources must be withdrawn from the production of consumer goods. In the long run, however, investment in capital goods augments the production of consumer goods. Thus, both capital and consumer goods are important. The problem is determining the optimal production ratio between the two The problem of all economic efficiency Resources are scarce and it is important to use them as efficiently as possible. Thus, it is essential to know if the production and distribution of national product made by an economy is maximally efficient. The production becomes efficient only if the productive resources are utilized in such a way that any reallocation does not produce more of one good without reducing the output of any other good. In other words, efficient distribution means that redistributing goods cannot make anyone better off without making someone else worse off. The inefficiencies of production and distribution exist in all types of economies. The welfare of the people can be increased if these inefficiencies are ruled out. Some cost must be incurred to remove these inefficiencies. If the cost of removing these inefficiencies of production and distribution is more than the gain, then it is not worthwhile to remove them The problem of full-employment of resources In view of the scarce resources, the question of whether all available resources are fully utilized is an important one. A community should achieve maximum

26 1.14 Business Economics satisfaction by using the scarce resources in the best possible manner not wasting resources or using them inefficiently. There are two types of employment of resources: Labour-intensive Capital-intensive In capitalist economies, however, available resources are not fully used. In times of depression, many people want to work but can t find employment. It supposes that the scarce resources are not fully utilised in a capitalist economy The problem of economic growth If productive capacity grows, an economy can produce progressively more goods, which raises the standard of living. The increase in productive capacity of an economy is called economic growth. There are various factors affecting economic growth. The problems of economic growth have been discussed by numerous growth models, including the Harrod-Domar model, the neoclassical growth models of Solow and Swan, and the Cambridge growth models of Kaldor and Joan Robinson. This part of economic problem is studied in the economies of development. 1.5 ECONOMIC SYSTEMS Economic systems are the means by which countries and governments distribute resources and trade goods and services. They are used to control the five factors of production, including: labor, capital, entrepreneurs, physical resources and information resources. In everyday terms, these production factors involve the employees and money

27 Nature of Economics 1.15 a company has at its disposal, as well as access to entrepreneurs, the people who want to run companies or start their own businesses. The physical materials and resources needed to run a business, along with the data and knowledge companies use to be successful, are also factors in production. Different economic systems view the use of these factors in different ways Planned Economies A planned economy is one in which the government decides how the factors of production are used. For example, the government determines who owns the businesses, who buys and sells to whom, and who makes the ultimate decisions regarding businesses, including who works for them. Communism is a primary example of a planned economy in that the government makes all business decisions and handles all factors of production. In a communist country, the government decides if you re going to college and chooses your field of study; they can also designate you as a laborer. In this type of economic system, you d have very few free choices Market Economies A market economy is the opposite of a planned economy. In a market economy, people decide on their own how to utilize the factors of production. They can choose from whom they buy, for whom they work, and what businesses they own and operate. If you want to invest your own capital or be an entrepreneur and start your own company, you re free to do so. A market economy, also known as a capitalistic or free market economy, relies on capitalism, free enterprise, and freedom of choice.

28 1.16 Business Economics While the United States has a market economy in that its citizens can usually make their own choices, such as what they do with their resources, some of these choices come with provisions. For example, in the United States, Americans cannot buy certain products, like alcohol and tobacco, unless they are of a certain age. Although citizens of the United States can choose their carriers or providers, they must purchase car insurance and health insurance Mixed Economy In all Western European countries, the balance between state provision (government planning) and free market provision is more or less equal. The government decides the degree of mixing. They will decide how much business activity there will be in the private sector and the public sector. In countries where the government plays an important - major economic role, the social provision will tend to be greater, taxed higher and distribution of wealth and income more equal. (Sweden) Whereas in countries where the private sector plays the most important economic role, social provision is lower with fewer free goods and services, also taxes will be lower and the distribution of wealth and income less equal.(great Briton) Some resources are allocated by the government and the rest by the market system. Most decisions are taken in the market place but the government plays an important role in modifying the functioning market.

29 Nature of Economics BUSINESS ECONOMICS (OR) MANAGERIAL ECONOMICS Managerial economics is a discipline which deals with the application of economic theory to business management. It deals with the use of economic concepts and principles of business decision making. Formerly it was known as Business Economics but the term has now been discarded in favour of Managerial Economics. Managerial Economics may be defined as the study of economic theories, logic and methodology which are generally applied to seek solution to the practical problems of business. Managerial Economics is thus constituted of that part of economic knowledge or economic theories which is used as a tool of analysing business problems for rational business decisions. Managerial Economics is often called as Business Economics or Economics for Firms Definition of Business Or Managerial Economics Business or Managerial Economics is economics applied in decision making. It is a special branch of economics bridging the gap between abstract theory and managerial practice. Haynes, Mote and Paul. Business Economics consists of the use of economic modes of thought to analyse business situations. -McNair and Meriam Business Economics (Managerial Economics) is the integration of economic theory with business practice for the purpose of facilitating decision making and forward planning by management. - Spencer and Seegelman.

30 1.18 Business Economics Managerial economics is concerned with application of economic concepts and economic analysis to the problems of formulating rational managerial decision. Mansfield Nature of Managerial Economics The primary function of management executive in a business organisation is decision making and forward planning. Decision making and forward planning go hand in hand with each other. Decision making means the process of selecting one action from two or more alternative courses of action. Forward planning means establishing plans for the future to carry out the decision so taken. The problem of choice arises because resources at the disposal of a business unit (land, labour, capital, and managerial capacity) are limited and the firm has to make the most profitable use of these resources. The decision making function is that of the business executive, he takes the decision which will ensure the most efficient means of attaining a desired objective, say profit maximisation. After taking the decision about the particular output, pricing, capital, raw-materials and power etc., are prepared. Forward planning and decision-making thus go on at the same time. A business manager s task is made difficult by the uncertainty which surrounds business decision-making. Nobody can predict the future course of business conditions. He prepares the best

31 Nature of Economics 1.19 possible plans for the future depending on past experience and future outlook and yet he has to go on revising his plans in the light of new experience to minimise the failure. Managers are thus engaged in a continuous process of decision-making through an uncertain future and the overall problem confronting them is one of adjusting to uncertainty. In fulfilling the function of decision-making in an uncertainty framework, economic theory can be, pressed into service with considerable advantage as it deals with a number of concepts and principles which can be used to solve or at least throw some light upon the problems of business management. E.g are profit, demand, cost, pricing, production, competition, business cycles, national income, etc. The way economic analysis can be used towards solving business problems, constitutes the subject-matter of Managerial Economics. Thus in brief we can say that Managerial Economics is both a science and an art Scope of Managerial Economics The scope of managerial economics is not yet clearly laid out because it is a developing science. Even then the following fields may be said to generally fall under Managerial Economics: 1. Demand Analysis and Forecasting 2. Cost and Production Analysis 3. Pricing Decisions, Policies and Practices

32 1.20 Business Economics 4. Profit Management 5. Capital Management These divisions of business economics constitute its subject matter. Recently, managerial economists have started making increased use of Operation Research methods like Linear programming, inventory models, Games theory, queuing up theory etc., which have also come to be regarded as part of Managerial Economics. 1. Demand Analysis and Forecasting: A business firm is an economic organisation which is engaged in transforming productive resources into goods that are to be sold in the market. A major part of managerial decision making depends on accurate estimates of demand. A forecast of future sales serves as a guide to management for preparing production schedules and employing resources. It will help management to maintain or strengthen its market position and profit base. Demand analysis also identifies a number of other factors influencing the demand for a product. Demand analysis and forecasting occupies a strategic place in Managerial Economics. 2. Cost and production analysis: A firm s profitability depends much on its cost of production. A wise manager would prepare cost estimates of a range of output, identify the factors causing variations in cost estimates and choose the cost-minimising output level, taking also into consideration the degree of uncertainty in production

33 Nature of Economics 1.21 and cost calculations. Production processes are under the charge of engineers but the business manager is supposed to carry out the production function analysis in order to avoid wastages of materials and time. Sound pricing practices depend much on cost control. The main topics discussed under cost and production analysis are: Cost concepts, cost-output relationships, Economics and Diseconomies of scale and cost control. 3. Pricing decisions, policies and practices: Pricing is a very important area of Managerial Economics. In fact, price is the genesis of the revenue of a firm and as such the success of a business firm largely depends on the correctness of the price decisions taken by it. The important aspects dealt with this area are: Price determination in various market forms, pricing methods, differential pricing, product-line pricing and price forecasting. 4. Profit management: Business firms are generally organized for earning profit and in the long period, it is profit which provides the chief measure of success of a firm. Economics tells us that profits are the reward for uncertainty bearing and risk taking. A successful business manager is one who can form more or less correct estimates of costs and revenues likely to accrue to the firm at different levels of output. The more successful a manager is in reducing uncertainty, the higher are the profits earned by him. In fact, profit-planning and profit

34 1.22 Business Economics measurement constitute the most challenging area of Managerial Economics. 5. Capital management: The problems relating to firm s capital investments are perhaps the most complex and troublesome. Capital management implies planning and control of capital expenditure because it involves a large sum and moreover the problems in disposing the capital assets off are so complex that they require considerable time and labour. The main topics dealt with under capital management are cost of capital, rate of return and selection of projects Role of Managerial Economics in Business Development Decision making is a process and a decision is the product of such a process. Managerial decisions are based on the flow of information. Decision making is both a managerial function and an organisational process. Managerial function is exercised through decision making. The purpose of decision making as well as planning is to direct human behaviour and effort towards a future goal or objective. Once the decision is taken it is implemented within the minimum time and cost. Executives make many types of decisions connected with the business such as production, inventory, cost, marketing, pricing, investment and personnel. In the long-run, application of principles of business decisions will result in successful outcomes. A good decision is one that is based on logic, considers all available data and possible alternatives and applies the quantitative approach.

35 Nature of Economics 1.23 Organisational decisions are those which the executive makes in his personal capacity as a manager. They include the adoption of the strategies, the framing of objectives and the approval of plans. These decisions can be delegated to the organisational members so that decisions could be implemented with their support. These decisions aim at achieving the best interests of the organisation. The basic decisions are those which are more important, they involve long-range commitment and heavy expenditure of funds. A high degree of importance is attached to them. A serious mistake will endanger the company s existence. The selection of a location, selection of a product line, and decision relating to manage the business are all basic decisions. They are considered basic because they affect the whole organisation. 1.7 BUSINESS ECONOMICS DECISION MAKING IN AN INDUSTRIAL SETTING (i) Production Decisions Production is an economic activity which supplies goods and services for sale in a market to satisfy consumer wants, thereby profit maximisation is made possible. The business executive has to make the rational allocation of available resources at his disposal. He may face problems relating to best combination of the factors to gain maximum profit or how to use different machine hours for maximum production advantage, etc. (ii) Inventory Decision Inventory refers to the quantity of goods, raw material or other resources that are idle at any given point of time held by the firm. The decision to hold inventories to meet

36 1.24 Business Economics demand is quite important for a firm and in certain situation the level of inventories serves as a guide to plan production and is therefore, a strategic management variable. Having large inventory of raw materials, intermediate goods and finished goods means blocking of capital. (iii) Cost Decisions The competitive ability of the firm depends upon the ability to produce the commodity at minimum cost. Hence, cost structure, reduction of cost and cost control has come to occupy important places in business decisions. In the absence of cost control, profits would come down due to increasing cost. Business decisions about the future require the businessmen to choose among alternatives, and to do this, it is necessary to know the costs involved. Cost information about the resources is very essential for business decision making. (iv) Marketing Decisions Within market planning, the marketing executive must make decisions on target market, market positioning, product development, pricing channels of distribution, physical distribution, communication and promotion. A businessman has to take mainly two different but interrelated decisions in marketing. They are the sales decision and purchase decision. Sales decision is concerned with how much to produce and sell for maximising profit. The purchase decision is concerned with the objective of acquiring these resources at the lowest possible prices so as to maximise profit. Here

37 Nature of Economics 1.25 the executive s basic skill lies in influencing the level, timing, and composition of demand for a product, service, organisation, place, person or idea. (v) Investment Decision The problems of risks and imperfect foresight are very crucial for the investment decision. In real business situation, there is seldom an investment which does not involve uncertainties. Investment decision covers issues like the decisions regarding the amount of money for capital investment, the source of financing this investment, allocation of this investment among different projects over time. These decisions are of immense significance for ensuring the growth of an enterprise on sound lines. Hence, decisions on investment are to be taken with utmost caution and care by the executive. (vi) Personnel Decision An organisation requires the services of a large number of personnel. These personnel occupy various positions. Each position of the organisation has certain specific contributions to achieve organisational objectives. Personnel decisions cover the areas of manpower planning, recruitment, selection, training and development, performance appraisal, promotion, transfer, etc. Business executives should take personnel decisions as an essential element.

38 1.26 Business Economics 1.7 CASE STUDY Plant Location A Plant is a place, where men, machines, materials, money, equipments etc. are brought together for manufacturing products. Plant location means selection of suitable site, area, place etc., where the plant or factory will start functioning. A good plant location will reduce the cost of production and facilitate the customer to get the products at lesser price. At the same time the entrepreneur will get a good profit. It is not an easy task to select a proper site because if the selection is not proper, the money spent on factory building, equipments and their installation will become waste. Then the entrepreneur will suffer a great loss. Therefore, it is essential to analyse various factors which may provide maximum advantage while starting an industry. Plant location involves two main activities. 1. General location of a plant. 2. Selection of specific site in that region General Location of a plant The following factors must be considered in this activity. They are 1. Nearness to Raw materials 2. Nearness to market 3. Transport facilities 4. Availability of labour 5. Availability of power and fuel 6. Availability of water 7. Climate and Atmospheric conditions 8. Land

39 Nature of Economics Waste disposal 10. Availability of capital 11. Community Attitude 12. Social and Recreational facilities 13. Labour laws and Taxation 14. Existence of Related industries 15. Other factors 1. Nearness to Raw Materials The site is to be selected where plenty of raw materials are available, so that the cost of transportation of raw materials to the site will be minimum. For example, a sugar mill can be started where plenty of sugar-cane is cultivated in nearby agricultural lands. The final product (sugar) can be transported to any place with less cost where as, the transportation cost of the raw meterial (ie sugar cane) is costlier. Similarly, the cement factory is to be located near a quarry where plenty of lime stones are available. A brick industry is to be located where plenty of clay is available and a steel plant is to be located where plenty of iron ore is available. 2. Nearness to Market If a factory is situated near the market, the cost of transportation of the finished goods, the chances of finished products getting damaged will be greatly reduced. Also if a plant is located nearer to the market, it can catch a big share and the service to the customers will be quick and easy. Therefore, it is necessary to locate the factory like food products, fish products, products like glass, dairy plants, ice cream factories etc., nearer to the market.