Subject Paper No and Title Module No and Title Module Tag 02: Managerial Economics 03: Principles: Individual and Market COM_P2_M3
TABLE OF CONTENTS 1. Learning Outcomes 2. Introduction 3. Principles- Individual and Market 4. Incremental Principle 5. The Discounting Concept 6. Equi-Marginal Principle 7. The Opportunity Cost Concept 8. The Concept of Time Perspective 9. The Concept of Risk and Uncertainty 10. Summary
1. Learning Outcomes After studying this module, you shall be able to Know the importance of rational decision making. Learn the various principles that assist the manager in making a rational and objective decision.
2. Introduction Economic decision-making is one of the most challenging tasks for a firm. The manager, given the constraints of scarce resources and factors operating in economic, political and legal environment has to undertake such decisions. Given the various constraints it is task of the manger to take decisions that can help an organization achieve its objectives effectively and efficiently. In this module we shall be dwelling upon the various principles that assist mangers in rational economic decision making. Managerial Economics is a synthesis of the principles of economics and the practices of management. It involves both concepts and measurement methods. Before we examine the practical aspects of economics from the point of view of management we need to understand the basic principles of managerial economics. Therefore, it would be useful to identify and understand some of the basic concepts underlying the subject. Economic theory provides the basic tools of analysis which can be of great help to a manager in decision making and business planning. While in the real world there may be differences between principles and actual problems solving still it is necessary to understand the principles for realizing where they differ from the real world. Any theory attempts to explain the real world but at the same times it needs to abstract or draw away from reality for having a better, simpler and more elegant solution to the real world economic and business problems. Therefore, it is necessary to examine the basic principles of managerial economics. Through this we can arrive at the nature economic theory of the firm and how it helps in management decision making. The basic principles of managerial economics are: 1. The Incremental Concept 2. The Concept of Time Perspective 3. The Opportunity Cost Concept 4. The Discounting Concept 5. The Equi-marginal Concept 6. Risk and Uncertainty 3. Principles: Individual and Market The individual manager or consumer undertakes certain decisions which relate them to the market. This is done with the help of certain principles. Managerial economic principles do not offer any ready-made solutions to the problems faced by managers in the changing business world. These principles only assist managers in rational reasoning and defined thinking by developing logical ability. The following economic concepts/ principles are fundamental to business analysis and decision-making.
4. Incremental Principle The most fundamental principle in economics is the incremental concept. It is the most frequently used principle in Managerial Economics. This also known as the marginal principle. There are three situations in which the marginal principle is used: 1. Production decision. 2. Consumption decision. 3. Technological decision. 1. Production decision. Incremental concept involves estimating the impact of the decision on the alternatives on costs and revenues of the firm generated as a result of that decision. Incremental cost: Is defined as the change in total cost resulting from a particular decision Incremental revenue: Defined as the change in total revenue resulting from a particular decision. In the production decision two things are compared at the margin: a. Marginal cost the increase in total cost due to a unit increase in production. b. Marginal revenue the increase in the total revenue due to a unit increase in production. Each producer is faced with this decision, that is, how to decide when to increase production and when to decrease. If the optimal plan is not achieved then either the producer may incur a notional loss (less that maximum profit) or he may incur an actual loss. The former happens when marginal revenue is above marginal cost. The latter happens when marginal cost is above marginal revenue. The marginal principle involves a comparison of benefit with cost, at the margin. That is, comparison of incremental revenue with incremental cost. Incremental cost denotes change in total cost, whereas incremental revenue means change in total revenue resulting from a unit increase in production. As each unit of production increases two things happen. The total cost of production increases and simultaneously the total revenue from the sale of production also increases. The former is knows as marginal cost and the latter is known as marginal revenue. The incremental principle may be stated as follows: A decision is clearly a profitable one if at the margin: (i) Upon the increase in production marginal revenue remains constant or falls and marginal cost rises such that marginal revenue remains above marginal cost and total profit rises. (ii) Upon the decrease in production marginal revenue remains constant or rises and marginal cost falls such that marginal cost remains above marginal revenue but total profit rises. (iii) Upon decrease or increase in production total profit falls.
Production can be increased only on the basis incremental reasoning. Incremental reasoning does not mean that the firm should not invariably increase production at all prices. It is the relationship between incremental costs and incremental revenue that determines the course of action to increase or decrease production. Following the marginal principle has the advantage that it does not require a direct calculation of profit at each point or while considering each production plan. The concept is mainly used by the progressive concerns. Even though it is a widely followed concept, it has certain limitations: (a) The concept cannot be generalized because observed behavior of the firm is always variable. (b) The concept can be applied only when there is excess capacity in the concern. (c) The concept is applicable only during the short period. If a firm decides to increase production, then the additional revenue it earns by selling one additional unit of the product will be termed as marginal revenue and the extra cost of producing the additional unit is called marginal cost. Thus when the incremental revenue exceeds incremental cost the decision to produce an additional unit will be regarded as profitable. Thus, the marginal principle helps a producer to decide whether to continue further production or stop. 2. Consumption decision. Similarly, if a consumer wants to decide how much to buy he/she has will receive an additional utility from one additional unit of consumption called marginal utility. The cost of obtaining one such additional unit is the price, which is normally the average revenue (AR). This is usually equal to the marginal revenue (MR) under competitive conditions. Thus, is the marginal utility exceeds price then the consumer is encouraged to consume more of the commodity. On the other hand, is on increasing consumption the marginal utility falls and becomes less that the price or average revenue then the consumer is discouraged from buying more. Only when the Marginal Utility from consuming one additional unit equals the price or AR does the consumer stop increasing consumption. At this point the consumer obtains maximum utility. So there is no advantage in either reducing consumption nor is there any advantage in increasing consumption. This is how the marginal principle helps the consumer. 2. Technological decision. Each producer has to employ different factors of production, like labor and capital. There is a choice that the producer faces. He could either use more of labor and less of capital or the other way round. While employing one more unit of labor there are two outcomes. i) the production increases by a certain amount known as marginal productivity of labor. ii) the cost of employing one more unit of labor is the additional wage. This is known as marginal wage and often is equal to average wage under competitive labor market conditions.
If employment increases the marginal productivity falls and usually the marginal wage rises. As long as the marginal productivity is greater that marginal or average wage it pays for the producer to engage more units of labor. But if the employment goes beyond a limit then the marginal productivity may go below the marginal or average wage and it may lead to a loss to the producer. At the margin a producer would decide to stop employ more of labor as soon as marginal productivity and marginal wage become equal to each other. 5. Discounting Principle It is one of the fundamental principles that state that the worth of a rupee tomorrow will be lesser than it s worth today. Money actually has time value. Thus, one Rupee held today does not have the same value as one Rupee held tomorrow. The household that has generated this saving would like to be compensated for postponing their consumption. This is because they prefer consuming today. Savings are obtained from households by tightening the belt. It pinches the households to forgo consumption today. Therefore, there is a premium on present consumption over future consumption. The discounting principle implies that any future value that obtains from an investment is a long term investment project as cash flow cannot be treated as being equal to the present value. Any investment project needs investment which, in turn is obtained from savings obtained from households. Firms invest and households save. In the anticipation of getting a return on their savings households expect a higher value in the future which shall compensate them for the consumption forgone in the present. Without forgoing consumption savings cannot be generated. The return that households get should at least be sufficient to compensate them for the postponement of consumption. Therefore, the rate at which households prefer present consumption over future consumption is a measure of premium on present consumption. Any future value (cash flow) generated through such investment needs to be adjusted for this premium. This rate is known as the discount rate. Also another important fact is from the point of view of investment. Money received today can be invested to receive greater money in future. An amount to be received at some future date could not be invested until it is received. For instance, Rs.1000 invested today at 10% interest is equivalent to Rs.1100 next year. This phenomenon is known as time value of money. Discounting therefore can be defined as a process used to convert future value into an equivalent present value. That is, the principle states that if a decision affects costs and revenues in the long-run then all such costs and revenues must be discounted to present values, then only a valid comparison of alternatives is feasible. The discount rate is the obverse of the interest rate. Ordinarily we are familiar with the compounding process. FV = PV*(1+r) t where, FV is the future value (time at some future time), PV is the present value (value at time zero),
r is the interest rate; and t is the time between the future value and present value. In this case the present value is lower but it grows over time. Hence, we use interest rate which makes the present value grow over time. But when we consider discounting the opposite happens. A future value needs to be reduced and brought in line with the present value which is lower. Therefore, the relevant economic calculation is that future value (future cash flow) needs to discounted. Thus; PV0 = FVi/(1+r) t FVi = Future cash flow in ith year. PV0 = Present value of future cash flow. This principle equally applies to consumers who have the choice to consume today or not consume today and save for tomorrow. Therefore, there are two rates of discount: (i) investment rate of discount and (ii) the consumption rate of discount. 6. Equi-marginal Principle Marginal utility is defined as the utility derived from the consumption of an additional unit of a commodity. A consumer has unlimited needs and wants, and therefore he consumes/ avails a variety of products/ services. The law of Equi-marginal utility states that, consumer reaches the stage of equilibrium when the marginal utility of various commodities consumed by him are equal. That is an input should be allocated in such a way that the value added by the last unit is the same in all cases. According to the modern economists, the law has been formulated in form of law of proportional marginal utility. It states that the consumer will spend his money-income on different goods and services in such a way that the marginal utility of each good is proportional to its price, i.e., MUx / Px = MUy / Py = MUz / Pz Where, MU represents marginal utility and P is the price of good. If the consumer finds that the utility is greater in case of a particular commodity as compared to the other, than the consumer must realize the fact that an optimum/ equilibrium level has not been achieved.
7. The Opportunity Cost Concept In everyday life, we apply the notion of opportunity cost even if we are unable to articulate its significance. In Managerial Economics, the opportunity cost concept is useful in decision involving a choice between different alternative courses of action. Resources are scarce, we cannot produce all the commodities. For the production of one commodity, we have to forego the production of another commodity. We cannot have everything we want. We are, therefore, forced to make a choice. Opportunity cost of a decision is the sacrifice of alternatives required by that decision. Sacrifice of alternatives is involved when carrying out a decision requires using a resource that is limited in supply with the firm. Opportunity cost, therefore, represents the benefits or revenue forgone by pursuing one course of action rather than another. The concept of opportunity cost implies three things: 1. The calculation of opportunity cost involves the measurement of sacrifices. 2. Sacrifices may be monetary or real. 3. The opportunity cost is termed as the cost of sacrificed alternatives. Opportunity cost is just a notional idea which does not appear in the books of account of the company. If resource has no alternative use, then its opportunity cost is nil. In managerial decision making, the concept of opportunity cost occupies an important place. The economic significance of opportunity cost is as follows: 1. It helps in determining relative prices of different goods. 2. It helps in determining normal remuneration to a factor of production. 3. It helps in proper allocation of factor resources. 8. Concept of Time Perspective The time perspective concept states that the decision maker must give due consideration both to the short run and long run effects of his decisions. He must give due emphasis to the various time periods. It was Marshall who introduced time element in economic theory. The economic concepts of the long run and the short run have become part of everyday language. Managerial economists are also concerned with the short run and long run effects of decisions on revenues as well as costs. The main problem in decision making is to establish the right balance between long run and short run. In the short period, the firm can change its output without changing its size. In the long period, the firm can change its output by changing its size. In the short period, the output of the industry is fixed because the firms cannot change their size of operation and they can vary only variable factors. In the long period, the output of the industry is likely to be more because the firms have enough time to increase their sizes and also use both variable and fixed factors. In the short period, the average cost of a firm may be either more or less than its average revenue. In the long period, the average cost of the firm will be equal to its average revenue. A decision may be made on the basis of short run considerations, but may as time elapses have long run repercussions which make it more or less profitable than it at first appeared.
9. The Concept of Risk and Uncertainty Managerial decisions are actions of today which bear fruits in future which is unforeseen. Future is uncertain and involves risk. The uncertainty is due to unpredictable changes in the business cycle, structure of the economy and government policies. This means that the management must assume the risk of making decisions for their institution in uncertain and unknown economic conditions in the future. Firms may be uncertain about production, market prices, strategies of rivals, etc. Under uncertainty, the consequences of an action are not known immediately for certain. Economic theory generally assumes that the firm has perfect knowledge of its costs and demand relationships and of its environment. Uncertainty is not allowed to affect the decisions. Uncertainty arises because producers simply cannot foresee the dynamic changes in the economy and hence, cost and revenue data of their firms with reasonable accuracy. Also dynamic changes are external to the firm, they are beyond the control of the firm. The result is that the risks from unexpected changes in a firm s cost and revenue data cannot be estimated and therefore the risks from such changes cannot be insured. But products must attempt to predict the future cost and revenue data of their firms and determine the output and price policies. The managerial economists have tried to take account of uncertainty with the help of subjective probability. The probabilistic treatment of uncertainty requires formulation of definite subjective expectations about cost, revenue and the environment. The probabilities of future events are influenced by the time horizon, the risk attitude and the rate of change of the environment. 10. Summary In this module, we have discussed that the most important task of a manager is decision making. A manger is faced by various constraints, and thus it becomes crucial to make decisions that enable a firm to achieve its objectives effectively. In taking such decisions managers rely on certain fundamental principles. These principles guide the manager to make a sound decision. Incremental principle emphasizes that the manager should consider the incremental cost and revenue the firm will incur as a result of that decision. Discounting principle emphasizes the fundamental concept of time value of money, and therefore provides that all the expected cost and revenue that the firm will generate in future, should be discounted in present value, so that a feasible comparison between various alternatives can be made. Similarly, there is a consumption rate of discount that a consumer values on the basis of consumption forgone. The discounting principle implies that any future value that obtains from an investment is a long term investment project as cash flow cannot be treated as being equal to the present value. Any investment project needs investment which, in turn is obtained from savings obtained from households. Firms invest and households save Equi-marginal principle states that the consumer spends the money on the basket of goods and services, and he spends the money on different goods and services in such a way that the marginal utility of each good is proportional to its price.
The concept of Opportunity cost of a decision is the sacrifice of alternatives required by that decision. Sacrifice of alternatives is involved when carrying out a decision requires using a resource that is limited in supply with the firm. Opportunity cost, therefore, represents the benefits or revenue forgone by pursuing one course of action rather than another. The time perspective concept states that the decision maker must give due consideration both to the short run and long run effects of his decisions Managerial economists are also concerned with the short run and long run effects of decisions on revenues as well as costs. The concept of risk & uncertainty implies that the management must assume the risk of making decisions for their institution in uncertain and unknown economic conditions in the future. Firms may be uncertain about production, market prices, strategies of rivals, etc. Under uncertainty, the consequences of an action are not known immediately for certain.