MANAGERIAL ECONOMICS

MANAGERIAL ECONOMICSManagement is Coordination of various resourcesAn activity or ongoing process A process with a purpose or goalAn art of getting things done by othersEconomicsStudies the behaviour of human beings organisations in situations involving choiceProblem of choice arises due to Human wants are unlimited but of varying degrees of importanceEconomic resources are limited and have alternative uses

MANAGERIAL ECONOMICSA close relationship between management and economics has led to the development of managerial economics

Managerial economics application of principles and methods of economics to analyse problems faced by management of business or other types of organisations and to help find solutions that advance the best interest of such organisation(Davis and S. Chang)MANAGERIAL ECONOMICSManagement decision problems|-------------------------------------------------| |Economic theory decision sciencesMicro economics mathematical economicsMacroeconomics econometricsUsed byManagerial economics|Optimal solution to managerial decision problemsMANAGERIAL ECONOMICSProcess of decision making

Establish objectivesDefine the problemIdentify possible solutionsSelect the best possible solution( considering input constraints consider legal and other constraints)Implement the decisions

MANAGERIAL ECONOMICSSCOPE OF MANAGERIAL ECONOMICS++++++++++++++++++++++++++++++++Managerial economics is concerned withMicro economicsMacroeconomicsMICROECONOMICS is the study of particular firms ,particular households, individual prices ,wages, income,individual industries, particular commoditiesMACROECONOMICS deals not with individual quantities as such but with aggregates of these ,not with individual incomes but with national income, not with individual prices but with price level, not with individual outputs but with national outputMANAGERIAL ECONOMICSApplication of micro economics

Micro economics deals with internal issues(all those problems which are within the business and fall within the purview and control of managementWhat to produceHow to produceWhere to locate the production unitHow to promote salesWhat technology to be adoptedWhich category of customer to cater toHow to decide on new investmentsMANAGERIAL ECONOMICSApplication of macro economics

Macro economics deals with external issuesType of economic system in the countryGeneral trends in national income ,employment,prices savings & investment Political environment state attitude towards private businessSocial factors-value system of society, customs and habits governments economic policies- industrial,monetary fiscal, price,foreign Trends in labour supplyECONOMIC CONCEPTS RELEVANT TO BUSINESSECONOMIC CONCEPTS RELEVANT TO BUSINESS+++++++++++++++++++++++++++++++++++++++1.THE OPPORTUNITY COST PRINCIPLE:The opportunity cost of anything is the next best alternative that could be produced instead,by the same factors and costing the same amount of money

*All decisions which involve choice must involve opportunity cost calculations* The opportunity cost may be either real or monetary,non quantifiable or quantifiableECONOMIC CONCEPTS RELEVANT TO BUSINESSThe concept of opportunity cost can be explainrd by using a PRODUCTION POSSIBILITY CURVEThe PPC joins the different combination of goods which an economy can produce,given its state of technology and total resources.

PPC demonstrates thatThere is a limit to what one can achieve,given the available resources* Every choice made has an accompanying opportunity cost.* in most cases thePPC is concave to the origin.This is due to the increasing opportunity costsECONOMIC CONCEPTS RELEVANT TO BUSINESS2. INCREMENTAL CONCEPT the two basic concepts in incremental analysis areIncremental cost:Change in total cost as a result of change in output2. Incremental revenueChange in total revenue resulting from a change in level of output

A manager always determines the worth of a decision on the basis of the criterion IR> ICECONOMIC CONCEPTS RELEVANT TO BUSINESS3.CONCEPT OF PROFITAccounting concept of profit isProfit= Total Revenue-Explicit costsEconomic profits isProfit=Total revenue-(explicit+implicit costs)

4.OPTIMISATION CONCEPTOptimisation is the act of choosing the best alternative out of the available onesOptimisation problems have three elements1.Decision variables: variables whose optimal values have to be determined

ECONOMIC CONCEPTS RELEVANT TO BUSINESS2. The objective function: (mathematical relationship between choice variables and some variables whose values are to be maximised or minimised3. Feasible set: (available set of alternatives)5.THE DISCOUNTING PRINCIPLE(TIME VALUE OF MONEY)If a decision affects both costs and revenues at a future date,it is essential to discount these costs and revenues to make them comparable to some present value before a valid comparison of alternatives is made6.CONCEPT OF DEMANDThe decisions which management takes with respect to production,advertising ,pricing etc call for an analysis of demand

ECONOMIC CONCEPTS RELEVANT TO BUSINESS7.CONCEPT OF SUPPLYSupply is the willingness and ability of producers to make a specific quantity of output available to consumers at a particular price over a given period of time8 PRODUCTIONThe essence of production is the creation of utilities.the term production in economics is not confined to bringing about physical transformation in the matter .It also covers rendering of services9. DISTRIBUTIONDistribution is concerned with sharing of national inciome among the different factors of production

ECONOMIC CONCEPTS RELEVANT TO BUSINESS10.TIME PERIODShort run: Operating period of the business in which at least one factor of production is fixedLong runA period in which all factors of production is variable11MARGIN AND AVERAGEMargin refers to small (incremental ) increases or decreasesThe concept of average refers to an arithmetic mean12.ELASTICITYThe concept of elasticity measures the responsiveness of one variable to a change in another variable

ECONOMIC CONCEPTS RELEVANT TO BUSINESS13.CONSUMPTION FUNCTIONThe most important determinant of consumption is income.This relationship between consumption and income is termed as consumption function or the propensity to consumeC= f(Y)C is consumption, f is function ,Y is incomeThe law consists of 3 propositions1.When aggregate income increases , consumption expenditure also increases but by a somewhat smaller amount2 . When income increases, the increment of income will be divided in a certain proportion between consumption and saving3.As income increases both consumption spending and saving will go up ECONOMIC CONCEPTS RELEVANT TO BUSINESSThe income consumption relationship can be specified by the equation C = a + b.Y (a > 0, 0 1Constant returns to scale: output increase proportionate to input increase (QE) = 1Decreasing returns to scale: output increase less than proportionate to increase in inputs. (QE) AC or TR > TCTHEORIES OF PROFIT==================Risk and uncertainty theory of profitRisk bearing is the special function of the entrepreneur and it leads to the emergence of profit :- Prof HawleyRisks are an inherent in any business and they are of two types ,insurable risks and non insurable risks:- Prof F . H. Knight

PROFIT ANALYSIS2. Dynamic theory of profitProfits belong to dynamic economy. In a static economy pure profits would be eliminated as fast as they could be created:- Prof Clark

3. Innovations theory of profitProfits are the results of innovations introduced by entrepreneurs. Innovational profits have a tendency to appear , disappear and reappear as a result of emergence of new and more clever innovation:- Prof J A Schumpeter

4. Profit is a reward for organising other factors of production.an entrepreneur combines the factors of production to produce output

MARKET ANALYSISPERFECT COMPETITIONEquilibrium of the firm in the short run:* A firm is said to be in equilibrium when it has no incentive to produce a unit more or a unit less.* The rational firm aiming at maximisation of profit produces output upto the POINT OF EQUILIBRIUM which is achieved when 1 MC = MR and 2. MC is increasing at the point of equilibriumIn the short run , a firm which is in equilibrium may earn normal profit, supernormal profit or may even incur lossIf a firm is incurring losses it will continue to produce if at least the total variable costs are recovered. If the price is so low that the firm cannot recover its total variable cost ,it would prefer to close down (SHUT DOWN POINT)

MARKET ANALYSISPERFECT COMPETITION=================Equilibrium of the industry in the short run:

All firms have similar cost curves. In the short run, firms will be in equilibrium earning normal profits, supernormal profits or losses For an industry to be in equilibrium there would have to be no incentive for the number of firms in the industry to change i.e entry or exit of firmsIn the short period, the industry will not be in equilibrium MARKET ANALYSISEquilibrium of the firm & industry in the long run:--------------------------------------------------In the long run Each firm gets only normal profitsEach firm is producing at an optimum scale and using its plant to the optimum pointThe condition for the long run equilibrium of the firm is LMC =LAC = P In the long run all the firms are earning only normal profit and therefore the industry is in equilibrium with normal proditMC = MR =AC = AR(price)MARKET ANALYSISMONOPOLY==========Short run equilibrium:In the short run monopolist maximises his short run profits or minimises his short run losses if1. MC = MR2. MC cuts the MR from belowIn the short run monopolist can expand or contract output by varying the amount of variable factors but working with a given existing plantIn the short run monopolist may earn excess profit . Being a price maker he may charge a price based on demand that gives him excess profit

MARKET ANALYSISHaving a monopoly does not guarantee profits. Profits depends upon whether there are customers who will pay prices high enough to exceed production costsMonopoly firm may suffer losses on account of non recovery of fixed costsIf the price falls below AVC the monopolist would shut down even in the short run

Long run equilibrium:----------------------------*The long run equilibrium output is produced at a point where LMC cuts MR from below.In the long run monopolist has time to expand his plant or intensively utilise his existing plant which will maximise his profit.

MARKET ANALYSISThe size of his plant and the degree of utilization of any given plant size depends entirely on MARKET DEMANDSince even in the long run , the monopolists demand curve remains sloping downward,it cannot be tangent to average cost curve at minimum AC. It implies that the firm will produce less than its optimum output level in the long run* Monopoly firm can get supernormal profits even in the long run

Price discrimination under monopoly ============================* A seller indulges in price discrimination when he sells the same product at different prices to different buyers

MARKET ANALYSISEquilibrium under PRICE DISCRIMINATION==========================Case 1:A monopolist firm sells a single product in two different markets with different elasticities of demandIt is assumed that production takes place at same pointResale among the customers is not possibleMonopolist will produce that amount of output where MC = CMR (combined marginal revenue)He will divide the whole output between the two markets such that MR of one market =MR of the other marketCase 2:* The firm has a monopoly in the domestic market but faces perfect competition in the world marketMARKET ANALYSISMonopolist produces that output where MC = CMRThe producer is said to be DUMPING in the world market since he is charging less price in the world market than in the home marketMONOPOLISTIC COMPETITION===========================It is a market situation where the forces of monopoly and competition interplay in determining the price (e.g soaps & detergents ,ice cream parlours, fast food restaurants)The consumers preference of particular product confer monopoly element on the productsProducers compete with one another in two ways 1.price competition2. non price competition (PRODUCT DIFFERENTIATION ,SELLING COSTS)MARKET ANALYSISFeatures of monopolistic competition 1.Large number of independent sellers2. Free entry and exit of firms3. Existence of large number of imperfect substitutes (product differentiation4. Large number of buyersShort run equilibrium:===============In the short run , a monopolistic competitive firm attains equilibrium where its MC = MR and MC is rising at the equilibrium pointThe firm may get abnormal profit or suffer losses. Normal profit situation is not likely in the short run

MARKET ANALYSISLong run equilibrium================In the long run the entry of new firms and the consequent changes in the demand curve will wipe out the supernormal profitsThe final equilibrium will be such that all firms in the group will attain equilibrium by equating MC = MR and the group as a whole attain s equilibrium when each firm gets only normal profits with AC = ARThe equilibrium output is less than optimum i.e minimum point of U shaped AC curve

MARKET ANALYSISOLIGOPOLY================Oligopoly refers to a market situation in which a few firms produce goods which are either close substitutes or homogeneous productsFeatures of oligopoly:Large number of buyersSellers are few in number Interdependence in price output policyIndeterminate demand curveProducts are fairly good substitutes of each otherEntry of firms is possible but made difficult by the strategy of existing playersMARKET ANALYSISEquilibrium in oligopoly:THE KINKED DEMAND CURVE MODEL OF OLIGOPOLYAn oligopolistic firm is guided in its decisions by the imagined demand curve which is based on its expected reaction of its rivalsFor upward changes in price ,a firms demand is expected to be highly elasticFor downward changes in the price the firms demand curve is expected to be less elasticBecause of differences in elasticity( and slope ) the demand curve of the firm has a corner or KINK at the current priceDue to the kink in demand curve, the MR curve is discontinuous at the level of output corresponding to the kinkTotal profit is maximised at the point of kinkThe price remains rigid or sticky at the existing level

MARKET ANALYSISCOLLUSIVE OLIGOPOLY MODELS=====================Two types of collusioncartels: firms jointly fix a price and output policy through agreementThe industry demand and industry MR are used to determine profit maximising output and priceThe industry output is divided among the members of the cartel through negotiations Price leadership : Price is determined by the price leaderone firm sets the price and others follow itIt is more successful in industries where product differentiation is low

CAPITAL BUDGETINGCapital budgeting refers to the process of planning capital projects , raising funds and efficiently allocating resources to those capital projectsTypes of capital projects:1. replacement2. Cost reduction3. Output expansion of traditional products and markets4. Expansion into new products or markets5. Government regulationImportance of capital budgeting:-------------------------------------Irreversibility of capital investment decisionsSubstantial outlay

CAPITAL BUDGETING3. Long gestation period4. Capital budgeting decisions are subject to uncertainty5. Impact on future costsPROCESS OF CAPITAL BUDGETINGThe capital budgeting is an application of the marginal revenue and marginal cost principleFirms should undertake capital expenditure projects as long as the marginal returns from the projects exceed their marginal costsThe stages in capital budgeting process aregeneration of capital investment projects estimation of cashflowsEvaluation of investment projectsEx-post evaluation of projects

CAPITAL BUDGETINGMETHODS OF EVALUATION OF INVESTMENTS==================================PAYBACK PERIOD METHODThis method calculates the time period required to return the original investmentThe shorter the payback period , the more desirable the projectPayback period = original investment ------------------------------------ Annual net cash inflow2. AVERAGE RATE OF RETURN ON INVESTMENT(ARR)It is the ratio of average annual net income from the project to the original investment in percentage termsWhere net income is difference between the net cash inflows generated by the project and cash outflows from initial investment

CAPITAL BUDGETING*The higher the ARR , the better the project

3.NET PRESENT VALUE METHODThis method is based on the economic reasoning of discounting future cash flows to make them comparableThe NET PRESENT VALUE of a project is the sum of the present value of all the cash flows associated with the projectThe discount rate employed for evaluating the present value of the expected future cash flows should reflect the risk of the project* If NPV is positive, ACCEPT the projectIf NPV is negative REJECT the project

CAPITAL BUDGETING4. PROFITABILITY INDEX METHOD (BENEFIT COST RATIO)* This is a variant of the NPV method.* Profitability index = present value of cash inflows ---------------------------------------- Original cash outlay* If PI is > 1 ,accept the projectIf PI is < 1 reject the projectAmong the projects , the project with higher PI will be selected5. INTERNAL RATE OF RETURN METHED (IRR)The IRR is the rate of discount which equates the present value of the income stream over the life of the project with the present value of the net cash investmentIf IRR is > the opportunity rate of interest the project is acceptedIf IRR is < opportunity rate of interest, the project is rejected

CAPITAL BUDGETINGCAPITAL RATIONING

Capital rationing refers to the selection of the investment proposals in a situation of constraint on availability of capital funds , to maximise the wealth by maximising the NPV of its projects selected for implementation

Capital rationing may arise due tomanagements ability to manage the projectsLimited internal fundsCapital expenditure budget

MACRO ECONOMICSINPUT OUTPUT ANALYSIS===================The technique of input output analysis was developed by W.W. Leontief in the context of American economy in 1941.Input output analysis takes into account the INTERDEPENDENCE of production plans and activities of the many industries which constitute an economyThe analysis deals almost exclusively with productionAn input output table shows the purchases by a particular sector from all the other sectors and sales by the sector to the other sectorsFrom the input output table , input coefficients can be calculatedMACRO ECONOMICSAssumptions1.Each industry produces one homogeneous good2. Inputs employed in fixed proportions3. Factor & commodity prices are given4. No external economies or diseconomies of production5. Firms enjoy constant returns to scaleUSES1. Gives a total picture of the market for any group of commodities2. Companies can forecast the input requirements needed to meet a forecasted change in demand for their product3. Helps to determine what effect changes in demand will have on different industries