Basic Concepts of Managerial Economics

Managerial Economics can be defined as amalgamation of economic

theory with business practices so as to ease decision-making and future
planning by management. Managerial Economics assists the managers of
a firm in a rational solution of obstacles faced in the firms activities. It
makes use of economic theory and concepts. It helps in formulating logical
managerial decisions. The key of Managerial Economics is the microeconomic theory of the firm. It lessens the gap between economics in
theory and economics in practice. Managerial Economics is a science
dealing with effective use of scarce resources. It guides the managers in
taking decisions relating to the firms customers, competitors, suppliers as
well as relating to the internal functioning of a firm. It makes use of
statistical and analytical tools to assess economic theories in solving
practical business problems. Therefore, it would be useful to examine the
basic tools of managerial economics and the nature and extent of gap
between the economic theory of the firm and the managerial theory of the
firm. The contribution of economics to managerial economics lies in
certain principles which are basic to managerial economics. There are five
basic principles of managerial economics. They are:
1. The Opportunity Cost Concept
2. The Concept of Time Perspective
3. The Incremental Concept
4. The Equi-marginal Concept

5. Risk and Uncertainty

6. Discounting Concept

1. The Opportunity Cost Concept:

The concept of opportunity cost is related to the alternative uses of scarce
resources. Both natural and man-made are scarce. Resource though
scarce have alternative uses. 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. The
scarcity and the alternative uses of the resources gives rise to the concept
of opportunity cost. The difference between actual earning and its
opportunity cost is called economic gain or economic profit. Both micro
and macro economics make abundant use of the fundamental concept of
opportunity cost. In everyday life, we apply the notion of opportunity cost
even if we are unable to articulate its significance. The applicability of
opportunity cost concept is not limited to decisions involving finances. The
concept can be applied to all other kinds of resources involved in business
decisions, especially where there are at least two alternative options
involving cost and benefits.
The concept of opportunity cost thus 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.
2. Concept of Time Perspective:
According to this principle, a manger/decision maker should give due emphasis, both to
short-term and long-term impact of his decisions, giving apt significance to the different time
periods before reaching any decision. Short-run refers to a time period in which some factors
are fixed while others are variable. The production can be increased by increasing the
quantity of variable factors. While long-run is a time period in which all factors of production
can become variable. Entry and exit of seller firms can take place easily. From consumers
point of view, short-run refers to a period in which they respond to the changes in price,
given the taste and preferences of the consumers, while long-run is a time period in which

the consumers have enough time to respond to price changes by varying their tastes and
preferences.

3. The Marginal and Incremental Concept:

This principle states that a decision is said to be rational and sound if
given the firms objective of profit maximization, it leads to increase in
profit, which is in either of two scenarios

If total revenue increases more than total cost.

If total revenue declines less than total cost.

Marginal analysis implies judging the impact of a unit change in one

variable on the other. Marginal generally refers to small changes. Marginal
revenue is change in total revenue per unit change in output sold.
Marginal cost refers to change in total costs per unit change in output
produced (While incremental cost refers to change in total costs due to
change in total output). The decision of a firm to change the price would
depend upon the resulting impact/change in marginal revenue and
marginal cost. If the marginal revenue is greater than the marginal cost,
then the firm should bring about the change in price.
Incremental analysis differs from marginal analysis only in that it analysis
the change in the firm's performance for a given managerial decision,
whereas marginal analysis often is generated by a change in outputs or
inputs. Incremental analysis is generalization of marginal concept. It refers
to changes in cost and revenue due to a policy change. For example adding a new business, buying new inputs, processing products, etc.
Change in output due to change in process, product or investment is
considered as incremental change. Incremental principle states that a
decision is profitable if revenue increases more than costs; if costs reduce
more than revenues; if increase in some revenues is more than decrease
in others; and if decrease in some costs is greater than increase in others.
4. Equi-Marginal Concept:
The equi marginal principle was originally associated with consumption
theory and the law is called, and the law is called the law of equi marginal
utility. The law equi-marginal utility states that, a utility maximising
consumer distributes its consumption expenditure between various goods
and services he/she consumes in such a way that the marginal utility
derived from each unit of expenditure on various goods and services is the
same. This pattern of consumption expenditure maximises a consumers
total utility.

Law of equi-marginal principle was overtime applied by business

managers to allocation of resources between their alternative uses with a
view to maximising profit in case a firm carries out more than business
activity. This principle suggests that, available resources should be so
allocated between the alternative options that the marginal productivity
gains from the various activities are equalised.
The equi-marginal principle can be applied only where
Firms have limited investible resources
Resources have alternative uses.
The investment in various alternative uses is subject to diminishing to
marginal productivity or returns.
5. 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 firms 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.
6. Discounting Concept:
According to this principle, if a decision affects costs and revenues in longrun, all those costs and revenues must be discounted to present values
before valid comparison of alternatives is possible. This is essential
because a rupee worth of money at a future date is not worth a rupee
today. Money actually has time value. Discounting can be defined as a
process used to transform future money into an equivalent number of
present value. For instance, Re1 invested today at 10% interest is
equivalent to Rs 1.10 next year. Where, FV is the future value (time at
some future time), PV is the present value (value at t0, r is the discount
(interest) rate, and t is the time between the future value and present
value.

REFERENCES:
Vanitha Agarwal, Managerial Economics (2003), Pearson, Delhi
Asis Banerjee & Debashis Maszumdar, Principles of Economics (1999), Volume 1
ABS Publishing House, Kolkata
D N Dwivedi, Managerial Economics (2008), Vikas Publishing House Pvt Ltd,
Delhi