What is Economics?

According to Adam Smith Economics is concerned with the creation and distribution of wealth. Economist Alfred Marshall defined economics in terms of welfare Robbins defined economics in terms of scarcity of resources. A general definition. Economics is the study of allocation of scarce resources among alternative uses Resources are always scarce and have alternative uses. Resources at the disposal of an individual consumer, producer, firm or nations are always limited. So one needs to choose the best alternative and this is the subject matter of economics. e.g. individual consumers, firms. So individual, firms and nations try to maximize with limited resources.

What is Microeconomics and Macroeconomics?

Microeconomics is the study of individual behaviour. The unit of in Microeconomics study is small i.e. individual consumers, firms, an industry and how they achieve equilibrium. Macroeconomics is the study of economy wide aggregates. i.e. national output, national income, total employment etc.

What is Managerial Economics?

Economics which is useful for a manager is known as managerial economics. There are certain tools, techniques and concepts of Economics which are relevant for a practicing manager. According to Haynes, Mote and Paul ME is economics applied in decision-making. It is a special branch of economics bridging the gap between abstract theory and managerial practice. ME is the study of the allocation of scarce resources available to a firm among the alternative uses. According to Milton Spencer, Integration of economics theory with business practice for the purpose of facilitating decision-making and forward planning. A manager is supposed to take important decisions for the firm. ME helps a manager in taking rational decisions. How a firm allocates its scarce resources among alternative uses is the subject matter of ME.

Difference between Managerial Economics and Business Economics

ME has a broad connotation i.e. is applicable to business as well as non business organizations

BE has a narrow connotation i.e. is applicable only to business organizations

Salient Features/ Nature of Managerial Economics

Pragmatic Practical in nature Eclectic in nature Borrows concepts from different disciplines. Normative in nature Universal applicability Most of the theories of ME stem from Microeconomics

Scope / Core content of Managerial Economics

Demand Analysis
How much a firm should produce depends on the demand for its products If the demand falls short of production, the manager tries to create more demand with the help of advertising and promotion.

Demand Forecasting
Forecasting is estimation of future demand. Prediction about future sales. Methods of demand forecasting for existing products

 Theory of Production
What quantity of a product is to be produced Input Output decisions. What happens to output when inputs are mixed in a given proportion. If all the inputs are held constant and one input varies, what happens to the production.

Cost Analysis
Relationship between output and costs What happens to the cost of production when output varies?

Pricing Decisions
How pricing decisions are made under different market conditions i.e. Market structure. Profit Analysis Management of Profit, Investment decisions etc.

The theory of the firm

The theory of firm behavior is the central theme of Managerial Economics

What is a firm?
An organization which combines and organizes resources for produce goods and /or services for sale and to earn profits.

Why do firms exist?

Firms exist to save on transaction costs by performing many managerial functions within the firm It would be very costly for entrepreneurs to enter into contracts with workers and resource owners for each step of the production and distribution process. Instead, a general contract would be beneficial for both the parties.

Can firms grow larger and larger indefinitely?

Firms can not grow larger and larger indefinitely due to diseconomies of scale or internal disadvantages of large size i.e. increased communication traffic, distancing of management from operations etc. The function of the firm is to purchase resources and transform them into goods and services which ultimately leads to the circular flow of economic activity.

 The objective and value of the firm

Initially the theory of the firm was based on the assumption that the primary objective of the firm is to maximize short term profits. However, it has been observed that firms focus more on long term profits. E.g. R &D expenditure, new capital equipment etc. Therefore the theory of the firm suggests that the primary objective of the firm is to maximize the value or wealth of the firm. The present value of the firm can be obtained by discounting all the expected future profits of the firm. PV = Pt/ (1+r)t, where P is the profit and R is appropriate discount rate. If the stream of expected future profits is uncertain, a higher discount rate is used. Profit can be rewritten as Total Revenue (TR) Total Cost (TC), so the formula can be rewritten as Value of the firm = TRt TCt / (1+r)t

 TR depends on sales and pricing decision (Marketing Department) TC depends on the technology of production and resource prices. (Production and HR department) Discount rate depends on the perceived risk of the firm and the cost of borrowing funds. (Finance Department) Hence the equation of the value of the firm shows how various departments of the firm interact with each other.

Constraints faced by the firm

Resource constraints i.e. limited availability of capital, land, skilled workers, raw material etc. Legal constraints i.e. minimum wage laws, health and safety standards, pollution emission standards, prevention against unfair trade practices Due to these constraints the firms focus on Constrained Optimization Therefore the primary objective of the firm is to maximize the value of the firm subject to the constraints it faces

 Limitations of the theory of the firm

The theory has been criticized as being too narrow and unrealistic. Instead some broader theories of firm behavior have been suggested. 1. Sales maximization model or Baumol model Managers seek to maximize sales after adequate profit has been earned to satisfy stock holders. 2. Management utility maximization model The model arose due to principal agent problem. This problem can be resolved by tying the managers reward to the firms performance in relation to other firms in the same industry. 3. Satisficing behavior model Due to the complexity of running a large company, managers are not able to maximize profits but can strive for some satisfactory goals in terms of sales, profit, growth, market share etc

The Nature and Function of Profits

Business Profit v/s Economic Profit
Business Profit = Revenue Explicit Accounting costs Economic Profit (above normal profits) = Revenue Explicit costs Implicit Costs

Implicit costs = Opportunity Costs i.e. the salary the entrepreneur could earn by working for someone else, return which could be earned by the resources in their best alternative use outside the firm

The concept of economic profit must be used to make investment decisions An Example. What the entrepreneur could earn by working as a manager in some other firm.

Theories of Profit
1. Risk Bearing theories of Profit The higher the risk, the higher the return. The firms which take greater risks end up earning higher profits. Frictional theory of Profit In the long run, firms end up earning only normal returns because when profits are earned in an industry in the short run, more firms enter into that industry Monopoly theory of Profit Profit can be earned by firms in an industry when entry of other firms into that industry is restricted Innovation theory of Profit According to this theory, profit is the reward for introducing a successful innovation. E.g. Steve Jobs Managerial Efficiency theory of Profit This theory states that firms which are more efficient enjoy above normal profits

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 Function of Profit
Profits provide important signals for the reallocation of societys resources and reflect changes in consumers tastes and demands Higher profits indicate that consumers want more of a product Profits can also indicate reward for greater efficiency Thus profits provide the firms the incentive to increase their efficiency or to produce less of a product