BBA I Semester Fundamental Economics tools Study Material Notes
Table of Contents
BBA I Semester Fundamental Economics tools Study Material Notes: The Opportunity cost Concept The Incremental Concept The Principle pf time Perspective The Discounting Principle Illustration Limitations Equi Marginal Concept Risk and Uncertainty Exercise :
MCom I Semester Managerial Economics National Income Study Material Notes
FUNDAMENTAL ECONOMIC TOOLS INTRODUCTION
Managerial Economics is both conceptual and practical. Economic theory provides a number of concepts and analytical tools which are of immense help to a manager in taking many decisions and business planning. Managerial economics applies the following concepts and principles of economics.
1 The Opportunity Cost Concept
Since 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. In economics, the opportunity cost of anything is the next best alternative that could be produced by the same factors, costing the same amount of money. In managerial economics the 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 producing one thing rather than another. The opportunity cost of a manager is what he could have earned as manager in some other company.
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 opportunity missed or alternative foregone.
Opportunity cost is just a notional idea which does not appear in the books of account of the company. If a resource has no alternative use, then its opportunity cost is nil. Its Importance
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 the proper allocation of factor resources.
4. The Incremental Concept
The incremental concept is the most important concept in economics which is used in managerial economics. The two major concepts in this analysis are incremental cost and incremental revenue. Incremental cost is defined as the change in total cost resulting from a decision of the firm. It measures the difference between the old and the new total cost.
Similarly incremental revenue is defined as the change in total revenue resulting from a HECISION of the firm. It measures the difference between the old and the new total revenue,
The incremental principle may be stated as follows: A decision is clearly a profitable one if (i) It increases revenue more than costs. (ii) It decreases some cost to a greater extent than it increases others. (iil) It increases some revenues more than it decreases others. (iv) It reduces costs more than revenues.
Illustration
Some businessmen hold the view that to make an overall profit, they must make a profit on every job. So they refuse orders that do not cover full costs plus some provision of profit. This will lead to rejection of an order which prevents short run profit. This problem is illustrated below. Suppose a new order is estimated to bring in an additional revenue of Rs. 10,000 to a firm. The costs are estimated as under:
Labour Rs. 3,000
Materials Rs.4,000
Overhead charges Rs. 3,600
Selling and administrative expenses Rs. 1,400
Full Cost Rs. 12,000
The order appears to be unprofitable because cost (Rs. 12,000) is more than revenue (Rs. 10,000). It results in a loss of Rs. 2,000. However, suppose there is idle capacity which can be utilised to execute this order. If order adds only Rs. 1,000 to overhead charges, and Rs. 2000 by way of labour cost because some of the idle workers already on the pay roll will be deployed without additional pay and no extra selling and administrative expenses, then the actual incremental cost is as follows:
Labour Rs. 2,000
Materials Rs. 4,000
Overhead charges Rs. 1,000
Total Incremental Cost Rs. 7,000
Thus there is a profit of Rs. 3,000 because incremental revenue (Re. 10,000) is more than incremental cost (Rs. 7,000). The order can be accepted on the basis of incremental reasoning. Incremental reasoning does not mean that the firm should accept all orders at prices which cover merely their incremental costs.
Its Limitations
This concept has certain limitations:
(a) The concept cannot be generalised because observed behaviour of the firm is always variable.
(b) The concept can be applied only when there is excess capacity in the firm,
(c) The concept is applicable only during the short period.
3. The Principle of Time Perspective
The time perspective principle states that t consideration both to the short run and long run effects of perspective principle states that the decision maker must give due who introduced time element in economic theory. Managerial economics short run and long run effects of his decisions. It was Marshall the short run and long run effects of decisions on revenues as well as cost theory. Managerial economics is concerned with problem in decision making is to establish the right balance between cessions on revenues as well as costs. The main In the short period, the firm can change its sort period, the firm can change its output without changing its size. The Mon Period relates to a few months in which supply can be changed in accordance with demand. This is possible by changing the variable factors. For instance, if the HICUse the supply of its product, it can do so by working the fixed factors like CASS plants, machines, etc. more fully. This can be done by starting two or three shirts and by employing more labour, raw materials, etc. In the short period, it is not possible to change the fixed factors, the scale of production and organisation. Therefore, supply can be increased or decreased to match the increase or decrease in demand by changing the variable factors.
In the long period, the firm can change its output by changing its size.
The long period is of many years in which supply can be fully adjusted to demand. This is done by changing the fixed factors. During this period the old machines, equipments and plants can be replaced by the new. New firms can enter the industry and old firms can leave it. The scale of production, organisation and management can also be changed. Thus supply can be adjusted to demand in every possible way in the long-run.
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.
4. The Discounting Principle
Every one knows that a rupee today is worth more than a rupee tomorrow. This is famous saying that “a bird in hand is worth two in the bush.” Therefore, any body will prefer Rs. 100 today to Rs. 100 next year. There are two reasons for this:
(a) There is risk and uncertainty in the future. So Rs. 100 today are preferable to get than after a year.
(b) Ever if a person is sure to receive Rs. 100 next year, it would be better to receive Rs. 100 now and invest it for a year and earn a rate of interest on Rs. 100 for one year.
For making a decision in regard to an investment which will yield a return over a period of time, its present worth or value is calculated by the discounting principle. This is used in managerial economics in making decisions relating to investment planning and capital budgeting.
The formula of computing the present value is given below:
5. Equi-Marginal Concept
One of the famous principles of economics is the equimarginal concept. The principle states that an input should be so allocated that value added by the last unit is the same in all cases. Let us assume a case in which the firm has 100 unit of labour at its disposal, and the firm is involved in three activities viz., A, B, C. The firm should allocate these workers in such a work that the marginal productivity (value) of the last worker employed in each activity is the same.
An optimum allocation cannot be achieved if the value of the marginal product is greater in one activity than in another. It would be, therefore, profitable to shift labour from low marginal value activity to high marginal value activity, thus increasing the total value of all products taken together. If, for example, the value of the marginal product of labour in activity A is Rs. 50 while that in activity B is Rs. 70 then it is possible and profitable to shift labour from activity A to activity B. The optimum is reached when the values of the marginal product is equal to all activities. This can be expressed symbolically as follows:
Fundamental Economics tools
The Equi marginal principle is an extremely practical concept. (1) It is used as a rational budgetary procedure. (2) It is also applied in investment decisions. (3) It is used allocation of research expenditures. For a consumer, this concept implies that money may be allocated over various commodities such that marginal utility derived from the use of each commodity is the same. (5) For a producer this concept implies that resources be allocated in such a manner that the marginal product of the inputs is the same in all uses.
6. 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. Dunamic changes are also 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 This requires formulation of definite subjective expectations about subjective probability.
This requires the formulation of definite subjective 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.
EXERCISES
1 What fundamental economic tools are used in managerial economics? Explain.
2. Explain the incremental concept.
3. What is the opportunity cost? How can it be measured?
4. Write short notes on:
(a) The Principle of Time Perspective.
(b) The Discounting Principle.
(c) The Equi-marginal Concept.
(d) Risk and Uncertainty.
