Module 1- Nature And Scope Of Managerial Economics

Nature and Scope of Managerial Economics Mr. Deepak Kulkarni

What’s Economics Artha – Money/Income Shasthra – Body of Knowledge Economics – Body of knowledge which deals with the management of money

Managerial Economics According to Milton H Spencer and Louis Siegelman “Managerial Economics is the integration of economic theory with business practice for the purpose of facilitating decision making and forward planning by the management.

Economic Theory and Methodology

Business Management Decision Problems

Business Economics Application of Economics to solve business problems Optimal solutions to business problems

Nature of Managerial Economics  Micro in nature- concerned with the study of the problems of the firm. Pragmatic in nature- aims at solutions to problems considering the environment in which the business operates.

 Prescriptive in nature rather than descriptive- aims at prescribing solutions to business problems rather than describing theories. Uses Macro-Economics too – enables an executive to understand the business environment nd adjust with the uncontrollable external factors

Scope of Managerial Economics 1) Demand Analysis and Forecasting: - Forecasting future sales of products and services. - Identify demand determinants - guidelines to manipulate demand

2) Cost Analysis: - Discovering and measuring them for effective profit planning and cost control - covers cost-output relationships, economies and diseconomies of scale, cost control and cost reduction

3) Production and Supply Analysis: - deals with planning production and its managerial uses - supply analysis deals with various aspects of supply of a commodity - maximize firm’s revenue through proper planning of production and supply.

4) Pricing decisions, policies and practices: - correct pricing decisions form the backbone of success of the firm - covers price determination in various market conditions, pricing methods and price forecasting.

5) Profit Management: - high level of uncertainty in variation of costs caused by sudden change in the internal and external factors - ME helps in estimating considerably such uncertainties by manipulating costs - covers break even analysis, measurement of profit, profit policies and techniques etc

6) Capital Management: - most complex decisions of business often revolve around planning and allocation of capital - decisions irreversible in nature - ME helps in planning and control of capital expenditure. - covers cost of capital, rate of return and selection of projects

Fundamental Concepts 1) Opportunity Cost Principle: The interest or the income that could have been earned had the money been employed on other ventures instead of the current venture. - Represents the income foregone/sacrificed as a result of investing in the current venture. Example: Bank FD@ 7.25% Vs Child’s marriage

2) The Concept of incremental reasoning: Incremental/marginal=one extra unit Two components 1. Incremental cost- change in total cost resulting from a particular decision 2. Incremental revenue- change in total revenue resulting from a particular decision

Statement of the Principle: A decision is a profitable decision if, (i)It increases revenue more than costs (ii)Decreases some costs to a greater extent than it increases other costs (iii) Increases some revenues more than it decreases others (iv)Reduces costs more than revenues

Illustration: Estimated Revenue from a new order is Rs 5000 Estimated costs on execution(in Rs) Labour 1500 Materials 2000 Overhead 1800 S&D 700 Full Cost 6000

Loss on execution 5000 – 6000= 1000 Change in circumstance 1.Existence of idle capacity 2.Incremental Overhead New Estimated costs(in Rs) Labour 1000 Materials 2000 Overhead 500 Incremental cost 3500

Incremental Profit= 5000-3500= Rs. 1500 Depends upon existence of idle capacity

3) Principle of time perspective: Statement of the Principle A managerial decision should take into account both the short run and long run effects on revenues and costs and maintain the right balance between long run and short run perspectives.

A decision may be made based on short run considerations/gains but it may boomerang in the long run. Ex. Reduction in price to gain customers in the short run may affect the image of the firm in the long run when it increases prices owing to an increase in costs in the future.

4) The Discounting Principle: Statement of the principle Any decision which affects costs and revenues at future dates should discount those costs and revenues to present values before comparing the alternatives. Thumb rule: A rupee received today is more worth than if it is received tomorrow. ---- Uncertainty of receipts in future ---- Inflation/Price Rise

Formula: V= Rs.100/(1+i)n Assume a cash flow of rent of Rs.500 every year on an asset let out for rent Bank Interest rate: 10% p.a NPV= 500/(1+0.10) + 500/(1+0.10)2 = 500/1.10+500/1.21 = 454.5+413.2 = Rs. 867.70 /-

Ex: Calculate the NPV with the given information a. Year end cash flow: Rs. 1000 b. Rate of interest: 5% p.a c. Tenure: 4 years

Answer, V= Rs.100/(1+i)n NPV= 1000/1.05+1000/(1.05)2 +1000/(1.05)3+1000/(1.05)4 = 952.381+907.0295+863.8376+822.7025 = 3545.951 NPV.xls

5) The concept of Contribution: The concept explains about contribution of unit of output to the overheads and profit. - Helps in determining the best product mix when scarce resources are involved - Fresh order Vs Shut down Vs Continue with existing product - Unit contribution is the per unit difference between incremental revenue and incremental cost

Illustration: A rather confused product manager approaches you with a problem. With only a few scarce resources at his disposal he needs to choose which product to manufacture given that the firm has the capacity to produce 1000 units of the selected product. With your knowledge advise the product manager

Solution: Contribution.xls Best pick : Produce 1000 units of product 4

Managerial Economics and Economics - Differences

Concept of risk and return Risk: The element of uncertainty about the occurrence of a desired event in future. Return: The profit which the entrepreneur gets for his function of bearing risk and uncertainty.

Circular Flow of Money