Chapter 1

Basic Concepts and

Principles

Lecture plan

Objectives

What is Economics?
Basic Assumptions
Types of Economic Analysis
Managerial Economics

Managerial Decisions
Economic Principles Relevant to Managerial Decisions
Production Possibilities Curve

Managerial Economics and Functions of Management

Relationship with Other Disciplines
Summary

Objectives

To introduce key economic concepts like scarcity,

rationality, equilibrium, time perspective and
opportunity cost.
To explain the basic difference between
microeconomics and macroeconomics.
To help the reader analyze how decisions are made
about what, how and for whom to produce.
To define managerial economics and demonstrate
its importance in managerial decision making.
To discuss the scope of managerial economics and
its relationship with various other disciplines and
functional areas.

What is Economics?

Discusses how a society tries to solve the human

problems of unlimited wants and scarce resources.
Scientific study of the choices made by individuals and
societies with regard to the alternative uses of scarce
resources employed to satisfy wants.
Theoretical aspect and an applied science in its practical
aspects.
Not an exact science; An art as well
A social science
Deals with the society as a whole and human behaviour in
particular
Studies the production, distribution, and consumption of
goods and services.
A science in its methodology, and art in its application.

Basic Assumptions

Ceteris Paribus
Latin

phrase
With other things (being) the same or all other
things being equal.

Rationality
Consumers

maximize utility subject to given money

income.
Producers maximize profit subject to given resources
or minimize cost subject to target return.

Types of Economic Analysis

Micro and Macro

Microeconomics (micro meaning small): study of

the behaviour of small economic units

An individual consumer, a seller/ a producer/ a

firm, or a product.

Focus on basic theories of supply and demand in

individual markets
Macroeconomics (macro
meaning large):

study of aggregates.

Industry as a unit, and not the firm.

Focus on aggregate demand and aggregate
supply, national income, employment, inflation,
etc.

Types of Economic Analysis

Positive and Normative

Positive economics: what is in economic matters

Establishes a cause and effect relationship between

variables.
Analyzes problems on the basis of facts.

Normative economics:
economic matters.

what

ought

to

be

in

Concerned with questions involving value judgments.

Incorporates value judgments about what the economy
should be like.

Types of Economic Analysis

contd..

Short Run and Long Run

Short run: Time period not enough for consumers and
producers to adjust completely to any new situation.
Some inputs are fixed and others are variable
Long run: Time period long enough for consumers and
producers to adjust to any new situation.
All inputs are variable
Decisions to adjust capacity, to introduce a larger
plant or continue with the existing one, to change
product lines.

Types of Economic Analysis

Partial and General Equilibrium

Partial equilibrium analysis: Related to micro analysis
Studies the outcome of any policy action in a
single market only.
Equilibrium of one firm or few firms and not
necessarily the industry or economy.
General equilibrium: explains economic phenomena
in an economy as a whole.
State in which all the industries in an economy are
in equilibrium.
State of full employment

Managerial Economics

Application of economic theory and the tools of analysis

of decision science to examine how an organisation can
achieve its objectives most effectively
Study of allocation of the limited resources available to a
firm or other unit of management among the various
possible activities of that unit
Applies economic theory and methods to business and
administrative decision-making
Application of economic principles and methodologies to
the decision-making process within the firm or
organization

Managerial Economics

Contd

Micro as well as Macro

Applied
microeconomics: demand analysis, cost and
production analysis, pricing and output decisions
Macroeconomic: national income, inflation and stages of
recession and expansion
Normative Bias
Prescriptive: States what firms should do in order to reach
certain objectives.
Decides on whether or not the probable outcome of a
managerial decision is desirable.
Decisions Resulting in Partial Equilibrium
Decisions taken by any firm would relate to the equilibrium of
that particular firm.
Deals with partial equilibrium analysis

Economic Principles Relevant to

Managerial Decisions
Concept of scarcity

Unlimited human wants

Limited resources available to satisfy such wants
Best possible use of resources to get:

maximum satisfaction (from the point of view of consumers) or

maximum output (from the point of view of producers or firms)

Concept of opportunity cost

Opportunity cost is the benefit forgone from the alternative

that is not selected.
Highlights the capacity of one resource to satisfy multitude of
wants
Helps in making rational choices in all aspects of business,
since resources are scarce and wants are unlimited

Economic Principles Relevant to

Managerial Decisions
Contd

Concept of margin or increment

Marginality:

a unit increase in cost or revenue or

utility.

Marginal cost: change in Total Cost due to a unit change in

output.
Marginal revenue: change in Total Revenue due to a unit
change in sales.
Marginal utility: change in Total Utility due to a unit change
in consumption.

Incremental:

applied when the changes are in bulk,

say 10% increase in sales.

Economic Principles Relevant to

Managerial Decisions

Discounting Principle
Time

value of money : Value of money depreciates

with time

A rupee in hand today is worth more than a rupee received

tomorrow.

Outflow

and inflow of money and resources at

different points of time

PVF =

1
(1 r) n

where
PVF = Present Value of Fund,
n = period (year, etc.)
R = rate of discount

Production Possibilities Curve

Highlights the concepts of scarcity and opportunity cost

Indicates the opportunity cost of increasing one item's production

(or consumption) in terms of the units of the other forgone
Slope of the curve in absolute terms

Assumptions

The economy is operating at full employment.

Factors of production are fixed in supply; they can however be
reallocated among different uses.
Technology remains the same.

Production Possibilities Curve

Technically
Infeasible Area

Food
FP

FQ

Productively
Inefficient Area

CP

CQ

Clothing

PPC for the Society

Shows
the
different
combinations of the quantities of
two goods that can be produced
(or consumed) in an economy at
any point of time.
Below the curve is productively
inefficient area and above it is
technically infeasible area, so
the equilibrium will be at the
curve (FP and CP at point P).
Depicts the trade off between
any two items produced (or
consumed).
To increase the quantity of
clothing from CP to CQ some
amount of food (FP-FQ) will have
to be sacrificed. New point of
equilibrium on PPC is at Q.

Production Possibilities Curve

Contd

All points on the PPC (like P and Q) are points of

maximum productive efficiency.
In the figure, OFp of food and OCp of clothing can be
produced at Point P and OFQ of food and OCQ
respectively at point Q, when production is run
efficiently.
All points inside the frontier are feasible but productively
inefficient.
All points to the right of (or above) the curve are
technically impossible (or cannot be sustained for long).
A move from P to Q indicates an increase in the units of
clothing produced and vice versa.
It also implies a decrease in the units of food produced.
This decrease in the units of food is the opportunity cost
of producing more clothing.

Managerial Economics and

Functions of Management
All functional areas have to find the most
efficient way of allocating scarce
organizational resources
Managerial economics:

Facilitates the process of evaluating

relationships between functional areas
Helps in making rational decisions across
managerial functions.

Managerial Economics and

Functions of Management

Financial Management
From where to collect resources
Equity
Debt
How to allocate resources
How much profit to be retained/distributed

Human Resource Management

Recruitment
Wage and Salary
Training and development
Retirement

Contd

Managerial Economics and

Functions of Management

Marketing Management
Which product
For whom
What price

How

to sell

Operations Management
Which
Inputs

technology

Processing

Information System Management

Communication channels
Use of information Technology

Relationship Other Disciplines

Economic Theory
Microeconomics
Theory of firm
Theory of consumer behaviour (demand)
Production and cost theory (supply)
Market structure and competition
Price theory
Macroeconomics
National income and output
Business cycle
Inflation

Quantitative Analysis

Numeric and algebraic analysis

Optimization
Discounting and time value of money
techniques
Statistical estimation and forecasting
Game theory

Managerial Economics

Solutions to Managerial Decision Making

Quantity and quality of product
Price of product
Marketing Management
Financial Management
Human Resource Management
Research and Development

Summary

Economics studies the choices made by individuals and societies in

regard to the alternative uses of scarce resources which are employed to
satisfy unlimited wants.
Microeconomics is the study of the behaviour of individual economic
units, such as an individual consumer, a seller, a producer, a firm, or a
product.
Macroeconomics deals with the study of aggregates, the economy as a
whole.
Ceteris paribus is a Latin phrase, literally translated as with other things
(being) the same.
The assumption of rationality means that consumers and firms measure
and compare the costs and benefits of a decision before going ahead for
that decision.
Partial equilibrium analysis studies the outcome of any policy action in a
single market only, while general equilibrium analysis seeks to explain
economic phenomena in an economy as a whole.
Opportunity cost is the benefit forgone from the alternative that is not
selected.

Summary

Concept of Time value of money tells that Value of money

depreciates with time.
Concept of Marginal/increment tells about impact of
unit/proportionate change in cost/revenue on decision making.
Managerial economics is a means to finding the most efficient way
of allocating scarce organizational resources and reaching stated
objectives. It is micro as well as macro in nature; it has a normative
bias, and deals with partial equilibrium.
Production Possibilities Curve (PPC) is a graph that shows the
different combinations of the quantities of two goods that can be
produced (or consumed) in an economy, subject to the limited
availability of resources.
The knowledge of managerial economics helps to understand the
interrelationships among the various functional units of any firm
(namely production, marketing, HR, finance, IT and legal)
Decision sciences provide the tools and techniques of analysis
used in managerial economics, in particular numerical and
algebraic analysis, optimization, statistical estimation and
forecasting.