Managerial Economics and

Decision Science
Unit I
Topic to be covered
Introduction –Nature of Managerial decision making –
Types of Business Decision –Nature of the Firm - The
Firm’s Objectives: Profit Maximisation – Value
Maximization Model of the Firm – Nature of Profit.
Innovations theory of profits: Risk and Uncertainty
theory of profit – Social Responsibility of Business
 Introduction
Managerial Economics According to Spencer:
“Managerial economics is the integration of economic
theory with business practice for purpose of facilitating
decision making and forward planning by
management”.
It means management of limited funds available in
most economical way. It deals with basic problems of
the economy i.e. what, how & for whom to produce.
Economics
Science which studies human behaviour as a
relationship between ends and scarce means which
have alternative uses – Lord Robins
Managerial Economics – heavily on decisions sciences
for the techniques used for decision making.
Optimization techniques :used in the analysis of
alternative courses of action and the evaluation of
results obtained so that best alternative which helps in
attaining the objective efficiently is chosen.
In addition to the optimization techniques, methods of
statistical estimation, game theory of decision rules that
can help managers in achieving firm’s objectives.
Techniques of decision sciences have now become a
part of modern economic theory.
ME has both descriptive and prescriptive roles
Descriptive explains various economic forces affect the
working of a firm but also predicts the consequences of the
decisions made by it. It is positive or descriptive role.
ME prescribes the rules for the improvement of decision
making by firms or their managers so that they can achieve
their objectives efficiently. This is its prescriptive role.
ME deals with not only private firms but also public
enterprises.
The technique, approach or way of thinking of ME can also
be profitably used in Non-profit making organization such
as colleges, universities. This is because managers of all
types of organizations face similar problems
Managerial Economics and Economic
Theory
ME uses economic theory to solve business decision- making problems.
Economic theory has been broadly divided into micro economics and macro
economics.
ME draws on both microeconomics and macroeconomics.
Micro economics has built models which explain how an individual consumer
chooses among goods so as to maximise his satisfaction and individual business
firm decided to fix price and output of its products to maximise cost for a given
level of output.
Macroeconomics focuses on the study of economy as whole and its various
aggregates such as national income, aggregate level of employment, general
price level.
The study of macroeconomics which focuses on the economy as a whole is also
highly useful for management economist who is faced with various
decision-making problems. The level of overall economic activity, national
income and employment, aggregate demand conditions, government policies,
interest rate, the changes in price level greatly affect business firms. These
aggregates of the economy make up the macroeconomics environment which
affects business decisions of managers.
Managerial Economics and
Decision Sciences
ME depends on economic theory for theoretical framework for
analyzing the problems of business decision- making.

Business economics uses optimization techniques including differential

calculus, linear and other types of mathematical programming for
deriving decision rules which assist managers for achieving the
objectives of business firms.
Statistical tools of the decision sciences are used to estimate
relationship between important variables which help in decision
making.

Forecasting techniques play and important role in managerial

decision-making. ie., forecasting of future demand, and yield from
capital investment

Optimization techniques, statistical estimation, and forecasting methods

have now become an integral part of modern economic theory.
Nature of Managerial Decision-
Making
To solve the business decisions problems is the task of
Managerial Economist.
Resource at the disposal of an organization are scarce.
Therefore optimum solution to the business decision-making
problem requires that resources should be so used as to achieve
the objective efficiently.
The limited amount of resources is one type of constraint faced
by the manager of a firm.
Constraint faced by manager of a firm economic environment
which includes the state of the economy, the phase of business
cycle, the competitions from the rival firms, government’s fiscal
and monetary policies, export and import policies etc, therefore
the DM problem faced by manager is one of constrained DM.
DM problem requires a choice among alternative courses of action
so as to achieve the objective.
These alternative courses of action among which choice has to
made are often called business strategies.
“To identify the alternative courses of action of achieving given
objectives, and then to select the course of action that achieves
the objective in the economically most efficient way”
EX: Maruti Udyog two possible courses of action (strategies) to
meet the growing market demand for its products.
* First -Strategy is to plan for its internal expansion of productive
capacity. (S1)
* Second- take over the premier auto limited and use its capacity to
increase output to meet growing demand of the product. (S2)
Choose strategy S1 if profits from S1 > profits from S2
Choose strategy S2 if profits from S2> profits from S1.
Manager should have economic theory knowledge to formulate the
objective and to arrive the decision rule for choosing a strategy
plan.
Modern economics is divided into two broad branches:
micro economics and macro economics.
Managers get assistance from both the microeconomics
and macroeconomics while making business decisions,
but concepts and techniques of microeconomic theory
is of greater help for them.
Micro economics tell how to allocate scarce resources
of the firm while making decisions regarding price,
output, technology, advertising expenditure and capital
investment expenditure which are the direct concern of
business management
Inflation in macro economics
Types of business decisions
Price and output decision : cost-output relationship-
demand, market structure, monopoly and monopolistic
competition.
Demand Estimation:
Choice of a technique of production:
Advertising decision:
Long-run production decisions:
Investment decision:
Price and output decision : Cost-output relationship-
demand, market structure, monopoly and monopolistic
competition.
The areas of ME which deals with demand theory, cost
theory, and product pricing are particularly useful for
making decisions about what price to be charged and
what quantity of output to be produced.

Demand Estimation: correct estimates of demand not

only study consumer’s behaviour and their preference
but also GNP, price, changes in the level of
employment and balance of payments.
Choice of a technique of Production: A technique of
production involves the use of particular combination of
factors, i.e., labour and capital to produce a commodity.
Some production techniques involve the use of more labour
as compared to capital and are therefore called
labour-intensive technique. Some production techniques
involve the use of more capital as compared to labour. It is
called capital-intensive technique. Scarcity of resources
demands that goods should be produced with the most
efficient method.
Advertising Decision: Advertising expenditure plays an
important role in the market structure of monopolistic
competition and differentiated oligopoly where firms have
to compete to sell their products.
Advertisement is required to promote sales of a product, and
to create wants for the new product which is planned to be
introduced in the market.
Long-run production decisions: How much quantity of
output is to be produced in the short run, but long-run
decisions pertaining to production have also to be taken by
firms mgt. (eg. : where to locate the plant for manufacturing,
what size of plant, magnitude of productive capacity to be
built up and technology for production)
Investment decision : It is related to investment or capital
expenditure. Investment expenditure is required to expand the
productive capacity, developing and introducing new products.
Investment decisions related to how much investment or
capital expenditure is to be undertaken in a period, what
should be the rate of investment over the year, and on what
projects capital expenditure is to be made.
Nature of firm
The firm is an agent in the economy that produces goods and
services to satisfy wants of the people.
In its productive activity, it transforms inputs such as labour, raw
material, capital, natural resources into useful products which are
demanded by consumers.
Firm exist to use scarce resources of the society efficiently and thus
help the economy to cope with the basic problem of scarcity.
Business firms exist for three main reasons :
They exploit the economies of mass production: Efficient
production of goods requires the use of specialized machines and
factories, assembly lines and division of labour .
They raise funds to finance its productive activities : Eg: Aircraft
They organise the production process. – arrange the required
financial resources, introduce new products and processes, makes
other business decisions and is responsible
Why does a firm Exist? Coase’s View
1937 Ronald coase – nobel prize winner in economics in 1991 explained why a firm exists.
In theory, the existence of a firm is not really necessary.
One can think of separate contracts made by various individuals between them to
produce without the existence of any institution of the firm. EX: consider production of
a car. One individual cam make a part of the car and sell it to another individual who
could produce another part and add another part bought from the first individual..
The second individual can sell these two parts to the car together to a third individual
who in turn can add another part of car and then sell the three parts of the car together
to a fourth individual and so on the chain of individuals adding their parts continue
until the complete car is manufactured and sold to the ultimate buyer. In this way
assembly line of manufacturing car will be replaced by a series of individual contracts
made between various individuals selling and buying different parts of the car.
This entire process of producing and selling different parts by individuals of the car is
coordinated by prices at which different parts are bought and sold. In this way the firm
is eliminated for the process.
Coase’s explained the existence of a firm producing the complete car in a single
organisation rather than a series of contracts between individuals working
independently to produce different parts and selling them to each other.
1) Lower Transaction costs – price components and inputs,
purchasers of goods, writing bills and records and expenses
made on contracts, (if necessary courts and tribunals)
2) Higher productivity under team work with division of
labour.- is divided on the basis of their specialisation which
greatly enhances productivity. Economies of scale and
consequently lower cost per unit.
Decisions by firms: to maximize profits and use its resources for
production of goods and services to satisfy.
1. Which goods and services to produce and in what quantities
2. Which production technique to use for production of a product
3. Which production resources or inputs to use and in what
quantities.
4. How to organize its mgt structure so as to coordinate the
activities.
5. How to finance its productive activity.
The firm’s objective – Profit
Maximisation
Profit is a difference between total revenue and total cost i.e., π = TR-TC. Π
stands for economic profit, TR=total revenue, TC total economic costs at
different levels of output.
OM level of output TR=TC, this level of output is breaking even at a point B.
where TR cuts TC.
Beyond the Break even level of output positive profits start accruing to the firm
as its level of its output.
Profit goes on increasing till output level OQ is reached.
OQ the difference between TC & TR is max, JH is the largest distance between
the TR and TC curves.
JH is the max profits that can be earned by the firm, given the TR and TC
conditions
Profit are Max at output level OQ i.e., π = TR-TC.
First derivative d π/dQ = d (TR)/ dQ – d(TC)/dQ = 0 (or)
d(TR)/ dQ= d (TC)/dQ
The slope of the TR and TC curves corresponding to
output level OQ are the same as the slope of the
tangents drawn to these curves are the same at this
output level.
Total profits curve TP which first rises and then beyond
point N it starts falling indicating that profits are max at
output level OQ.
The profit start declining as output is expanded beyond
OQ.
Price or average revenue equals TR divided by a level
of output, price charged by the firm at output level OQ
is given by TR/OQ or QJ/ OQ.
it brings about increase in TR more than increase in
costs.
It causes increase in revenue, costs remaining
unchanged
It reduces cost more than it reduces revenue
It reduces costs, revenue remaining the same.
Limitations
It does not incorporate time dimension in the
decision-making process by the firm.
It does not analyse the firm’s behaviour under
conditions of risk and uncertainty.
Value maximization model of the
firm
Value maximization of a firm implies maximization of
shareholder’s wealth. It is known as “Shareholders wealth
maximization model”
Modern theory of the firm assumes that primary objective of the
firm or their managers is to max value of wealth or shareholder’s
wealth.
Value of the firm is measured by calculating present value of cost
flows of profits of the firm over a number of years in the future.
The value of the firm or shareholders wealth is given by the PV
of all expected future profits of the firm.
Value of the firm = Present value of expected future profits
PV = π1/(1+i)1+ π2/(1+i) 2 + ….+ πn/(1+i) n = nΣ t=1 πt/(1+i) t -1
Equation 2 since profit = R – C
n
Σ t=1 (R-C) t /(1+i) t
Time dimension has been included in the maximization model by considering
the expected future profits rather than only the profits of the current year.
Secondly, this model also allows for the consideration of risk and uncertainty.
If a series of future profits is highly uncertain it will involve a great deal of risk.
To compensate the shareholders for bearing this risk, the discount rate of
interest can be raised.
quantity of output sold TR= Pt * Qt
cost can be obtained by taking a sum of variable cost and fixed costs. TC = Vt *
Qt + F
PV = nΣ t=1 Pt * Qt – (Vt * Qt + F)/ (1+i) t
Sales and pricing decision of a firm depends on demand function for the firm
and its marketing strategies.
Capital budgeting decision determines the proportions of fixed and variable
cost in the total cost function of the firm.
Thus, choice of a capital- intensive method by the firm will mean a greater
proportion of fixed cost and vice-versa.
Cost of production also depends on physical production conditions including
the technology used and prices of inputs,
 Value of a Firm (PV)

n
Σ t=1 = Pt * Qt – (Vt * Qt + F)/ (1+i) t

Discount rate of Stream of expected future

interest profits
•Risk and uncertainty faced •Demand function and marketing strategies
by the firm of the firm
•Conditions in financial •Cost which are determined by production
markets technology, nature of cost function and
prices of inputs
Constrained Optimization
Legal constrained : Legal constraints relate to such laws as
minimum wage acts, company act to regulate CG,
Anti-Trust Act or Competition Promotion Act to prevent the
emergence of monopolies and unfair trade practices, SEBI
regarding issue and pollution emission standard for
protection of environment, health and safety std of the
employees.
Input constrained: Limited availability of essential
physical inputs. A firm may not be able to obtain as many
skilled workers as it needs for the production of a good.
Procuring specific raw materials, limited factory space and
storage facilities
Financial constraints:
Issuing shares or debentures to raise resources from
stock market. Obtaining loans from the commercial
banks and other financial institutions.
Constrained Optimization:
Subject to the various constraints a firm seeks to
maximizes its profits or the stream of expected future
profits. Therefore decision-making by a firm to
maximize profits or value of the firm is called
constrained optimization. Marginal analysis,
differential calculus and linear programming that are
used by managerial economists to show how the firm
achieves constrained optimization.
Limitation of the value- maximization
model of the firm
The primary objective of the manager is to maximize value of the firm
or shareholders wealth has been criticized on the ground that it is quite
unrealistic.
Maximizing short-run profits or PV of the firm considers higher profits
alone as the sale objective of the firms or the basis of firm’s behaviour.
Managers seek to maximize sales rather than profits or value of the
firm.
Sales maximization model as an alternative to profit or value
maximization model
Managers of modern corporate firms seek to maximize their utility
rather than maximizing short-run profits or value of the firm.
Utility of a manager depends on their salaries, fringe benefits, stock
options, the number of subordinate staff under him, and the extent of his
control on the company.
Manager have to attempt to have satisfactory performance in terms of
profits, sales, market share or growth of the firm.
NATURE Of PROFITS
Business profit is an accounting concept and represents the
residual sales revenue to the owners of the firm after
making payments to all other factors or resources the firm
uses
These payments to hired factors include wages to hired
labour, interest on borrowed capital, rent on land and
factory buildings and expenditure on raw materials used by
the firm. These is called explicit costs
Business profit refers to the sales revenue of the firm minus
its explicit cost
BP =Total Sales Revenue – Explicit Costs
BP is generally used by the business community and
accountants.
Economic profit deduct explicit cost and also implicit
costs from the sales revenue of the firm
Implicit cost refer to the opportunity costs of the
resources provided by the firms owner themselves
including capital and entrepreneurial ability
These self-owned factors must be paid if they are to
employed by the firm in its own production process
otherwise they will be employed elsewhere on hired
basis
Thus, economists take into account the normal rate of
return on capital used by the owner of the firm in its
own business and the transfer earnings of the
owner-entrepreneur as costs of doing business.
The risk adjusted rate of return on capital is the minimum
return that is necessary to attract or retain it in business and
is equal to what the owner could earn from investing in
other firms.
Similarly, the opportunity cost of the entrepreneurial effort
made by the owner entrepreneur is the salary that he could
earn in his next best activity. Likewise, the opportunity
costs of other self-owned factors or inputs such as land,
buildings used by the owner-entrepreneur in his own
business will be counted as implicit costs.
Economic profits= sales revenue-explicit cost –implicit
costs
Maximization of short-run profits or present value of
the stream of expected profits in the future, economists
assume that it is economic profits that owner-
entrepreneur or managers of corporations seek to
maximize.
In long-run equilibrium economic profits will be zero if
all firms work in perfectly competitive market. Then,
how does an economic profit, positive or negative,
come into existence.
Frictional Theory of Economic Profits
It states that markets are sometimes in disequilibrium
because of unanticipated changes in demand or cost
conditions.
Unanticipated shocks produce positive or negative
economic profits for some firms.
Abnormal profits observed by unanticipated changes
in demand or cost conditions.
 Monopoly Theory of Profits
Monopoly is a market structure in which there is only
one producer/seller for a product.
This theory assert that some firms are sheltered from
competition by high barriers to entry.
Firms with monopoly power restrict output and
charge higher prices than under perfect competition.
This causes above-normal profits to be earned by the
monopolistic firms.
Compensatory Theory of Economic
Profits
Compensatory Theory of Economic Profits
Above-normal rates of return that reward efficiency.
It states above-normal rates of return that reward firms
for extraordinary success in meeting customer needs,
maintaining efficient operations, etc.
 Innovation theory
According to Schumpeter, the principal function of the
entrepreneur is to make innovations and profits are a reward for
successful innovations.
Innovation means think different from the rest.
Above normal profits arise because of successful innovations
introduced by the entrepreneurs.
Above-normal profits that by successful invention or
modernization Innovation Theory of Economic Profits
Innovations may be of two types
1. Those which change the production function and reduce the
cost of production. i.e. Introduction of new machinery, improved
production techniques or processes.
2. Those innovations which stimulate the demand for the product,
i.e., which change the demand or utility function.
Risk and uncertainty bearing theory of
profit
This theory explains that profits are a necessary reward of the
entrepreneur for bearing risk and uncertainty in a changing
economy
Profits arise as a result of uncertainty of future
Entrepreneurs have to undertake the work of production under
conditions of uncertainty
They realize the value of output produced by the hired factors after
it has been produced and sold in the market
But a good deal of time is spent in the process of producing and
selling the product.
But between the times of contracts and sale of output many changes
may take place which may upset anticipations for good or for worse
and thereby give rise to profits, positive and negative.
 Causes of uncertainty
Changes in tastes and fashions of the people
Changes in govt. policies and laws especially taxation,
wage and labour policies and laws, liberalization of
imports, etc
Movements of prices as a result of inflation and
depression
Change in income of the people
Changes in production technology
Competition from the new firms that might enter the
industry.
Social Responsibility of business and
profit motive
Business firms should be socially responsible and
works in a way that provides maximum benefits to the
society
This implies that in their efforts to maximize private
profits business firms should not harm social welfare
They should take proper steps to reduce pollution of
environment caused by their activities and adopt
measures for the safety and health of the workers and
fulfill other social obligations