Basic Tools In Managerial Basic Tools In Managerial EconomicsEconomics

Opportunity Cost Opportunity Cost

Discounting PrincipleDiscounting Principle

Marginalism and Incremental PrincipleMarginalism and Incremental Principle

Time PerspectiveTime Perspective

Demand AnalysisDemand Analysis

Opportunity CostOpportunity Cost

In Words of Ferguson “the alternative or In Words of Ferguson “the alternative or opportunity cost of producing one unit of opportunity cost of producing one unit of commodity ‘X’ is the amount of commodity commodity ‘X’ is the amount of commodity ‘Y’, that must be sacrificed in order to use ‘Y’, that must be sacrificed in order to use resources to produce , ‘X’ rather than ‘Y’.’’resources to produce , ‘X’ rather than ‘Y’.’’

Example:Example: The opportunity cost of the funds employed The opportunity cost of the funds employed

in one’s own business is the interest that in one’s own business is the interest that could be earned on those funds had they could be earned on those funds had they been employed in other venture.been employed in other venture.

The opportunity cost of the time of The opportunity cost of the time of entrepreneur devotes to his own businessentrepreneur devotes to his own business

is the salary he could earn by working is the salary he could earn by working somewhere else. somewhere else.

Important FeaturesImportant FeaturesOpportunity costs require ascertainment of Opportunity costs require ascertainment of sacrifice . sacrifice . If a decision involves no sacrifice, If a decision involves no sacrifice, its opportunity cost is Zeroits opportunity cost is Zero

If there is unutilized plant capacity, or if workers If there is unutilized plant capacity, or if workers do not have sufficient work to engage it for do not have sufficient work to engage it for requisite number of hours, the opportunityrequisite number of hours, the opportunity

cost of plant capacity is zero cost of plant capacity is zero

Opportunity cost involve measurement of the Opportunity cost involve measurement of the sacrifice which can be monetary or real. sacrifice which can be monetary or real. Monetary sacrifice can be expressed as Monetary sacrifice can be expressed as explicit cost, recognized in the book of accounts. explicit cost, recognized in the book of accounts. Real sacrifice may be expressed only as implicit Real sacrifice may be expressed only as implicit cost, not recognized in the book accounts.cost, not recognized in the book accounts.

Explicit Cost :Explicit Cost :

The out-of-pocket monetary payments made The out-of-pocket monetary payments made for market supplied inputs (labour services, for market supplied inputs (labour services, raw material and capital equipment).raw material and capital equipment).

Example:Example:

If Dell Computer Company require micropr-If Dell Computer Company require micropr-ocessor chip to manufacture its ‘8300 model ocessor chip to manufacture its ‘8300 model personal computer’. This chip costed $300. personal computer’. This chip costed $300. Thus it is explicit cost because it has to be Thus it is explicit cost because it has to be paid to owner of input. paid to owner of input. The opportunity cost to obtain Chip is $300/ The opportunity cost to obtain Chip is $300/ –

Implicit costImplicit cost::

The non-monetary out-of-pocket payments The non-monetary out-of-pocket payments made for using made for using owner-supplied resourcesowner-supplied resources (time and labour services provided by firm's (time and labour services provided by firm's owner and any land, buildings or capital owner and any land, buildings or capital equipment owned and used by the firmequipment owned and used by the firm). ).

ExampleExampleIf firm owners are not managing their own business, If firm owners are not managing their own business, They could obtain jobs with some other firms. They could obtain jobs with some other firms. TheThesalary that could be earned in an alternativesalary that could be earned in an alternativeoccupation is an implicit cost occupation is an implicit cost which is part ofwhich is part ofthe total cost of production because it is an oppor-the total cost of production because it is an oppor-tunity cost to these owners. tunity cost to these owners.

Measurement of Opportunity Measurement of Opportunity costcost

For example, in this For example, in this diagram, the diagram, the decision to increase decision to increase the production of the production of computers from 5 to computers from 5 to 6 (from point Q to 6 (from point Q to point R) requires a point R) requires a minimum loss of food minimum loss of food output. However, the output. However, the decision to add a decision to add a tenth computer (from tenth computer (from point T to point V) point T to point V) has a much more has a much more substantial substantial opportunity costopportunity cost. .

The Law of Increasing The Law of Increasing Opportunity CostOpportunity Cost

•The slope of the PPF curve is also called the marginal rate of transformation (MRT).

•The negative slope of the PPF curve reflects the law of increasing opportunity cost. As we As we increase the production increase the production of one good, we sacrifice of one good, we sacrifice progressively more of the progressively more of the otherother..

ProblemProblemA A engineer turns down a job offer at Rs. 30,000/- to engineer turns down a job offer at Rs. 30,000/- to start his own business.start his own business.He has invested Rs.50,000 of his own money which has He has invested Rs.50,000 of his own money which has been in a bank account earning 7% been in a bank account earning 7%

rate of interest per year. rate of interest per year. Revenue from the new business during the first year Revenue from the new business during the first year was of Rs.107,000/-was of Rs.107,000/-Other expenses were-Other expenses were- Advertising – Rs. 5000/Advertising – Rs. 5000/Rent Rs/ 10000/-Rent Rs/ 10000/-Taxes 5,000/-Taxes 5,000/-Employee salaries - Rs.40,000 Employee salaries - Rs.40,000 Suppler Rs. 5000/-Suppler Rs. 5000/-Prepare tow income statement using the traditional Prepare tow income statement using the traditional accounting approach and one using opportunity cost accounting approach and one using opportunity cost approach to determine profit. approach to determine profit.

Marginalism & IncrementalismMarginalism & IncrementalismIn economic theory any firm makes a decision In economic theory any firm makes a decision to produce by equating marginal revenues to produce by equating marginal revenues

with marginal costs. (MR=MCwith marginal costs. (MR=MC).). Marginal Revenue – is the change in Total Marginal Revenue – is the change in Total revenue resulting from an one–unit change revenue resulting from an one–unit change

in the volume of output produce (firm decides in the volume of output produce (firm decides to produce n+1).to produce n+1).

Marginal Cost-It refers to the cost of produ-Marginal Cost-It refers to the cost of produ-cing additional unit of output. cing additional unit of output.

Marginal Product – it is the addition made to Marginal Product – it is the addition made to total produce as a result of employing an total produce as a result of employing an additional factor of production. (Labour) additional factor of production. (Labour)

Marginalism & IncrementalismMarginalism & Incrementalism

In making economic decision, management In making economic decision, management is interested in knowing the impact of a is interested in knowing the impact of a chunk-change rather than a unit change .chunk-change rather than a unit change .

Marginal concepts are always defined in Marginal concepts are always defined in terms of unit changes, but incremental terms of unit changes, but incremental concepts are defined in terms of chunk concepts are defined in terms of chunk changes .changes .

Incremental principle concept refers to :Incremental principle concept refers to :

Incremental Revenue - Change in total Incremental Revenue - Change in total revenue caused by a decision.revenue caused by a decision.

IR = IR = TRTR (IR = Incremental Revenue) (IR = Incremental Revenue)

Q (TR = Total Revenue)Q (TR = Total Revenue)

(Q= Total Output)(Q= Total Output)

IR = IR = TRTR

I (I = Total Investment)I (I = Total Investment)

Incremental Cost - Change in total cost.Incremental Cost - Change in total cost.

IC = IC = TC TC (IC = Incremental Cost) (IC = Incremental Cost)

Q (TC = Total Cost)Q (TC = Total Cost)

(Q = Total Output)(Q = Total Output)

Managerial Rule of Thumb- Managerial Rule of Thumb-

IR >ICIR >IC

Example Example An automobile firm adopts a new factory plant to An automobile firm adopts a new factory plant to increase its output. This may involve a rise in its increase its output. This may involve a rise in its total cost by 20% against increase in output by total cost by 20% against increase in output by 10%. 10%.

IC = IC = 20% 20% = 2% = 2%

10%10% On other hand, firm expects rise in total sale On other hand, firm expects rise in total sale

revenue by 30% because of increase in 10% revenue by 30% because of increase in 10% output.output.

IR = IR = 30% 30% = 3% ( IR= 3% > IC = 2%) = 3% ( IR= 3% > IC = 2%)

10%10%

The incremental principle may be stated as The incremental principle may be stated as under :under :

A A decision is obviously a profitable one if decision is obviously a profitable one if

(i) It increases revenue more than costs.(i) It increases revenue more than costs.

(ii) Reduces costs more than revenue (ii) Reduces costs more than revenue

Incremental revenue and incremental cost areIncremental revenue and incremental cost are

two basic concepts for making optimumtwo basic concepts for making optimum

economic decisions. A decision is optimum if iteconomic decisions. A decision is optimum if it

reduces cost more than revenue i.e. if the net reduces cost more than revenue i.e. if the net

incremental revenue is positiveincremental revenue is positive. .

Equi-MarginalismEqui-MarginalismSince resources are limited a very Since resources are limited a very fundamental questions arises : How to decide fundamental questions arises : How to decide on an optim-um allocation of resources. When on an optim-um allocation of resources. When we use resources, we get returns in either we use resources, we get returns in either physical volume or its money value.physical volume or its money value.

If there is only one resource, then we may go If there is only one resource, then we may go on utilizing it till its Marginal return is zero i.e. on utilizing it till its Marginal return is zero i.e. Do not go beyond zero marginal returnDo not go beyond zero marginal return , , if a if a resource has only one useresource has only one use. This is known as ” . This is known as ” absolute activity level principle”. (Consider absolute activity level principle”. (Consider given example)given example)

..

IllustrationIllustrationNo. of

LabourersTotal

OutputAverageOutput

MarginalOutput

1 12 12.0 -

2 22 11.0 10

3 33 11.0 11

4 47 11.8 14

5 59 11.8 12

6 68 11.3 9

7 72 10.3 4

8 72 9.0 0

9 70 7.7 -2

IllustrationIllustrationNo. of No. of LabourersLabourers

Marginal output FromMarginal output From

Project A Project B Project CProject A Project B Project C

1st1st 1010 99 88

2nd2nd 99 88 77

3rd3rd 88 77 66

4th4th 77 66 55

5th5th 66 55 44

6th6th 55 44 33

The equi-marginal principle deals with the The equi-marginal principle deals with the allocation of the available resources among allocation of the available resources among the alternative activities.the alternative activities.

The Principle of equi-marginal return or “Relative Activity Level Principle” states that a resource should be allocated in such a way so that the value added by the last unit is the

same in all uses. But a resource may have various uses. The question arises that how a resource should be used in alternative activities?

When six labourers are at disposal, the When six labourers are at disposal, the optimum allocation of labour resources –optimum allocation of labour resources –

3 labors – A Project (Yield a total output of 3 labors – A Project (Yield a total output of

27)27)

2 Labors –B Project (Yield a total output of 2 Labors –B Project (Yield a total output of

17)17)

1 Labors – C Project (Yield a total output of1 Labors – C Project (Yield a total output of

8) 8)

Total returns are maximum at 52, when Total returns are maximum at 52, when marginal return from each project is 8. marginal return from each project is 8.

Discounting Principle/Present Discounting Principle/Present Value AnalysisValue Analysis

Many transaction involve making or Many transaction involve making or receiving cash payments at receiving cash payments at various various future datesfuture dates..– A person who takes out a mortgage loan A person who takes out a mortgage loan

trades a promise to make monthly trades a promise to make monthly payment for thirty years for a large payment for thirty years for a large amount of cash now to pay for a home.amount of cash now to pay for a home.

– A person injured in an automobile A person injured in an automobile accident accepts an insurance company’s accident accepts an insurance company’s settlement of $1,000 per month for life as settlement of $1,000 per month for life as compensation for the damage associated compensation for the damage associated with the injury.with the injury.

Time value of money make sound Time value of money make sound decisions making or receiving cash decisions making or receiving cash payment at future date. payment at future date.

Time value of Money : refers to the fact Time value of Money : refers to the fact that a Dollar/Rupee to be received in the that a Dollar/Rupee to be received in the futurefuture is not worth a $/Rs. is not worth a $/Rs. Today.Today.

It is important to know a technique to It is important to know a technique to measure present value of dollar to be measure present value of dollar to be received or paid at different points in the received or paid at different points in the future.future.

Present Value of Rs.100 @ 15% Present Value of Rs.100 @ 15% received in different yearsreceived in different years

Rs100 received Rs100 received inin

Present valuePresent value WorkingWorking

Y-1Y-1 86.9686.96 100/ (1.15)100/ (1.15)11

Y-2Y-2 75.6175.61 100/(1.15)100/(1.15)22

Y-3Y-3 65.7565.75 100/(1.15)100/(1.15)33

Y-4Y-4 57.1857.18 100/(1.15)100/(1.15)44

Y-5Y-5 49.7249.72 100/(1.15)100/(1.15)55

Y-10Y-10 24.7224.72 100/(1.15)100/(1.15)1010

Y-25Y-25 3.043.04 100/(1.15)100/(1.15)2525

Y-50Y-50 .09.09 100/(1.15)100/(1.15)5050

AnnuityAnnuity :A series of equal payments per :A series of equal payments per period for a specified length of time. Specific period for a specified length of time. Specific installments for loan payment.installments for loan payment.

Amount Amount :A specific number of dollars :A specific number of dollars

to be paid or received on specific date.to be paid or received on specific date.

Present ValuePresent Value : The value today of an : The value today of an amount or an annuity taking into amount or an annuity taking into consideration that interest can be earned.consideration that interest can be earned.

Present Value of an AmountPresent Value of an Amount PV = PV = $ / $ /(1+i)n (1+i)n

The bracketed term is present value of The bracketed term is present value of $ 1 in n period if the interest rate is i%.$ 1 in n period if the interest rate is i%.

It is called present –value-interest-It is called present –value-interest-factor. factor.

ExampleExample

What is the present value of $1,080 in 1 What is the present value of $1,080 in 1 year if the interest rate is 8% per yearyear if the interest rate is 8% per year??

PV = $1080 /(1.08)PV = $1080 /(1.08)11

= $1,000 = $1,000 In one year $1,000 would increase to In one year $1,000 would increase to $1,080 at 8% interest. Present value takes $1,080 at 8% interest. Present value takes account the potential interestaccount the potential interest,,

Time PerspectiveTime Perspective

Economics normally make a distinction Economics normally make a distinction between “Short- Run” and “ Long-Run”.between “Short- Run” and “ Long-Run”.

By Short -Run , the reference is to the time By Short -Run , the reference is to the time period when the structure of industry , the period when the structure of industry , the size of firm and the scale of plant are not size of firm and the scale of plant are not alterable; the time is so short that any change alterable; the time is so short that any change in the scale of output has to be brought about in the scale of output has to be brought about by changing the intensity of exploiting the by changing the intensity of exploiting the fixed factors like land and machineries.fixed factors like land and machineries.

In ”long- Run” all factors become variable ; In ”long- Run” all factors become variable ; then enough time is available to adjust the then enough time is available to adjust the scale of plant, size of firm and the structure scale of plant, size of firm and the structure

of industry so as to change the volume of of industry so as to change the volume of output.output.