Unit 1

Contents
Nature, Scope, Definitions of Business Economics, Difference Between Business Economic
and Economics, Contribution and Application of Business Economics to Business. Micro
Vs. Macro Economics. Opportunity Costs, Time Value of Money, Marginalism,
Incrementalism, Market Equilibrium and Forces, Risk, Return and Profits.

Meaning and Definitions of Business Economics

DEFINING ECONOMICS
Economics is a social science. It is concerned with the problem of allocation of scarce resources
to achieve the given ends which are essentially competing in nature.
The sole aim is to maximize total satisfaction.
“Management without Economics has no roots & Economics without management bears no
fruits!”
The application of economic theory in business is all pervasive. This has led to the emergence of
separate branch of study called Managerial Economics.
MANAGERIAL ECONOMICS/BUSINESS ECONOMICS
Meaning:
Managerial economics is the application of economic theory to economic practice with an aim of
ensuring that business decisions meet their intended goal. It is through management economics
that a business understands how to access and utilize scarce resources to ensure optimal
performance of the same to generate revenues and profits.

The application assists in decision making with regards to issues about optimum production,
profit maximizing prices and type of product among other economic variables. For instance, a
manufacturing company needs to understand what type of product or which additional features
would boost the utility and sales of their product. This will be determined against analyzing
competitor product offerings or substitutes that exist in the market. The market research is part of
economic theory and application of the information in the business when making the choice of
the product is regarded as economic practice.
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Definitions:
According to Mc Nair and Meriam, “Business economic consists of the use of economic modes
of thought to analyse business situations.”
Siegel man has defined managerial economics (or business economics) as “the integration of
economic theory with business practice for the purpose of facilitating decision-making and
forward planning by management.”

Nature of Business Economics

NATURE OF MANAGERIAL ECONOMICS

1. Micro economic –There are two approaches to study of Economics-Macro and Micro.
Macro-economic approach deals with the economy as a whole. National Income, Trade
Cycles etc. are its themes.
Micro economic approach deals with individual economic behavior thus providing Micro
Economics orientation to Managerial Economics. It concentrates only on the study of an
individual firm.

2. Theory of Firm: The subject matter of Managerial Economics revolves around the Theory
of the firm. This theory of firm has two aspects-Financial aspect and Physical aspect.
Financial aspect comprises of the cost side and the revenue side. Towards this end, the
firm has to
i. fix price,
ii. predict or forecast demand,
iii. consider forms of market.
iv. work out price output relations condition for profit maximization
condition for loss minimization
v. Work out means for survival or decide to shut-down.

Physical aspect requires managers to consider:

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 i. Production process
ii. Optimization of the available resources to produce maximum,
desirable output
iii. Project planning
iv. Tangibles items of the firm like employees, machinery, raw material
etc.
v. Capital budgeting
vi. Use of mathematical tools like diagrams, derivatives, correlation,
regression, probability theory etc

Managerial economics employs economic concepts and principles, which are known as the
theory of Firm or 'Economics of the Firm'. Thus, its scope is narrower than that of pure economic
theory.

3. It takes the help of Macro Economics- Knowledge of Macro Economics Essential since
firms do not work in isolation, managers have to consider competition, government intervention,
tariffs, trade & monetary policies, liberalization business cycles, taxation policies, industrial
policy of the government, price and distribution policies, wage policies and anti-monopoly
policies etc which are integral to the successful functioning of a business enterprise. This makes
knowledge of macro economics essential for a student of Managerial Economics to have better
understanding of the environment in which the business operates and adjust accordingly.

4. Pragmatic- Managerial economics involves analytical tools for rational decision making. It
involves the complications ignored in economic theory to face the overall situations in which
decisions are made. In pure micro-economic theory, analysis is performed, based on certain
exceptions, which are far from reality. So business economics analyses the situation and take the
decisions which help in solving the problems.

5. Positive and Normative Approach- Managerial Economics belongs to both normative

economics (what ought to be) and positive economics (what is). It has two aspects:

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• Defines the aims and objectives which the firm should pursue
• Tells how best to achieve these aims in particular situations

It is concerned with varied corrective measures that a management undertakes under various
circumstances. It deals with goal determination, goal development and achievement of these
goals. Future planning, policy-making, decision-making and optimal utilisation of available
resources, come under the banner of managerial economics. It is a study of Economics which
covers issues like welfare, money, agriculture, international trade, public finance, etc and help in
the attainment of the goals with the available resources. Thus it has been defined both normative
and positive science.

6. Both Conceptual and Metrical- It provides conceptual framework for decision making on
one hand and on the other it takes the help of quantitative techniques for measurement of various
economic entities and their relation and impact on each other.
7. Decision making of economic nature – identification of economic choices and allocation of
scarce resources.

8. Multi-disciplinary in nature- Business economics is not just the involvement of economics

but it also includes various other disciplines like-Statistics, Management, Operations Research,
Mathematics, Psychology etc.

Scope of Business Economics

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1) Theory of Demand Analysis: It deals with consumer behavior, demand and factors
effecting demand like price of consumers, income of consumers, income of related goods
etc, Different elasticities of demand and demand forecasting.

2) Theory of Consumer’s Equilibrium helps in understanding how a consumer allocates

his income between different needs. It attempts to answer: How do the consumers decide
whether or not to buy a commodity? When do they stop consuming a commodity? How
do they behave when changes occur in prices, fashion, technology etc? An understanding
of the decision-making process of a consumer helps business managers in devising more
effective sales, marketing and advertising strategies.
3) Theory of Production and Production decisions: Production theory is also known as
Theory of Firm. A Business Manager has to take several decisions regarding production
– eg. What to produce, what should be the plant capacity, what should be the capacity
utilization, which technology to use, and the amount of capital and labour to be
employed. Thus managerial economics explains relationship between input and output
and answers

Production theory tells the relationship between average cost, marginal costs and
production. It highlights how a change in production can bring about a parallel change in
average and marginal costs. Production theory also deals with other issues such as
conditions leading to increase or decrease in costs , changes in total production when one
factor of production is varied and others are kept constant, substitution of one factor with
another when all increased simultaneously and methods of achieving optimum
production.

4) Analysis of Market-structure and Pricing Theory. How many players are competing
for the given market demand? What is the market structure and how will it impact the
firm’s own sales? How prices are determined under different market conditions? What is
Price Discrimination? What extent of advertising required? What should be the pricing
policy of the firm?

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5) Cost Analysis: In order to maximize profits, a firm needs to minimize costs. Costs are
impacted by several factors. Primary among them are quantity of production and factor
prices. Managerial economics studies Costs Concepts, cost classification, Methods of
estimating costs, Relation between cost and output, Forecasting costs and profits,
Economies and diseconomies of scale etc.

6) Profit Analysis: Every business and industrial enterprise aims at maximising profit.
Profit is the difference between total revenue and total economic cost. Profitability of an
organisation is greatly influenced by the following factors:

•Demand of the product

•Prices of the factors of production
•Nature and degree of competition in the market
•Price behaviour under changing conditions
Hence, profit planning and profit management are important requisites for improving
profit earning efficiency of the firm. Profit management involves the use of most efficient
technique for predicting the future.

7) Theory of Capital and Investment: Capital is the building block of a business. Like
other factors of production, it is also scarce and expensive. It should be allocated in most
efficient manner. Theory of Capital and Investment evinces the following important
issues:
 Selection of a viable investment project
 Efficient allocation of capital
 Assessment of the efficiency of capital
 Cost- Benefit Analysis is done
 Pay Back Period: How quickly the invested amount is returned in the hand
of investors.
 Annual Returns from the investments.
 Minimising the possibility of under capitalisation or overcapitalisation.

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 8) Inventory Management: Managerial economics also helps in identifying the ideal
stocks, low stocks of inventory, Maximum and minimum order of inventories, maintain
the smooth and uninterrupted flow of production process.

9) Environmental issues: Managerial economics also encompasses some aspects of

macroeconomics. These relate to social and political environment in which a business
and industrial firm has to operate. This is governed by the following factors:
•The type of economic system of the country
•Business cycles
•Industrial policy of the country
•Trade and fiscal policy of the country
•Taxation policy of the country
•Price and labour policy
•General trends in economy concerning the production, employment, income,
prices, saving and investment etc.
•General trends in the working of financial institutions in the country
•General trends in foreign trade of the country
•Social factors like value system of the society

Contribution and Application of Business Economics to Business

Business Economics or Managerial Economics is the application of economic theory and
methodology to business. It is a part of economic theory which focuses on business enterprises and
inquires into the factors contributing to the diversity of organizational structures and to the
relationships of firms with labour, capital and product markets. It may be that business economics
serves as a bridge between economic theory and decision-making in the context of business.

Siegel man has defined managerial economic (or business economic) as “the integration of economic
theory with business practice for the purpose of facilitating decision-making and forward planning by
management.”

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Managerial economics applies economic theory and methods to business and administrative decision
making. Managerial economics prescribes rules for improving managerial decisions. Managerial
economics also helps managers recognize how economic forces affect organizations and describes the
economic consequences of managerial behavior. It links traditional economics with the decision
sciences to develop vital tools for managerial decision making. This process is illustrated in Figure
below. The Contribution and application of Managerial Economics in Business Decision
Making

Management Decision Problems

 Product Price and Output
 Make or Buy
 Production Technique
 Advertising Media and Intensity
 Investment and Financing

Economic Concepts Decision Sciences

Framework for Decisions Tools and Techniques
 Theory of consumer of Analysis
behavior  Statistical analysis
 Theory of the firm  Forecasting
 Theory of the market  Game Theory
structure and pricing

Managerial Economics
Use of Economic Concepts and Decision Science Methodology
to solve Managerial Decision Problems

Optimal Solutions to Managerial

Decision Problems
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Managerial economics provides production and marketing rules that permit the company to
maximize net profits once it has achieved growth objectives. Managerial economics has
applications in both profit and not-for-profit sectors.

For example, an administrator of a nonprofit hospital strives to provide the best medical care
possible given limited medical staff, equipment, and related resources. Using the tools and
concepts of managerial economics, the administrator can determine the optimal allocation of these
limited resources. In short, managerial economics helps managers arrive at a set of operating rules
that aid in the efficient use of scarce human and capital resources. By following these rules,
businesses, nonprofit organizations, and government agencies are able to meet objectives
efficiently.

Hence, tools of managerial economics can be used to achieve all the goals of a business
organization in an efficient manner. Typical managerial decision making may involve one of the
following issues:

1. Deciding the price of a product and the quantity of the commodity to be produced.
2. Deciding whether to manufacture a product or to buy from another manufacturer.
3. Choosing the production technique to be employed in the production of a given product.
4. Deciding on the level of inventory a firm will maintain of a product or raw material.
5. Deciding on the advertising media and the intensity of the advertising campaign
6. Making employment and training decisions.
7. Making decisions regarding further business investment.

It should be noted that the application of managerial economics is not limited to profit-seeking
business organizations. Tools of managerial economics can be applied equally well to decision
problems of nonprofit organizations. While a nonprofit hospital is not like a typical firm seeking
to maximize its profits, a hospital does strive to provide its patients the best medical care
possible given its limited staff (doctors, nurses, and support staff), equipment, space, and other
resources. The hospital administrator can use the concepts and tools of managerial economics to
determine the optimal allocation of the limited resources available to the hospital.

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 Difference between Business Economics and Economics

Economics relates to the study of all the economic factors which affect the revenue and cost of the
firm. These include the demand analysis, production analysis, cost analysis, market structures, pricing
policies of the firms, investment decisions of the firms. Business Economics, on the other hand, is the
application of economic theory and methodology to business. However, the difference between
business economics and economics are:

Table 1: Difference between Business Economics and Economics

Area of difference Business Economics Economics

1. Nature It deals with application of It deals with the body of the
economic principles to the principles itself.
problems of the firms.

2. Nature of It basically deals with the It deals with the both micro and
Economic Principles application of normative macro-economic
Studied. micro-principles and involves principles-normative and
value judgments. It is concerned positive.
with what decisions ought to be
made. Thus, it is perspective.
3.Scope of the Study Through business economics is Micro economics as a
micro in character, it deals with the
multifaceted branch of
problems of the business firms. only economics, deals with the
economic problems of
business firms but also
individual’s economic
problems. Thus, economics
has a wider scope of study.

4.Focus of Study The main focus of the study of Under, micro economics, as a
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 business economics is profit theory. branch of economics,
Other distribution theories have not
distribution theories like rent,
much relevance here. wage, and interest are dealt
along with the theory of profit.

5.Approach of the Study It adopts, modifies or Economic theory

reformulates already existing makes assumptions and
economic models to suit the hypothesizes
specific conditions and economic relationships and
serve the specific problem of the
generates economic models.
business firm.
6.Methodology Business economics is pragmatic Economic theory avoids
in the sense that it introduces many complexities and
some realistic aspects such makes
as simplified assumptions to
objectives of the firm , resource, solve complicated theoretical
legal and behavioral issues.
constraints, environmental and
technological factors and
attempts to solve some real life
complex business problems using
other related branches like
mathematics , statistics, etc.

Micro Vs Macro Economics

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Modern economic theory is divided into two branches:
1) Micro Economics (Price theory)
2) Macro Economics (Income theory)

1) Micro Economics: The term micro is derived from the greek word ‘mikros’ which means
small. Thus micro economics is a theory of small and is also called the microscopic study of the
economy.

It is an analysis of individual behavior. This branch of economics analyzes the market behavior of
individual consumers and firms in an attempt to understand the decision-making process of firms
and households. It is concerned with the interaction between individual buyers and sellers and the
factors that influence the choices made by buyers and sellers.

In particular, microeconomics focuses on patterns of supply and demand and the determination
of price and output in individual markets (e.g. coffee industry). It includes:

(i) Product pricing;

(ii) Consumer behaviour
iii) Factor pricing;
iv) Economic conditions of a section of the people;
(v) Study of firms; and
(vi) Location of a industry.

Micro–Economics, thus involves the study of economic behaviour of an individual, firm or

industry in the national economy. It is thus a study of a particular unit rather than all the units
combined.

2) Macro Economics:

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The term macro is derived from the greek word ‘makros’ which means large. It is a branch of
economics dealing with the performance, structure, behavior, and decision-making of the entire
economy. This includes a national, regional, or global economy. Macroeconomists develop
models that explain the relationship between such factors as national income, output,
consumption, unemployment, inflation, savings, investment, international trade and international
finance.

Macroeconomics is thus the study of aggregates; hence called Aggregative Economics. It is the
analysis of the entire economic system, the overall conditions of an economy like total
investment and total production. In Macro-Economics, we study the economic behaviour of the
large aggregates such as the overall conditions of the economy such as total production, total
consumption, total saving and total investment in it.
It is the study of overall economic phenomena as a whole rather than its individual parts. It
includes:
(i) National income and output;
(ii) Inflation
(iii) Balance of trade and payments;
(iv) Saving and investment; and
(v) Employment and economic growth.
There are quite a few differences between the two concepts. While microeconomics stresses on
the individual firms and consumer, macroeconomics deals with the whole economy as a single
unit. This invariably means that the former takes into consideration the demand and supply of the
individual goods and services, while the later takes into consideration the aggregate of demand
and supply of all goods and services. Yet another point of distinction in the macroeconomics vs
microeconomics comparison is the point of the equilibrium. In microeconomics, the equilibrium
occurs when the quantity demanded equals the quantity supplied.

In macroeconomics, on the other hand, equilibrium occurs when the aggregate demand equals
aggregate supply. The following will make it clear:
BASIS Microeconomics Macroeconomics
Simplicity/ Simple Complex
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Complexity

View of Economy Microscopic view (worm’s eye view) Macroscopic view (bird’s eye
view)

Meaning Microeconomics is the branch that Macroeconomics is the branch

deals with the functionality and that deals with the functionality
behaviour of individual entities, such and behaviour of the entire
as business firms and households. economy of the nation or the
The effect of the functioning and world. This includes concepts
behaviour of these individual units on like national income, price
the supply and demand for goods and level, employment, interest
services is also taken into rates, etc.
consideration in this subcategory of
economics.
Degree of Studies individual units Studies aggregates
Aggregation
(Based on slicing) (based on lumping)

Difference in It deals with the determination of It is the study of principles and

objectives problems concerning the optimum problems concerning the full
utilization of resources. employment of resources and
the growth of resources.
Difference in It deals with the determination of It deals with full employment,
subject matter price, consumer’s equilibrium. national income, general price
level and economic growth.
Difference in It studies the equilibrium between the It studies the equilibrium
forces of forces of individual demand and between the forces of aggregate
equilibrium individual supply. demand and aggregate supply.
Assumption of Micro economics assumes full Macro economics does not
full employment employment. assume full employment.

Assumption of Applicable Not Applicable

Ceteris Paribus

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Fundamental By Prof. G. Thimma- It is a Price By J.M. Keynes- It is a Income
Difference Theory as it deals with equilibrium Theory as it deals with national
price income

Major Price is the major determinant of Income is the major determinant

determinant micro- economic analysis. of macro- economic analysis.

FUNDAMENTAL CONCEPTS OF APPLIED MANAGERIAL ECONOMICS

1. Principle of Opportunity Cost:

Every scarce goods or activity has an opportunity cost. Opportunity cost of anything is the cost
of the next best alternative which is given up. It refers to the cost of foregoing or giving up an
opportunity. It is the earnings that would be realized if the available resources were put to some
other use.
The opportunity cost of using a machine to produce one product is the income forgone which
would have been earned from the production of other products. If the machine has only one use,
it has no opportunity cost.

Similarly, the opportunity costs of funds invested in one's own business is the amount of interest
earned if the amount had been used in other projects.

If an old building is proposed to be used for a business, likely rent of the building is the
opportunity cost.

These are called opportunity costs because they represent the opportunities which are foregone.

How to Evaluate Opportunities:- Before selecting any opportunity we have to evaluate the
different alternative opportunities available in the market. Following are the steps which a
businessman/ firm’s owner takes to evaluate the market opportunities:-

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 1. Look at the opportunity for given time period: In market there is ‘n’ number of
opportunities but because of limited resources we can select only one. Eg: A businessman
has to open a new project at that time he has different market opportunities like opening a
restaurant, opening a café shop or opening a gift shop with coffee shop.
2. Evaluate the first opportunity by what would be gained if you choose to do the
second opportunity.
3. Add up the cost of the first opportunity that would not be incurred if you choose
second opportunity.
4. Evaluate the second opportunity in the light of the first opportunity.
5. Choose based on which Opportunity cost seems higher.

2. Time Value of Money- Discounting Principle. Generally people consider a rupee tomorrow
to be worth less than a rupee today. This is also implied by the common saying that a bird in
hand is worth than two in the bush.
Money has time value. A rupee today is more valuable than a year hence. It is on this concept
“the time value of money” is based. It recognizes that the value of money is different at different
points of time. The difference in the value of money today and tomorrow is referred as time
value of money.

Anybody will prefer Rs. 1000 today to Rs. 1000 next year. The main reasons for this are:
Reasons for Time Value of Money: Money has time value because of the following reasons:

1. Risk and Uncertainty: Future is always uncertain and risky. Outflow of cash is in our control
as payments to parties are made by us. There is no certainty for future cash inflows. Cash inflows
are dependent out on our Creditor, Bank etc. As an individual or firm is not certain about future
cash receipts, it prefers receiving cash now.

2. Inflation: In an inflationary economy, the money received today, has more purchasing power
than the money to be received in future. In other words, a rupee today represents a greater real
purchasing power than a rupee received tomorrow.

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3. Consumption: Individuals generally prefer current consumption to future consumption.

4. Investment opportunities: An investor can profitably employ a rupee received today, to give
him a higher value to be received tomorrow or after a certain period of time.

TECHNIQUES USED FOR CALCULATING TIME VALUE OF MONEY

Compounding Techniques/Future Value Technique

In this concept, the interest earned on the initial principal amount becomes a part of the principal
at the end of the compounding period.
FOR EXAMPLE: Suppose you invest ` 1000 for three years in a saving account that pays 10 per
cent interest per year. If you let your interest income be reinvested, your investment will grow as
follows:

BASIC CONCEPT OF TIME VALUE OF MONEY

First year : Principal at the beginning 1,000
Interest for the year 10%
Principal at the end – 1000 + 10% of 1000=1,100

Second year : Principal at the beginning 1,100

Interest for the year =10%
Principal at the end 1100+ 10% of 1100= 1210

Third year : Principal at the beginning 1210

Interest for the year =10%
Principal at the end - 1210+ 10% of 12101= 1331
This process of compounding will continue for an indefinite time period. The process of
investing money as well as reinvesting interest earned there on is called Compounding. But the
way it has gone about calculating the future value will prove to be cumbersome if the future
value over long maturity periods of 20 years to 30 years is to be calculated. A generalized
procedure for calculating the future value of a single amount compounded annually is as follows:
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Formula: FVn = PV(1 + r)n
In this equation (1 + r)n is called the future value interest factor (FVIF).
Where,
FVn = Future value of the initial flow n year
Hence,
PV = Initial cash flow
r = Annual rate of Interest
n = number of years
By taking into consideration, the above example, we get the same result.
FVn = PV (1 + r)n
Here PV= 1000
R= 10%
n= 3 years
Therefore,
FVn= 1,000 (1.10)3
FVn = 1331

To solve future value problems, we can consult a future value interest factor (FVIF) table. This
shows the future value factor for certain combinations of periods and interest rates. To simplify
calculations, this expression has been evaluated for various combinations of ‘r’ and ‘n’.

Discounting Principle

A rupee now is worth more than a rupee earned a year after. To take decision regarding
investment which will yield return over a period of time it is necessary to find its present worth
by using discounting principle. The process of determining present value of a future payment or
receipts or a series of future payments or receipts is called discounting. The compound interest
rate used for discounting cash flows is also called the discount rate.

Discounting Principle is the extension of time perspective and it is based on the principle that as
future is full of risk and uncertain, the return in future is less attractive than the same return
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today. The future there fore must be discounted both for the elements of delay, risk and
uncertainty. The concept of discounting future is based on the fundamental fact that, a rupee
earned now is worth more than a rupee earned a year after, even if there will be a certain future
return, yet it must be discounted because to wait for future implies a sacrifice for the present.

This principle helps to bring value of future rupees to present rupees

PVn = FV/(1 + r)n

OR
V= R1/(1+i) + R2/(1+i)2………Rn/(1+i)n

OR

Where, R= Principal Amount, i= Interest Rate & t= number of years investment is to be made

ILLUSTRATION: What is the present worth (PW) of Rs. 1000 obtainable after one year ?
Where rate of interest is 8percent per annum and it is invested for two years. So, find out the
present value of future cash flows.
The principle of economics used in the calculations given above is called the discounting
principle. It can be explained as "If a decision affects costs and revenues at future dates, it is
necessary to discount those costs and revenues to obtain the present values of both before a valid
comparison of alternatives can be made" present values of both before a comparison of
alternatives can be made’’

3. Marginalism and Incrementalsim:

Marginalism refers to the use of marginal concepts in economic theory. Marginal Principle
refers to change (increase or decrease) in total of any quantity due to a unit change in its

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determinant. Marginalism implies the change in dependent variable associated with a 1-unit
change in a particular independent variable

MC= TC n - TC n-1

MR = TR n -TR n-1

Decision Rule FOR Profit Maximization: MR=MC

Marginalism includes two important components. They are:-

1) Marginal cost- Marginal cost can be defined as the change in total cost as a result of
producing one more unit of commodity.

Formula of Marginal Cost (MC) = TCn – TC(n-1)

Where,

TCn= Total cost of producing ‘n’ units

TC(n-1)= Total cost of producing ‘n-1’ units

For Example:

Total Cost of producing 100 units= INR 2500

Total Cost of producing 101 units= INR 2550

Here,

TCn = 2550 and TC(n-1) =2500

So, MC= 2550-2500= 50

2) Marginal Revenue- Marginal revenue is benefits which get by producing one more or next
unit of commodity.

Formula of Marginal Revenue (MR) = TRn – TR(n-1)

Where,

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TRn= Total revenue of producing ‘n’ units

TR(n-1)= Total revenue of producing ‘n-1’ units

Decision Rule:

MR<MC- Condition of Loss.

MR=MC- No profit No Loss.

MR>MC- Condition of Profit.

This concept of marginality assumes special significance where maximization and minimization
problem can be solved. This is used in business analysis where businessman has to see the affect
adding or subtracting one variable factor on the total output.

Limitations of Marginalism

When used in cost analysis MC refers to change in variable cost only. Generally firms do not
have knowledge of MC & MR because most firms produce in and sell their products in bulk
except cases such as airplanes, ships, etc

Therefore, in the real world of business management, marginalism should better be replaced by
Incrementalism.

INCREMENTALISIM

Incremental Principle is applied to business decisions which involve a large change in total cost
or total revenue. In making economic decision, management is interested in knowing the impact
of a chuck-change rather than a unit-change. Incremental cost can be defined as the change in
total cost due to a particular business decision i.e. change in level of output, investment, etc.
Includes both fixed & variable cost but does not include cost already incurred i.e. sunk cost.

From the above we can make out that Incrementalsim consider two major aspects:-

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A. Incremental Cost- It includes the fixed cost and variable cost. But it doesn't include the sunk
cost, cost already incurred on the excess capacity or cost on unused material. The three major
components related to incremental cost are:-

 Present Explicit Cost- Fixed and Variable Cost

 Opportunity Cost
 Future Cost- Advertising cost, depreciation

B. Incremental Revenue- The increase in the total revenue resulting from a business decision
is called as Incremental revenue.

The difference between IC and IR is known as Contribution. It is useful in taking the decision
like:-

 Whether or not accept a project.

 Whether or not introduce a new product.
 Whether or not accept the new order.
 Whether or not add an additional plant, etc.

Decision Rule:

 TR<TC-Reject the project

 TR=TC- No profit No Loss.
 TR>TC- Accept the project

The concept of Incrementalsim is helpful in taking the business decision that whether to accept
or reject the business proposition or option.

Incremental revenue is a change in total revenue resulting from a change in level of output, price
etc.

Business decision’s worthwhileness is always determined on the basis of criterion that

incremental revenue should exceed incremental cost

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Marginal Concepts Incremental Concepts
Marginal concepts are always defined in' terms Incremental' concepts are defined in terms of
of unit changes chunk changes
Marginal concepts are more rigid Incremental -concepts are more flexible than
marginal concepts
In Marginalism, the reference is to one In Incrementalsim, more than one independent
independent variable. Eg. Marginal revenue is variable can be considered at a time. Eg
the increase in revenue due to one-unit increase revenue may increase due to a change in not
in level of output only output, but also price and production
process.

Market Forces & Equilibrium

A market is a group of buyers and sellers of a particular good or service. The buyers as a group
determine the demand for the product, and the sellers as a group determine the supply of the
product. Supply and demand are the forces that make market economies work. They determine
the quantity of each good produced and the price at which it is sold.

There are two main market forces:

1) Demand: Quantity demanded of any good, which is the amount of the good that buyers are
willing and able to purchase.

2) Supply: The quantity supplied of any good or service is the amount that sellers are willing
and able to sell.

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Supply and Demand: Together Supply and demand together determine the quantity of a good
sold in a market and its price. There is one point at which the supply and demand curves
intersect; this point is called the market’s equilibrium. The price at which these two curves cross
is called the equilibrium price, and the quantity is called the equilibrium quantity.

The Concept of Market Equilibrium

Equilibrium means a state of equality or a state of balance between market demand and
supply. Without a shift in demand and/or supply there will be no change in market price. In the
diagram below, the quantity demanded and supplied at price P1 are equal. At any price above P1,
supply exceeds demand and at a price below P1, demand exceeds supply. In other words, prices
where demand and supply are out of balance are termed points of disequilibrium.

Equilibrium Determination

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At O P Price, demand of the buyers is OL, while sellers are ready to sell OK quantity. (OK>OL)
i.e. There is excess supply. In this situation there will be a competition among the sellers. On the
contrary at 0T prices demand will be ON units where as supply will be OM units. In this case
demand will be more than supply & prices will tent to increase.

At Point ‘E’ there will be equilibrium of Demand supply. This will be equilibrium price.

Shifts in demand and supply play a critical role in altering market

equilibrium price points. There are two types of shifts:

Demand Shifts
Demand shifts are defined by more or less of a given product or service being

required at a fixed price, resulting in a shift of both price and quantity. As would be

assumed, an increase in demand will shift price upwards and volume to the right,

increasing the overall value of both metrics relative to the prior equilibrium point .

Alternately, a decrease in demand will shift price downwards and volume to the left,

decreasing both measurements to realign equilibrium with a reduced demand.

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Supply Shifts
Supply shifts are defined by more or less of a particular product/service being

available to fulfill a given demand, affecting the equilibrium point by shifting the

supply curve upwards or downwards. A supply shift to the right, indicating more

availability of the specified product or service, will create a lower price point and a

higher volume assuming a fixed demand . Alternately, a decrease in supply with a

consistent given demand will see an increase in price and a decrease in quantity.

This is an intuitive theory underlining the fact that scarcity is relevant to the

willingness to pay.

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 RISK, RETURN & PROFITS

Definition of 'Risk'
Risk is defined as “The probability that an actual return on an investment will be lower than the
expected”.
Risk includes the possibility of losing some or all of the original investment. Different versions
of risk are usually measured by calculating the standard deviation of the historical returns or
average returns of a specific investment. High standard deviation indicates a high degree of risk.

Risk is broadly classified in to two categories:

1. Systematic Risk: Systematic risk is risk associated with market returns. This is risk that can
be attributed to broad factors. It is risk to your investment portfolio that cannot be attributed to
the specific risk of individual investments.
Sources of systematic risk could be macroeconomic factors such as inflation, changes in interest
rates, fluctuations in currencies, recessions, wars, etc. Macro factors which influence the
direction and volatility of the entire market would be systematic risk. An individual company
cannot control systematic risk.

2. Unsystematic Risk: Unsystematic risk is company specific or industry specific risk. This is
risk attributable or specific to the individual investment or small group of investments. It is
uncorrelated with stock market returns. Other names used to describe unsystematic risk are
specific risk, diversifiable risk, idiosyncratic risk, and residual risk.

Examples of risk that might be specific to individual companies or industries are business risk,
financing risk, credit risk, product risk, legal risk, liquidity risk, political risk, operational risk,
etc. Unsystematic risks are considered governable by the company or industry.

Risk and Return

A fundamental idea in finance is the relationship between risk and return. The greater the amount
of risk that an investor is willing to take on, the greater the potential return. The reason for this is
that investors need to be compensated for taking on additional risk.

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For example, a U.S. Treasury bond is considered to be one of the safest (risk-free) investments
and, when compared to a corporate bond , provides a lower rate of return . The reason for this is
that a corporation is much more likely to go bankrupt than the U.S. government. Because the risk
of investing in a corporate bond is higher, investors are offered a higher rate of return.
Uncertainity

Situation where the current state of knowledge is such that

(1) the order or nature of things is unknown,
(2) the consequences, extent, or magnitude of circumstances, conditions, or events is
unpredictable, and
(3) credible probabilities to possible outcomes cannot be assigned.

Profit

Accounting profit is defined as total revenue (sales) minus accounting (explicit) costs i.e.
monetary payments (or cash expenditures) made to supply labor services, materials, fuel,
transportation services, depreciation, interest and taxes.

Accounting profits tend to be higher than economic profits as they omit certain implicit costs,
such as opportunity costs.

An Economic profit arises when the company’s revenue exceeds the total (opportunity) cost of
its inputs. It is the difference between the revenue received from the sale of an output and the
opportunity cost of the inputs used. This can be used as another name for "economic value
added"(EVA)
In calculating economic profit, opportunity costs are deducted from revenues earned.

Difference between Accounting and Economic Profit

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HOW A FIRM ARRIVES AT A PROFIT-MAXIMIZING POINT

Profit Maximization Objective

Profit maximization objective helps in predicting the behavior of business firms in the real
world, as well as in predicting the behavior of price and output under different market
conditions. There are some theoretical profit-maximizing conditions and these are presented
below.

We first define profit as:

Profit = TR – TC,
Where TR = Total Revenue = Unit price (P) x Quantity (Q) = PQ, and,
TC = Total cost = Variable Cost (VC) + Fixed Cost (FC).
Now, Two marginal conditions for profit maximization:

(i) The first-order (or necessary) condition, and

(ii) The second-order (or supplementary) condition.

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The first-order condition requires that at a maximum profit, marginal revenue (MR) must equal
marginal Cost (MC). Note that by the term ‘marginal revenue’, we mean the revenue obtained
from the production and sale of one additional unit of output, while ‘marginal cost’ is the cost
arising from the production of the one additional unit of output. A firm maximizes profits, in
general, when its marginal revenue equals marginal cost. If the firm produces beyond this point
of equality between the marginal revenue and marginal cost, the marginal cost will be higher
than the marginal revenue. In other words, the addition to total production beyond the point
where marginal revenue equals marginal cost, leads to lower, not higher, profits.

The second-order condition is the sufficient condition for profit maximizations. The second-
order condition requires that the first-order condition must be satisfied under the condition of
decreasing marginal revenue (MR) and increasing marginal cost (MC). This implies that at the
optimum point of profit maximisation, marginal cost (MC) must intersect the marginal revenue
(MR) from below.
We conclude that maximum profit occurs where the first- and second-order conditions are
satisfied.
1. First-order condition, MR = MC.
2. Second-order condition: if MC cuts MR from below

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