MANAGERIAL ECONOMICS

MODULE 1
The Fundamentals of Managerial Economics
Overview
This module dwells on the fundamentals of managerial economics specifically
on the preliminaries to managerial, scope and the nature of the managerial
economics. This segment emphasis the basic concepts, foundation of the
managerial tasks in business management. Nature, principles, and models used in
effective management decision – making. Role and anticipated responsibilities of a
managerial economist are stress.

Lesson 1- Introduction to Managerial Economics

Lesson 2- Scope of Managerial Economics
Lesson 3- Nature of Managerial Economics

LEARNING OUTCOMES

At the end of the module the students would be able to:

define and identify the basic concepts, theories, and business

practices of managerial economics;

solves managerial issues/complications in actual business events

applying the pertinent principles, models, and theories;

develop personal values on the importance of resource management

in view of scarcity and limitation of economic resource;

practice the duties and responsibilities as managerial economist in

the organization you belong.

Lesson 1- Introduction to Managerial Economics

Managerial Economics can be defined as amalgamation of economic theory
with business practices so as to ease decision-making and future planning by

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management. Managerial Economics assists the managers of a firm in a rational

solution of obstacles faced in the firm’s activities. It makes use of economic theory
and concepts. It helps in formulating logical managerial decisions.

The key of Managerial Economics is the micro-economic theory of the firm. It

lessens the gap between economics in theory and economics in practice.
Managerial Economics is a science dealing with effective use of scarce resources.
It guides the managers in taking decisions relating to the firm’s customers,
competitors, suppliers as well as relating to the internal functioning of a firm. It makes
use of statistical and analytical tools to assess economic theories in solving practical
business problems.

Study of Managerial Economics helps in enhancement of analytical skills,

assists in rational configuration as well as solution of problems. While
microeconomics is the study of decisions made regarding the allocation of resources
and prices of goods and services, macroeconomics is the field of economics that
studies the behavior of the economy as a whole (i.e. entire industries and
economies). Managerial Economics applies micro-economic tools to make business
decisions. It deals with a firm.

The use of Managerial Economics is not limited to profit-making firms and

organizations. But it can also be used to help in decision-making process of non-
profit organizations (hospitals, educational institutions, etc). It enables optimum
utilization of scarce resources in such organizations as well as helps in achieving
the goals in most efficient manner. Managerial Economics is of great help in price
analysis, production analysis, capital budgeting, risk analysis and determination of
demand.

Managerial economics uses both Economic theory as well

as Econometrics for rational managerial decision making. Econometrics is defined
as use of statistical tools for assessing economic theories by empirically measuring
relationship between economic variables. It uses factual data for solution of
economic problems. Managerial Economics is associated with the economic theory
which constitutes “Theory of Firm”. Theory of firm states that the primary aim of the
firm is to maximize wealth. Decision making in managerial economics generally
involves establishment of firm’s objectives, identification of problems involved in
achievement of those objectives, development of various alternative solutions,
selection of best alternative and finally implementation of the decision. 1

The following figure tells the primary ways in which Managerial Economics
correlates to managerial decision-making.

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1Source:https://www.managementstudyguide.com/managerial-economics.htm

The correlates of managerial economics to managerial decision - making

Lesson 2 - Scope of Managerial Economics

Managerial Economics deals with allocating the scarce resources in a

manner that is different from microeconomics and macro-economics.
Managerial Economics has a narrower scope - it is actually solving
managerial issues using micro-economics. Wherever there are scarce resources,
managerial economics ensures that managers make effective and efficient decisions
concerning customers, suppliers, competitors as well as within an organization. The
fact of scarcity of resources gives rise to three fundamental questions-

a. What to produce?
b. How to produce?
c. For whom to produce?

To answer these questions, a firm makes use of managerial economics

principles.

The first question relates to what goods and services should be

produced and in what amount/quantities. The managers use demand theory for
deciding this. The demand theory examines consumer behavior with respect to the
kind of purchases they would like to make currently and in future; the factors
influencing purchase and consumption of a specific good or service; the impact of
change in these factors on the demand of that specific good or service; and the
goods or services which consumers might not purchase and consume in future. In
order to decide the amount of goods and services to be produced, the managers
use methods of demand forecasting.

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The second question relates to how to produce goods and services. The
firm has now to choose among different alternative techniques of production. It has
to make decision regarding purchase of raw materials, capital equipment,
manpower, etc. The managers can use various managerial economics tools such
as production and cost analysis (for hiring and acquiring of inputs), project appraisal
methods (for long term investment decisions) etc. for making these crucial decisions.

The third question is regarding who should consume and claim the goods
and services produced by the firm. The firm, for instance, must decide which is its
niche market-domestic or foreign? It must segment the market. It must conduct a
thorough analysis of market structure and thus take price and output decisions
depending upon the type of market.

Managerial economics helps in decision-making as it involves logical thinking.

Moreover, by studying simple models, managers can deal with more complex and
practical situations. Also, a general approach is implemented.

Managerial Economics take a wider picture of firm, i.e., it deals with questions
such as what is a firm, what are the firm’s objectives, and what forces push the firm
towards profit and away from profit. In short, managerial economics emphasizes
upon the firm, the decisions relating to individual firms and the environment in which
the firm operates. It deals with key issues such as what conditions favors entry and
exit of firms in market, why are people paid well in some jobs and not so well in other
jobs, etc. Managerial Economics is a great rational and analytical tool.

Managerial Economics is not only applicable to profit-making business

organizations, but also to non- profit organizations such as hospitals, schools,
government agencies, etc.

2Source: https://slidetodoc.com/managerial-economics-unit-1-meaning-definition-the-word/

Various principles in understanding the concepts of managerial economics

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The Concept of Opportunity Cost

You choose because resources are limited selecting one from different
choices is a loss of opportunity in the other choice. Opportunity cost is the value
foregone due to other options.

The idea behind opportunity cost is that the cost of one item is the lost
opportunity to do or consume something else; in short, opportunity cost is the
value of the next best alternative.2

A fundamental principle of economics is that every choice has an opportunity

cost. If you sleep through your economics class (not recommended, by the way), the
opportunity cost is the learning you miss. If you spend your income on video games,
you cannot spend it on movies. If you choose to marry one person, you give up the
opportunity to marry anyone else. In short, opportunity cost is all around us.

Since people must choose, they inevitably face trade-offs in which they have
to give up things they desire to get other things they desire more.

Components of opportunity cost:

▪ Opportunity Cost and Individual Decisions

▪ Opportunity cost and Societal Decisions
▪ Lost time
Principle of Time perspective

The time perspective concept states that the decision maker must give due
consideration both to the short run and long run effects of his decisions. He must
give due emphasis to the various time periods as Marshall an economist in 18th
century pointed out.3

Incremental Principle

What is Incremental cost?

Incremental cost is the total cost incurred due to an additional unit of

product being produced. Incremental cost is calculated by analyzing the additional
expenses involved in the production process, such as raw materials, for one
additional unit of production. Understanding incremental costs can help companies
boost production efficiency and profitability.

• Incremental cost is the amount of money it would cost a company to make

an additional unit of product.
• Companies can use incremental cost analysis to help determine the
profitability of their business segments.

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• A company can lose money if incremental cost exceeds incremental

revenue.4

Discounting Principles in Managerial Economics

Discounting

What Is Discounting?
Discounting is the process of determining the present value of a payment or
a stream of payments that is to be received in the future. Given the time value of
money, a peso is worth more today than it would be worth tomorrow. Discounting is
the primary factor used in pricing a stream of tomorrow's cash flows.

Discounting with The Discount Rate

How discounting works

For example, the coupon payments found in a regular bond are discounted
by a certain interest rate and added together with the discounted par value to
determine the bond's current value.

From a business perspective, an asset has no value unless it can produce

cash flows in the future. Stocks pay dividends. Bonds pay interest, and projects
provide investors with incremental future cash flows. The value of those future cash
flows in today's terms is calculated by applying a discount factor to future cash flows.

Synthesis

• Discounting is the process of determining the present value of a future

payment or stream of payments.
• A peso is always worth more today than it would be worth tomorrow,
according to the concept of the time value of money.
• A higher discount indicates a greater the level of risk associated with an
investment and its future cash flows.5

One of the fundamental ideas in economics is that a peso tomorrow is

worth less than a peso today.

A simple example would make this point clear. Suppose a person is offered
a choice to make between a gift of 100php today or 100php next year. Naturally he
will choose the 100php today. What are the probable reasons?

Discounting principle is necessary If a decision affects costs and revenues

at future dates. In making decision then with regards to any investment which will

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yield return over a period of time, it is advisable to find out its ‘net present worth’.
Unless these returns are discounted and the present value of returns calculated, it
is not possible to judge whether or not the cost of undertaking the investment today
is worth.

The concept of discounting is found most useful in managerial economics in

decision problems pertaining to investment planning or capital budgeting.6

Related concepts of discounting showing the Time Value of Money and

Discounting is illustrated with an example.

When a car is on sale for 10% off, it represents a discount to the price of the
car. The same concept of discounting is used to value and price financial assets.
For example, the discounted, or present value, is the value of the bond today. The
future value is the value of the bond at some time in the future. The difference in
value between the future and the present is created by discounting the future back
to the present using a discount factor, which is a function of time and interest rates.

Examples of Discounting Principles

The discounting principle comes from psychology. It says that when making
decision people tend to give less credence to expected evidence or data
supporting one option when many options exist. This principle has several possible
applications in the process of hiring, training and leading employees, as well as in
making business decisions. 7

Marginal Principle

This principle states that a decision is said to be rational and sound if given
the firm’s objective of profit maximization, it leads to increase in profit, which is in
either of two scenarios-

• If total revenue increases more than total cost.

• If total revenue declines less than total cost.

Marginal analysis implies judging the impact of a unit change in one variable
on the other. Marginal generally refers to small changes. Marginal revenue is change
in total revenue per unit change in output sold. Marginal cost refers to change in total
costs per unit change in output produced (While incremental cost refers to change
in total costs due to change in total output). The decision of a firm to change the
price would depend upon the resulting impact/change in marginal revenue and

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marginal cost. If the marginal revenue is greater than the marginal cost, then the firm
should bring about the change in price.1

Scarcity Principle

Definition: Scarcity refers to resources being finite and limited. Scarcity

means we have to decide how and what to produce from these limited resources. It
means there is a constant opportunity cost involved in making economic decisions.
Scarcity is one of the fundamental issues in economics.

Examples of scarcity

• Land – a shortage of fertile land for populations to grow food. For example,
the desertification of the Sahara is causing a decline in land useful for farming
in Sub-Saharan African countries.
• Water scarcity – Global warming and changing weather, has caused some
parts of the world to become drier and rivers to dry up. This has led to a
shortage of drinking water for both humans and animals.
• Labor shortages. In the post-war period, the UK experienced labor
shortages – insufficient workers to fill jobs, such as bus drivers. In more recent
years, shortages have been focused on particular skilled areas, such as
nursing, doctors and engineers
• Health care shortages. In any health care system, there are limits on the
available supply of doctors and hospital beds. This causes waiting lists for
certain operations.
• Seasonal shortages. If there is a surge in demand for a popular Christmas
present, it can cause temporary shortages as demand as greater than supply
and it takes time to provide.
• Fixed supply of roads. Many city centers experience congestion – there is
a shortage of road space compared to number of road users. There is a
scarcity of available land to build new roads or railways.8

Equi-marginal Principle

Marginal Utility is the utility derived from the additional unit of a commodity
consumed. The laws of equi-marginal utility states that a consumer will reach the
stage of equilibrium when the marginal utilities of various commodities he consumes
are equal. According to the modern economists, this law has been formulated in
form of law of proportional marginal utility. It states that the consumer will spend his
money-income on different goods in such a way that the marginal utility of each good
is proportional to its price, i.e.,
MUx / Px = MUy / Py = MUz / Pz

Where, MU represents marginal utility and P is the price of good.

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Similarly, a producer who wants to maximize profit (or reach equilibrium) will use the
technique of production which satisfies the following condition:

MRP1 / MC1 = MRP2 / MC2 = MRP3 / MC3

Where, MRP is marginal revenue product of inputs and MC represents marginal

cost.

Thus, a manger can make rational decision by allocating/hiring resources in a

manner which equalizes the ratio of marginal returns and marginal costs of various
use of resources in a specific use.1

Risk and Uncertainty Principles

Economic risk is the chance of loss because all possible outcomes and their
probability of happening are unknown. Actions taken in such a decision environment
are purely speculative, such as the buy and sell decisions made by traders and other
speculators in commodity, futures, and options markets. All decision makers are equally
likely to profit as well as to lose; luck is the sole determinant of success or
failure. Uncertainty exists when the outcomes of managerial decisions cannot be
predicted with absolute accuracy but all possibilities and their associated probabilities
are known. Under conditions of uncertainty, informed managerial decisions are
possible. Experience, insight, and prudence allow managers to devise strategies for
minimizing the chance of failing to meet business objectives. Although luck still plays a
role in determining ultimate success, managers can deal effectively with an uncertain
decision environment by limiting the scope of individual projects and developing
contingency plans for dealing with failure.9

Lesson 3- Nature of Managerial Economics

Managers study managerial economics because it gives them insight to reign
the functioning of the organization. If manager uses the principles applicable to
economic behavior in a reasonably, then it will result in smooth functioning of the
organization.

Managerial Economics is a Science

Managerial Economics is an essential scholastic field. It can be compared to

science in a sense that it fulfils the criteria of being a science in following sense:

▪ Science is a Systematic body of Knowledge. It is based on the methodical

observation. Managerial economics is also a science of making decisions with
regard to scarce resources with alternative applications. It is a body of knowledge
that determines or observes the internal and external environment for decision
making.

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▪ In science any conclusion is arrived at after continuous experimentation. In

Managerial economics also, policies are made after persistent testing and
trailing. Though economic environment consists of human variable, which is
unpredictable, thus the policies made are not rigid. Managerial economist
takes decisions by utilizing his valuable past experience and observations.
▪ Science principles are universally applicable. Similarly, policies of Managerial
economics are also universally applicable partially if not fully. The policies
need to be changed from time to time depending on the situation and attitude
of individuals to those particular situations. Policies are applicable universally
but modifications are required periodically.

Managerial Economics requires Art

Managerial economist is required to have an art of utilizing his capability,

knowledge and understanding to achieve the organizational objective. Managerial
economist should have an art to put in practice his theoretical knowledge regarding
elements of economic environment.

Managerial Economics for administration of organization

Managerial economics helps the management in decision making. These

decisions are based on the economic rationale and are valid in the existing economic
environment.

Managerial economics is helpful in optimum resource allocation

The resources are scarce with alternative uses. Managers need to use these
limited resources optimally. Each resource has several uses. It is manager who
decides with his knowledge of economics that which one is the preeminent use of
the resource.

Managerial Economics has components of micro economics

Managers study and manage the internal environment of the organization and
work for the profitable and long-term functioning of the organization. This aspect
refers to the micro economics study. The managerial economics deals with the
problems faced by the individual organization such as main objective of the
organization, demand for its product, price and output determination of the
organization, available substitute and complimentary goods, supply of inputs and
raw material, target or prospective consumers of its products etc.

Managerial Economics has components of macro economics

None of the organization works in isolation. They are affected by the external
environment of the economy in which it operates such as government policies,
general price level, income and employment levels in the economy, stage of
business cycle in which economy is operating, exchange rate, balance of payment,

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general expenditure, saving and investment patterns of the consumers, market

conditions etc. These aspects are related to macroeconomics.

Managerial Economics is dynamic in nature

Managerial Economics deals with human-beings (i.e. human resource,

consumers, producers etc.). The nature and attitude differ from person to person.
Thus, to cope up with dynamism and vitality managerial economics also changes
itself over a period of time.1

Top 5 Responsibilities of Managerial Economist

1. To make a reasonable profit on capital employed:

He must have a strong conviction that profits are essential and his main
obligation is to assist the management in earning reasonable profits on capital
employed in the firm.

2. He must make successful forecasts by making in depth study of the

internal and external factors:

This will have influence over the profitability or the working of the firm. He
must aim at lessening if not fully eliminating the risks involved in uncertainties. He
has a major responsibility to alert management at the earliest possible time in case
he discovers any error in his forecast, so that the management can make necessary
changes and adjustments in the policies and programs of the firm.

3. He must inform the management of all the economic trends:

A managerial economist should keep himself in touch with the latest

developments of national economy and business environment so that he can keep
the management informed with these developments and expected trends of the
economy.

4. He must establish and maintain contacts with individuals and data

sources:

(i) To establish and maintain contacts:

A managerial economist should establish and maintain contacts with individuals and
data sources in order to collect relevant and valuable information in the field.

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(ii) To develop personal relations:

To collect data, he should develop personal relations with those having specialized
knowledge of the field.

(iii) To join professional associations and should take active part in their
activities:
The success of this lies in how quickly he gathers additional information in the best
interest of the firm.

5.He must earn full status in the business and only then he can be helpful to
the management in good and successful decision-making.

(I) He must receive continuous support for himself and his professional ideas
by performing his function effectively.

(ii) He should express his ideas in simple and understandable language with
the minimum use of technical words, while communicating with his management
executives.10

Suggested Readings’ links

MSG: https://www.managementstudyguide.com/managerial-
economics.htm#:~:text=Managerial%20Economics%20can%20be%20defined,faced%20in%20t
he%20firm's%20

Discussion Questions

1. Define and explain the uses of managerial economics in decision - making

of issues/complexities in the firm.
2. Differentiate managerial economics from micro and macro-economics.
3. How do managers make effective and efficient decision on scarcity of
resources?
4. Briefly distinguish the eight (8) fundamental concepts of managerial
economics.
5. Describe managerial economics as a science.
6. Relate managerial economics to:
➢ art
➢ administration of organization
➢ optimum resource allocation
➢ components of micro and macro-economics

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➢ dynamic in nature
7. Inspect the responsibilities of the managerial economics.
Learning Exercises/ Activities
1. How do you calculate the present value of Money? Give at least 3
examples. Present your calculation.
2. Role play the responsibilities of the managerial economist in a firm and
in the government via video.

END NOTES
1 Prachi Juneja “Managerial Economics” Reviewed by MSG,with ISO 2001;2015 Certified
Education Provider. Retrieved on August 4, 2021.
https://www.managementstudyguide.com/managerial-economics.htm
2Module: Economic Thinking. Retrieved on August 12, 2021.
https://courses.lumenlearning.com/suny-microeconomics/chapter/reading-the-concept-of-
opportunity-cost/
3 Time perspective. Retrieved August 13, 2021.
https://www.google.com=Prinicples+of+time+perspective&rlz=1C1CHBD_enPH950PH950&

4 Charles Potters. May 31, 2021. “What is Incremental Cost”. Retrieved August 13. 2021.
https://www.investopedia.com/terms/i/incrementalcost.asp

5Gordon Scott, March 25, 2020. “Discounting” Retrieved August 13, 2021.
https://www.investopedia.com/terms/d/discounting.asp

6MBA- knowledge base. “Discounting Principles in Managerial Economics”. Retrieved on August

13, 2021.https://www.mbaknol.com/managerial-economics/discounting-principle-in-managerial-
economics

7Neil Kokemuller. “Exampleof Discounting Principles” Retrieved on August 13, 2021.

https://yourbusiness.azcentral.com/examples-discounting-principles-28974.html

8Tejvan Pettinger., June 2019, “Scarcity in economics”. Retrieved August 15, 2021.
https://www.economicshelp.org/blog/586/markets/scarcity-in-economics/

9Wisdomjob.com. “Risk and Uncertainty”. Retrieved Aug. 15, 2021.

https://www.wisdomjobs.com/e-university/managerial-economics-tutorial-307/concepts-of-risk-and-
uncertainty-10282.

10 Saqib Shaikh. “Top 5 Responsibilities of Managerial Economist”. Retrieved Aug. 15, 2021.
https://www.economicsdiscussion.net/economists/managerial-economist/top-5-responsibilities-of-
managerial-economist/

IMAGES

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1Source:https://www.managementstudyguide.com/managerial-economics.htm
2Source: https://slidetodoc.com/managerial-economics-unit-1-meaning-definition-the-word/

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