Chapter 1

Basic Concepts and

Principles
Lecture plan
 Objectives
 What is Economics?
 Basic Assumptions
 Types of Economic Analysis
 Managerial Economics
 Managerial Decisions
 Economic Principles Relevant to Managerial Decisions
 Production Possibilities Curve
 Managerial Economics and Functions of Management
 Relationship with Other Disciplines
 Summary
Objectives

 To introduce key economic concepts like scarcity,

rationality, equilibrium, time perspective and
opportunity cost.
 To explain the basic difference between
microeconomics and macroeconomics.
 To help the reader analyze how decisions are made
about what, how and for whom to produce.
 To define managerial economics and demonstrate its
importance in managerial decision making.
 To discuss the scope of managerial economics and
its relationship with various other disciplines and
functional areas.
What is Economics?
 Discusses how a society tries to solve the human
problems of unlimited wants and scarce resources.
 Scientific study of the choices made by individuals and
societies with regard to the alternative uses of scarce
resources employed to satisfy wants.
 Theoretical aspect and an applied science in its practical
aspects.
 Not an exact science; An “art” as well
 A social science
 Deals with the society as a whole and human behaviour in
particular
 Studies the production, distribution, and consumption of
goods and services.
 A science in its methodology, and art in its application.
Basic Assumptions
 Ceteris Paribus
 Latin phrase
 “With other things (being) the same” or “all other things
being equal”.
 Rationality
 Consumers maximize utility subject to given money
income.
 Producers maximize profit subject to given resources
or minimize cost subject to target return.
 Types of Economic Analysis
 Micro and Macro
 Microeconomics (“micro” meaning small): study of
the behaviour of small economic units
 An individual consumer, a seller/ a producer/ a
firm, or a product.
 Focus on basic theories of supply and demand in
individual markets
 Macroeconomics (“macro” meaning large):
study of aggregates.
 Industry as a unit, and not the firm.
 Focus on aggregate demand and aggregate
supply, national income, employment, inflation,
etc.
Types of Economic Analysis

 Positive and Normative

 Positive economics: “what is” in economic matters
 Establishes a cause and effect relationship between
variables.
 Analyzes problems on the basis of facts.
 Normative economics: “what ought to be” in
economic matters.
 Concerned with questions involving value judgments.
 Incorporates value judgments about what the economy
should be like.
Types of Economic Analysis
contd..
 Short Run and Long Run
 Short run: Time period not enough for consumers and
producers to adjust completely to any new situation.
 Some inputs are fixed and others are variable

 Long run: Time period long enough for consumers and

producers to adjust to any new situation.
 All inputs are variable

 Decisions to adjust capacity, to introduce a larger

plant or continue with the existing one, to change

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

 Application of economic theory and the tools of analysis

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

 Micro as well as Macro

 Applied microeconomics: demand analysis, cost and
production analysis, pricing and output decisions
 Macroeconomic: national income, inflation and stages of
recession and expansion
 Normative Bias
 Prescriptive: States what firms should do in order to reach
certain objectives.
 Decides on whether or not the probable outcome of a
managerial decision is desirable.
 Decisions Resulting in Partial Equilibrium
 Decisions taken by any firm would relate to the equilibrium of
that particular firm.
 Deals with partial equilibrium analysis
Economic Principles Relevant to
Managerial Decisions
 Concept of scarcity
 Unlimited human wants
 Limited resources available to satisfy such wants
 Best possible use of resources to get:
 maximum satisfaction (from the point of view of consumers) or
 maximum output (from the point of view of producers or firms)
 Concept of opportunity cost
 Opportunity cost is the benefit forgone from the alternative
that is not selected.
 Highlights the capacity of one resource to satisfy multitude of
wants
 Helps in making rational choices in all aspects of business,
since resources are scarce and wants are unlimited
Economic Principles Relevant to
Managerial Decisions Contd…

 Concept of margin or increment

 Marginality: a unit increase in cost or revenue or
utility.
 Marginal cost: change in Total Cost due to a unit change in
output.
 Marginal revenue: change in Total Revenue due to a unit
change in sales.
 Marginal utility: change in Total Utility due to a unit change
in consumption.
 Incremental:applied when the changes are in bulk,
say 10% increase in sales.
Economic Principles Relevant to
Managerial Decisions
 Discounting Principle
 Time value of money : Value of money depreciates
with time
 A rupee in hand today is worth more than a rupee received
tomorrow.
 Outflow and inflow of money and resources at
different points of time
1
PVF = (1 +r) n

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

 Shows the different combinations of the quantities of two

goods that can be produced (or consumed) in an economy
at any point of time.
 Depicts the trade off between any two items produced (or
consumed).
 Highlights the concepts of scarcity and opportunity cost
 Indicates the opportunity cost of increasing one item's production
(or consumption) in terms of the units of the other forgone
 Slope of the curve in absolute terms
 Assumptions
 The economy is operating at full employment.
 Factors of production are fixed in supply; they can however be
reallocated among different uses.
 Technology remains the same.
Production Possibilities Curve
Contd…

Food

Technically
P Infeasible Area
FP

FQ Q

Productively
Inefficient Area

O
CP CQ Clothing
Figure 1.3: PPC for the Society
Production Possibilities Curve
Contd…

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

maximum productive efficiency.
 In the figure, OFp of food and OCp of clothing can be
produced at Point P and OFQ of food and OCQ respectively
at point Q, when production is run efficiently.
 All points inside the frontier are feasible but productively
inefficient.
 All points to the right of (or above) the curve are
technically impossible (or cannot be sustained for long).
 A move from P to Q indicates an increase in the units of
clothing produced and vice versa.
 It also implies a decrease in the units of food produced.
This decrease in the units of food is the opportunity cost
of producing more clothing.
Managerial Economics and
Functions of Management
 All functional areas have to find the most
efficient way of allocating scarce
organizational resources
 Managerial economics:
 Facilitates the process of evaluating
relationships between functional areas
 Helps in making rational decisions across
managerial functions.
Managerial Economics and
Functions of Management Contd…

 Financial Management
 From where to collect resources
 Equity
 Debt
 How to allocate resources
 How much profit to be retained/distributed
 Human Resource Management
 Recruitment
 Wage and Salary
 Training and development
 Retirement
Managerial Economics and
Functions of Management
 Marketing Management
 Which product
 For whom
 What price
 How to sell
 Operations Management
 Which technology
 Inputs
 Processing
 Information System Management
 Communication channels
 Use of information Technology
 Relationship Other Disciplines
Economic Theory
Microeconomics Quantitative Analysis
•Theory of firm •Numeric and algebraic analysis
•Theory of consumer behaviour (demand) •Optimization
•Production and cost theory (supply) •Discounting and time value of money
•Market structure and competition techniques
•Price theory •Statistical estimation and forecasting
Macroeconomics •Game theory
•National income and output
•Business cycle
•Inflation

Managerial Economics

Solutions to Managerial Decision Making

•Quantity and quality of product
•Price of product
•Marketing Management
•Financial Management
•Human Resource Management
•Research and Development
Summary
• Economics studies the choices made by individuals and societies in
regard to the alternative uses of scarce resources which are employed to
satisfy unlimited wants.
• Microeconomics is the study of the behaviour of individual economic units,
such as an individual consumer, a seller, a producer, a firm, or a product.
• Macroeconomics deals with the study of aggregates, the economy as a
whole.
• Ceteris paribus is a Latin phrase, literally translated as “with other things
(being) the same”.
• The assumption of rationality means that consumers and firms measure
and compare the costs and benefits of a decision before going ahead for
that decision.
• Partial equilibrium analysis studies the outcome of any policy action in a
single market only, while general equilibrium analysis seeks to explain
economic phenomena in an economy as a whole.
• Opportunity cost is the benefit forgone from the alternative that is not
selected.
Summary
• Concept of Time value of money tells that Value of money depreciates
with time.
• Concept of Marginal/increment tells about impact of unit/proportionate
change in cost/revenue on decision making.
• Managerial economics is a means to finding the most efficient way of
allocating scarce organizational resources and reaching stated
objectives. It is micro as well as macro in nature; it has a normative bias,
and deals with partial equilibrium.
• Production Possibilities Curve (PPC) is a graph that shows the different
combinations of the quantities of two goods that can be produced (or
consumed) in an economy, subject to the limited availability of resources.
• The knowledge of managerial economics helps to understand the
interrelationships among the various functional units of any firm (namely
production, marketing, HR, finance, IT and legal)
• Decision sciences provide the tools and techniques of analysis used in
managerial economics, in particular numerical and algebraic analysis,
optimization, statistical estimation and forecasting.