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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.

 

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:

                                                                    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 analysis 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:

•      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

 

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?

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.

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.”    

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

                                               

Management Decision Problems Product Price and Output Make or Buy Production Technique Advertising Media and Intensity Investment and Financing

 

 

                  

 

 

Economic Concepts Framework for Decisions  Theory of consumer behavior Theory of the firm Theory of the market   structure and pricing

Decision Sciences   Tools and Techniques of Analysis Statistical analysis Forecasting Game Theory

 

 

 

 

 

 

 

 

 

 

 

 

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

                                                                                                    

 

Optimal Solutions to Managerial Decision Problems

 

 

 

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: Deciding the price of a product and the quantity of the commodity to be produced. Deciding whether to manufacture a product or to buy from another manufacturer. Choosing the production technique to be employed in the production of a given product. Deciding on the level of inventory a firm will maintain of a product or raw material. Deciding on the advertising media and the intensity of the advertising campaign Making employment and training decisions. 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.

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  economic principles to the problems of the firms.	It deals with the body of the principles itself.
2. Nature of Economic Principles Studied.	It basically deals with the application of normative micro-principles and involves value judgments. It is concerned  with what decisions ought to be  made. Thus, it is perspective.	It deals with the both micro and macro-economic principles-normative and positive.
3.Scope of the Study	Through business economics is micro in character, it deals with the problems of the business firms.	Micro economics as  a multifaceted branch of 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 business economics is profit theory.  Other distribution theories have not much relevance here.	Under, micro economics, as a  branch of economics, distribution theories like rent, wage, and interest are dealt along with the theory of profit.
5.Approach of the Study	It adopts, modifies or reformulates already existing economic models to suit the specific conditions and serve the specific problem of the business firm.	Economic theory makes assumptions and hypothesizes economic relationships and generates economic models.
6.Methodology	Business economics is pragmatic in the sense that it introduces  some realistic aspects such as objectives of the firm , resource, legal and behavioral constraints, environmental and technological   factors and attempts to solve some real life complex business problems using other related branches like mathematics , statistics, etc.	Economic theory avoids many complexities and makes simplified assumptions to solve complicated theoretical  issues.

 

 

 

 

 

 

 

Micro Vs Macro Economics

 

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:

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/ Complexity	Simple	Complex
View of Economy	Microscopic view (worm’s eye view)	Macroscopic view (bird’s eye view)
Meaning	Microeconomics is the branch that deals with the functionality and behaviour of individual entities, such as business firms and households. The effect of the functioning and behaviour of these individual units on the supply and demand for goods and services is also taken into consideration in this subcategory of economics.	Macroeconomics is the branch that deals with the functionality and behaviour of the entire economy of the nation or the world. This includes concepts like national income, price level, employment, interest rates, etc.
Degree of Aggregation	Studies individual units (Based on slicing)	Studies aggregates (based on lumping)
Difference in objectives	It deals with the determination of problems concerning the optimum utilization of resources.	It is the study of principles and problems concerning the full employment of resources and the growth of resources.
Difference in subject matter	It deals with the determination of price, consumer’s equilibrium.	It deals with full employment, national income, general price level and economic growth.
Difference in forces of equilibrium	It studies the equilibrium between the forces of individual demand and individual supply.	It studies the equilibrium between the forces of aggregate demand and aggregate supply.
Assumption of full employment	Micro economics assumes full employment.	Macro economics does not assume full employment.
Assumption of Ceteris Paribus	Applicable	Not Applicable
Fundamental Difference	By Prof. G. Thimma- It is a Price Theory as it deals with equilibrium price	By J.M. Keynes- It is a Income Theory as it deals with national income
Major determinant	Price is the major determinant of micro- economic analysis.	Income is the major determinant 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:-

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.

 

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:

 

Formula: FV_n = PV(1 + r)ⁿ

In this equation (1 + r)ⁿ is called the future value interest factor (FVIF).

Where,

FV_n = 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.

FV_n = 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 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………R_n/(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 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) = TC_n – TC_(n-1)

Where,

TC_n= 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,

TC_n = 2550 and  TC_(n-1) =2500

So, MC= 2550-2500= 50

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

Formula of Marginal Revenue (MR) = TR_n – TR_(n-1)

Where,

TR_n= 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:-

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:-

v  Whether or not accept a project.

v  Whether or not introduce a new product.

v  Whether or not accept the new order.

v  Whether or not add an additional plant, etc.

Decision Rule:

 

v  TR<TC-Reject the project

v  TR=TC- No profit No Loss.

v  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

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

 

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

 

 

 

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.

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.

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

 

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.

 

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

 

 

Explain the above graph by our own