Fundamental concepts of managerial economics

In managerial economics, economic theories and principles are used to make choices on how to allocate limited resources.

The following points highlight the fundamental concepts of managerial economics .Let us discuss as below:

1.  The Incremental Concept

The concept of incremental thinking is simple to grasp. However, putting it into practice is extremely tough. “It entails assessing the impact of choice options on costs and revenues, emphasizing changes in total cost and total revenue that emerge from changes in prices, products, procedures, investments, or whatever may be at stake in the decision,” says T.J. Coyne. The two basic concepts lie at the heart of incremental analysis, viz., incremental cost and incremental revenue. The former refers to the change in total cost resulting from a decision. Similarly, the latter may be defined as the change in total revenue re­sulting from a decision.

A decision is surely profita­ble if:

1. It increases revenues more than it increases cost.
2. It reduces some costs more than it increases others.
3. It increases some revenues more than it de­creases others.
4.   It decreases costs more than it decreases reve­nue.

2.  The Concept of Time Perspective

We frequently distinguish between the short-run and the long-run in economics. This distinction is made without regard to a calendar period, such as a month, quarter, or year. It is predicated on the speed with which decisions may be made and the variety of factors that go into production.

The short run is the time span during which some things can be changed but not others. The long-run, on the other hand, is the period during which all factors can be changed. For example, more output can be produced in the short- run by using more labor and raw materials. This is basically a short-term decision. But setting up a new factory or building an entirely new plant is a long-term decision.

As a matter of fact, however, the distinction between the two often gets vague. What’s left is an estimate of those costs that fluctuate and those that do not by the decision under consideration. In managerial economics we are concerned with the short-run and long-run effects of decisions on revenues as well as on costs.

The distinction between short-run and long-run income (or demand) is even less clear than the one between short-run and long-run costs. Maintaining the correct balance across several runs, i.e., the long-run, short-run, and intermediate-run perspectives, is critical for managerial decision making. A decision may be based on specific short-term reasons, but it may have a variety of long-term ramifications, making it more or less advantageous than it appears at first glance.

But the following two long-term repercussions must be taken into account:

I. If the management commits itself to a series of repeat orders at the same price, the fixed costs (which are ignored temporarily) will become vari­able cost. For instance, sooner or later it will be­come compulsory to replace the machinery and equipment which wear out. True enough, the grad­ual accumulation of orders may require an addition to capacity, with added depreciation and added top-level supervision.

II. If a lower price is charged for the extra order, old customers who pay a higher price for the same product may become aggravated. This practice will come out to be unethical and may raise the compa­ny’s image. This will be damaging in the long-run.

Now on the basis of our above discussion we can state the above principle — the principle of time perspective — in the following words: A decision should always take into considera­tion both the short-term and long-term effects on revenues and costs, giving proper weight to the most relevant time periods.

Also read this: What is Managerial Economics. Nature, Scope, Importance & Definitions 2024

3. The Concept of Discounting Principle

This concept is an extension of the concept of time perspective. Since the future is unfamiliar and incalculable, there is a lot of risk and uncertainty in the future. Everyone knows that a rupee today is worth more than a rupee will be two years from now. This appears similar to the saying that “a bird in hand is worth more than two in the bush.” This judgment is made not on account of the uncertainty surround­ing the future or the risk of inflation.

It’s simple: a sum of money can earn a return in the interim, which is impossible if the same value is only accessible at the end of the time. The present value of one rupee available at the end of two years is the present value of one rupee available now, according to technical terms. ‘Discounting’ is a mathematical approach for compensating for the time worth of money and determining present value. In managerial economics, the notion of discounting is useful in decision problems involving investment planning or capital budgeting.                                                  The formula of computing the present value is given below:

V = A/1+i

Where:

V = Present value, A = Amount invested Rs. 100, i = Rate of interest 5 per cent,

V = 100/1.05 = 100/1.05 =Rs. 95.24

Similarly, the present value of Rs. 100 which will be discounted at the end of 2 years: A 2 years V = A/ (1+i) ²

For n years V = A/ (1+i) ⁿ

4.  The Opportunity Cost Concept

Both micro and macro economics make abundant use of the fundamental concept of opportunity cost. In everyday life, we apply the notion of opportunity cost even if we are unable to coherently understand its significance. In Managerial Economics, the opportunity cost concept is useful in decisions involving a choice between different alternative courses of action.

Resources are limited; we cannot produce all the commodities. For the production of one com­modity, we have to sacrifice the production of another commodity. We cannot have the whole thing we want. Consequently, we are forced to make a choice.

Opportunity cost of a decision is the sacrifice of alternatives required by that decision. Sacrifice of alternatives is involved when carrying out a decision requires using a resource that is limited in supply with the firm. Opportunity cost, therefore, represents the benefits or revenue forgone by pursuing one course of action rather than another.

The concept of opportunity cost implies three things:

• The calculation of opportunity cost involves the measurement of sacrifices.
• Sacrifices may be monetary or real.
• The opportunity cost is termed as the cost of sacrificed alternatives.

Opportunity cost is just a notional idea which does not appear in the books of account of the company. If a resource has no alternative use, then its opportunity cost is nil.

In managerial decision making, the idea of opportunity cost occupies an important place. The economic importance of opportunity cost is as follows:

• It helps in determining relative prices of different goods.
• It helps in determining normal remuneration to a factor of production.
• It helps in proper allocation of factor resources.

5. The Concept of Equi-marginal Principle

One of the widest known principles of economics is the equi-marginal principle. The principle states that an input should be allocated so that value added by the last unit is the same in all cases. This sweeping statement is popularly called the equi-marginal.

Let us assume a case in which the firm has 100 units of labor at its disposal. And the firm is involved in five activities viz., А, В, C, D and E. The firm can increase any one of these activities by employing more labor but only at the cost i.e., sacrifice of other activities.

An optimum allocation cannot be achieved if the value of the marginal product is greater in one activity than in another. Consequently, it would be profitable to shift labor from low marginal value activity to high marginal value activity, increasing the total value of all products taken together.

For instance, if the value of the marginal product of labor in activity A is Rs. 50 while that in activity В is Rs. 70 then it is possible and profitable to shift labor from activity A to activity B. The optimum is reached when the values of the marginal product are equal to all activities. This can be expressed symbolically as follows:

VMP_LA = VMP_LB = VMP_LC = VMP_LD = VMP_LE

Where VMP = Value of Marginal Product, L = Labour, ABCDE = Activities 

The value of the marginal product of labor employed in A is equal to the value of the marginal product of the labor employed in В and so on. The equi-marginal principle is really a practical notion. It is behind any rational budgetary procedure. The idea is also applied in investment decisions and allocation of research expenditures. For a consumer, this concept implies that money may be allocated over various commodities such that marginal utility derived from the use of each commodity is the same. Likewise, for a producer this concept implies that resources be allocated in such a manner that the marginal product of the inputs is the same in all uses.

6. Risk and Uncertainty Concept

Managerial decisions are actions taken today that have unforeseeable consequences in the future. The future is uncertain and fraught with danger. Unpredictable shifts in the business cycle, the economy’s structure, and government policies are causing the uncertainty. This indicates that management must accept the risk of making decisions for their institution in the future under unpredictable and unknown economic situations. Firms may be unsure about production, market prices, competitor strategies, and so on. The repercussions of an activity are not immediately known for sure when there is uncertainty.

Economic theory generally assumes that the firm has ideal knowledge of its costs and demand relationships and of its environment. Uncertainty is not allowed to have an effect on the decisions. Uncertainty arises because producers simply cannot forecast the dynamic changes in the economy and so, cost and revenue data of their firms with reasonable accuracy.

Furthermore, dynamic changes are external to the firm, they are beyond the control of the firm. The result is that the risks from unpredicted changes in a firm’s cost and revenue data cannot be estimated and therefore the risks from such changes cannot be insured. But products must attempt to predict the future cost and revenue data of their firms and determine the output and price policies.

With the use of subjective probability, management economists have attempted to account for uncertainty. The probabilistic treatment of uncertainty necessitates the construction of specific subjective cost, income, and environmental expectations. The time horizon, risk attitude, and rate of change of the environment all influence the likelihood of future events.