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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. DEFINING MANAGERIAL ECONOMICS/BUSINESS ECONOMICS  The terms mostly used interchangeably  Lately, the term managerial economics has become more popular and is displacing the other term  Business economics was focused primarily to business decision making  Managerial economics applies to both business and non business decision making, as well as to public and private organizations/ institutions. With modifications the principles of managerial economics can be applied to the management of non-business, non-profit organizations like schools, hospitals, government organizations. Meaning: Business Economics, also called Managerial Economics, is the application of economic theory and methodology to business. It is the "application of the economic concepts and economic analysis to the problems of formulating rational managerial decisions". Thus, it is a branch of 1

economics that applies microeconomic analysis to decision methods of businesses or other management units. As such, it bridges economic theory and economics in 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. Input-output relationships or production process ii. Optimization of the available resources to produce maximum, desirable output iii. Project planning 2

iv. v.

Capital budgeting 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.

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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: Theory of Demand Analysis: It deals with consumer behavior, demand and demand determinants, demand distinctions, Different elasticities of demand and demand forecasting. 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. 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. 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? 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. 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: 4

•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.. 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 •Minimising the possibility of under capitalisation or overcapitalisation. Inventory Management: Managerial economics also helps in identifying the ideal stocks, low stocks of inventory, EOQ etc to maintain the smooth and uninterrupted flow of production process. 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 5

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

Economic Concepts

Decision Sciences

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

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 7

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.

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Hence, tools of managerial economics can be used to achieve all the goals of a business organization in an efficient manner. Typical managerial decision making may involve one of the following issues: 1. Deciding the price of a product and the quantity of the commodity to be produced. 2. Deciding whether to manufacture a product or to buy from another manufacturer. 3. Choosing the production technique to be employed in the production of a given product. 4. Deciding on the level of inventory a firm will maintain of a product or raw material. 5. Deciding on the advertising media and the intensity of the advertising campaign 6. Making employment and training decisions. 7. Making decisions regarding further business investment.

It should be noted that the application of managerial economics is not limited to profitseeking 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.

Relationship of Business Economics with Other Disciplines By its nature, managerial economics borrows heavily from several other disciplines. The nature and scope of managerial economics can also be understood well by studying its relationship with other disciplines. Managerial economics draws heavily from the following disciplines: 1) Economics and Econometrics – As stated earlier that managerial economics is an application of economic theory into business practices / management. Managerial economics uses both micro and macro economics-their concepts, theories, tools and techniques. In managerial economics, we also use various types of models such as schematic models (diagrams) analog models (flow charts) and mathematical models and stochastic models. The roots of most of these models lie in economic logic. Economics also tells us the art of constructing models. Empirically estimated functions, which are being used in managerial economics, are basically econometric estimates. 2) Mathematics and Statistics – Mathematical tools are widely used in model building for exploring the relationship between related economic variables. Most of the decision models are constructed in terms of mathematical symbols. Geometry, trignometry and algebra are different branches of mathematics and they provide various tools & concepts 9 such as logarithms, exponentials, vectors, determinants, matrix algebra, and calculus, differentials and integral. Similarly, statistical tools are a great aid in business decision-

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: Difference between Business Economics and Economics

Area of difference 1. Nature

Business Economics It deals with application of

Economics It deals with the body of the

economic principles to the

principles itself.

problems of the firms. 2. Nature of

It basically deals with the

It deals with the both micro and

Economic Principles

application of normative

macro-economic

Studied.

micro-principles and involves

principles-normative and

value judgments. It is concerned

positive.

with what decisions ought to be 3.Scope of the Study

made. Thus, it is perspective. Through business economics is

Micro economics as a

multifaceted branch of micro in character, it deals with the problems of the business firms.

only economics, deals with the economic problems of business firms but also individual’s economic problems. Thus, economics has a wider scope of study.

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4.Focus of Study

The main focus of the study of

Under, micro economics, as a

business economics is profit theory.

branch of economics,

Other distribution theories have not distribution theories like rent, much relevance here.

wage, and interest are dealt along with the theory of profit.

5.Approach of the Study

It adopts, modifies or

Economic theory

reformulates already existing

makes assumptions and

economic models to suit the

hypothesizes

specific conditions and

economic relationships and

generates economic models. serve the specific problem of the 6.Methodology

business firm. Business economics is pragmatic

Economic theory avoids

in the sense that it introduces

many complexities and

some

realistic

aspects

such

makes simplified assumptions to as

objectives of the firm , resource,

solve complicated theoretical

legal and behavioral

issues.

constraints,

environmental

and

technological factors and attempts to solve some real life complex business problems using other related branches like mathematics , statistics, etc.

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

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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. The branch of economics that 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...