UnitManagerial Economics for BbALlB.pptx

Chanderprabhu Jain College of Higher Studies & School of Law
Plot No. OCF, SectorA-8, Narela, New Delhi – 110040
(Affiliated to Guru Gobind Singh Indraprastha University and Approved by Govt of NCT of Delhi & Bar Council of India)
COURSE & SEMESTER: BBA LL.B FIRST SEMESTER
NAME OF THE SUBJECT: MANAGERIAL ECONOMICS
PAPER CODE: BBALLB 115
UNIT - 1
TOPIC: INTRODUCTION TO MANAGERIAL ECONOMICS
FACULTY NAME: Ms. Vandna Munjal
Assistant Professor

Plot No. OCF, Sector A-8, Narela, New Delhi – 110040
CONTENTS
UNIT-I: INTRODUCTION TO MANAGERIAL ECONOMICS
A. The Circular Flow of Economic Activity
B. The Nature of the Firm: The Rationale for the Firm, the Objective of the
Firm, Maximizing versus Satisficing
C. The Principal-Agent Problem, Constrained Decision Making
D. The Concept of Economic Profit
E. Profit in a Market System
F. Economics and Decision Making

MANAGERIAL ECONOMICS DEFINED
• Managerial Economics is a stream of management studies which emphasises
solving business problems and decision-making by applying the theories and
principles of microeconomics and macroeconomics. It is a specialised stream
dealing with the organisation’s internal issues by using various economic
theories.
• Managerial economics is the study of how scarce resources are directed most
efficiently to achieve managerial goals. It is a valuable tool for analyzing
business situations to take better decisions.
• Managerial Economics provides an essential tool for determining the business
goals and targets, the actual position of the organization, and what the
management should do fill the gap between the two.
• Managerial Economics is widely applied in organizations to deal with different
business issues. Both the micro and macroeconomics equally impact the business
and its functioning.

NATURE OF MANAGERIAL ECONOMICS

SCOPE OF MANAGERIAL ECONOMICS
Managerial economics is widely applied in organizations to deal with different
business issues. Both the micro and macroeconomics equally impact the
business and its functioning.

THE CIRCULAR FLOW IN A TWO-SECTOR ECONOMY
In a simplified economy with only two types of economic agents, households or
consumers and business firms, the circular flow of economic activity is shown in
figure. Consumers and firms are linked through the product market where goods and
services are sold. They are also linked through the factor market where the factors of
production are sold and bought.
Consumers and firms have a dual role, and exchange with one another in two distinct
ways:
(1) Consumers or households own all the factors of production, that is, land, labour,
capital and entrepreneurship, which are also called productive resources. They sell
them to firms for producing goods and services. In the diagram, the sale of goods and
services by firms to consumers in the product market is shown in the lower portion of
the inner circle from left to right; and the sale of their services to firms by households
or consumers in the factor market is shown in the upper portion of the inner circle
from right to left. These are the real flows of goods and services from firms to
consumers.

(2) In a modern economy, exchange takes place through financial flows which move
in the reverse direction to the “real” flows. The purchase of goods and services in the
product market by consumers is their consumption expenditure which becomes the
revenue of the firms and is shown in the outer circle of the lower portion from right
to left in the diagram. The expenditure of firms in buying productive resources in the
factor market from the consumers becomes the incomes of households, which is
shown in the outer circle of the upper portion from left to right in the diagram.

CIRCULAR FLOW IN A THREE-SECTOR ECONOMY

CIRCULAR FLOW IN A FOUR-SECTOR ECONOMY

NATURE OF THE FIRM
• Although managerial economics is not concerned solely with the management of
business firms, this is its principal field of application. To apply managerial
economics to business management, we need a theory of the firm, a theory
indicating how firms behave and what their goals are.
• The concept of the firm plays a central role in the theory and practice of
managerial economics. An understanding of the reason for the existence of firms,
their specific role in the economy, and their objective provides a background for
that theory.
• Definition : A collection of resources that is transformed into products demanded
by consumers. The firm buys and coordinates the services of production factors
such as land, labour and capital along with its organization for producing a
commodity and sells it in the market to the households.
• Firm is controlled by entrepreneur who takes major decisions like: What to
produce? Where to produce? How and how much to produce? Whom to sell and
at what price?

THE OBJECTIVES OF THE FIRM
Each firm lays down its own objectives which is fundamental to the existence of a
firm.
The major objectives of the firm are:
1. To maximize the Output/Sales.
2. To maximize the Profit of the Organization.
3. To maximize the Customer and Stakeholders Satisfaction.
4. To maximize Shareholder’s Return on Investment.
5. To maximize the Growth of the Organization.

MAXIMIZING VERSUS SATISFICING
• “Maximizing” means expending time and effort to ensure you’ve solved
something as best as possible. It requires exploration and analysis to ensure “the
best” option hasn’t been overlooked, and that we have confidence in our
evaluation of all options.
• “Satisficing” means picking the first option that satisfies the requirements.
Prefer a faster decision to the best decision. It means not getting paralyzed by the
pursuit of “perfect,” but it often doesn’t result in the very best solution.
• People naturally tend to be Maximizers or Satisficers, although it depends on the
subject.
• A recent study showed something interesting: Maximizers make better choices,
but Satisficers enjoy their choices more, and spend less time and create less
stress in making the choice.

CONCEPT OF ECONOMIC PROFIT
• The firm’s objective is to make profit.
• As economists measure costs differently, they also measure profit differently.
ECONOMIC COSTS
• Economic costs are the payments that must be made to secure and retain the needed
amounts of resources needed for production.
• As with land, labor, and capital, entrepreneurial ability is a scarce resource that has
a cost.
• Therefore, the economic costs must include payments to the entrepreneur for
organizing and combining the other resources to produce a good or service.
• The payment for (cost of) the entrepreneur’s contributions is called normal profit.

ECONOMIC PROFITS
• Therefore, a product will be produced only if the total revenue is large enough to
pay wages, interest, rent and a normal profit to the entrepreneur.
• If the total revenue exceeds all these economic costs, the rest goes to the
entrepreneur as an added reward. This return is called economic profit or pure
profit.
• Economic profit is above-the-normal profit.
• Economic profit is what attracts other producers to a particular industry.
• An economist measures a firm’s economic profit as a firm’s total revenue minus all
the opportunity costs (explicit and implicit) of producing the goods and services
sold.
• An accountant measures the firm’s accounting profits as the firm’s total revenue
minus the firm’s explicit costs.

The relationship between Accounting Profit and Economic Profit may be
summarized as follows:
Accounting profit: = TR – TC (explicit cost)
Economic profit: = TR-TC = TR- TC (explicit cost) – TC (implicit cost)
Economic profits are equal to total revenue less total economic costs, which
is the sum of explicit and implicit costs.
Accounting profits, on the other hand, are equal to total revenue less total
explicit costs.
It is, of course, a simple matter to make accounting profit equivalent to
economic profit by making explicit all relevant implicit costs.

PRINCIPAL-AGENT PROBLEM

• In a principal-agent relationship, the principal is the party that legally appoints
the agent to make decisions and take actions on its behalf.
• The principal-agent problem occurs when a principal delegates an action to
another individual (agent), but the principal does not have full information
about how the agent will behave. Secondly, the interests of the principal
diverge from that of the agent, meaning that the outcome is less desirable than
the principal expects.
• A principal-agent problem arises when there is a conflict of interest between
the agent and the principal, which typically occurs when the agent acts solely
in his/her own interests.
• The separation of the “ownership” (principal) and the “control” (agent) in
principal-agent relationships creates the grounds for potential conflict of
interests between the two parties.

For example, a shareholder (principal) wants to maximise profits for his firm. He
hires a manager (agent) to run the business. However, due to agency costs, the
shareholder cannot fully know how hard the agent is working and to what extent
the manager is fulfilling the contract. Also, in this situation, the manager does
not share the same interest in maximising profits as the owner.
REQUIREMENTS OF PRINCIPAL-AGENT PROBLEM
• Multiple actors who have a different set of objectives (e.g. shareholders vs
workers.
• Asymmetric information (the agent having more information than principle.)
The shareholder can see some stats like profit, but only the manager knows
exactly how hard he worked or didn’t.

DECISION MAKING
Decision making is the most important function of business managers. Decision
making is the central objective of Managerial Economics.
Decision Making may be defined as the process of selecting the suitable action from
among several alternatives courses of action. The problem of decision making arises
when a number of alternatives are available and the resources are scarce.
While performing his function, a manager has to take a lot of decisions in conformity
with the goal of the firm. Most of the decisions are taken under the condition of
uncertainty, and involves risks.
The main reasons behind uncertainty and risks are uncertain behavior of the market
forces which are as follows: - Changing demand and supply , Changing business
environment , Government policies , External influence on the domestic market, Social
and political changes, etc.

Making effective decisions, as well as recognizing when a bad decision has
been made and quickly responding to mistakes, is a key ingredient in
organizational effectiveness. Some experts believe that decision making is the
most basic and fundamental of all managerial activities.
Decision making is the act of choosing one alternative from among a set of
alternatives.
• We have to first decide that a decision has to be made and then,
• Secondly, identify a set of feasible alternatives before we select one.
Effective decisions must be made to:
• Optimize some set of factors such as profits, sales, employee welfare and
market share or
• Minimize loss, expenses or employee turnover or
• Select best method for going out of business, laying off employees, or
terminating a strategic alliance.

DECISION-MAKING CONDITIONS
1. DECISION MAKING UNDER CERTAINTY
2. DECISION MAKING UNDER RISK
3. DECISION MAKING UNDER UNCERTAINTY
DECISION MAKING UNDER CERTAINTY - A state of certainty exists
when a decision maker knows with reasonable certainty, what the alternatives
are and what conditions are associated with each alternative. Very few
organizational decisions, however, are made under these conditions. The
complex and turbulent environment in which businesses exist rarely allows for
such decisions.

DECISION MAKING UNDER RISK - A state of risk exists when a decision
maker makes decisions under a condition in which the availability of each
alternative and its potential payoffs and costs are all associated with probability
estimate. Decisions such as these are based on past experiences, relevant
information, the advice of others and one’s own judgment. Decision is
‘calculated’ on the basis of which alternative has the highest probability of
working effectively.
DECISION MAKING UNDER UNCERTAINTY - A state of uncertainty exists
when a decision maker does not know all of the alternatives, the risks associated
with each, or the consequences each alternative is likely to have. Most of the
major decision making in today’s organizations is done under these conditions. To
make effective decisions under these conditions, managers must secure as much
relevant information as possible and approach the situation from a logical and
rational view. Intuition, judgment and experience always play major roles in the
decision-making process under these conditions.

CONSTRAINED DECISION MAKING
The essence of the science of economics is determining optimum behavior where
that behavior is subject to constraints. The decisions of a manager of a firm is
subject to various constraints:
1. Legal constraint.
2. Inputs constraint.
3. Financial constraint.
4. Technological constraint.
5. Environmental constraint.
6. Information constraint.
7. Contractual constraint.
8. Moral constraint.
The primary decision making role of managerial economics is in determining the
optimal course of action where there are constraints imposed on the decision.

Economics help us in economizing our means. It helps us in understanding the
problem and making the right decision so that its helpful for the organization for
its further planning.
Managerial economic is concerned with decision making at the firm level.
Decision making problems faced by business firms:
• To identify the alternative courses of action of achieving given objectives.
• To select the course of action that achieves the objectives in the
economically most efficient way.
• To implement the selected course of action in a right way to achieve the
business objectives.
The prime function of management is Decision making and forward planning.
Forward planning goes hand in hand with decision making. Forward planning
means establishing plans for the future.
ECONOMICS AND DECISION MAKING

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