Chapter 2 Fundamental Concepts of Managerial Economics Review

Chapter 2 Fundamental Concepts of Managerial Economics

Review of Economic Terms • Because of scarcity, an allocation decision must be made. The allocation decision is comprised of three separate choices: § What and how many goods and services should be produced? § How should these goods and services be produced? § For whom should these goods and services be produced?

Fundamentals concepts of Managerial Economics 1. 2. 3. 4. 5. 6. OPPORTUNITY COST CONCEPT INCREMENTAL REASONING CONCEPT DISCOUNTING CONCEPT TIME PERSPECTIVE CONCEPT CONTRIBUTION CONCEPT EQUI MARGINAL CONCEPT

1. Opportunity Cost Concept • Represents the benefits or profit foregone by pursuing one course of action rather than another. • The opportunity cost of the funds employed in the one’s own business is the amount of interest which could have been earned had these funds been invested in the next best channel of investment. • When a product X rather than a product Y is produced by using a machine which can produce both, the opportunity cost of producing X is the amount of Y sacrificed as a result. • The opportunity cost of using an idle machine is zero, as its use needs no sacrifice of opportunities. • The opportunity cost of one’s labour in one’s own business is the income one could have earned by accepting a job outside. • Implicit cost are considered by an economist not by an accountant.

Accounting Profit VS Economic Profit • Usually, profit is defined as revenue minus cost, that is, as the price of output times the quantity sold (revenue) minus the cost of producing that quantity of output. However, we need to be a little careful in interpreting that. Economists understand cost as opportunity cost - the value of the opportunity given up. In calculating economic profit, opportunity costs are deducted from PROFITS earned. • Opportunity costs are the alternative returns / benefits / profits foregone by using the chosen option. As a result, one can have a significant accounting profit with little to no economic profit. • For example, say you invest Rs 100, 000 to start a business, and in that year you earn Rs 120, 000 in profits. Your accounting profit would be Rs 20, 000. However, say that same year you could have earned an income of Rs 45, 000 had you been employed. Therefore, you have an economic loss of Rs 25, 000 (120, 000 - 100, 000 - 45, 000).

Example • Suppose a firm has Rs. 100 million at its disposal and there are only three alternative uses. § to expand the size of the firm § to set up a new production unit in another locality, and § to buy shares in another firm • Suppose also that the expected annual return fro the three alterative uses of finance are given as follows: § Alternative 1 = Expansion of the size of the firm Rs. 20 million § Alternative 2 = Setting up a new production unit Rs. 18 million § Alternative 3 = Buying shares in another firm Rs. 16 million

2. Incremental Reasoning Concept • A change in output because of a change in process, product or investment is regarded as an incremental change. § § • Incremental cost Incremental revenue The incremental principle states that a decision is profitable when 1. It increases revenue more than costs; 2. It decreases some costs to a greater extent than it increases others; 3. It increases some revenues more than it decreases others; and 4. It reduces costs more than revenues.

Incremental Reasoning Example • A firm gets an order that brings additional revenue of Rs 3, 000. The normal cost of production of this order is: Rs Labour 800 Material 1300 Overheads 1000 Selling and administration expenses Full Cost 700 3800 • The incremental cost to accept the order will be Rs Labour 600 Material 1000 Overheads 800 Selling and administration expenses 700 Full Cost 2400 • Incremental reasoning shows that the firm would earn a net profit of Rs 600 (Rs 3, 000 – 2, 400),

Marginal analysis - Profit Function of a Firm • Theorem I: A course of action should be pursued up to the point where its marginal benefits equal its marginal costs.

Comparison - Incremental Reasoning and Marginal Analysis Incremental Reasoning Marginal Analysis 1 Cost Effectiveness is between alternatives Cost Effective is within a given alternative 2 Not restricted by a unit change Unit change in independent variable 3 Useful when cost and revenue functions are linear Useful when cost and revenue functions are curvilinear 4 Special case of incremental analysis

3. Discounting Principle Concept § According to this principle, if a decision affects costs and revenues in long-run, all those costs and revenues must be discounted to present values before valid comparison of alternatives is possible. This is essential because a rupee worth of money at a future date is not worth a rupee today. Money actually has time value. § Discounting can be defined as a process used to transform future money into an equivalent number of present money. § There is a lot of risk and uncertainty about future. The return in future is less attractive than the same return today. The future must, therefore, be discounted both for the elements of delay and risk of future.

Formulae • Future Value of a Lump sum Amount: • Present Value of Annuity

Discounting Principle Example: One may ask how much money today would be equivalent to Rs 100 a year from now if the rate of interest is 5%. The present value of Rs 100 to be received after one year is: PV = Rs 100/1+i = Rs 100/1. 05 = Rs 95. 24 Hence, PV = Rn/(1+i)n ; where PV = present value, R = amount to be received in future, i = rate of interest, n = number of years lapsing between the receipt of money

4. Time Perspective concept • The economic concept of the long run and the short run effects of decisions on revenues as well as costs. • Maintain the right balance with the short run and long run considerations • Example § Suppose there is a firm with temporary idle capacity. An order of 5, 000 units comes to management’s attention. The customer is willing to pay Rs 4 per unit. Generally the firm’s selling price per unit is Rs 5 per unit. The short term incremental cost (ignoring the fixed cost) is only Rs 3. Therefore, the contribution to overhead and profit is Rs 1.

Time Perspective § Analysis • Long run repercussions of the order ought to taken into account as well § If the management commits itself with too much business at lower prices or with a small contribution, it may not have sufficient capacity to take up business with higher contributions when the opportunity arises therefore. The management may be compelled to consider the question of expansion of capacity and in such cases, even the so-called fixed costs may become variable. § If the other customers come to know about this low price, they may demand a similar low price. The reduction of prices under conditions of excess capacity may adversely affect the image of the company in the minds of clientele ultimately affecting its sales.

5. Contribution concept • The concept of contribution tells us about the contribution of a unit of output to overheads and profit. • Unit contribution is the per unit difference of incremental revenue from incremental cost. • It helps in determining the best product mix when allocation of scarce resources is involved. • It also indicates whether or not it is advantageous to accept a fresh order, to introduce a new product, to shut down, to continue with the existing plant, etc.

Contribution Concept • Example: If the firm has only a single resource which is scarce, machine time availability( other factors adequately available) and if the firms has to make choice between 4 products, all needing to use the same scarce machine time. Compare the contribution per unit of machine hour for each product and evaluate the best use of machine time. Product Price Incremental cost per unit Contribution Machine time required (min) 1 44 26 18 180 2 40 24 16 120 3 37 22 15 90 4 20 8 12 60 • Contribution into per machine time Product Contribution per unit 1 6 per machine hour 2 8 3 10 4 12 • Order of contribution should be worked out only after taking into account the limitation of resources.

6. Equi-marginal Concept • It states that a rational decision maker would allocate or hire his resources in such a way that the ratio of marginal returns and marginal costs of various uses of a given resource or of various resources in a given use is the same, e. g. , a consumer seeking maximum utility (satisfaction) from his consumption basket will allow his consumption budget on goods and services such that MU 1/MC 1=MU 2/MC 2=. . . =MUn/MCn; Where, MU 1 = marginal utility from product 1 MC 1 = marginal cost of product 1, and so on.