UNIT 1 ENGINEERING ECONOMICS AND FINANCIAL ACCOUNTING
1. Managerial Economics: Study of economic theories, logic and methodology for solving the practical problems of business. To analyze business problems for rational business decisions. Application of economic concepts and economic analysis to the problems of formulating rational managerial decisions. ( Mansfield) Also called Business Economic or Economics for firms.
1.1 Principles of Managerial Economics Economic principles assist in rational reasoning and defined thinking. They develop logical ability and strength of a manager. Some important principles of managerial economics are: i. Marginal and Incremental Principle This principle states that a decision is said to be rational and sound if given the firm’s objective of profit maximization, it leads to increase in profit, which is in either of two scenarios
If total revenue increases more than total cost. If total revenue declines less than total cost.
Marginal analysis implies judging the impact of a unit change in one variable on the other. Marginal revenue is change in total revenue per unit change in output sold. Marginal cost refers to change in total costs per unit change in output produced (While incremental cost refers to change in total costs due to change in total output).The decision of a firm to change the price would depend upon the resulting impact/change in marginal revenue and marginal cost. If the marginal revenue is greater than the marginal cost, then the firm should bring about the change in price. Incremental analysis differs from marginal analysis only in that it analysis the change in the firm's performance for a given managerial decision, whereas marginal analysis often is generated by a change in outputs or inputs. Incremental analysis is generalization of marginal concept. It refers to changes in cost and revenue due to a policy change. For example - adding a new business, buying new inputs, processing products, etc. Change in output due to change in process, product or investment is considered as incremental change. Incremental principle states that a decision is profitable if revenue increases more than costs; if costs reduce more than revenues; if increase in some revenues is more than decrease in others; and if decrease in some costs is greater than increase in others.
ii.Equi-marginal Principle Marginal Utility is the utility derived from the additional unit of a commodity consumed. The laws of equi-marginal utility states that a consumer will reach the stage of equilibrium when the marginal utilities of various commodities he consumes are equal. According to the modern economists, this law has been formulated in form of law of proportional marginal utility. It states that the consumer will spend his moneyincome on different goods in such a way that the marginal utility of each good is proportional to its price, i.e., MUx / Px = MUy / Py = MUz / Pz Where, MU represents marginal utility and P is the price of good. Similarly, a producer who wants to maximize profit (or reach equilibrium) will use the technique of production which satisfies the following condition: MRP1 / MC1 = MRP2 / MC2 = MRP3 / MC3 Where, MRP is marginal revenue product of inputs and MC represents marginal cost. Thus, a manager can make rational decision by allocating/hiring resources in a manner which equalizes the ratio of marginal returns and marginal costs of various use of resources in a specific use. iii.Opportunity Cost Principle By opportunity cost of a decision is meant the sacrifice of alternatives required by that decision. If there are no sacrifices, there is no cost. According to Opportunity cost principle, a firm can hire a factor of production if and only if that factor earns a reward in that occupation/job equal or greater than it’s opportunity cost. Opportunity cost is the minimum price that would be necessary to retain a factor-service in it’s given use. It is also defined as the cost of sacrificed alternatives. For instance, a person chooses to forgo his present lucrative job which offers him Rs.50000 per month, and organizes his own business. The opportunity lost (earning Rs. 50,000) will be the opportunity cost of running his own business. iv.Time Perspective Principle According to this principle, a manger/decision maker should give due emphasis, both to short-term and long-term impact of his decisions, giving apt significance to the different time periods before reaching any decision. Short-run refers to a time period in which some factors are fixed while others are variable. The production can be increased by increasing the quantity of variable factors. While long-run is a time period in which all factors of production can become variable. Entry and exit of seller firms can take place easily. From consumers point of view, short-run refers to a period in which they
respond to the changes in price, given the taste and preferences of the consumers, while long-run is a time period in which the consumers have enough time to respond to price changes by varying their tastes and preferences. v.Discounting Principle 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 dollars into an equivalent number of present dollars. For instance, $1 invested today at 10% interest is equivalent to $1.10 next year. FV = PV*(1+r)t Where, FV is the future value (time at some future time), PV is the present value (value at t0, r is the discount (interest) rate, and t is the time between the future value and present value. 2. Managerial Decisions/ Decision Analysis Process of selecting the best out of alternative opportunities, open to the firm. 2.1 4 main phases of decision making 1. Determine and define the objective. 2. Collection of information regarding economic, social, political and technological environment and foreseeing the necessity and occasion for decision. 3. Inventing, developing and analyzing possible courses of action. 4. Selecting a particular course of action from the available alternatives.
2.2 Decision Making Process • The intelligence phase – Finding / Identifying / formulating problems • The design phase – Develop alternative decisions • The choice phase – Chose the best decision from the pool
2.3 Types of Decisions • Based on convenience – Structured • Well defined decision making procedure where every decision is broken down in distinct stages of evaluation, alternative search, elimination and acceptance criteria. – Semi Structured • It is a mixed kind of situation where very limited amount of structuring is maintained at some areas of operation but otherwise no segmenting and structuring is done. – Unstructured • All three phases of decision making are unstructured and clustered. Any one of the functions (Input, Output or Internal Process) is not readily available because the decision must be very rare or new so that it was not extensively studied to incorporate procedures to deal with it within the system. • Based on criticality – Strategic • Affect the entire organization or a major part of it. These are quite long-term decisions and generally made at upper level of management. – Tactical • This is also called management control decisions and affects only a part of the organization. This is taken by middle level management with the objective to meet the strategic plan. – Operational • Affect only one or two functional areas at a time. These are very short term and made at lower management levels. • Based on availability -Certainty / Uncertainty / Risk – • Based on programmability – Programmed • All resources for decision making are already available and the system can respond on the go. – Non Programmed • All resources are not available for instant decision making.
2.4 Decision Making Models a. Rational Decision Making Model Consists of a structured four-step sequence identifying the problem generating alternative solutions selecting a solution implementing and evaluating the solution
b. Political Decision Making Model o Assumes that people bring preconceived notions and biases into the decision-making situation o Self-interest may block people from making the most rational choice o Sometimes it is difficult to determine if a decision maker is operating rationally or politically c· Normative Model of Decision Making – Simon’s Model Based on premise that decision making is not rational Decision making is characterized by limited information processing use of judgmental heuristics sacrificing
Relationship of Managerial Economics with other discipline 1. ME and Economics Micro economics Study of economic behaviour of individuals, firms and other such micro organisations. ME makes use of several micro economic concepts such as marginal cost, marginal revenue, elasticity of demand etc. Macroeconomics Study of economy as a whole. It deals with the analysis of national income, level of employment, general price level, consumption and investment in the economy etc. These are all important issues related to the economic environment. Hence it will be useful to have a background of these areas for the successful management of a firm. ME dealing with national income forecasting is very essential for a managerial economist in demand forecasting for his products. Business sales is affected by business conditions which is depended on whether we are in boom or recession. 2. The usefulness of economics to the operations of firm can be seen in 4 different areas: Marketing and Sales, Production and Finance. Marketing and sales applications: Economics can contribute much to marketing through the use of applied demand theory. Sales function is closely related to an analysis of consumer demand. Size of market is depended on the size and composition of population, advertisement cost, price and income elasticity of demand and the supply elasticity of the competitors. Economics makes use of demand theory especially price elasticity concept to measure consumer sensitivity. Production application: Managers have to plan for monthly and weekly production schedules. Production function and input-output relations are very useful concepts here. Financial applications: Financial decisions involve the economies of time and uncertainty. A business firm has to decide whether to invest a large sum of money in new plant and equipment or whether to spend it on advertisement. Here the economies of time become an important determinant whether the firm should allocate its resources for present or future. Planning interest rate structures on loans also require time value of money considerations.
3. Management theory and accounting Accounting refers to the recording of financial transactions of the firm. A proper knowledge of accounting techniques is very essential for the success of the firm. Because profit maximisation is the major objective of the firm. The firms may aim at wealth maximisation or growth maximisation or try to maximise provision of services as in the case of non-profit organisations like Hospitals, Universities, Govt. etc. 4. ME and Mathematics: The use of Mathematics is significant in view of its profit maximisation goal along with optimum use of resources. The major problem of the firm is how to minimise cost, how to maximise profit or how to optimise sales. Mathematical concepts and techniques are used in economic logic to solve these problems. Also mathematical methods help to estimate and predict the economic factors for decision making and forward planning. Mathematical symbols are more convenient to handle and understand various concepts like incremental cost, elasticity of demand etc. 5. ME and Statistics: Statistical tools are used in collecting data and analysing them to help in decision making process. Statistical tools like the theory of probability and forecasting techniques help the firm to predict the future course of events. ME also make use of correlation and multiple regression in related variables like price and demand to estimate the extent of dependence of one variable on the other. The theory of probability is very useful in problems involving uncertainty. 6. ME and Computer science Computers are used in data and accounts maintenance, inventory and stock controls, supply and demand predictions. It helps reduce time and workload of managers. 7. ME and Operations research Taking effective decisions is the major concern of ME and OR. The development of techniques and concepts such as linear programming, inventory models and game theory is due to the development of OR. OR is concerned with the complex problems arising out of the management of men, machines, materials and money. OR provides a scientific model of the system and it helps managerial economists in the field of product development, materials management, inventory control, quality control, marketing and demand analysis.
The varied tools of OR are helpful to ME in decision making. The Linear programming techniques has proved to be a useful tool for the ME in the matter of reducing transportation costs and allocation of purchases among different suppliers. Dynamic programming is useful when a sequence of decisions must be made with each decision affecting future decisions. Such uses arise in the matter of investment decisions of funds. Input output analysis can be used by firms for planning, coordination and mobilisation of resources in various departments. Queuing theory is helpful when a firm has to depend upon several allied service organisations. Queuing theory is useful to find out ways of reducing the waiting period in meeting demand. Theory of games is useful in explaining the behaviour of competitors. Each competitor aims certain guaranteed minimum gain. Its behaviour with this goal prevents its opponents from achieving their aim. This theory helps us to solve the problems of price determination and the indeterminate condition of oligopoly. Thus statistical tools have helped to bring more accuracy and determinateness to the decision making process of a firm which operates in an uncertain environment.
3. FIRMS
