managerial economics ch 2

7/21/2019 Managerial Economics Ch 2

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Dr. Karim Kobeissi



Chapter 2: Basic Principles in

Managerial Economics



The Basic Economic Principles forDecision Making

Economic theory ofers a variety o concepts and

analytical tools which can be o considerable assistanceto the managers in their decision making practice.

These tools (principles) are helpul or managers insolving their business related problems. These tools are

taken as guide in making decision.Following are the basic economic principle or decision

making:

) !pportunity cost principle

") #ncremental principle$) Time perspective principle

%) &iscounting principle

') Euimarginal principle

) *isk + ,ncertainty principle



1) pport!nit" Cost Principle

#n managerial economics- the opportunity cost concept is useul in

decision involving a choice between diferent alternative courses oaction. *esources are scarce e cannot produce all the

commodities For the production o one commodity- we have to

orego the production o another commodity e cannot have

everything we want. e are- thereore- orced to make a choice.

!pportunity cost o a decision represents the bene/ts or revenue

orgone by pursuing one course o action rather than another.

#n managerial decision making- the concept o opportunity costoccupies an important place. The economic signi/cance o

opportunity cost is as ollows:

. #t helps in determining relative prices o diferent products.

". #t helps in determining normal remuneration to a actor o



2) # nc rementa l P r inc ip le#ncremental concept involves estimating the impact o decision

alternatives on costs and revenues- emphasi0ing the changes in totalcost and total revenue resulting rom changes in prices- products-

procedures- investments or whatever may be at stake in thedecisions.

The two basic components o incremental reasoning are:

) #ncremental 1ost (the increase in total costs resulting rom anincrease in production or other activity. For instance- i a company3s

total costs increase rom 4$"5-555 to 4$5-555 as the result oincreasing its machine hours rom 6-555 to 5-555- the incrementalcost o the "-555 machine hours is 4%5-555).

") #ncremental *evenue (the increased revenue rom a speci/edincrease in sales- or the additional return rom one investment).

The incremental principle may be stated as:7$ %ecision is ob&io!sl" a pro'table one if 8

a) it increases revenue more than costs

b) it decreases some costs to a greater e9tent than it increases others

c) it increases some revenues more than it decreases others and

d) it reduces cost more than revenues



() Concept of Time Perspecti&eThe time perspective concept states that decision

makers should be concerned about the short

r!n an% long r!n efects o their decisions on

re&en!es as ell as costs. The main problem

in decision making is to establish the right

balance between long run and short run.

; decision may be made on the basis o short run

considerations- but may as time elapses have

long run repercussions which make it more or

less pro/table than it at /rst appeared.



pp e *amp e n e oncep o mePerspecti&e

<uppose- a /rm having a temporary inactive capacity- received an

order or 5-555 units o its product. The customer is willing to pay

only 4 %.55 per unit or 4 %5-555 or the whole lot but no more.

The short run incremental cost (ignoring the /9ed cost) is only 4 $.

Thereore- the contribution to overhead and pro/t is 4 per unit (or

4 5- 555 or the lot). # the /rm e9ecutes this order- it will have to

ace the ollowing repercussion in the long run:

(a) #t may =ot be able to take up business with higher contributions in

the long run.

(b) The other customers may also demand a similar low price.

(c) The image o the /rm may be spoilt in the business community.

(d) The long run efects o pricing below ull cost may be more than

ofset any short run gain.



+) Disco!nting Principle

!ne o the undamental ideas in economics is

that a dollar tomorrow is worth less than adollar today. <uppose a person is ofered achoice to make between receiving 4 55 todayor 4 55 ne9t year. =aturally he will chose to

receive 4 55 today. This is true or tworeasons

)The uture is uncertain and there may be

uncertainty in getting the 4 55 ne9t year.") Even i the person is sure to receive the 4 55

ne9t year- today>s 455 can be invested at acertain interest rate (e.g. i ? '@) so that it will

become 45' ne9t year.



,) E-!imarginal Principle

!ne o the widest known principles o economics is theeuimarginal principle. The principle states that an

input should be allocated so that the value added bythe last unit is the same in all cases.

Aet us assume a case in which the /rm has 55 unit olabor at its disposal. ;nd the /rm is involved in /ve

activities B- C- 1- & and E. The irm can increase anyone o these activities by employing more labor butonly at the cost i.e.- sacri/ce o other activities.

;n optimum allocation cannot be achieved i the value

o the marginal product is greater in one activitythan in another. #t would be- thereore- pro/table toshit labor rom low marginal value activity to highmarginal value activity- thus increasing the total

value o all products taken together.



$pplie% E*ample on The E-!imarginal Principle

# the value o the marginal product o labor in activity (;) is 4 '5 whilethat in activity (C) is 4D5 then it is desirable and proitable to shit laborrom activity (;) to activity (). ;n optimum allocation is reached when

the values o the marginal product is eual in all activities. This can bee9pressed symbolically as ollows:

GHA; ? GHA ? GHA1 ? GHA& ? GHAE

The value o the marginal product o labor employed in (;) is eual to thevalue o the marginal product o the labor employed in (C) and so on.

here GH ? alue o Garginal Hroduct.

A ? Aabor

The euimarginal principle is an e9tremely practical notion. #t is behind anyrational budgetary or investment procedure. For a consumer- thisconcept implies that money may be allocated over various commoditiessuch that marginal utility derived rom the use o each commodity isthe same. <imilarly- or a producer this concept implies that resources

be allocated in such a manner that the marginal product o the inputs isthe same in all uses.



) / i s k 0 n c e r t a i n t "

Ganagerial decisions are actions o today which bear ruits inuture which is unoreseen. Future is uncertain and involvesrisk. ,ncertainty is due to unpredictable changes in thebusiness cycle- structure o the economy and governmentpolicies- competitors> strategies etc.

This means that the management must assume the risk omaking decisions or their institution in uncertain economic

conditions in the uture. ,nder uncertainty- the conseuenceso an action are not known immediately. Iowever- producersmust attempt to predict the uture cost and revenue data otheir /rms and determine the output and price policies.

Ganagerial economy have tried to handle uncertainty with thehelp o subJective probability. The probabilistic treatment ouncertainty reuires ormulation o de/nite subJectivee9pectations about cost- revenue and the rate o change in theenvironment.

managerial economics ch 2

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