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ENGINEERING ECONOMICS AND FINANCIAL ACCOUNTING

UNIT I
INTRODUCTION

Managerial Economics - Relationship with other disciplines - Firms: Types, objectives


and goals -Managerial decisions - Decision analysis.

ECONOMICS
Economics is the study of how societies use scarce resources to produce
valuable commodities and distribute them among different people.
SCOPE OF ECONOMICS
1. Consumption: Satisfaction of human wants is called consumption which
forms one of the important branches of economics. This tells how people
behave in consumption of goods and services in order to maximize their
satisfaction.
2. Production: Goods and services have to be produced with the help of
factors of production. So, production is another branch of economics. It
concerned with how maximum goods are produced with minimum cost or
how the scarce factors could be utilized economically for better results.
3. Exchange: Goods and services cannot be produced at one place or at
one point of time. Goods produced by one are exchanged for the goods
produced by the others. So, exchange forms another branch of study in
economics.
4. Distribution: Goods and services are produced with efforts, i.e., by
combining the factors of production. These efforts have to be paid for or
rewarded. The land gets rent, the labor get wages, the capital gets interest
and the organizer gets profit. This branch of study is called distribution in
economics.
5. Public Finance: This branch of study in economics studies about the
sources of revenue to the government and the principles governing the
expenditure for the benefit of the people. It also studies about public debt
and financial administration.
ECONOMICS IS A SCIENCE OR AN ART
Economics as a Science: A science is a systematized body of knowledge
ascertainable by observation experimentation. It is a body of generalizations,
principles, theories or laws which traces out a casual relationship between
cause and effect. Economics is a systematized body of knowledge in which
economic facts are studied and analyzed in a systematic manner. For
instance, economics is divided into consumption, production, exchange,
distribution and public finance which have their laws are theories on whose
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basis these departments are studied and analyzed in a systematic manner.


Hence economics is a science like any other science which has its own
theories and laws which establish a relation between cause and effect.
Economics is also a science because its laws possess universal validity such
as the law of diminishing returns, the law of diminishing marginal utility the
law of demand, Greshams law, etc. Again, economics is a science because
of its self corrective nature. It goes on revising its conclusions in the light of
new facts based on observations. Economic theories or principles are being
revised in the fields of macro economics, monetary economics, international
economics, public finance and economic development.
Economics as an Art: Unlike natural science, there is no scope for
experimentation in economics because economics is related to man, his
problems and activities. Economic phenomena are very complex as they
related to man whose activities are bound by his tastes, habits, and social
and legal institutions of the society in which he lives. Economics is thus
concerned with human beings who act irrationally and there is no scope for
experimentation in economics. Even though economics possess statistical,
mathematical and econometric methods of testing its phenomena but these
are not so accurate as to judge the true validity of economic laws and
theories. As a result, exact quantitative predication is not possible in
economics.
Economics as both a Science and an Art: Economics is not only a
science but also an art. It is a science in its methodology and an art in its
application. It has a theoretical aspect and is also an applied science in its
practical aspects
FUNDAMENTAL ECONOMIC PROBLEMS
Economic Problem: Due to the scarcity of means and the multiplicity of ends,
the economic problem lies in making the best possible use of our resources
so as to get maximum output satisfaction in the case of a consumer and
maximum output or profit for a producer. Hence economic problem consists
in making decisions regarding the ends to be pursued and the goods to be
produced and the means to be used for the achievement of certain ends.
Fundamental problems facing the economy:
1. What to produce: The first major decision relates to the quantity and
the range of goods to be produced. Since resources are limited, we must
choose between different alternative collection of goods and services that
may be produced. It also implies the allocation of resources between the
different types of goods. Example: Consumer goods and capital goods.
2. How to produce: Having decided the quantity and the type of goods to
be produced, we must next determine the techniques of production to be
used. Example: labor intensive or capital intensive.
3. For whom to produce: This means how the national product is to
distributed, i.e., who should get how much. This is the problem of the sharing
the national product.
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4. Are the Resources Economically Used? This is the problem of


economic efficiency or welfare maximization. There is to be no waste or
misuse of resources since they are limited.
5. Problem of Full employment: Fullest possible use must be made of the
available resources. In other words, an economy must endeavor to achieve
full employment not only of labor but of all its resources.
6. Problem of Growth: Another problem for an economy is to make sure
that it keeps expanding or developing so that it maintains conditions of
stability. It is not to be static. Its productive capacity must continue to
increase. If it is an under developed economy, it must accelerate its
process of growth.
CAPITALIST SYSTEM
Capitalism is that profit-oriented system which is characterized by private
ownership of objects of labor instruments of labor and means of labor.
Production is mainly carried out with the help of labor services rendered by
the working class in return for wages and the class of capitalists has the right
to whatever output is produced within the system.
Characteristics of the capitalist system:
1. Private ownership of means of production: Under the capitalist
system anything which helps man in the production process like machinery,
tools, land, raw-materials, etc. is owned by the capitalist class.
2. Production for the market: Under capitalism business firms produce
mainly with the aim of selling the output in the market. Wherever any good
is produced for the market it is termed as a commodity and any economy in
which production is undertaken with the sole object of exchange is call a
commodity economy.
3. Price mechanism: In a capitalist economy neither an individual nor any
institution makes decisions in a planned manner concerning its day-to-day
functioning. That is, there is no conscious effort to arrive at some kind of
solution to its central problems.
4. Labor power as a commodity: In a capitalist economy, majority of the
people own only on thing viz., their capacity to work or their labor power.
5. Exploitation of labor: Workers are exploited under capitalism. Very often
due to the freedom granted to the workers at a formal level, many people
are wrongly given to believe that the workers by bargaining in the free
market are able to get a fair price in return for their labor power.
6. Growing wealth of the capitalists: In a capitalist economy the wealth
of the capitalist class increases in a sustained manner.
7. Emergence of the working class: Under capitalism the increasing used
of machinery leads to widespread unemployment and an increase in the rate
of exploitation of workers which implies a decline in the share of workers in
the national income over time.
8. Class contradiction: Hence, the two major classes found in a capitalist
society are those of the capitalists and the workers. The clash of interests of
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the capitalists and the workers take the form of the class conflict with the
further development of capitalism.
SOCIALISM
Under socialism not only is there social ownership of the means of production
but also the functioning of the economy is such so as to maximize social
benefit rather than private benefit. Unlike capitalism in a socialist society the
market mechanism does not play the all dominating role of determining the
type and quantity of various commodities produces their priority sequence
and the necessary allocation of resources.
Characteristics (or) Salient features of the socialist economic
system:
1. Social ownership of the means of production: In a socialist society
private ownership of the means of production is abolished in the various
sectors of the economy.
2. Predominance of public sector: An important precondition for the
establishment of socialism is the existence of the public sector which is
founded on the principle of social ownership of the means of production
3. Decisive role of economic planning: Economic planning under
socialism plays exactly the same role as is played by the price mechanism in
a capitalist economy.
4. Production guided by social benefit: In a socialist economy, however,
income inequalities are drastically reduced so that everyone has an
adequate amount of disposable income. While determining the pattern and
size of output the planning commission has to see to it that its decisions in
this regard are such that they ensure the availability of commodities for all in
the market.
5. Abolition of exploitation of labor: Once the development of human
society reaches the stage of socialism. Exploitation of man by man comes to
an end.
MIXED ECONOMY
According to Samuelson, a mixed economy is characterized by the existence
of both public and private institutions exercising economic controls.
CHARACTERISTICS OF A MIXED ECONOMY:
1. Private and state ownership of the means of production and profit
induced private business:
In a mixed economy people enjoy right of property through constitutional
provisions.
2. Decisive role of market mechanism: Market mechanism has a
predominant position in a mixed economy. In such an economy markets exist
not only for various products, but also for productive factors, such as labor
and capital.
3. Interventionist role of the state: The market mechanism is a mixed
economy may not be entirely free from state control. Often legislative
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measures are undertaken to provide a regulatory system for industrial


activity in the country.
4. Public sector activities are supposedly guided by social benefit:
Activities of the public enterprises are considered to be guided by the social
benefit. Thus performance of these enterprises is often judged on the
criterion of social benefit and thus most of this enterprise ignore profit
maximization goal.
5. Supportive role of economic planning: The role of economic planning
in basically capitalistic economic framework is supportive. Hence planning in
these economies is usually indicative in nature. Economic planning in
developing economies, in which both private and public sectors co- exists,
has nothing to do with socialism.
ENGINEERING ECONOMICS
It is the application of economic principles to engineering problems. For
example, in comparing the comparative costs of two alternative capital
projects.
IMPORTANCE OF ENGINEERING ECONOMICS:
1. Engineering economics is concerned with the monetary consequences (or)
financial analysis of the projects, products and processes that engineers
design.
2. Engineers are required to use economic concepts in the major fields such
as increasing production, improving productivity, reducing human efforts,
increasing wealth by maximizing profit, controlling and reducing cost.
3. Engineering economics provides has very important role to play in all
engineering decisions.
4. Engineering economics provides a number of tools and techniques to
solve engineering problems related to product-mix, output level, pricing the
product, investment, quantum of advertisement, etc.
5. Engineering economics helps in understanding the market conditions,
general economic environment in which the firm is working.
6. Engineering economics provide basis for resource allocation problem.
7. Engineering economics deals with identification of economic choices, and
is concerned with the decision making of engineering problems of economic
nature.
APPLICATIONS OF ENGINEERING ECONOMICS
1. Selection of location and site for a new plant-It is concerned with
comparing the cost of establishment and operation of various locations and
sites.
2. Production Planning and Control.
3. Selection of equipment and their replacement analysis.
4. Selection of a material handling system.
5. Determination of plant capacity. It is associated with investment of funds
such as initial outlay and operating expenses which determines the capacity
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of a plant. The capacity is a measure of ability to produce goods and services


or rate of output.
6. Determination of wage structure of the workers.
7. Selection of choice between a concrete structure and a steel structure,
between various insulation thickness, and between prices at which to sell a
product.
8. It can be applied by a major corporation to analyze plans for a new
manufacturing facility or a new research and development (R&D) thrust.
CHARACTERISTICS OF ENGINEERING ECONOMICS
1. Engineering economics is a traditional and important part of engineering
practice.
2. Engineering economics is concerned with application of economic
principles in technical and managerial decision making.
3. Engineering economics embarrasses both micro and macroeconomic
principles when applied to engineering problems. For example, the study of
demand analysis is mostly concerned with individual or household as a small
unit of study. Whereas, the study of impact of taxes on raw- materials will
influence engineers to look for alternative materials for manufacturing or
designing a product or processes which is of course a macro economic issue.
The demand analysis is microeconomic principle.
4. Engineering economics also take in its fold certain concepts and principles
from other fields such as statistics, accounting, management, etc.
5. Engineering economics aids decision making aspect of an engineer and it
avoids the abstract nature of economic theory.
6. Engineering economics is mostly an application tool, whereas economics
is a social science with broad characteristics.
7. Economic theory conveniently ignores the significant backgrounds which
are common to individual firms but engineering economics take in to
consideration the individual firms environment of decision making.
8. Engineering economics provides an analytical and scientific approach
resulting in qualitative decisions.
ADVANTAGES OF ENGINEERING ECONOMICS
1. Better decision making on the part of engineers.
2. Efficient use of resources results in better output and economic
advancement.
3. Cost of production can be reduced.
4. Alternative courses of action using economic principles may result in
reduction of prices of goods and services.
5. Elimination of waste can result in application of engineering economics.
6. Competitive strength on the part of the firm in adopting engineering
economics.
7. More capital will be made available for investment and growth.
8. Improves the standard of living with the result of better products, more
wages and salaries, more output, etc. From the firm applying economics.
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MANAGERIAL ECONOMICS
Managerial Economics has been described as economics applied to decisionmaking. It may be viewed as a special branch of economics bridging the gulf
between pure economic theory and managerial practice.
CHIEF CHARACTERISTICS
1. Managerial Economics is micro-economic in character. This is because the
unit of study is a firm;it is the problems of a business firm which are studied
in it. Managerial Economics does not deal with the entire economy as a unit
of study.
2. Managerial Economics largely uses that body of economic concepts and
principles which is known as Theory of the Firm or Economics of the Firm.
In addition, it also seeks to apply Profit Theory which forms part of
Distribution Theories in Economics.
3. Managerial Economics is pragmatic. It avoids difficult abstract issues of
economic theory but involves complications ignored in economic theory to
face the overall situation in which decisions are made. Economic theory
appropriately ignores the variety of backgrounds and training found in
individual firms but Managerial Economics considers the particular
environment of decision-making.
4. Managerial Economics belongs to normative economics rather than
positive economics (also sometimes known as descriptive economics). In
other words, it is prescriptive rather than descriptive. The main body of
economic theory confines itself to descriptive hypothesis, attempting to
generalize about the relations among different variables without judgment
about what is desirable or undesirable.
5. Macro-economics is also useful to Managerial Economics since it provides
an intelligent understanding of the environment in which the business must
operate. This understanding enables a business executive to adjust in the
best possible manner with external forces over which he has no control but
which play a crucial role in the well-being of his concern.
SCOPE OF MANAGERIAL ECONOMICS
1. Demand Analysis and Forecasting: A major part of managerial
decision-making depends on accurate estimates of demand. Before
production schedules can be prepared and resources employed, a forecast of
future sales is essential.
2. Cost Analysis: A study of economic costs, combined with the data drawn
from the firms accounting records, can yield significant cost estimates that
are useful for management decisions.
3. Production and Supply Analysis: Production analysis mainly deals with
different production function and their managerial uses. Supply analysis
deals with various aspects of supply of a commodity. Certain important
aspects of supply analysis are: Supply schedule, curves and function. Law of
supply and its limitations, Elasticity of supply and Factors influencing supply.
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4. Pricing Decisions, Policies and Practices: The important aspects dealt


with under this area are: Price Determination in various Market Forms, Pricing
Methods, Differential Pricing, Product-line Pricing and Price Forecasting.
5. Profit Management: Business firms are generally organized for the
purpose of making profits and, in the long run, profits provide the chief
measure of success. In this connection, an important point worth considering
is the element of uncertainty existing about profits because of variations in
costs and revenues which, in turn, are caused by factors both internal and
external to the firm.
6. Capital Management: Capital management implies planning and control
of capital expenditure. The topics dealt with are: Cost of Capital, Rate of
Return and Selection of projects.
BASIC ECONOMIC TOOLS IN MANAGERIAL ECONOMICS
1. Opportunity Cost Principle: By the opportunity cost of a decision is
meant the sacrifice of alternatives required by that decision. Thus, it should
be clear that opportunity costs require ascertainment of sacrifices. If a
decision involves no sacrifice, its opportunity cost is nil. For decision-making,
opportunity costs are the only relevant costs. The opportunity cost principle
may be stated as under: The cost involved in any decision consists of the
sacrifices of alternatives required by that decision. If there are no sacrifices,
there is no cost.
2. Incremental Principle: Incremental concept involves estimating the
impact of decision alternatives on costs and revenues, emphasizing the
changes in total cost and total revenue resulting from changes in prices,
products, procedures, investments or whatever may be at stake in the
decision. The two basic components of incremental reasoning are:
Incremental cost and incremental revenue. Incremental cost may be defined
as the change in total cost resulting from a particular decision. Incremental
revenue is the change in total revenue resulting from a particular decision.
3. Principle of Time Perspective: The economic concepts of the long run
and the short run have become part of everyday language. Managerial
economics are also concerned with the short-run and long-run effects of
decisions on revenues as well as costs. The really important problem in
decision- making is to maintain the right balance between the long-run and
the short-run considerations. A decision may be made on the basis of shortrun considerations, but may as time elapses have long- run repercussions
which make it more or less profitable than it at first appeared.
4. Discounting Principle: One of the fundamental ideas in economics is
that a rupee tomorrow is worth less than a rupee today. This seems similar to
saying that a bird in hand is worth two in the bush. If a decision affects
costs and revenues at future dates, it is necessary to discount those costs
and revenues to present values before a valid comparison of alternatives is
possible.
5. Equi-marginal Principle: This principle deals with the allocation of the
available resources among the alternative activities. According to this
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principle, an input should be so allocated that the value added by the last
unit is the same in all cases. This generalization is called the equi-marginal
principle.
RELATIONSHIP
OF
MANAGERIAL
ECONOMICS
WITH
OTHER
DISCIPLINES
1. Managerial Economics and Economics: Managerial Economics has
been described as economics applied to decision-making. It may be viewed
as a special branch of economics bridging the gulf between pure economic
theory and managerial practice. Economics has two main divisions: microeconomics and macro-economics. Micro-economics has been defined as that
branch where the unit of study is an individual or a firm. Macro-economics,
on the other hand, is aggregative in character and has the entire economy as
a unity of study.
2. Managerial Economics and statistics: Managerial Economics employs
statistical methods for empirical testing of economic generalizations. These
generalizations can be accepted in practice only when they are checked
against the data from the world of reality and are found valid.
3. Managerial Economics and Mathematics: Mathematics is yet another
important tool-subject closely related to Managerial Economics. This is
because Managerial Economics is metrical in character, estimating various
economics relationships, predicting relevant economic quantities and using
them in decision-making and forward planning.
4. Managerial Economics and Accounting: Managerial Economics is also
closely related to accounting which is concerned with recording the financial
operations of a business firms. Indeed, accounting information is one of the
principal sources of data required by a managerial economist for his
decision-making purpose.
5. Managerial Economics and Operations Research: The significant
relationship between managerial economics and operations research can be
highlighted with reference to certain important problems of managerial
economics which are solved with the help of or techniques. The problems
are: allocation problems, competitive problems, waiting line problems and
inventory problems.
DIFFERENCE BETWEEN MANAGERIAL ECONOMICS AND ECONOMICS
1. Managerial Economics involves application of economic principles to the
problems of the firm. Economics deals with the body of the principles itself.
2. Managerial Economics is micro-economic in character; Economics is both
macro-economic and micro-economic.
3. Managerial Economics, though micro in character, deals only with firms
and has nothing to do with an individuals economic problems. But microEconomics as a branch of Economics deals with both economics of the
individual as well as economics of the firm.
4. Under Micro-Economics as a branch of Economics, distribution theories,
viz., wages, interest and profit, are also dealt with but in Managerial
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Economics, mainly Profit Theory is used: other distribution theories have not
much use in Managerial Economics. Thus, the scope of Economics is wider
than that of Managerial Economics.
5. Economic theory hypothesizes economic relationships and builds
economic models but Managerial Economics adopts, modifies and
reformulates economic models to suit the specific conditions and serves the
specific problem solving process. Thus Economics gives the simplified model,
whereas Managerial Economics modifies and enlarges it.
6. Economic theory makes certain assumptions whereas Managerial
Economics introduces certain feedbacks such as objectives of the firm, multiproduct nature of manufacture, behavioural constraints, environmental
aspects, legal constraints, constraints on resource availability, etc., thus
embodying a combination of certain complexities assumed away in economic
theory and then attempts to solve the real-life, complex business problems
with the aid of tool subjects, e.g., mathematics, statistics, econometrics,
accounting, operations research, marketing research and so on.
ROLE OF MANAGERIAL ECONOMISTS IN BUSINESS
1. Decision Making and Forward Planning: Managerial economists play
a vital role in managerial decision making and forward planning.
2. Inventory Schedules of the Firm: He plays an effective role in price
fixation, location of a plant, quality improvement, etc. and inventory
schedules of the firm.
3. Demand Forecasting: The most important role of the managerial
economist relates to demand forecasting.
4. Economic Analysis: The managerial economists undertake an economic
analysis of the industry.
5. Price Fixation: Another role played by a managerial economist is to
fixing prices for new as well as existing products of a firm.
6. Environmental Issues: A managerial economist is also undertakes the
analysis of environmental issues.
7. Cost of the Firm: He is also responsible and playing a vital role in input
cost of the firm.
8. Governments Economic Policies: Lastly, managerial economist has
also to keep in touch with the governments economic policies and the
central banks monetary policies annual budgets of the government.
DECISION MAKING ENVIRONMENTS
The decisions are also categorized in terms of the degree of certainty that
exists in a situation. Thus every decision making situation falls into one of
the four categories that exist along a certainty continuum namely Certainty,
Risk, Uncertainty and Ambiguity
1. Certainty: This is a state of certainty that exists only when the decision
maker knows the available alternatives and the conditions and consequences
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of those actions. Making decisions under certainty assumes that the decision
maker has all the necessary information about the problem situation.
2. Risk: A state of risk exists when the decision maker is aware of all the
alternatives, but is unaware of their consequences. In this situation, the
decision maker at best can make guess as to which alternative to choose.
The decision in order risk usually involves clear and precise goals and good
information, but future outcomes of the alternatives are just not known to a
degree of certainty. However, sufficient information is available to allow the
decision maker to ascribe the probability of successful outcomes for each
alternative.
3. Uncertainty: Most significant decisions made in todays complex
environment are formulated under a state of uncertainty, where there is an
unawareness of all the alternatives and so also the outcomes even for the
known alternatives. Such decisions demand creativity and the willingness to
take a chance in the face of such uncertainties. In such situations, decision
makers do not even have enough information to calculate degree of risk.
4. Ambiguity: The most difficult decision situation is the state of ambiguity,
in which the decision problems are not at all clear. The alternative courses of
action are difficult to identify, and the information about consequences is not
available. In this state, nothing is known for sure and the risk of failure is
quite high.
PROFIT MAXIMIZATION AS BUSINESS OBJECTIVE
Profit maximization objective of the firm has been the traditional approach to
the study of a firm in equilibrium analysis. Profit maximization means the
largest absolute amount of profits over a time period, both short-term. And
long term. The short run is a period where adjustments cannot be made
quickly in matters of supply and demand. Long run however enables
adjustment to changed conditions. Profit can be defined as the difference
between total revenue (TR) and total cost (TC).
Profit=TR-TC
CRITISIMS OF PROFIT-MAXIMISING THEORIES
1. Separation of Ownership from Control: The rise of corporate firm of
organization has resulted in a separation of ownership and control.
Ownership is vested with the shareholders and control is wielded by the
managers. It has not been empirically proved that shareholders are more
concerned with profitability than anything else.
2. Difficulties in Pursuing Profit Maximization: The modern firm faces
lot uncertainties. As a result, short run profit maximizing behaviour is
subordinated to the more important objective of long-run survival of the firm,
for example, the firms objective to pursue good-will in the long-run may
clash with short-run profit objective.
3. Problems in the Measurement of Profit: There are some problems
about the measurement of profit as a measure of firms efficiency. Profit may
be the result of imperfection in the market and profits may be the reward of
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monopolistic exploitation. Worse still, profit measurement process itself is


dubious.
4. Social responsibility of the firm: he firm is now-a-days not just an
economic entity concerned with production or sales alone. The firm owes a
responsibility to offer good, well paid jobs for employees, to provide efficient
services to customers. In short the firm has a social responsibility beyond
profit maximization.
5. Deliberate limitation of profits: Firms may deliberately show lesser
profits in the short run in order to discourage labourers from asking for
higher wages or to discourage entry of new firms. Limited profits may be
shown to prevent the government from taking over the business.
6. Aversion for business expansion: Profit maximization requires
business expansion and it means additional risk and responsibility.
Businessmen may be satisfied with the prevent level of profit and may not
expand.
ARGUMENTS IN FAVOUR OF PROFIT MAXIMIZATION
1. Profit is indispensable for firms survival: The survival of all the
profit-oriented firms in the long run depends on their ability to make a
reasonable profit depending on the business conditions and the level of
competition.
2. Achieving other objectives depends on firms ability to make
profit: Many other objectives of business firms have been cited in economic
literature, e.g., maximization of managerial utility function, maximization of
long-run growth, maximization of sales revenue, satisfying all the concerned
parties, increasing and retaining market share, etc. the achievement of such
alternative objectives depends wholly or partly on the primary objective of
making profit.
3. Evidence against profit maximization objective not conclusive:
Profit maximization is a time- honored objective of business firms. Although
this objective has been questioned by many researchers, the evidence
against it is not conclusive or unambiguous.
4. Profit maximization objective has a greater predicting power
Compared to other business objectives, profit maximization assumption has
been found to be a much more powerful premise in predicting certain
aspects of firms behaviour.
5. Profit is a more reliable measure of firms efficiency: Thought not
perfect, profit is the most efficient and reliable measure of the efficiency of a
firm.
ALTERNATIVE OBJECTIVE OF FIRMS
Baumols Theory of Sales Revenue Maximization
Prof. J. Baumol has postulated seller revenue maximization approach as an
alternative to profit maximization objective. The factors which explain the
pursuance of this objective are following:
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1. Financial institutions evaluate the success and strength of the firm in


terms of rate of growth of its sales revenue.
2. Empirical evidence shows that the stock earnings and salaries of top
management are correlated more closely with sales than with profits.
3. Increasing sales revenue over a period of time gives prestige to the top
management, but profits are enjoyed only by the shareholders.
4. Growing sales means higher salaries and better terms. Hence sales
revenue maximizations results in a healthy personnel policy.
5. It is seen that managers prefer a steady performance with satisfactory
profits than spectacular profits year after year. They will be criticized if
spectacular profits decline. Hence they may prefer a safe and steady
performance with satisfactory profits but good sales.
6. Large and increasing sales help the firm to obtain a bigger market share
which gives it a greater competitive power.
ASSUMPTIONS OF BAUMOLS SALE MAXIMIZATION MODEL
i. Sales maximization goal is subject to a minimum profit constrain.
ii. Advertisement is a major instrument of sales maximization i.e.,
advertisement will shift the demand curve to the right.
iii. Advertisement costs are independent of production costs.
iv. Price of the product is assumed to be constant.
IMPLICATIONS OF BAUMOLS THEORY
i. His theory is more consistent with observed behavior. In the traditional
theory changes in fixed costs do not influence output or prices except for
fixing the breakeven point. But according to Baumol a firm which
experiences any increase in fixed costs will try to reduce them or pass them
on to the consumer in the form of higher prices, through large scales.
ii. This theory also establishes that businessmen may consider non-price
competition through sales maximization to be the more advantageous
alternative.
iii. However, Baumols theory does not explain how the firms maximize their
sales volume within a profit constraint. Further it explains business behavior,
without elaborating the mechanism by which they try to find new alternative.
MARRIS THEORY OF MAXIMISATION OF FIRMS GROWTH RATE
According to Robin Marris, managers maximize firms balanced growth rate
subject to managerial and financial constraints. He defines firms balanced
growth rate (G) as, G= GD=GC
Where GD=growth rate of demand for firms product and GC=growth rate of
capital supply to the firm.
In simple words, a firms growth rate is balance when demand for its product
and supply of capital to the firm increase at the same rate. The two growth
rates are according to Marris, translated into utility functions:
(i) Managers utility function: The managers utility function (Um) and
owners utility(Uo) may be satisfied as follows. Um=f(salary, power, job
security, prestige, status).
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(ii) Owners utility function Owners utility function (Uo): Uo=f


(output, capital, market-share, profit, public esteem), implies growth of
demand for firms product and supply of capital.
Therefore, maximization of Uo means maximization of demand for firms
product or growth of capital supply. According to Marris, by maximizing these
variables, managers maximize both their own utility function and that of the
owners. The managers can do so because most of the variables (e.g.,
salaries, status, job security, power, etc) appearing in their own utility
function and those appearing in the utility function of the owners (e.g., profit,
capital market, share, etc) are positively and strongly correlated with a single
variable, i.e., size of the firm. Maximization of these variables depends on the
maximization of the growth rate of the firms. The managers, therefore, seek
to maximize a steady growth rate. Marriss theory, though more rigorous and
sophisticated than Baumols sales revenue maximization, has its own
weaknesses. It fails to deal to deal satisfactorily with oligopolistic
interdependence & it ignores price determination which is the main concern
of profit maximization hypothesis
WILLIAMSONS THEORY OF MAXIMIZATION OF MANAGERIAL UTILITY
FUNCTION
Like Baumol and Marris, Willamson argues that managers have discretion to
pursue objectives other than profit maximization. The managers seek to
maximize their own utility function subject to a minimum level of profit.
Managers utility function (U) is expresses as: U = f(S, M, ID) Where S=
additional expenditure on staff, M= managerial emoluments, ID=
discretionary investments.
According to Williamsons theory managers maximize their utility function
subject to a satisfactory profit. A minimum profit is necessary to satisfy the
shareholders or else managers job security is endangered. The utility
functions which managers seek to maximize include both quantifiable
variables like salary and slack earnings, and non-quantitative variable such
as prestige power, status, job security, professional excellence, etc. The nonquantifiable variables are expresses, in order to make them operational, in
terms of expense preference defined as satisfaction derived out of certain
types of expenditures (such as slack payments), and ready availability of
funds for discretionary investments. Williamsons theory suffers from certain
weakness. His model fails to deal with problem of oligopolistic
interdependence. Williamsons theory is said to hold only where rivalry
between firms is not strong. In case of strong rivalry, profit maximization is
claimed to be a more appropriate hypothesis. Thus, Williamsons managerial
utility function too does not offer a more satisfactory hypothesis than profit
maximization.
CYERT-MARCH THEORY OF SATISFICING BEHAVIOUR
Cyert-March theory is an extension of Simons theory or firms. Satisfying
behaviour or satisfying behaviour. Simon had argued that the real business
world is full of uncertainly; accurate and adequate data are not readily
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available; where data are available managers have little time and ability to
process them; and managers work under a number of terms of rationality
postulated under profit maximization hypothesis. Nor do the firms seek to
maximize sales, growth or anything else. Instead they seek to achieve a
satisfactory profit a satisfactory growth, and so on. This behaviour of firms
is termed as Satisfaction Behaviour. Cyert and March added that, apart
from dealing with an uncertain business world, managers have to satisfy a
variety of groups of people-managerial staff, labour, shareholders,
customers, financiers, input suppliers, accountants, lawyers, authorities etc.
All these groups have their interest in the firms-often conflicting. The
managers responsibility is to satisfy them all. Thus, according to the CyertMarch, firms behaviour is satisfying behaviour. The satisfying behaviour
implies satisfying various interest groups by sacrificing firms interest or
objective. The underlying assumption of Satisfying Behaviour is that a firm
is a coalition of different groups connected with various activities of the
firms, e.g., shareholders, managers, workers, input supplier, customers,
bankers, tax authorities, and so on. All these groups have some kind of
expectations-high and low- from the firm, and the firm seeks to satisfy all of
them in one way or another in sacrificing some of its interest. In order to
reconcile between the conflicting interests and goals, managers form an
aspiration level of the firm combining the following goals: (a) Production goal,
(b) Sales and market share goals, (c) Inventory goal, and (d) Profit goal.
These goals and aspiration level are set on the basis of the managers past
experience and their assessment of the future market conditions. The
aspiration levels are modified and revised on the basis of achievements and
changing business environment. The behavioural theory has, however, been
criticized on the following grounds. First, though the behavioural theory deals
realistically with the firms activity, it does not explain the firms behaviour
under dynamic conditions in the long run. Secondly, it cannot be used to
predict exactly the future
course of firms activities; thirdly, this theory does not deal with the
equilibrium of the industry. Fourthly, like other alternative hypotheses, this
theory too fails to deal with interdependence of the firms and its impact on
firms behaviour.
SOURCES OF BUSINESS RISK
1. Risk of Market Fluctuation: General economic conditions are rarely
stable. Firms face booms and depressions. Though with the help of certain
forecasting techniques the firm can somewhat hedge itself against cyclical
fluctuation, but there is no way the firm can generally know with certainty
the timing and volatility of changes. The firm is, therefore, unstable to
completely prepare itself for these changes.
2. Risk of Industry Fluctuations: There may be fluctuations specific to the
industry, which are least as uncertain and may not always coincide with
those of the overall market.
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3. Competition risks: These are the risk arising from the policy changes of
the rivals, which include things like changes in prices, product line,
advertisement expenditure, etc.
4. Risk of technological change: This is also called the risk of
obsolescence, which grows with advancement of an economy. These risks
arise from the possibility of newly installed machinery becoming obsolete
with the discovery of new and more economical process of production.
5. Risk of taste fluctuation: In many cases, vagaries of consumer demand
create uncertain
conditions. Successful product of one season may become discarded in the
next season. These risks are most common in fashion and entertainment
industries.
6. Risk of cost fluctuation: Unless contractually agreed upon, the future
prices of labour, material etc. may change. Thus estimates of future
expenditure are subject to uncertainty.
7. Risk of public policy: Government policy regarding business undergoes
a change over time, some of which cannot be precisely predicted. These
relate to price control, foreign trade policy, corporate taxation etc.
THE THREE CATEGORIES OF DECISION-MAKERS
1. Risk-neutral: A decision-maker is risk-neutral if each added rupee of
wealth gives him the same additional utility.
2. Risk-averse: A decision-maker is considered risk-averse if addition of
each successive rupee to his wealth gives him lesser utility than the earlier
rupee.
3. Risk-preferer: A decision-maker is considered as risk-preferrer when
addition of each successive rupee to decision-makers wealth gives him
greater utility each time.
DECISION MAKING
Decision making is the process of selection from a set of alternative courses
of action which is thought to fulfil the objective of the decision problem more
satisfactorily than other.
FEATURES OF DECISION MAKING
1. Selection process: Decision making is a selection process. The best
alternative is selected out of many available alternatives.
2. Goal-oriented process: Decision making is goal-oriented process.
Decisions are made to achieve some goal or objective.
3. End process: Decision making is the end process. It is preceded by
detailed discussion and selection of alternatives.
4. Human and Rational process: Decision making is a human and rational
process involving the application of intellectual abilities. It involves deep
thinking and foreseeing things.
5. Dynamic process: Decision making is a dynamic process. An individual
takes a number of decisions each day.
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6. Situational: Decision making is situational. A particular problem may


have different decisions at different times, depending upon the situation.
7. Continues or Ongoing process: Decision making is a continuous or
ongoing process. Managers have to take a series of decisions on particular
problems.
8. Freedom to the decision makers: Decision making implies freedom to
the decision makers regarding the final choice. It also involves the using of
resources in specified ways.
9. Positive or Negative: Decision may be positive or negative. A decision
may direct others to do or not to do.
10. Gives happiness to an Endeavour: Decision making gives happiness
to an Endeavour who takes various steps to collect all the information which
is likely to affect decisions.
STEPS IN DECISION MAKING PROCESS IN AN ORGANIZATION
1. Identification of problem: Decision making process begins with the
identification of problem that means recognition of a problem. The managers
have to use imagination, experience, and judgment in order to identify the
real nature of the problem.
2. Diagnosis and analysis of the problem: In order to diagnose the
problem correctly, a manager must obtain all pertinent facts and analyze
them correctly. The most important part of the diagnosing problem is to find
out the real cause or source of the problem. After analyzing the problem next
phase of the decision making is to analyze problem. This process involves
classifying the problem and gathering information.
3. Search for alternatives: A problem can be solved in many ways. All
possible ways cannot be equally satisfying. Managers are advice to limit him
to the discovery of the alternatives which are strategic or critical to the
problem. The principle of limiting factor is given as By recognizing and
overcoming that factor that stand critically in the way of a goal, the best
alternative course of action can be selected. Creative thinking is necessary
to develop alternatives such as decision makers past experience, practices
followed by others, and using creative techniques.
4. Evaluation of alternatives: Evaluation is the process of measuring the
positive and negative consequences of each alternative. Some alternatives
offer maximum benefit than others. An alternative is compared with the
others. Management must set some criteria against which the alternatives
can be evaluated. Criteria to weigh the alternative courses of action includes
Risk- Degree of risk involved in each alternative, Economy of effort- Cost,
time and effort involved in each alternative, Timing or Situation- Whether the
problem is urgent & Limitation of resources- Physical, financial and human
resources available with the organization.
5. Selecting an alternative: In this stage, decision makers can select the
best alternatives. Optimum alternative is one which maximizes the results
under given conditions.
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6. Implementation and follow-up: Once an alternative is selected, it is


put into action in systematic way. The future course of action is scheduled on
the basis of selected alternatives. When a decision is put into action, it may
yield certain results. These results provide the indication whether decision
making and its implementation is proper. The follow-up action should be in
the light of feedback received from the results.
RATIONAL DECISION MAKING
Decision making is the process of selection from a set of alternative courses
of action which is thought to fulfil the objective of the decision problem more
satisfactorily than other. The concept of rationality is defined in terms of
objective and intelligent action.
TYPES OF DECISION MAKING DEPENDING UPON RATIONALITY
1. Major and supplementary decisions: Major decisions refer to the
decisions with regard to the quality of the product, price of the product,
developing a new product etc. These decisions have direct bearing on the
achievement of the goals of the concern and so these decisions should be
made very carefully. Minor or supplementary decisions, on the other hand,
are made in the course of conversion of major decisions into action.
2. Organizational and personal decision: Organizational decisions are
made by the executive in his capacity as manager in order to achieve the
best interests of the organization. These decisions can be delegated to the
other members in the organization. Personal decisions, on the other hand,
are made by the manager in his personal capacity and not in his capacity as
a member of the organization. These decisions are not delegated. These
decisions relate to the executives personal work.
3. Basic and routine decisions: Basic decisions involve long range
commitment and large funds. Decisions with regard to selection of a location,
selection of a product line, merger of the business are known as basic
decisions. As these decisions affect the entire organization, they are
considered as basic decisions. They are also now as vital decisions. Decisions
that are taken to carry out the day-today activities are called routine
decisions. These decisions are repetitive in nature. They have only a minor
impact on the business. These decisions are made at middle and lower levels
of management. For eg., purchase of sundry materials.
4. Group and individual decisions: If the decision is taken by one person,
it is called individual decision. Group decisions are taken by a group of
persons.
5. Policy and operating decisions: Policy decisions are made at top
management levels. These decisions are taken to determine the basic
policies and goals of the organization. Operating decisions are taken to
execute the policy decisions. These decisions are taken at the middle and
lower management levels and are related to routine activities of business.
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6. Programmed decision: Programmed decision is otherwise called routine


decision or structured decision. The reason is that these types of decision are
taken frequently and they are repetitive in nature. Such decision is generally
taken by middle or lower level managers, and has a short term impact. This
decision is taken within the preview of the policy of the organization.
7. Non-Programmed decision: Non programmed structures are otherwise
called strategic decisions or basic decision or policy decision or unstructured
decisions. This decision is taken by top management people whenever the
need arises. This decision deals with unique or unusual or non- routine
problems. Such problems cannot be tackled in a predetermined manner.
There are no established methods or readymade answers for such problems.
8. Organizational decisions: Organizational decisions are decisions taken
by an individual in his official capacity to further the interest of the
organization known as organizational decision. These decisions are based on
rationality, judgment and experience.
9. Personal decisions: Personal decisions are decisions taken by an
individual based on his personal interest. it is oriented to the individuals
goals. These decisions are based on self ego, self prestige etc.
10. Objectively rational decision: If the decision is really the correct
behavior for maximizing given values in a given situation, then it is called
objectively rational decision.
11. Subjectively rational decision: If a decision maximizes attainment
relative to the actual knowledge of the subject, then it is called subjectively
rational decision.
12. Consciously rational decision: A decision is consciously rational to
extend that he adjustment of means to ends is a conscious process.
13. Economic model: Economic rationality implies that decision making
tries to maximize the values in a given situation by choosing the most
suitable course of action. A rational business decision is one which effectively
and efficiently assures the attainment of aims for which the means are
selected.
RATIONAL DECISION MAKING PROCESS
1. Clear and well defined goal: The decision makers has clear and well
defined goal that he is trying to maximize.
2. Uninfluenced by emotions: He is fully objective and rational
uninfluenced by emotions. 3. Identification of the problem: The decision
makers can identify the problem clearly and precisely.
4. Alternative course of action: He must have clear understanding of
alternative course of action by which a goal can be reached under existing
circumstances.
5. Analyze and evaluate alternatives: He must have the ability to
analyze and evaluate alternatives in the light of the goals.
6. Effectively satisfies goal achievement: He must have a desire to
come to the best solution by selecting the alternative that most effectively
satisfies goal achievement.
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ADMINISTRATIVE PROBLEMS IN DECISION MAKING


1. The decisions taken by the management should be of sound one. The
soundness of the decisions refers to its quality and reliability. If the decisions
taken are not sound then it will mean waste of efforts and funds. The
soundness of decision depends upon the sophistication of the decision
maker, the information available to him and the techniques that he can make
use of.
2. Another problem that is faced by the management is timing of decision. If
it is not properly timed, there is no use in taking a useful decision.
3. The physical and psychological environments have their influence on
decision making. If the environment is satisfactory then there will be cooperation, proper understanding among the members of the organization.
This will provide better scope for research and analysis.
4. Effective communication of the decision is another important
administrative problem of the management. Decisions taken should be clear,
simple and unambiguous. Decision made should be communicated to the
concerned persons in the language understandable by the receiver.
5. All members of an organization should be encouraged to give their opinion
on various aspects while arriving at important decisions. In most cases, top
executives feel that it is below their dignity to get their views. In such cases,
decisions are taken by a few persons at the top management level. But this
is not a good practice because making decision by a few at the top level will
create some problem in its implementation.
6. Another problem faced by the management is implementation of decision.
Once a decision is made, executive and his subordinates should take all
possible steps to implement it. While making decision, the manager may
have consulted hired specialist but the finals decision will be of his own.
Therefore, final responsibility lies on him. Implementation of decision
involves several steps which brings a number of problems. Manager should
handle it very carefully so that the problems can be tackled easily.

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