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NATIONAL INSTITUTE OF TECHNOLOGY KARNATAKA, SURATHKAL

DEPARTMENT OF HUMANITIES, SOCIAL SCIENCES AND MANAGEMENT


V/VI SEMESTER B. Tech. [COMMON]

HU 300 ENGINEERING ECONOMICS

3-0-0: 3

Unit 1
INTRODUCTION:

Economic science is primarily concerned with the processes of mobilising,


allocating, and utilising resources for the purpose of promoting human development and
welfare. In these processes, it is more important to uphold truth and humanitarianism
than to apply-sophisticated theories, models and techniques backed by mathematical
logic, econometric methodology and computer software.
Economics as a branch of knowledge is concerned with the study of the allocation
of scarce resources among competing ends. Problems of resource allocation are
constantly faced by individuals, enterprises and nations. Over the years, the science of
economics has developed a variety of concepts and analytical tools to deal with such
allocation problems. The necessity for economising arises from the fact that we have
limited productive resources such as land, raw materials, skilled manpower, capital
equipments, and technology at our disposal. Because these resources are found in limited
quantity, the goods they can produce are also limited. Therefore, resources need to be
used and managed most efficiently and economically. Efficient and economic use of
resources is not an easy task. It is achieved over time, and is a function of many physical,
financial, engineering, human and institutional factors.
Economics contributes a great deal towards the performance of managerial duties
and responsibilities. All other things remaining the same, managers with working
knowledge of economics, can perform their functions more efficiently than those without
it. The emphasis here is on the maximization of the objective and limitedness of the
resources. Resources at the disposal of a person /firm /nation, be it finances, men or

Course Instructor
Email:kbheem@nitk.ac.in

Dr. K. B. Kiran

material, are by all means limited. Therefore, the basic task of the management is to
optimise the use of the resource.
In performing his functions, a manager has to take a number of decisions in
confirmity with the goals of the firm. Many of the decisions are taken under the condition
of uncertainty and therefore involve risk. Uncertainty and risk arise mainly due to
uncertain behavior of the market forces, i.e., the demand and supply, changing business
environment, govt. policy, external influence on the domestic market and social and
political changes in the country. However, the degree of uncertainty and risk can be
greatly reduced if market conditions could be predicted with a high degree of reliability.
Taking appropriate business decisions requires a clear understanding of the
technical and environmental conditions under which decisions are to be taken.
Application of economic theories to explain and analyse the technical conditions and the
economic environment in which a business undertaking operates contributes a good deal
to the rational decision-making. Economic theories have therefore gained a wide
application to the analysis of practical problems of business. Therefore, a working
knowledge of economics, not necessarily a formal degree, is essential requirement for the
managers. Moreover the modern engineering graduate is increasingly finding himself in
positions in which his responsibility is extended to include economic factors.
Nowadays, the economic environment of most manufacturing enterprises is
drastically changing. The economy of scale is being replaced by an economy of scope.
Customisation, i.e., product adaptation to specific customer requirements, is driving the
demand. Globalisation, i.e., the necessity to be present on worldwide markets, implies a
timely deployment strategy in terms of product manufacturing and distribution,
sometimes forcing strategic alliance with partner companies. Fierce competition with
emerging countries forces industrialised countries to produce at lower cost, with higher
quality and in shorter delays. Finally, the consequence of widespread automation and the
need to gain on productivity are pushing manufacturing enterprises to lean their
management and manufacturing operations, therefore employing less and less people.

Course Instructor
Email:kbheem@nitk.ac.in

Dr. K. B. Kiran

Thus, with the growing complexity of business environment, the usefulness of


economic theory as a tool of analysis and its contribution to the process of decisionmaking has been widely recognised. Possibly, because modern business problems are so
complex that decision makers personal experience, insight, intuition, foresight and
judgement alone are no longer adequate to find out an appropriate solution to the
complex business problems. The application of economic tools and logic to the business
problems helps in arriving at an optimum solution to the problem.
Economic life is an enormously complicated hive of activity, with people buying,
selling bargaining, investing, persuading and threatening. The ultimate purpose of
economic science is to understand this complex undertaking.
Every subject deals with a particular field of knowledge. For example, Natural
Sciences deal with mans physical environment. But Economics, as a social science,
studies man as a member of the organised society. What is the behaviour of most of the
people in a society when they buy goods in the market? Obviously, the group behaviour
is that more people would buy at low prices and less people would buy at high prices.
This group reaction in buying is known as the law of demand.
Engineering is not a science but is an application of science. It is an art composed
of the skill and ingenuity in adapting knowledge to the uses of humanity. To the engineer,
knowledge is not an end in itself but is the raw material from which he fashions
structures, systems, and process. Engineering involves the determination of the
combination of material forces, and human factors that will yield a desired result.
Engineering activities are rarely carried out for the satisfaction that may be derived from
them directly. With few exceptions, their use is confined to satisfying human wants.
The technological and social environment is which we live continue to change at a
rapid rate. In recent decades, advances in science and engineering have made space travel
possible, revolutionized communication, transformed our transportation systems,
revolutionized the practice of medicine, and miniaturized electronic circuits so that a
computer can be placed on a semiconductor chip. The list of such achievements seems
almost endless.
Course Instructor
Email:kbheem@nitk.ac.in

Dr. K. B. Kiran

The Accreditation Board for Engineering and Technology (USA) states that
engineering is the profession in which a knowledge of the mathematical and natural
sciences gained by study, experience, and practice is applied with judgement to develop
ways to utilize, economically, the materials and forces of nature for the benefit of
mankind. In this definition the economic aspects of engineering are emphasized as well
as the physical aspects. Clearly, it is essential that the economic part of engineering
practice be accomplished well.
Engineering Economy involves the systematic evaluation of the economic merits
of proposed solutions to engineering problems. To be economically acceptable (i.e.,
affordable), solutions to engineering problems must demonstrate a positive balance of
long-term benefits over long-term costs, and they must also:
Promote the well-being and survival of an organization,
Embody creative and innovative technology and ideas,
Permit identification and scrutiny of their estimated outcomes, and
Translate profitability to the bottom line through a valid and acceptable measure of
merit.
Engineering activities of analysis and design are not an end in themselves but are a
means for satisfying human wants. Thus, engineering has two aspects. One aspect
concerns itself with the materials and forces of nature; the other is concerned with the
needs of mankind. Because we live in a resource-constrained world, engineering must be
closely associated with economics. It has become absolutely essential that engineering
proposals be evaluated in terms of worth and cost before they are undertaken. Therefore,
we can say that the essential prerequisite of successful engineering application is
economic feasibility.
Engineers are confronted with two important interconnected environments, the
physical and the economic. Their success in altering the physical environment to produce
goods and services depends upon knowledge of physical laws. However, the worth of
these products and services lies in their utility measured in economic terms.
Course Instructor
Email:kbheem@nitk.ac.in

Dr. K. B. Kiran

Want satisfaction in the economic environment and engineering proposals in the


physical environment are linked by the production or the construction process. Figure: 1
illustrates the relationship between the engineering proposals, production or construction,
and want satisfaction:
THE TOTAL ENVIRONMENT

Physical environment

Economic environment

Engineering proposals

Production / Construction

Want satisfaction

Figure: 1 The Engineering Environment


The usual function of engineering is to manipulate the elements of one
environment, the physical, to create utility in a second environment, the economic.
However, engineers some times have a tendency to disregard economic feasibility and are
often appalled in practice by the necessity for meeting situations in which action must be
based on estimates and judgement. Yet the modern engineering graduate is increasingly
finding himself in positions in which his responsibility is extended to include economic
factors.
Engineers can readily extend their inherent ability of analysis to become proficient
in the analysis of the economic aspects of engineering application. The large percentage
of engineers who will eventually be engaged in managerial activities will find such
proficiency of necessity.
An engineering economy study is accomplished using a structured procedure and
mathematical modeling techniques. The economic results are then used in a decision
situation that involves two or more alternatives and normally includes other engineering
knowledge and input.
Engineering Economic Analysis Procedure

Course Instructor
Email:kbheem@nitk.ac.in

Dr. K. B. Kiran

Engineering Design Process

Step
1. Problem recognition, definition,
and evaluation.

Activity
1. Problem/need definition.

2. Development of the feasible alternatives.

2. Problem/need formulation
and evaluation.

3. Development of the cash flows for each


alternative.

3. Synthesis of possible
solutions (alternatives).

4. Selection of a criterion (or criteria).

4. Analysis, optimization, and


evaluation.

5. Analysis and comparison of the alternatives.


alternative.

5. Specification of preferred

6. Selection of the preferred alternative.

6. Communication.

7. Performance monitoring and postevaluation of results.

Economic Development and its Impact on Science, Engineering Technology and


Society (Environment):
Growth in real percapita income has more generally been accepted as an index of
economic development of a country. As Dan Usher puts it, to economists, journalists,
historians, politicians and the general public, the rate of economic growth is a summary
measures of all favourable developments in the country. We are pleased when economic
growth occurs and displeased when it does not.
Development is not the same thing as economic growth. Economic development is
synonymous with a general rise in standard of living; and increase in the percapita
income may not accomplish it. A continuous rise in the real percapita income may be
indicative of the growth of an economy, but not of its development. Growth means
more output. Development implies not only more output but also different kinds of output

Course Instructor
Email:kbheem@nitk.ac.in

Dr. K. B. Kiran

than were previously produced as well as changes in the technical and institutional
arrangements by which output is produced and distributed
Economic development is the function of several determinants, which can
conveniently be classified into two categories, viz., Economic factors and scientific
factors.

Economic Development

Economic factors

(a) Natural resources

Scientific factors

(a) The propensity to develop


Fundamental Sciences

(b) Capital formation

(b) The propensity to apply


Science to economic ends.

(c) Capital output ratio

(c) The propensity to accept


Innovations.

(d) Technological progress

(d) The propensity to seek


material advance.

(e) Size of market.

(e) The propensity to consume.

(f) Human Resources


Besides, the various political and social factors also condition the rate of economic
development.
In short, economic development is the result of concerted efforts of both economic
and scientific factors. However, the mere presence of one or more or all of these factors
may not ensure that the economy will be in a position to generate forces that bring about
Course Instructor
Email:kbheem@nitk.ac.in

Dr. K. B. Kiran

a fast economic development. Some further factors may also be required that may work
as a catalyst for growth. This function can well be performed by the state (Government).
Recent empirical studies of the developed countries suggest that technological
progress has been a major source of economic growth. Only a minor part of the total
increases in output over a long period, in these empirical studies, has been attributed to
increased physical inputs, such as labour and capital; the greater part of the increase has
been due to Technological Progress or human factors, such as education, research and
development etc., which are responsible for the increase in the productivity of the
physical factors.
Economic development and development of Science, Engineering Technology and
Society (environment) are interdependent. Science is the foundation upon which the
engineer builds toward the advancement of mankind. With the continued development of
Science and the widespread application of engineering, the standard of living may by
expected to improve and further increase the demand for those things that contribute to
peoples love for the comfortable and beautiful.
Rate of economic development to a large extent is conditioned by technological
progress. Technological progress implies the application of improved technical knowhow in the production activity. This depends upon the advancement of fundamental and
applied sciences, resulting in scientific inventions. When an invention is adopted, it
becomes an innovation. Innovations result in an improvement in technology, which
increases productivity. In Samuelsons language, a High Invention nation will grow at
a faster rate than a High Investment Nation.
For technological progress to take place, three conditions are necessary:
(a) Technological progress requires large capital investments in research as well as in
industries.
(b) It needs entrepreneurs who have the ability to understand the possibilities of using
scientific inventions for commercial purposes.
(c) There must be expanding market for products.
Course Instructor
Email:kbheem@nitk.ac.in

Dr. K. B. Kiran

All these conditions are fulfilled in a developed economy; hence the rate of
technological progress is very fast in these countries. In an economically backward
country, these conditions do not obtain, and, hence the technological progress is retarded.

MACRO-ECONOMICS AND MICRO-ECONOMICS:


One useful distinction that economic theorists make is between macro and
microeconomics.
The micro-economic analysis deals with the theory of the firm, and the behaviour
and problems of individuals and of micro-organizations. In other words micro-economics
is a study of the small individual units of the economic system in detail. According to
Prof. Boulding, Micro-economics is the study of individuals firms, households,
individual prices, wages, and particular industries.
On the other hand macro-economics is concerned with the behaviour of the
economy as a whole, and the theories about its operation. In the words of Prof. Boulding,
Macro-economics deals not with individual quantities as such, but with the aggregates
of those quantities not with individual prices but with price level, not with individual
outputs, but with the national output.
Thus, the study of the level and determination of National Income, employment
and general prices and the analysis of aggregate consumption and balance of payments
belong to macro-economics.
However, in actuality micro and macro-economics are interdependent. In fact,
neither macro-economic nor micro-economic analysis alone can adequately explain the
working of the economic system. This is because what is true of an individual unit of the
economy may not be true of the economy as a whole, and what is true of the economy as
a whole may not be true of an individual unit of the economy. For instance, saving by an
individual is good but not by, the nation as a whole. Similarly, the general price level in
the economy might have remained constant over a specified period, but the prices of
Course Instructor
Email:kbheem@nitk.ac.in

Dr. K. B. Kiran

some specific units might have fluctuated violently during the same period. To quote
Prof. Paul A Samuelson, you are less than half educated if you understand the
one while being ignorant of the other. So both the approaches are necessary for a
perfect study of economics.
MICRO-ECONOMICS IN MANAGERIAL DECISION MAKING:
The roots of Managerial economics spring from micro-economic theory. In the
case of managerial economics, micro economics helps in studying what is going on
within the firm, how best to use the available scarce resources between various activities
of the firm, how to be technically as well as economically efficient, etc.
Some of the popular micro-economic concepts are the elasticity of demand,
marginal cost, the short and long run economies, and diseconomies of scale, opportunity
cost, present value and market structures. Managerial economics also uses some of the
well-accepted models in price theory. Such as the model for monopoly price, kinked
demand model, the model of price discrimination and the behavioural and managerial
models.
The dependence of Managerial Economics on Micro-economic theory is very
much like the dependence of engineering or technology on physics. It has an interest in
applying economic theory in order to solve real life problems of enterprises.
MACRO-ECONOMICS IN MANAGERIAL DECISION MAKING:
Macroeconomics is very useful in managerial decision making. Managerial
economics takes the help of macro-economics to understand the external conditions
which are relevant to the business. For instance macro-economic policies like industrial
policy, tax policy, exim policy, etc. of the government. Since these, conditions are beyond
the firms control it has to adjust itself to the changes in these conditions to survive and
grow.
Macro-economics helps managerial-economics in national income forecasting. It
is an important aid to business conditions analysis, which in turn could be a valuable
Course Instructor
Email:kbheem@nitk.ac.in

Dr. K. B. Kiran

10

input for forecasting the demand for specific product groups. Assumptions and estimates
of demand are essential data for most of the allocation decisions managerial economics is
concerned with.
Thus, the system of logic that managerial economics (managerial decision making)
uses come from this heritage of economic theory.
Operational Issues and Microeconomics
Operational problems are basically of internal nature. They include all those
problems, which arise within the business organization, and fall within the purview and
control of the management. Some of the basic internal issues are: (i) choice of
commodity, i.e., what to produce; (ii) choice of size of the firm, i.e., how much to
produce; (iii) choice of technology, i.e., choosing the factor-combination; (iv) choice of
price, i.e., how to price the commodity; (v) how to promote sales; (vi) how to face price
competition; (vii) how to expand the investment; (viii) how to manage profit and capital;
(ix) how to manage inventory, i.e., stock of both finished goods and raw materials. These
problems may also figure in forward planning. All these questions and alike confronted
by the managers of a business enterprise are related to various economic theories. The
branches of economic theories which deal with most of these questions are following:
Theory of demand: Demand theory explains the consumers behaviour. It answers the
question: why do consumers buy a commodity? How do they decide on the quantity of a
commodity to be purchased? When do they stop consuming a commodity? How do the
consumers behave when price of the commodity, their income, and taste and fashions,
etc., change? The knowledge of demand theory can, therefore, be helpful in choice of
commodities for production.
Theory of production: Production theory, also called Theory of Firm, explains how
average and marginal costs vary when production is increased; under what conditions
costs increase or decrease; how total output increases when units of one factor (input) are
increased keeping other factors constant, or when all factors are simultaneously
increased; to what extent one factor (say, labour) can substitute another, (say, capital),
how optimum size of output is achieved. Production theory thus helps in determining the
Course Instructor
Email:kbheem@nitk.ac.in

Dr. K. B. Kiran

11

size of the firm, size of the total output and the factor proportion, i.e., the amount of
capital and labour to be employed.
Theory of exchange or price theory: Price theory explains how prices are determined
under different market conditions; when price discrimination is desirable, feasible and
profitable; to what extent advertisement can be helpful in expanding the sale in a
competitive market. Price theory, thus, can be helpful in determining price policy of the
firm. Price and production theories together, in fact, help in determining optimum size of
the firm.
Theory of profit: Profit making is the most common objective of the business
undertakings. But, making a satisfactory profit is not always guaranteed because a firm
has to carry out its activities under conditions of uncertainty in regard to: (I) demand for
the product, (ii) input prices in the factor market, (iii) nature and degree of competition in
the product market, and hence (iv) price behaviour under changing conditions in the
product market, etc. therefore, an element of risk is always there even if most efficient
techniques are used for predicting future and even if business activities are meticulously
planned. The firms are therefore supposed to safeguard their interest and avert, as far as
possible, the possibilities of risk or minimize it. Profit theory guides in the measurement
and management of profit, in making allowances for risk premium, in calculating the
pure return on capital and pure profit and also in future profit planning.
Theory of capital and investment: Capital like all other inputs is a scarce and an
expensive factor. Capital is the foundation of a business. Its efficient allocation and
management is one of the most important tasks of the managers. The major issues related
to capital are: (I) choice of investment project, (ii) assessing the efficiency of capital, and
(iii) most efficient allocation of capital. Knowledge of capital theory can contribute a
great deal in investment-decisions, choice of projects, maintaining capital intact, capital
budgeting, etc.
Business Environment and Macroeconomics
Environmental issues pertain to the general business environment in which a
business operates. They are related to the overall economic, social and political
Course Instructor
Email:kbheem@nitk.ac.in

Dr. K. B. Kiran

12

atmosphere of the country. The factors which constitute economic environment may be
mentioned as: (i) the type of economic system of the country, (ii) general trends in
production, employment, income, prices, saving and investment, etc., (iii) structure of
end trends in the working of financial institutions, e.g., banks, financial corporations,
insurance companies, etc., (iv) magnitude of and trends in foreign trade, (v) trends in
labour and capital markets, (vi) governments economic policies, e.g., industrial policy,
monetary policy, fiscal policy, price policy, etc., (vii) social factors like value systems of
the society, property rights, customs and habits, (viii) social organisations like trade
unions, consumers cooperatives and producers union, (ix) social structure and class
character of the various social groups. Political environment is constituted of such factors
as political system-democratic, authoritarian, socialist, or otherwise, States attitude
towards private business, size and working of the public sector, and political stability.
It is far beyond the powers of a single business firm, howsoever large it may be, to
determine and guide the course of economic, social and political factors of the nation,
although all the firms together or at least giant business houses may jointly influence the
eco-political atmosphere of the country.
The environmental factors have a far-reaching bearing upon the functioning and
performance of the firms. Therefore, business decision-makers have to take into account
the changing economic, political and social conditions in the country and give due
consideration to the environmental factors in the process of decision-making. This is
essential because business decisions taken in isolation of environmental factors may not
only prove fatal, but may also lead to heavy losses. For instance, a decision to expand the
business beyond the paid up capital permissible under Monopoly and Restrictive Trade
Practices Act (MRTP Act) will amount to inviting legal shackle and hammer; a decision
to employ a highly sophisticated, labour-saving technology ignoring the prevalence of
mass open unemployment-an economic factor- may prove to be self-defeating; a decision
to expand the business on a large scale, in a society having a low per capita income and
hence a low purchasing power stagnated over a long period may lead to wastage of
resources. The managers of a firm are therefore supposed to be fully aware of the
Course Instructor
Email:kbheem@nitk.ac.in

Dr. K. B. Kiran

13

economic, social and political conditions prevailing in the country while taking decisions
on the wider issues of the business.
Managerial economics is however, concerned with only economic environment,
particularly with those economic factors, which form the business climate. The study of
political and social factors falls out of the purview of managerial economics. It should,
however, be borne in mind that economic, social and political behaviour of the people are
interdependent and interactive. For example growth of monopolistic tendency in the
industrial sector of India led to the enactment of Monopoly and Restrictive Trade
Practices Act (1961) which restricts the proliferation of large business houses. Similarly,
various industrial policy resolutions formulated until 1990 in the light of socio-political
ideology of the government restricted the scope and area of private business. Besides,
governments continuous effort to transfer the resources from the private to the public
sector with a view to setting up a socialist pattern of society has restrained the
expansion of private business in India. Some of the major areas in which politics
influences economics are concentration of economic power, growth of monopoly, state of
technology, existence of mass poverty and open unemployment, foreign trade, taxation
policy, labour relations, distribution system of essential goods etc.
Macroeconomic Issues
The major macro-economic or environmental issues, which figure in the business
decision-making, particularly in regard to forward planning, may be described under
three categories.
Firstly, there are issues that are related to the trends in macro variables, e.g., the
general trend in the economic activities of the country, investment climate, trends in
output and employment, and price trends. These factors not only determine the prospects
of private business, but also greatly influence the functioning of individual firms.
Therefore, a firm planning to set up a new unit or to expand its existing size would like to
ask itself what is the general trend in the economy. What would be the consumption
pattern of the society? Will it be profitable to expand the business? Answer to these
questions and alike are sought through the macroeconomic studies.
Course Instructor
Email:kbheem@nitk.ac.in

Dr. K. B. Kiran

14

Secondly, an economy is also affected by its trade relations with other countries,
more so the sectors or firms dealing in exports and imports. Fluctuations in the
international market, exchange rate, and inflows and outflows of capital in an open
economy have a serious bearing on its economic environment and, thereby, on the
functioning of its business undertakings. The managers of a firm would, therefore, be
interested in knowing the trends in international trade, prices, exchange rates, and
prospects in the international market. Answers to such problems are obtained through the
study of international trade and international monetary mechanism.
Lastly, the government policies designed to control and regulate the economic
activities of the people affect the functioning of the individual business undertakings.
Besides, firms activities as producer and their attempt to maximize their private gains or
profits leads to considerable social costs, in terms of environmental pollution, congestion
in the cities, creation of slums, etc. Such social costs not only bring firm interest in
conflict with that of the society, but also impose a social responsibility on the firms. The
government policies and its various regulative measures are designed, by and large, to
minimize such conflicts. The managers therefore should be fully aware of the aspirations
of the people and give such factors a due consideration in their decisions. The economic
concepts and tools of analysis help in determining such costs and benefits.
Thus, economic theories, both micro and macro, have wide application to the
business decision-making. Some of the major theories which are widely applied to
business analysis have been mentioned above. But it should always be borne in mind that
economic theories, models and tools of analysis do not offer readymade answers to the
practical problems of individual firms. They provide only logic and methods to find out
answers, not the answers as such. It depends on the managers own understanding,
experience and intelligence and training as to how to use the tools of economic analysis
to find a correct answer to the practical problems of business.
Briefly speaking, microeconomic theories including theory of demand, theory of
production, theory of price determination, theory of profit and capital budgeting, and
macroeconomic theories including theory of national income, theory of economic growth
Course Instructor
Email:kbheem@nitk.ac.in

Dr. K. B. Kiran

15

and fluctuations, international trade and monetary mechanism, and the study of state
policies and their repercussions on the private business activities constitute, by and large,
the scope of managerial economics. This should however not mean that only these
economic theories form the subject matter of managerial economics. Nor the knowledge
of these theories wholly fulfills the requirement of economic logic in decision-making.
An overall study of economics and a wider understanding of economic behaviour of the
society, individuals, firms, and state would always be desirable and more helpful.
Managerial Economics and Economic Theory:
Economics traditionally is divided into microeconomics and macroeconomics.
Microeconomics deals with the theory of individual choice; that is, decisions made by a
particular consuming unit, such as an individual, or a producing unit, such as a business
firm.

Macroeconomics focuses on the overall economy and general economic

equilibrium conditions.

Managerial economists draw on both of these branches of

economics during the decision-making process. Although a firms managers can do little
to affect the aggregate economy, their decisions should be consistent with the current
economic outlook.
The types of decisions made by managers usually involve questions of resource
allocation within the organisation in both the short and long run. In the short run, a
manager may be interested in estimating demand and cost relationships to make decisions
about the price to charge for a product and the quantity of output to produce. The areas
of microeconomics dealing with demand theory and with the theory of cost and
production are obviously useful in making decisions on such matters. Macroeconomic
theory also enters into decision making when a manager attempts to forecast future
demand based on forces influencing the overall economy.
In the long run, decisions must be made about expanding or contracting
production and distribution facilities, developing and marketing new products, and
possibly acquiring other firms. Basically, these decisions require the organisation to
make capital expenditures; that is, expenditure made in the current period that are
expected to yield returns in future periods. Economists have developed a theory of
Course Instructor
Email:kbheem@nitk.ac.in

Dr. K. B. Kiran

16

capital budgeting that can be used in deciding whether to undertake specific capital
expenditures.

MANAGERIAL ECONOMICS
Managerial economics refers to those aspects of economic theory and applications,
which are directly relevant to the practice of management and the decision-making
processes within the enterprises. Managerial economics may be viewed as economics
applied to problem solving at the level of the firm. The problems relate to choices and
allocation of resources, which are basically economic in nature and are faced by
managers all the time.
Managerial economics may be defined as the study of economic theories, logic
and methodology, which are generally applied to seek solution to the practical problems
of business. It is the integration of economic theory with business practice for the purpose
of facilitating decision-making and forward planning by management. Decision-making
is essentially a process of selecting the best out of alternative opportunities open to the
firm. And forward planning means establishing plans for the future.
In a sense managerial economics provides a link between economic theory and
business management for managerial decision making.
Application of economic theories to the problems of business not only guides
assists and streamlines the process of decision-making but also contributes a good deal to
the validity of decisions.
The scope of managerial economics comprehends all those economic concepts,
theories and tools of analysis, which can be used to analyse the business environment and
to find out solution to practical business problems.
Managerial economics can be viewed as an application of that part of
microeconomics that focuses on such topics as risk, demand, production, cost, pricing,
and market structure. Understanding these principles will help to develop a rational
Course Instructor
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Dr. K. B. Kiran

17

decision-making perspective and will sharpen the analytical framework that the executive
must bring to bear on managerial decisions.
Individuals and firms interact in both the product and the factor markets. Prices of
outputs and inputs are determined in these markets and guide the decisions of all market
participants. The firm is an entity that organizes factors of production in order to produce
goods and services to meet the demands of consumers and other firms. In a market
system, the interplay of individuals and firms is not subject to central control. The prices
of both products and factors of production guide this interaction. Within firms, however,
activity is directed by managers. Central control within the firm is advantageous because
transactions and information costs are reduced. The size of the firm is limited because
transaction costs within the firm will rise as the firm grows and because management
skill is limited.
It is assumed that the goal of the firm is to maximize the value of the firm or the
present value of all future profits, defined as revenue less all costs, explicit and implicit.
Opportunity costs such as the remuneration and interests that owner and managers have
forgone on their labor and capital must be included as costs. Failure to account for these
implicit costs may result in an inefficient allocation of resources. The objective of profit
maximization is subject to legal, moral, contractual, financial, and technological
constraints. Some economists argue that the firms objective is a satisfactory level of
profit rather than maximum profit.
Profit plays two primary roles in the free-market system. First, it acts as a signal to
producers to increase or decrease the rate of output or to enter or leave an industry.
Second, profit is a reward for entrepreneurial activity, including risk taking and
innovation. In a competitive industry, economic profits tend to be transitory. The
achievement of high profits by a firm usually results in other firms increasing their output
of that product, thus reducing price and profit. Firms that have monopoly power may be
able to earn above-normal profits over a longer period; such profit does not play a
socially useful role in the economy.

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Dr. K. B. Kiran

18

A primary role of economics in management is in making optimizing decisions


where constraints apply. In general, managerial economics will help managers to ensure
that resources are allocated efficiently within the firm and that the firm makes appropriate
reactions to changes in the economic environment.
With extremely hard work, a creative mind, and a willingness to take risks, Gates
has demonstrated how the market rewards the successful entrepreneur. He was able to
produce what consumers wanted at a price they were willing to pay; the result was that
both he and they are better off! . This is the essence of the free-market economic system.
Managerial economics is concerned with resource-allocation, strategic, and
tactical decisions that are made by analysts, managers, and consultants in the private,
public, and not-for-profit sectors of the economy. Managerial economic techniques seek
to achieve the objectives of the organization in the most efficient manner, while
considering both explicit and implicit constraints on achieving the objective(s).
The major emphasis is to provide the analytical tools and managerial insights
essential to the analysis and solution of those problems that have significant economic
consequences, both for the firm and society at large. Effective decision-making requires
an understanding of the limitations imposed on the decision-maker by the business
environment.
ECONOMIC ANALYSIS AND DECISIONS
1.
2.
3.
4.

Demand Analysis and Forecasting


Production and Cost Analysis
Pricing Analysis
Capital Expenditure Analysis

ECONOMIC, POLITICAL, AND SOCIAL


ENVIRONMENT
1. Business Conditions (Trends, Cycles,
and Seasonal Effects)
2. Factor Market Conditions (Capital,
Labour, Land and Raw Materials)
3. Competitors Responses
4. External, Legal, and Regulatory
Constraints
5. Organizational (Internal) Constraints

Cash Flows

Course Instructor
Email:kbheem@nitk.ac.in

Risk

Dr. K.
B. Value
Kiran
Firm
(Shareholders Wealth)

19

Managerial economics is the application of microeconomic theory and


methodology to decision-making theory and methodology to decision-making problems
faced by private, public, and not-for-profit institutions. Managerial economics assists
decision makers (managers) in efficiently allocating scarce resources, planning corporate
strategy, and executing effective tactics.
Managerial economics deals with the application of microeconomic reasoning to
real world decision-making problems faced by private, public, and not-for-profit
institutions. The field of managerial economics has experienced rapid growth over the
past three decades. This growth reflects a realization that analysts, directors, and senior
managers can use economic theory to make decisions consistent with the goals of the
organisation. Managerial economics extracts from microeconomic theory those concepts
and techniques that enable the decision maker to select strategic direction, to allocate
efficiently the resources of the organisation, and to respond effectively to tactical issues.
The tools of managerial economics can be applied by managers in profit-seeking
firms and in the public and not-for-profit sectors of the economy. Because managers in
all types of enterprises face a common set of problems. Managerial problems generally
follow this form:
To identity the alternative means of achieving given objective(s), and then to select
the alternative that accomplishes the objective(s) in the most resource efficient manner,
taking into account the constraints and the likely actions and reactions of interdependent
rival decision makers.
The Decision-Making Model:
The ability to make good decisions is the key to successful managerial
performance. Managers of profit-seeking firms are faced with a wide range of important
decisions in the areas of pricing, product choice, cost control, advertising, capital
investments, and dividend policy, to name but a few. Managers in the not-for-profit and
Course Instructor
Email:kbheem@nitk.ac.in

Dr. K. B. Kiran

20

the public sectors are faced with a similarly wide range of decisions. For example, the
dean of your school must decide how to allocate funds among such competing needs as
travel, phone services, and secretarial support. Longer-range decisions must be made
about new facilities, new programs, the purchase or lease of a new computer, and the
decision to establish an executive training center. Public sector managers face such
decisions as the need for a Stealth bomber, the capacity planning for public transit
systems, the enforcement of antitrust laws, the economic viability of passive restraint
devices in automobiles, and alternatives to reduce energy consumption.
Decision making in each of these areas shares several common elements. First, the
decision maker must establish or identify the objectives of the organisation. The failure
to identify organisational objectives correctly can result in the complete rejection of an
otherwise well-conceived and well-implemented plan. Later sections of this chapter deal
with the issue of organisation objectives.
Next, the decision make must identify the problem requiring a solution. For
example, the manager of a brewing plant in Milwaukee may note that the plants profit
margin on sales has been decreasing. This could be caused by pricing errors, labor force
problems, or the use of outdated production equipment. Once the source or sources of
the problem are identified, the manager can move to an examination of potential
solutions. If the problem is the use of technologically inefficient equipment, two possible
solutions are (1) updating and replacing the plants equipment or (2) building a
completely new plant. The choice between these alternatives depends on the relative
costs and benefits, as well as other organisational and social constraints that may make
one alternative preferable to another. For example, the decision to build a new brewery
in a suburban area may not be politically desirable if it means a major inner-city facility
must be closed.
The final step in the process, after all alternatives have been identified and
evaluated and the best alternative has been chose, is the implementation of the decision.
This phase often requires constant monitoring to ensure that results are as expected. If

Course Instructor
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Dr. K. B. Kiran

21

they are not, corrective action needs to be taken when possible. This five-step decisionmaking process is illustrated in Figure.

Establish and/ or identify


objectives

Define the problem

Identify possible
alternative solutions

Consider societal
Evaluate alternative and
BUSINESS
DECISIONS AND ECONOMIC
ANALYSIS
constraints
select the best

Consider organisational
and input constraints

Business decision-making is essentially a process of selecting the best out of alternative


opportunities open to the firm. The process of decision-making comprises four main
phases:

Implement and monitor


the decision

1. determining and defining 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 analysing possible courses of action, and
4. Selecting a particular course of action, from the available alternatives.
It is in this process of decision-making that the management of a company has to apply
economic theories as a tool of analysis.

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Email:kbheem@nitk.ac.in

Dr. K. B. Kiran

22

Economic theories state the functional relationship between two or more economic
variables, under certain given conditions. Application of relevant economic theories to
the problems of business facilitates decision-making in three ways.
Firstly, it offers clarity of various economic concepts (i.e., cost, price, demand,
etc.) used in business analysis.
Secondly, it helps in ascertaining the relevant variable and specifying the relevant
data.
Thirdly, since economic theories state general relationship between two or more
economic events, they provide consistency in analysis, which helps in arriving at right
conclusions. Thus, application of economic theories to the problems of business not only
guides, assists and streamlines the process of decision-making but also contributes a good
deal to the validity of decisions.
Nobel prize-winning economist Herbert Simon identifies the primary activities in
decision-making:
1. Finding occasions for making decisions.
2. Identifying possible courses of action.
3. Evaluating the revenues and costs associated with each course of action.
4. Choosing that one course that best meets the goal or objective of the firm (i.e., that
maximizes the value of the firm).
Thus the primary role of managerial economics is in evaluating the implications of
alternative courses of action and choosing the best or optimal course of action from
among those several alternatives.
Decision-making in this context implies the need for optimizing behavior. The
marketing vice-president strives to maximize sales revenue, the production manager
attempts to minimize cost or maximize production, and the division presidents goal is to
maximize profit. These management targets are constrained by other parameters relating
to that decision. For example, production costs might be minimized by producing
nothing, but this would be inconsistent with the firms goal of profit maximization. A
more typical goal for the production manager would be to minimize cost subject to
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Dr. K. B. Kiran

23

producing a specified output rate, while the objective of the marketing vice-president
would be to maximize sales subject to a given advertising budget.
The essence of efficient and rational management is constrained optimization.
Virtually all choices and decisions are subject to limitations, and this is where the tools of
managerial economics are most useful. The manager who can achieve the most despite
those constraints will be rewarded with the high salary, stock options, and the other
perquisites usually associated with success.

OBJECTIVES OF THE FIRM


The function of management is the efficient direction of a business organisation.
Management always faces the problems of scarcity and choice. Rational choice could be
made only if the objectives of the firm are clearly and unambiguously defined.
In modern society a firm invariably pursues multiple objectives even though one
or some of them may receive priority over others. It is a common experience to find firms
wishing to pursue every plausible goal, which one can propose to it. They wish to
maximize profits, while at the same time minimize costs, maximize sales, satisfying
consumers and so on. Unfortunately, it is not possible to fulfill all the attractive sounding
but mutually incompatible goals at the same time.
In conventional economics, however, no attention was given to these factors in the
context of the firm. Instead, the sole objective was assumed to be the maximization of
profits. The entire analytical apparatus of economics was evolved to aid the achievement
of this objective. As a result, the central concept in managerial economics continues to be
profit maximization.
** Profit maximization ---- The rational firms pursue the objective of profit maximization
subject to the technical and market constraints. There are two kinds of profit
maximization; the short-run profit maximization and long-run profit maximization. Shortrun gains are often sacrificed for the sake of long-run growth and survival.
** Minimization of cost;
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Dr. K. B. Kiran

24

** Sales maximization;
** Increasing the market share;
** Efficient inventory management;
** Quality management;
** Establishing a brand name and earning business reputation.
** Promotion of the long -run welfare of the firm;
** Stabilisation of prices and margins;
** Satisfying goalconsumers, community, investors, tax officials etc.,
** Achieving a satisfactory rate of growth;
** Marketing management,
** Developing R&D infrastructure;
** Employees welfare;
** Meeting Environmental concerns,
** Development of human resources,. And so on.
Thus, a firm invariably pursues multiple objectives even though one or some of
them may receive priority over others.
Objectives of Business
1. Organic Objectives. To try for survival, and then to gain prestige and win recognition
from the society and thus try to grow.
2. Economic Objectives. To earn as much profit as possible.
3. Social Objectives. Business must fulfill its obligations to society, by way of supply of
quality goods, avoidance of profiteering and antisocial practices, and providing
employment.
4. Human Objectives. These are (a) fair deal to employees, (b) development of human
resources, (c) participation, and (d) job satisfaction.
5. National Objectives. These are (a) ensuring social justice, (b) development of small
enterprises, (c) production according to national priorities, (d) self-sufficiency and
export development and (e) development of skill of personnel.

Course Instructor
Email:kbheem@nitk.ac.in

Dr. K. B. Kiran

25

TECHNICAL (PHYSICAL) AND ECONOMIC EFFICIENCY


Both individuals and organizations possess limited resources. This makes it
necessary to produce the greatest output for a given input-that is, to operate at high
efficiency. Thus, the search is not merely for a good opportunity for the employment of
limited resources, but for the best opportunity.
People are continually seeking to satisfy their wants. They give up certain utilities
in order to gain others that they value more. This is essentially an economic process, in
which the objective is the maximization of economic efficiency.
Engineering is primarily a producer activity that comes into being to satisfy human
wants. Its objective is to get the greatest end result per unit of resource expenditure.
Efficiency of a system is generally defined as the rate of its output to input. This is
essentially a physical process in which the objective is the maximization of physical
efficiency, which may be stated as
Technical Efficiency (physical) = Output
Input
If interpreted broadly enough, physical efficiency is a measure of the success of
engineering activity in the physical environment. However, the engineer must be
concerned with two levels of efficiency. On the first level is physical efficiency expressed
as outputs divided by inputs of such physical units as Btus, kilowatts, and foot-pounds.
When such physical units are involved, efficiency will always be less than unity, or less
than 100%.
On the second level are economic efficiencies. These are expressed in terms of
economic units of output divided by economic units of input, each expressed in terms of a
medium of exchange such as money. Economic efficiency may be stated as

Efficiency (economic) = Worth


Cost

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Dr. K. B. Kiran

26

It is well known that physical efficiencies over 100% are not possible. However,
economic efficiencies can exceed 100% and must do so for economic ventures to be
successful.
Physical efficiency is related to economic efficiency. For example, a power plant
may be profitable in economic terms even though its physical efficiency in converting
units of energy in coal to electrical energy may be relatively low. As an example, in the
conversion of energy in a certain plant, assume that the physical efficiency is only 36%.
Assuming that output Btus in the form of electrical energy have an economic worth of
Re. 14.65 per million and that input Btus in the form of coal have an economic cost of
Re. 1.80 per million, then

Efficiency (economic) = Btu output x worth of electricity


Btu input x cost of coal
= 0.36 x Re. 14.65 = 293%
Re. 1.80
Since physical processes are of necessity carried out at efficiencies less than 100%
and economic ventures are feasible only if they attain efficiencies greater than 100%, it is
clear that in feasible economic ventures the economic worth per unit of physical output
must always be greater than the economic cost per unit of physical input. Consequently,
economic efficiency must depend more upon the worth and cost per unit of physical
outputs and inputs than upon physical efficiency. Physical efficiency is always
significant, but only to the extent that it contributes to economic efficiency.
In the final evaluation of most ventures, even those in which engineering play a
leading role, economic efficiencies must take precedence over physical efficiencies. This
is because the function of engineering is to create utility in the economic environment by
altering elements of the physical environment.

Economic efficiency (%) = Output x 100 = Worth x100


Input
Cost

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Dr. K. B. Kiran

27

Worth is the annual revenue generated by way of operating the business and
cost is the total annual expenses incurred in carrying out the business. For the survival
and growth of any business the economic efficiency should be more than 100%.
Economic efficiency is also called productivity. There are several ways of
improving productivity.
Increased output for the same input.
Decreased input for the same output.
By a proportionate increase in the output which is more than the proportionate
increase in the input
By a proportionate decrease in the input which is more than the proportionate
decrease in the output
Through simultaneous increase in the output with decrease in the input.

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Email:kbheem@nitk.ac.in

Dr. K. B. Kiran

28