6 BASIC PRINCIPLES OF MANAGERIAL ECONOMICS

1. The Incremental Concept

2. The Concept of Time Perspective
3. The Opportunity Cost Concept
4. The Discounting Concept
5. The Equi-Marginal Concept
6. Risk and Uncertainty

1. The Incremental Concept:

The incremental concept is probably the most important concept in economics and is
certainly the most frequently used in Managerial Economics. Incremental concept is
closely related to the marginal cost and marginal revenues of economic theory.

The two major concepts in this analysis are incremental cost and incremental revenue.
Incremental cost denotes change in total cost, whereas incremental revenue means
change in total revenue resulting from a decision of the firm.

The incremental principle may be stated as follows:

1. It increases revenue more than costs.

2. It decreases some cost to a greater extent than it increases others.
3. It increases some revenues more than it decreases others.
4. It reduces costs more than revenues.

EXAMPLE:
Some businessmen hold the view that to make an overall profit, they must make a profit
on every job. The result is that they refuse orders that do not cover full costs plus a
provision of profit. This will lead to rejection of an order which prevents short run profit.
A simple problem will illustrate this point. Suppose a new order is estimated to bring in
an additional revenue of Rs. 10,000. The costs are estimated as under:
Labour Rs. 3,000
Materials Rs. 4,000
Overhead charges Rs. 3,600
Selling and administrative expenses Rs. 1,400
Full Cost Rs.12, 000

The order appears to be unprofitable. For it results in a loss of Rs. 2,000. However,
suppose there is idle capacity which can be utilized to execute this order. If order adds
only Rs. 1,000 to overhead charges, and Rs. 2000 by way of labour cost because some
of the idle workers already on the pay roll will be deployed without added pay and no
extra selling and administrative costs, then the actual incremental cost is as follows:

Labour Rs. 2,000

Materials’ Rs. 4,000
Overhead charges Rs. 1,000
Total Incremental Cost Rs. 7,000

Thus, there is a profit of Rs. 3,000. The order can be accepted on the basis of
incremental reasoning. Incremental reasoning does not mean that the firm should
accept all orders at prices which cover merely their incremental costs.

2. Concept of Time Perspective:

The economic concepts of the long run and the short run have become part of everyday
language. Managerial economists are also concerned with the short run and long run
effects of decisions on revenues as well as costs. The main problem in decision making
is to establish the right balance between long run and short run.

In the short period, the firm can change its output without changing its size. In the long
period, the firm can change its output by changing its size. In the short period, the
output of the industry is fixed because the firms cannot change their size of operation
and they can vary only variable factors. In the long period, the output of the industry is
likely to be more because the firms have enough time to increase their sizes and also
use both variable and fixed factors.
In the short period, the average cost of a firm may be either more or less than its
average revenue. In the long period, the average cost of the firm will be equal to its
average revenue. A decision may be made on the basis of short run considerations but
may as time elapses have long run repercussions which make it more or less profitable
than it at first appeared.

EXAMPLE:
The firm which ignores the short run and long run considerations will meet with failure
can be explained with the help of the following illustration. Suppose, a firm having a
temporary idle capacity, received an order for 10,000 units of its product. The customer
is willing to pay only Rs. 4.00 per unit or Rs. 40,000 for the whole lot but no more.

The short run incremental cost (ignoring the fixed cost) is only Rs. 3.00. Therefore, the
contribution to overhead and profit is Rs. 1.00 per unit (or Rs. 10, 000 for the lot). If the
firm executes this order, it will have to face the following repercussion in the long run:

 It may not be able to take up business with higher contributions in the long run.
 The other customers may also demand a similar low price.
 The image of the firm may be spoilt in the business community.
 The long run effects of pricing below full cost may be more than offset any short
run gain.

3. The Opportunity Cost Concept

The opportunity cost concept is useful in decision involving a choice between different
alternative courses of action.

Opportunity cost of a decision is the sacrifice of alternatives required by that decision.

Sacrifice of alternatives is involved when carrying out a decision requires using a
resource that is limited in supply with the firm. Opportunity cost, therefore, represents
the benefits or revenue forgone by pursuing one course of action rather than another.
 It helps in determining relative prices of different goods.
 It helps in determining normal remuneration to a factor of production.
  It helps in proper allocation of factor resources.

4. Equi-Marginal Concept
One of the widest known principles of economics is the Equi-marginal principle. The
principle states that an input should be allocated so that value added by the last unit is
the same in all cases. This generalization is popularly called the Equi-marginal.

An optimum allocation cannot be achieved if the value of the marginal product is greater
in one activity than in another. It would be, therefore, profitable to shift labour from low
marginal value activity to high marginal value activity, thus increasing the total value of
all products taken together.

5. Discounting Concept
This concept is an extension of the concept of time perspective. Since future is
unknown and incalculable, there is lot of risk and uncertainty in future. Everyone knows
that a rupee today is worth more than a rupee will be two years from now. This appears
similar to the saying that “a bird in hand is more worth than two in the bush.”

6. Risk and Uncertainty

Managerial decisions are actions of today which bear fruits in future which is
unforeseen. Future is uncertain and involves risk. The uncertainty is due to
unpredictable changes in the business cycle, structure of the economy and government
policies.

This means that the management must assume the risk of making decisions for their
institution in uncertain and unknown economic conditions in the future. Firms may be
uncertain about production, market prices, strategies of rivals, etc. Under uncer tainty,
the consequences of an action are not known immediately for certain.

Economic theory generally assumes that the firm has perfect knowledge of its costs and
demand relationships and of its environment. Uncertainty is not allowed to affect the
decisions. Uncertainty arises because producers simply cannot foresee the dynamic
changes in the economy and hence, cost and revenue data of their firms with
reasonable accuracy.

PRODUCTION POSSIBILITY CURVE

Human wants are unlimited and the means to satisfy them are limited,
every society is faced with the fundamental problem of choosing and
allocating its scarce resources among alternative uses.
The production possibility curve or frontier is an analytical tool which is
used to illustrate and explain this problem of choice.

The production possibility curve is based on the following Assumptions:

1. Only two goods X (consumer goods) and Y (capital goods) are
produced in different proportions in the economy.
2. The same resources can be used to produce either or both of the two
goods and can be shifted freely between them.
3. The supplies of factors are fixed. But they can be re-allocated for the
production of the two goods within limits.
4. The production techniques are given and constant.
5. The economy’s resources are fully employed and technically efficient.
6. The time period is short.

In this schedule, P and P1 are such possibilities in which the economy can
produce either 250 units of Y or 250 units of X with given quantities of
factors. But the assumption is that the economy should produce both the
goods. There are many possibilities to produce the two goods. Such
possibilities are В, С and D.

The economy can produce 100 units of X and 230 units of Y in possibility
B; 150 units of X and 200 units of Y in possibility C; and 200 units of X and
150 units of Y in possibility D. The production possibility schedule shows
that when the economy produces more units of X, it produces less units of
Y successively.

In other words, the economy withdraws the given quantities of factors from
the production of Y and uses them in producing more of X. For example, to
reach the possibility С from B, the economy produces 50 units more of X
and sacrifices 30 units of Y; whereas in possibility D for the same units of
X, it sacrifices 50 units of y.

THEORY OF THE FIRM

The theory holds that the overall nature of companies is to maximize profits meaning to
create as much of a gap between revenue and costs. The firm's goal is to determine
pricing and demand within the market and allocate resources to maximize net profits.

 The theory of the firm is the microeconomic concept that states the overall nature
of companies is to maximize profits meaning to create as much of a gap between
revenue and costs.
 The theory has been debated as to whether a company's goal is to maximize
profits in the short-term or long-term.
 Solely focusing on profit maximization comes with a level of risk in regard to
public perception and a loss of goodwill between the company, consumers,
investors, and the public.

Under the theory of the firm, the company's sole purpose or goal is to maximize profit.