BASIC ECONOMIC CONCEPTS

Session 2
Objectives
Key principles of managerial economics & their applications

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KEY PRINCIPLES OF ECOMOMICS

Principle of Opportunity Cost Discounting Principle Time Perspective Marginal Principle Increment Principle Risk and Uncertainty Spillover Principle Information Asymmetry
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The Principle of Opportunity Cost

An Opportunity Cost is
something what you sacrifice to get it. the cost incurred by the loss of potential gains from other alternatives when one action is taken, that is, that consideration of costs must include consideration of other forgone opportunities.

A focus on opportunity cost rather than measures of accounting cost is a central characteristic of economic reasoning.
E.g. when considering the potential profit from one investment, the calculation of costs should include income that would have otherwise been received (such as income from a bank deposit).
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Economic Costs
The total opportunity costs of explicit and implicit resources Explicit Costs Market Supplied Resources They are the direct payments made to others in the course of running a business, such as wages, rent and materials a firm spends $100 on electrical power consumed, their opportunity cost is $100. The firm has sacrificed $100, which could have been spent on other factors of production. Implicit Costs Owner Supplied Resources which are those where no actual payment is made
For example, a firm pays $300 a month all year for rent on a warehouse that only holds product for six months each year. The firm could rent the warehouse out for the unused six months, at any price (assuming a year-long lease requirement), and that would be the cost that could be spent on other factors of production. it is one of the most big consumption
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 Economic Profit = Total revenue Total Economic Cost = Total Revenue Explicit Costs Implicit Costs Accounting Profit = Total Revenue Explicit Costs Accounting Profit is larger than Economic Profit

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Marginal Principle
Marginal effect of a small or incremental change
Marginal principle is based on a comparison of the marginal benefits and marginal costs of a particular activity

Marginal Benefit - Additional benefit resulting from an activity Marginal Cost Additional cost resulting from small increase in some activity
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The Marginal Principle

How to decide go or no-go by considering the marginal benefits and marginal cost?
Increase the level of an activity if its marginal benefit exceeds its marginal cost Reduce the level of an activity if its marginal cost exceeds its marginal benefit. Go ahead if: Marginal benefit > Marginal cost If possible, pick the level at which the activitys marginal profit greater than or equal to its marginal cost.
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The Marginal Principle

Marginal cost is the change in total cost that arises when the quantity produced changes by one unit Marginal cost (MC) function = Derivative of the total cost (TC) function with respect to quantity (Q).

Total Cost (TC) = Fixed Cost (FC) + Variable Cost (VC) As fixed costs do not vary with production quantity d FC/dQ=0 Note:
Marginal cost is not related to fixed costs. This can be compared with average total cost or ATC, which is the total cost divided by the number of units produced and does include fixed costs.
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The Marginal Principle

Example: The marginal cost of keeping a bookstore open for one more hour equals the additional expenses for workers and utilities. If the marginal benefit is Rs.80 of additional revenue and the marginal cost is Rs30 of additional cost for workers and utilities, staying open for the additional hour increases the bookstores profit by Rs 50.

Applying the marginal principle, the bookstore should stay open for one more hour if the marginal benefit (the additional revenue) is at least as large as the marginal cost (the additional cost).
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Equi-marginal Principle

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Incremental Principle
involves estimating the impact of decision alternatives on costs and revenue, 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 decisions.

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Incremental Principle
A decision is profitable if it increases revenue more than costs it decreases some costs to a greater extent than it increases others it increases some revenues more than it decreases others and it reduces cost more than revenues

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Discounting Principle
Rupee tomorrow is worth less than a rupee today FV = PV*(1+r)t Or PV = FV/ (1+r)t
Incremental cost and incremental principle

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According to this principle, if a decision affects costs and revenues in long-run, all those costs and revenues must be discounted to present values before valid comparison of alternatives is possible. This is essential because a rupee worth of money at a future date is not worth a rupee today. Money actually has time value. Discounting can be defined as a process used to transform future dollars into an equivalent number of present dollars. For instance, $1 invested today at 10% interest is equivalent to $1.10 next year. FV = PV*(1+r)t Where, FV is the future value (time at some future time), PV is the present value (value at t0, r is the discount (interest) rate, and t is the time between the future value and present value.

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Time Perspective
Long run Short run

Short term decisions influences your long term decisions and vice versa Finance :short term and long term Production:short term some resources are fixed. Long term all the resources are fixed.
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 According to this principle, a manger/decision maker should give due emphasis, both to short-term and long-term impact of his decisions, giving apt significance to the different time periods before reaching any decision. Short-run refers to a time period in which some factors are fixed while others are variable. The production can be increased by increasing the quantity of variable factors. While long-run is a time period in which all factors of production can become variable. Entry and exit of seller firms can take place easily. From consumers point of view, short-run refers to a period in which they respond to the changes in price, given the taste and preferences of the consumers, while long-run is a time period in which the consumers have enough time to respond to price changes by varying their tastes and preferences

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The Spillover Principle

In some cases, the costs of producing or consuming the good are not confined to the producer and/or consumer of the good
So called Negative externality

Examples of Spillover Costs

1. Air pollution 2. Water pollution
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The Spillover Principle

In some cases, the benefits of producing or consuming the good are not confined to the producer and/or consumer of the good

So-called Positive externality.

Examples of Spillover Benefits
1. Developing high-speed railway can also benefit to many sectors, e.g. tourism, logistics, insuranceetc. 2. A flood-control dam benefits everyone in the area regardless of who pays for it. 3. If scientists discover a new way to treat a common disease, everyone suffering from the disease will benefit. 4. If engineer discover a new clean energy, everyone will benefit.
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Risk and Uncertainty

Risk refers to a situation in which there can be more than one possible outcomes, and the probability of each such outcome is known (When I can identify the outcome of an event) Uncertainty refers to a situation which may have more than one possible outcome and the probability of each outcome cannot be ascertained. (when I cannot identify the outcome of any item)
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Information Asymmetry
A situation in which one party in a transaction has more superior information compared to another. Adverse Selection: immoral behavior that takes advantage of asymmetric information before a transaction Moral Hazard: immoral behavior that takes advantage of asymmetric information after a transaction
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Queries

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