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Micro Economics

Introduction Mod-1 Managerial Economics: by; 1. D N Dwivedi, 7e, 2008. 2. ATMANAND ,1e, 2007, 3. Karam pal & Surender kumar, Excel books, 1/e, 2008. 4. VL Mote, Samuel paul, GSGupta, ME concepts & cases TataMcgrahil, 2005, Craig H peterson, W Cris Lewis and Sudhir K Jain, pearson,2009

Introduction
Adam Smith (1723 - 1790), the "father of modern economics" and author of the famous book "An Inquiry into the Nature and Causes of the Wealth of Nations", spawned(source) the discipline of economics by trying to understand why some nations prospered while others lagged behind in poverty. Others after him also explored how a nation's allocation of resources affects its wealth.

To study these things, economics makes the assumption that human beings will aim to fulfill their self-interests. It also assumes that individuals are rational(balanced) in their efforts to fulfill their unlimited wants and needs. Economics, therefore, is a social science, which examines people behaving according to their self-interests.

The definition set out at the turn of the twentieth century by Alfred Marshall, author of "The Principles Of Economics" (1890), reflects the complexity underlying economics: "Thus it is on one side the study of wealth; and on the other, and more important side, a part of the study of man." It is a study concerning wealth and man

introduction
What is economics: economics is a social science Its basic function is to study how people individuals, households, firms and nationsmaximize their gains from their limited resources and opportunities In economic terminology this is called maximizing behaviour or optimizing behaviour

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 Sophistication has entered this field in recent decades by increasing use of mathematical and statistical methodology

At macro level, economics studies how nations allocate their resources, men and material between competing needs of the society so that economic welfare of the society can be maximized It studies how government formulates its economic policies- taxation policy, expenditure policy, price policy, fiscal policy (government expenditure and revenue collection through taxation), monetary policy (supply of money), employment policy, foreign trade(export-import policy), tariff policy etc and effects of these policies Thus macro economics is the study of the economic system as a whole

At micro level, the focus of economics is on the behaviour of the firms and individuals and their interaction in markets The topics that we study include demand, production, cost, pricing, market structure and government regulation A strong grasp of principles that govern economic behaviour of firms and individuals is an important managerial talent

We study micro economics because of: 1. growing complexity of business decision making process due to changing market condition and business environment 2. increasing use of economic logic, concepts, theories and tools of economic analysis for decision making 3. rapid increase in demand for professionally trained managerial manpower

Role of ME in decision making


Economic laws and tools of economic analysis are applied in the process of business decision making Managerial decision areas:
Assessment of investible funds Selecting business area Choice of product Determining the optimum output Determining the price of the product Determining input-combination and technology Sales promotion

These decision areas can be effectively dealt with the


application of Economic Concepts and Theories in Decision-Making Use of quantitative methods
Mathematical tools Statistical tools Econometrics (application of mathematics and especially of statistical methods to economics). Thus micro or managerial economics is application of Economic concepts, Theories, and Analytical Tools to find Optimum Solution to Business Problems

Application of ME to business decisions


Business decision is a process of selecting the best out of alternative opportunities open to the firm. It comprises of four phases: 1. determining and defining the objective to be achieved 2. collection and analysis of business related data and other information regarding economic, social, political and technological environment 3. Inventing, developing and analysing possible courses of action 4. selecting a particular course of action from the available alternatives

For example a firm plans to launch new product for which close substitutes are available in the market. The two areas that need investigation and analysis are
Production related issues Sales prospects and problems

Production related issues require:


Available techniques of production Cost of production with each production technique Supply position of inputs required Price structure of inputs Cost structure of competitive products Availability of foreign exchange if imported

Sales prospects and problems include:


Market size, general market trends and demand prospects for the product Trends in the industry to which product belongs Major existing and potential competitors and respective market shares Price of the competing products Pricing strategy of prospective competitors Market structure and degree of competition Supply position of complementary goods

The micro economics is applied to operational or internal issues which include:


Choice of business and nature of product Choice of size of firm Choice of technology Choice of price How to promote sales How to face price competition How to decide on new investment How to manage profit and capital How to manage inventory

The following economic theories deals with most of these questions: 1. theory of demand: deals with consumer behaviour and answers questions such as:
How the consumers decide whether or not to buy a commodity What quantity to be purchased When to stop consuming a commodity How consumers behave when the price of commodity, their income, taste and fashions change? At what level of demand, does changing price become inconsequential in terms of total revenue Thus it helps in making choice of commodities, finding the optimum level of production, and determining the price of the product

2. Theory of Production and Production decisions: deals with relationship between inputs and output it explains:
Under what conditions cost increase or decrease How total output behaves when units of one factor(input) is increased keeping other factors constant or when all factors are increased How output can be maximized from a given quantity of resources How can the optimum size of output be determined Thus theory of Production helps in determining the size of the firm, size of the total output and amount of capital and labour to be employed , given the objective of the firm

3. Analysis of Market Structure and Pricing Theory: deals with how price determined under different kinds of market conditions
When price discrimination is desirable, feasible and profitable What extent advertisement can help expanding sales in competitive market Thus Pricing theory helps in determining the pricing policy of the firm. Pricing and production theories together help in determining optimum size of the firm

4. Profit Analysis and Profit Management: profit making is objective of all business firms Making satisfactory profit is not guaranteed because of the conditions of uncertainty with regard to:
Demand for the product Input prices in the factor market Nature and degree of competition in the product market Price behaviour under changing conditions in the market etc An element of risk is there even if most efficient techniques are used to predict future

Therefore firms have to safeguard their interest and minimize risk Profit theory guides firms in
the measurement and management of profit, Making allowance for risk premium Calculating pure return on capital & pure profit and Future profit planning

5. Theory of Capital and Investment Decisions: capital is scarce and expensive factor Its efficient allocation and management is most important tasks for success level of firm. The major issues related to capital are:
Choice of investment project Assessing the efficiency of capital Most efficient allocation of capital Capital theory helps in investment decision making, choice of projects, maintaining the capital and capital budgeting etc.,

Macro Economics applied to business environment


Environmental issues pertain to general business environment in which a business operates They are related to the overall economic, social and political atmosphere of the country The factors which constitute economic environment of a country include: 1. the type of economic system in the country (mainly capitalism & socialism, with many variants with in each)

2. general trends in national income, employment, prices, saving and investment etc 3. structure and trends in the working of financial institutions ex. Banks, SFCs, insurance companies etc., 4. magnitude of and trends in foreign trade 5. trend in labour supply and strength of the capital market 6. government s economic policies ex. Industrial policy, monetary, fiscal, price and foreign trade 7. social factors like value system of the society, property rights, customs and habits

8. socio-economic organisations like trade unions, consumer s associations, consumer cooperatives and producer s union 9. political environment constituted by political system- democratic, authoritarian, socialist, States attitude towards private business, size and working of public sector and political stability and 10. the degree of globalisation of the economy and the influence of MNCs on the domestic markets

All the above issues are far beyond power of a single business house however big it is However all firms together or giant business houses can jointly influence the economic and political environment of the country For business community the economic, social and political factors are to be treated as business parameters

The environmental factors have a far-reaching bearing on the functioning and performance of the firms Business decision makers have to consider present and future economic, political and social conditions in the country and environmental factors in the process of decision making Ex: 1. decision to set up new alcohol manufacturing unit or expansion of a unit ignoring impending prohibition a political factor would be suicidal for the firm

2. a decision to expand a business beyond paid-up capital permissible under Monopolies and Restrictive Trade Practices amounts to inviting legal shackles 3. a decision to employ a highly sophisticated a labour saving technology ignoring a prevalence of mass open unemployment an economic factor- may prove to be self defeating 4. a decision to expand a business on large scale, in a society having low per capita income and hence low purchasing power stagnant over a long period may lead to wastage of resources

Macro economic issues: The major macro economic or environmental issues that figure in business decision making such as forward planning and formulation of the future strategy are categorized under three heads: 1. Issues related to Macroeconomic Trends in Economy: macroeconomic trends are indicated by macro variables such as :
General trend in economic activities of the country The level of GDP Investment climate Trends in national output (measured by GNP or GDP) and employment price trends

These factors determine prospects of a private business and greatly influence the functioning of individual firm A firm planning to set up a new unit or expansion would have to examine:
What is the general trend in the economy What would be the consumption level and pattern of society Will it be profitable to expand business etc

2. issues related to foreign trade: most countries have trade and financial relations with other countries Fluctuations in international market, exchange rate and inflows and out flows of capital in an open economy have a serious bearing on its economic environment and thereby on the functioning business undertakings The sectors and firms dealing in export and imports are affected directly and more than the rest of the economy.

3.issues related to Government Policies: government policies designed to control and regulate economic activities of private business affect the functioning of business undertakings Firms attempt to maximize their profits leading to social cost in terms of environment pollution, traffic congestion in cities, creation of slum etc., Government policies are designed to minimize social costs and conflicts with society and impose a social responsibility on the firms

In brief the microeconomic theories include demand, production, price determination, profit and capital budgeting Macroeconomic theories include national income, economic growth and fluctuations, international trade and monetary mechanism and study of state policies and their repercussions on private business

Relationships of ME with other disciplines


ME is linked with various fields of study like: 1. Microeconomic theory: Price theory, demand concepts and theories of market structure are used by managerial economists 2. Macroeconomic theory: national income forecasting is an important aid to business condition analysis which is a valuable input for forecasting the demand for specific product groups

3. Operations research: is used to find the best of all possibilities. Linear programming helps in decision making such as
determination of facilities on machine scheduling, distribution of commodities, optimum product mix etc.,

4. Theory of decision making: deals with problems of choice or decision making under uncertainly, where the applicability of figures required for the utility calculus are not available Economic theory is based on assumptions of single goal whereas decision theory breaks new grounds by recognizing multiplicity of goals and persuasiveness of uncertainty in the real world of management (decision theory is concerned with identifying
the values, uncertainties and other issues relevant in a given decision, its rationality, and the resulting optimal decision. It is very closely related to the field of game theory.)

5. statistics: statistics helps in empirical testing of theory It helps in better decisions relating to demand and cost functions, production, sales or distribution ME is heavily dependent of statistical methods

6. Management theory and Accounting: maximisation of profit is the central concept of microeconomics In recent years organisation theorists have talked about satisficing instead of maximising as an objective of a firm Accounting data statements constitute the language of business and managerial accounting has been developed as specialized field

Economics as a normative approach


In thinking about economic problems, we must distinguish questions of fact from questions of fairness Positive Economics describes the facts of economy, while normative economics value judgements Positive economics deals with questions such as:

why do doctors earn more than janitors?. Does free trade raise or lower wages for most americans? What is the economic impact of raising taxes?

Although these are difficult questions to answer, they can be resolved by reference to analysis and empirical evidence

Economics as a normative approach


Normative economics involves ethical percepts and norms of fairness Should poor people be required to work if they are to get government assistance? Should unemployment be raised to ensure that price inflation does not become too rapid Should USA penalise China for pirating books and CDs Should tax on gasoline be raised? Will it hurt only automobile owners or since everyone use road it is beneficial to all

There is no right or wrong answer to these questions because they involve ethics and values rather than facts They can be resolved only by political debate and decisions not by economic analysis A positive economic statement are facts or relationships which can be proven or disproven

A normative economic statement is someone s opinion or value judgement about an economic issue. Such statements can not be proven Normative Economics deals with economic analysis that is concerned with what ought to be rather than with what is . It ultimately rests on value judgement

Scarcity
Economics is the study of how societies use resources to produce valuable commodities and distribute them among different people for satisfying their needs This definition highlights two key ideas: first these goods are scarce and second, society must use its resources efficiently. Scarcity: if infinite quantities of every good could be produced or if human desires were fully satisfied, what would be the consequence?

People would not worry about stretching out their limited incomes because they could have everything they wanted Business would not need to fret over the cost of labour or health care: Governments would not need to struggle over taxes or spending, because nobody would care Since all of us could have as much as we pleased, no one would be concerned about distribution of incomes among different people or classes

In such an affluence there would be no economic goods, that is, that are scarce or limited in supply All goods would be freely available like sand in the desert or seawater at the beach Prices and markets would be irrelevant In such a case economics would no longer be a useful subject

But no society has reached a utopia of limitless possibilities (perfect socio-politico-legal system, a Greek word) Goods are limited, while wants are unlimited Even after two centuries of rapid economic growth, production in the world is not enough to meet everyone s consumption desires Our global output has to be many times larger before the average world could live at the level of the average doctor or lawyer

In some countries particularly in Africa and Asia, hundreds of millions of people suffer from hunger and material deprivation Given unlimited wants, it is important that an economy makes the best use of its limited resources, that is, the notion of efficiency Efficiency denotes the most effective use of a society s resources in satisfying people s wants and needs More specifically, the economy is producing efficiently when it cannot increase the economic welfare of anyone without making someone else worse off.

Three choice problems of economy


Unlimited choice limited resources

Scarcity scarcity

What to produce

How to produce

For whom to produce