UNIT I :

Basic Concepts and principles: Definition, Nature and Scope of Economics-Micro Economics and Macro
Economics, Managerial Economics and its relevance in business decisions. Fundamental Principles of
Managerial Economics - Incremental Principle, Marginal Principle, Opportunity Cost Principle, Discounting
Principle, Concept of Time Perspective, Equi-Marginal Principle, Utility Analysis, Cardinal Utility and Ordinal
Utility.
Case Studies

Definition of Economics:

 Lionel Robbins:
"Economics is the science which studies human behaviour as a relationship between ends and scarce means
which have alternative uses."

This definition emphasizes the allocation of limited resources to satisfy unlimited wants.

 Adam Smith:
"Economics is the science of wealth."

This classical definition highlights wealth creation and management.

Nature of Economics:

 Science or Art:

 As a Science: Economics uses systematic methods, observations, and empirical data to form theories
(e.g., supply and demand laws).
 As an Art: Economics applies knowledge to solve real-world problems, like inflation control and
resource allocation.

 Positive and Normative:

 Positive Economics: Deals with facts and cause-effect relationships (e.g., "An increase in demand
raises prices").
 Normative Economics: Focuses on value judgments (e.g., "The government should reduce
unemployment").

 Microeconomics and Macroeconomics:

 Microeconomics: Studies individual units like consumers, firms, and markets.

 Macroeconomics: Examines the economy as a whole, focusing on aggregate factors like GDP,
inflation, and unemployment.

Scope of Economics:

 Wealth and Welfare:Studies the creation, distribution, and consumption of wealth and how it impacts
societal welfare.
 Scarcity and Choices:Explores the allocation of limited resources among competing uses.
 Production and Distribution:Investigates how goods and services are produced and distributed across
various sections of society.
 Economic Policies:Assesses government policies like taxation, monetary measures, and public expenditure
to achieve economic stability and growth.
 Globalization:Analyzes international trade, foreign investments, and economic integration in a global
context.

Basic Concepts of Economics:

 Scarcity:Scarcity refers to the limited availability of resources (like land, labor, capital, and time) to meet
the unlimited wants of individuals and societies. Economics is fundamentally concerned with how to
allocate scarce resources effectively.
 Opportunity Cost:The concept of opportunity cost refers to the value of the next best alternative that is
foregone when a decision is made. In other words, it’s the cost of what you give up to pursue a particular
course of action.
 Utility:Utility is the satisfaction or benefit derived from consuming a good or service. It is central to
understanding consumer choice and behavior in economics.
 Demand and Supply:Demand refers to the quantity of a good or service consumers are willing and able to
purchase at various prices, whereas supply refers to the quantity producers are willing to offer at different
prices.
 The interaction of demand and supply determines market prices and the quantity of goods exchanged in the
economy.
 Market Equilibrium:Market equilibrium occurs when the quantity demanded equals the quantity supplied
at a particular price. At this point, there is no tendency for price or quantity to change unless external factors
influence them.
 Elasticity:Elasticity measures how much the quantity demanded or supplied of a good changes in response
to changes in price or income. It helps in understanding consumer behavior and the effect of price changes
on total revenue.
 Production:Production refers to the creation of goods and services using resources. In economics, the
factors of production include land, labor, capital, and entrepreneurship, which are used to produce output.
 Costs of Production:Costs include fixed costs (do not change with production levels) and variable costs
(change with the level of output). Understanding costs is crucial for firms to maximize profit and make
production decisions.
 Economic Systems:The economic system refers to the structure of how an economy organizes the
production, distribution, and consumption of goods and services. Major types include market economies,
command economies, and mixed economies.
 Inflation and Deflation:

 Inflation is the rise in the general price level of goods and services over time, reducing the purchasing
power of money.
 Deflation is the opposite, where the price level falls, increasing the value of money.

Basic Principles of Economics:

 The Principle of Scarcity:Resources are limited, so choices must be made on how best to use them.
Scarcity forces individuals, businesses, and governments to make decisions about resource allocation.
 The Principle of Opportunity Cost:Every choice has an opportunity cost. The value of the next best
alternative gives us insight into the true cost of decisions, helping to evaluate trade-offs.
 The Principle of Marginalism:This principle suggests that decisions are made at the margin, meaning that
economic decisions are based on the additional or marginal benefit and marginal cost rather than the total
benefit or cost.
 The Law of Demand and Supply:

 Law of Demand: As the price of a good increases, the quantity demanded decreases, all else being
equal.
 Law of Supply: As the price of a good increases, the quantity supplied increases, all else being equal.

 The Principle of Diminishing Marginal Utility:This principle states that as an individual consumes more
units of a good or service, the satisfaction or utility gained from consuming each additional unit decreases.
 The Principle of Rationality:It assumes that individuals make decisions by weighing the marginal benefits
and marginal costs and always try to maximize their utility or satisfaction.
 The Principle of Equilibrium:In a competitive market, the forces of supply and demand naturally move
toward equilibrium. At equilibrium, there is no incentive for change unless external factors disrupt the
market.
 The Principle of Market Efficiency:Markets are typically efficient when resources are allocated in such a
way that no individual can be made better off without making someone else worse off, known as Pareto
efficiency.
 The Principle of Public Goods and Externalities:

 Public goods are goods that are non-excludable and non-rivalrous, like clean air.
 Externalities are costs or benefits of a decision that affect third parties, either positively (benefits) or
negatively (costs).

Microeconomics vs. Macroeconomics:

Basis Microeconomics Macroeconomics

Microeconomics is the study of individual Macroeconomics is the study of the economy as a
Definition units within the economy, such as whole, focusing on aggregate indicators like GDP,
consumers, firms, and industries. unemployment, and inflation.
Deals with specific markets, industries, and Deals with broad national or global economic
Scope
consumers. factors and performance.
Focuses on the overall performance of the
Focuses on individual behavior, such as how
Focus economy, like national income and employment
a consumer or firm makes decisions.
levels.
Level of Analyzes small economic units such as Analyzes larger economic aggregates like total
Analysis households, firms, and industries. output, national income, and unemployment.
Prices, supply and demand, costs of
National income, inflation, unemployment, interest
Key Variables production, individual income, and
rates, and government policy.
competition.
Decision Government, central banks, and international
Consumers, firms, and industries.
Makers organizations.
Examples of - Consumer behavior- Firm production - National output (GDP)- Inflation and deflation-
Topics decisions- Pricing in competitive markets Fiscal and monetary policies
Economic Uses models like supply and demand Uses models like aggregate demand and supply,
Models curves, cost curves, and elasticity. IS-LM curve, and business cycle models.
Focuses on the allocation of limited
Nature of Focuses on broad economic problems such as
resources among individual agents
Problems inflation, unemployment, and economic growth.
(households and firms).
Aims to stabilize the economy through fiscal and
Policy Aims to improve the efficiency of markets
monetary policy, addressing national issues like
Implications and the welfare of individuals and firms.
inflation and recession.
Typically short-term or immediate effects in Deals with long-term economic trends and the
Time Frame
individual markets. overall health of the economy.

Definition of Managerial Economics:

F. H. Johnston:
"Managerial Economics is the application of economic theory and methodology to business decision-making."

This definition focuses on the use of economic concepts and tools to help managers make informed decisions in
the business context.

Dominick Salvatore:
"Managerial Economics is a branch of economics that applies microeconomic analysis to decision-making
techniques of businesses and management units."

Salvatore highlights that managerial economics primarily draws from microeconomics to make decisions that
improve organizational efficiency and profitability.
Relevance of Managerial Economics in Business Decisions:

Managerial Economics plays a critical role in guiding business decisions by helping managers understand and
apply economic theories to solve practical problems. Its relevance can be summarized as follows:

 Optimization of Resources:
It aids in making decisions related to the efficient allocation of scarce resources to maximize profitability,
ensuring optimal production and cost management.
 Pricing Decisions:
Managerial Economics provides tools like elasticity of demand, cost analysis, and pricing strategies (e.g.,
price discrimination, monopolistic pricing) to determine the best pricing strategy that maximizes revenue.
 Demand Forecasting:
By applying statistical and econometric techniques, businesses can forecast demand for products and
services, helping in inventory management, production planning, and market strategies.
 Cost Analysis and Control:
It helps businesses in understanding cost structures, evaluating cost behaviors, and implementing cost-
control measures to improve profitability.
 Market Structure Analysis:
It helps managers analyze different market conditions (perfect competition, monopoly, oligopoly, etc.) and
formulate strategies based on market structure and competitive forces.
 Investment Decisions:
Managerial economics supports investment decisions by evaluating potential returns, risks, and the timing
of investments using techniques like net present value (NPV) and internal rate of return (IRR).
 Risk and Uncertainty Management:
The application of economic theories helps in understanding and managing risks and uncertainties in
business environments, especially in strategic planning and long-term decision-making.
 Decision Making under Uncertainty:
Managerial Economics helps businesses navigate uncertainty by using decision-making tools like decision
trees, expected value, and risk analysis, which are crucial for adapting to dynamic business environments.

Fundamental Principles of Managerial Economics:

These principles help managers make informed, rational, and effective decisions. Below are some of the key
principles:

 Principle of Scarcity and Choice

 Concept: Resources are limited (scarce), while human wants are unlimited. Thus, businesses must
make choices on how to allocate their resources effectively.
 Relevance: This principle emphasizes the need for cost-benefit analysis and prioritization in decision-
making to use resources efficiently.

 Principle of Opportunity Cost

 Concept: The cost of any decision is the value of the next best alternative that must be foregone.
 Relevance: This principle is critical in decision-making, as businesses need to consider not only the
direct costs of an action but also what they are sacrificing by choosing one alternative over another.

 Principle of Diminishing Marginal Utility

 Concept: As more units of a good or service are consumed, the additional satisfaction (utility) derived
from each additional unit decreases.
 Relevance: This principle is used to determine the optimal quantity of resources or goods to be utilized
for maximum satisfaction or profit.

 Principle of Marginal Analysis

  Concept: Decisions should be made based on the marginal benefits and marginal costs. The best
decision occurs when marginal cost equals marginal benefit.
 Relevance: This principle guides managers in optimizing their decisions by comparing the additional
costs and additional benefits associated with each action.

 Principle of Substitution

 Concept: If the cost of one input increases, firms will substitute that input with a less expensive
alternative, assuming other factors remain constant.
 Relevance: It helps businesses make decisions about resource allocation and cost reduction by
identifying substitute inputs or strategies.

 Principle of Profit Maximization

 Concept: The primary objective of a business is to maximize profit, which involves balancing revenue
and costs.
 Relevance: Managers apply this principle to ensure that the firm’s activities are aligned with achieving
the highest possible profitability.

 Principle of Risk and Uncertainty

 Concept: All business decisions involve a degree of uncertainty and risk. Managers must consider the
possible outcomes and the probability of each when making decisions.
 Relevance: Decision-making tools like expected value analysis and decision trees help in evaluating
risk and uncertainty.

 Principle of Equilibrium

 Concept: Equilibrium occurs when supply equals demand, and there is no tendency for change unless
external forces are applied.
 Relevance: This principle is used in pricing strategies, market analysis, and forecasting demand and
supply in the market.

 Principle of Time Perspective

 Concept: The time frame for decision-making affects business outcomes. Short-term decisions might
prioritize immediate gains, while long-term decisions focus on sustainable growth.
 Relevance: Managers need to balance short-term and long-term perspectives to ensure that their decisions
are aligned with both immediate goals and future sustainability.

 Principle of Incrementalism

 Concept: Many business decisions are made incrementally, with small adjustments being made to
existing processes rather than making large, abrupt changes.
 Relevance: This principle guides businesses in implementing changes gradually, minimizing risks and
uncertainties associated with major changes.

Here is a difference table based on the key principles of Managerial Economics:

Application in Impact on Business

Principle Definition Key Focus
Decision Making Decisions
Helps in making
Business decisions should be Leads to gradual
Small changes decisions based on
Incremental made incrementally, with improvement and
rather than small, manageable
Principle small adjustments to existing reduces the risks of
drastic shifts adjustments to avoid
processes or strategies. abrupt changes.
major risks.
Marginal Decisions should be made by Marginal costs Used for pricing, Ensures that businesses
 Application in Impact on Business
Principle Definition Key Focus
Decision Making Decisions
Principle evaluating marginal costs and and benefits resource allocation, and don’t overextend
marginal benefits to ensure production levels. resources, optimizing
that the next unit of output cost-to-benefit ratios.
maximizes profit.
Helps in evaluating the
Encourages businesses
The cost of any decision is the Trade-offs and cost of choosing one
Opportunity to weigh all available
value of the next best forgone option over another,
Cost Principle alternatives before
alternative that is forgone. alternatives ensuring efficient
making a decision.
resource use.
The value of money decreases Used in investment Ensures that future
Discounting over time, so future costs and Time value of decisions, project returns and costs are
Principle benefits should be discounted money evaluation, and cost- valued appropriately in
to their present value. benefit analysis. today's terms.
Balancing Helps in prioritizing
Time Business decisions must Encourages a balance
short-term vs. immediate profits while
Perspective consider both short-term and between quick wins
long-term planning for sustainable
Principle long-term implications. and long-term stability.
goals future growth.
Used in allocating
Resources should be allocated Maximizes resource
Equi- resources efficiently
in such a way that the Marginal efficiency, ensuring
Marginal across multiple options,
marginal returns (benefits) are returns equality that no resource is
Principle ensuring equalized
equal across all alternatives. underutilized.
returns.

Utility Analysis:

Utility analysis is a concept from microeconomics used to understand consumer preferences and the
satisfaction (or "utility") derived from consuming goods and services. The core idea is that individuals make
choices based on the utility or satisfaction they expect to receive. Utility analysis is central to understanding
demand, consumption behavior, and decision-making.

Types of Utility:

 Cardinal Utility

 Definition: Cardinal utility assumes that utility can be measured numerically. In this approach, the
satisfaction or utility derived from a good or service can be quantified in exact numerical terms.
 Key Features:

1. Utility is measured in terms of numerical units, called "utils."

2. Allows comparisons of the degree of satisfaction between different consumption levels.
3. Example: If consuming one apple provides 10 utils and two apples provide 18 utils, we
can directly compare the difference in satisfaction between consuming one apple and two
apples.

 Relevance:

1. Cardinal utility is useful in understanding concepts like total utility, marginal utility, and
the law of diminishing marginal utility.
2. It provides a way to evaluate consumer preferences in a numerical manner, which can
help in formulating economic policies or pricing strategies.

 Ordinal Utility
  Definition: Ordinal utility assumes that utility cannot be measured numerically. Instead, consumers
rank their preferences in order of preference (first, second, third, etc.) without assigning specific
numerical values to the level of satisfaction.
 Key Features:

1. Utility is ranked or ordered, but there is no quantification of the difference in satisfaction

between options.
2. Consumers can only say which option gives them higher satisfaction (first, second, etc.),
not by how much.
3. Example: If a consumer prefers an apple over an orange and an orange over a banana, we
can rank these preferences but cannot say how much more the apple is preferred over the
orange in numerical terms.

 Relevance:

1. Ordinal utility is widely used in modern economics because it reflects more accurately
how consumers make choices.
2. It is the basis for many consumer preference theories, including indifference curves and
budget constraints.

Key Differences Between Cardinal and Ordinal Utility:

Aspect Cardinal Utility Ordinal Utility

Utility is ranked in terms of preference
Measurement Utility is measured in numerical terms (utils).
order.
Direct comparison of satisfaction levels is possible
Utility Only the rank order of preferences is
(e.g., one apple provides 10 utils, another provides
Comparison known (e.g., apple is preferred to orange).
15 utils).
Satisfaction Focuses only on the preference ranking
Quantifies the exact level of satisfaction.
Level without quantifying satisfaction.
Used in modern consumer theory, such as
Use in Used in early economic theories like the law of
in indifference curves and preference
Economics diminishing marginal utility.
analysis.
More realistic as it does not require
Assumes that satisfaction can be numerically
Realism quantification of satisfaction, only
quantified, which is less realistic.
preference order.
A person gets 10 utils from an apple and 15 utils A person prefers apples to oranges and
Example
from an orange. oranges to bananas.

Case Studies:

Case Study 1: Consumer Preference and Marketing Strategy

Background: A company, XYZ Electronics, has developed two new models of smartphones: the Model A and
Model B. Model A offers a set of high-end features, while Model B provides more basic features at a lower
price. The company is trying to understand consumer preferences and how they can optimize their marketing
strategy.

Challenge: XYZ Electronics needs to determine which smartphone model would appeal more to consumers.
Should they target a premium market with Model A or a price-sensitive segment with Model B?

Application of Ordinal Utility: XYZ Electronics conducts market research and finds that consumers prefer
Model A over Model B due to its advanced features but rank Model B higher in terms of affordability. They use
ordinal utility analysis to understand that consumers are willing to rank their preferences for the features of
Model A but don’t necessarily express how much more they prefer it.
Decision: The company decides to target the premium market for Model A, while Model B is marketed to
budget-conscious consumers. The company uses the ranking (ordinal preference) of features to tailor their
advertisements: emphasizing the advanced features of Model A and the affordability of Model B.

Case Study 2: Marginal Utility in Pricing Strategy

Background: A luxury hotel chain, LuxeStay, is reviewing its pricing strategy for its rooms. They are trying to
determine the optimal price point for their rooms based on customer satisfaction and booking patterns.

Challenge: LuxeStay wants to increase its revenue without losing customers. The company needs to evaluate
the marginal utility of each additional dollar spent by a customer to ensure that they don’t price themselves out
of the market.

Application of Marginal Utility: LuxeStay applies the marginal utility principle to determine the optimal
pricing. They assess that the first few dollars spent on a room provide a high level of satisfaction (marginal
utility), but beyond a certain price point, the additional satisfaction decreases. For example, customers derive
significant satisfaction from a room costing $100, but if the price increases to $250, the additional satisfaction
(marginal utility) decreases.

Decision: By applying marginal utility analysis, LuxeStay determines that the best price point for maximizing
revenue is $150 per night. This price provides a balance between consumer satisfaction and the revenue
generated per booking.

Case Study 3: Opportunity Cost in Business Expansion

Background: A small business, GreenFarms, is considering expanding its production capacity by investing in
new machinery. However, the company has limited funds and is also considering investing in new marketing
campaigns to attract more customers.

Challenge: GreenFarms needs to make a decision: should they invest in new machinery to expand production or
invest in marketing to increase sales? The company needs to understand the opportunity cost of each decision.

Application of Opportunity Cost Principle: GreenFarms uses the opportunity cost principle to evaluate the
trade-offs involved in each option. If they invest in machinery, they will likely increase production and profits in
the long term but will miss out on the immediate potential sales boost from increased marketing. If they invest in
marketing, the opportunity cost is the lost potential growth from not expanding production.

Decision: After evaluating the potential returns and long-term benefits, GreenFarms decides to invest in
machinery to expand production capacity. They recognize that while marketing could provide short-term gains,
expanding production will provide more sustainable growth.

Case Study 4: Time Perspective and Strategic Planning

Background: TechInnovate, a software development company, has developed an innovative software product.
They have two options: release the product immediately and capitalize on the current demand, or take a few
more months to enhance the product and release it with additional features.

Challenge: TechInnovate must decide whether to focus on immediate short-term sales or long-term growth by
enhancing the product’s value over time.

Application of Time Perspective Principle: TechInnovate evaluates the time perspective principle and
recognizes that releasing the product now would generate immediate revenue, but adding more features could
create a better product and lead to greater customer satisfaction in the long run. They also consider the
opportunity cost of delaying the product launch.

Decision: TechInnovate decides to delay the release by a few months to enhance the product, believing that the
long-term benefits will outweigh the immediate sales loss.
Case Study 5: Equi-Marginal Principle in Resource Allocation

Background: A non-profit organization, CleanEarth, is working on multiple environmental projects. They have
a limited budget and need to allocate funds across projects such as forest conservation, recycling programs, and
renewable energy initiatives.

Challenge: CleanEarth needs to determine how to allocate its limited resources to maximize the overall impact
of its initiatives.

Application of Equi-Marginal Principle: CleanEarth applies the equimarginal principle and evaluates the
marginal returns of each project. They calculate that the marginal return (impact per dollar spent) is highest for
the renewable energy initiative, followed by forest conservation, and lowest for the recycling program.

Decision: CleanEarth decides to allocate more resources to renewable energy and forest conservation, as the
marginal returns for these projects are higher. The organization ensures that funds are distributed in such a way
that the marginal returns across all projects are equalized.