ECONOMIC THEORY AND MANAGERIAL ECONOMICS



Economic theory offers a variety of concepts and analytical tools that can assist the manager in the decision-making practices. Problem solving in business has, however, found that there exists a wide disparity between the economic theory of a firm and actual observed practice, thus necessitating the use of many skills and be quite useful to examine two aspects in this regard:

·The basic tools of managerial economics which it has borrowed from economics, and
  • The nature and extent of gap between the economic theory of the firm and the managerial theory of the firm.
Basic Economic Tools in Managerial Economics
The most significant contribution of economics to managerial economics lies in certain principles, which are basic to the entire range of managerial economics. The basic principles may be identified as follows:

1.   Opportunity Cost Principle
The opportunity cost of a decision means the sacrifice of alternatives required by that decision. This can be best understood with the help of a few illustrations, which are as follows:
·        The opportunity cost of the funds employed in one’s own business is equal to the interest that could be earned on those funds if they were employed in other ventures.
·        The opportunity cost of the time as an entrepreneur devotes to his own business is equal to the salary he could earn by seeking employment.
·        The opportunity cost of using a machine to produce one product is equal to the earnings forgone which would have been possible from other products.
·        The opportunity cost of using a machine that is useless for any other purpose is zero since its use requires no sacrifice of other opportunities.
·        If a machine can produce either X or Y, the opportunity cost of producing a given quantity of X is equal to the quantity of Y, which it would have produced. If that machine can produce 10 units of X or 20 units of Y, the opportunity cost of 1 X is equal to 2 Y.
·        If no information is provided about quantities produced, except about their prices then the opportunity cost can be computed in terms of the ratio of their respective prices, say Px/Py.
·        The opportunity cost of holding Rs. 500 as cash in hand for one year is equal to the 10% rate of interest, which would have been earned had the money been kept as fixed deposit in a bank. Thus, it is clear that opportunity costs require the ascertaining of sacrifices. If a decision involves no sacrifice, its opportunity cost is nil.
For decision-making, opportunity costs are the only relevant costs. The opportunity cost principle may be stated as under:
“The cost involved in any decision consists of the sacrifices of alternatives required by that decision. If there are no sacrifices, there is no cost.”
Thus in macro sense, the opportunity cost of more guns in an economy is less butter. That is the expenditure to national fund for buying armour has cost the nation of losing an opportunity of buying more butter. Similarly, a continued diversion of funds towards defence spending, amounts to a heavy tax on alternative spending required for growth and development.
2.   Incremental Principle
The incremental concept is closely related to the marginal costs and marginal revenues of economic theory. Incremental concept involves two important activities which are as follows:
  • Estimating the impact of decision alternatives on costs and revenues.
  • Emphasising the changes in total cost and total cost and total revenue resulting from changes in prices, products, procedures, investments or whatever may be at stake in the decision.
The two basic components of incremental reasoning are as follows:
  • Incremental cost: Incremental cost may be defined as the change in total cost resulting from a particular decision.
  • Incremental revenue: Incremental revenue means the change in total revenue resulting from a particular decision.
The incremental principle may be stated as under:
          A decision is obviously a profitable one if:
o   It increases revenue more than costs
    • It decreases some costs to a greater extent than it increases other costs
    • It increases some revenues more than it decreases other revenues
o   It reduces costs more that revenues.
Some businessmen hold the view that to make an overall profit, they must make a profit on every job. Consequently, they refuse orders that do not cover full cost (labour, materials and overhead) plus a provision for profit. Incremental reasoning indicates that this rule may be inconsistent with profit maximisation in the short run. A refusal to accept business below full cost may mean rejection of a possibility of adding more to revenue than cost. The relevant cost is not the full cost but rather the incremental cost. A simple problem will illustrate this point.
IIIustration
Suppose a new order is estimated to bring in additional revenue of Rs. 5,000. The costs are estimated as under:
Labour
Rs. 1,500
Material
Rs. 2,000
Overhead (Allocated at 120% of labour cost)
Rs. 1,800
Selling administrative expenses

(Allocated at 20% of labour and material cost)
        Rs.    700
Total Cost
Rs. 6,000

          The order at first appears to be unprofitable. However, suppose, if there is idle capacity, which can be, utilised to execute this order then the order can be accepted. If the order adds only Rs. 500 of overhead (that is, the added use of heat, power and light, the added wear and tear on machinery, the added costs of supervision, and so on), Rs. 1,000 by way of labour cost because some of the idle workers already on the payroll will be deployed without added pay and no extra selling and administrative cost then the incremental cost of accepting the order will be as follows.
Labour
Rs. 1,500
Material
Rs. 2,000
Overhead
Rs.    500
Total Incremental Cost
Rs. 3,500

While it appeared in the first instance that the order will result in a loss of Rs. 1,000, it now appears that it will lead to an addition of Rs. 1,500 (Rs. 5,000- Rs. 3,500) to profit. Incremental reasoning does not mean that the firm should accept all orders at prices, which cover merely their incremental costs. The acceptance of the Rs. 5,000 order depends upon the existence of idle capacity and labour that would go unutilised in the absence of more profitable opportunities. Earley’s study of “excellently managed” large firms suggests that progressive corporations do make formal use of incremental analysis. It is, however, impossible to generalise on the use of incremental principle, since the observed behaviour is variable.

3.   Principle 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 on costs. The actual problem in decision-making is to maintain the right balance between the long-run and short-run considerations. A decision may be made on the basis of short-run considerations, but may in the course of time offer long-run repercussions, which make it more or less profitable than it appeared at first. An illustration will make this point clear.

IIIustration
Suppose there is a firm with temporary idle capacity. An order for 5,000 units comes to management’s attention. The customer is willing to pay Rs. 4.00 per unit or Rs. 20,000 for the whole lot but not more. The short-run incremental cost (ignoring the fixed cost) is only Rs. 3.00. Therefore, the contribution to overhead and profit is Re. 1.00 per unit (Rs. 5,000 for the lot. However, the long-run repercussions of the order ought to be taken into account are as follows:
·         If the management commits itself with too much of business at lower prices or with a small contribution, it may not have sufficient capacity to take up business with higher contributions when the opportunity arises. The management may be compelled to consider the question of expansion of capacity and in such cases; even the so-called fixed costs may become variable.
·         If any particular set of customers come to know about this low price, they may demand a similar low price. Such customers may complain of being treated unfairly and feel discriminated. In response, they may opt to patronise manufacturers with more decent views on pricing. The reduction or prices under conditions of excess capacity may adversely affect the image of the company in the minds of its clientele, which will in turn affect its sales.
          It is, therefore, important to give due consideration to the time perspective. The principle of time perspective may be stated as under: ‘A decision should take into account both the short-run and long-run effects on revenues and costs and maintain the right balance between the long-run and short-run perspectives.”
          Haynes, Mote and Paul have cited the case of a printing company. This company pursued the policy of never quoting prices below full cost though it often experienced idle capacity and the management was fully aware that the incremental cost was far below full cost. This was because the management realised that the long-run repercussions of pricing below full cost would make up for any short-run gain. The management felt that the reduction in rates for some customers might have an undesirable effect on customer goodwill particularly among regular customers not benefiting from price reductions. It wanted to avoid crating such an “image” of the firm that it exploited the market when demand was favorable but which was willing to negotiate prices downward when demand was unfavorable.
4.   Discounting Principle
One of the fundamental ideas in economics is that a rupee tomorrow is worth less than a rupee today. This seems similar to the saying that a bird in hand is worth two in the bush. A simple example would make this point clear. Suppose a person is offered a choice to make between a gift of Rs. 100 today or Rs. 100 next year. Naturally he will choose the Rs. 100 today.
          This is true for two reasons. First, the future is uncertain and there may be uncertainty in getting Rs. 100 if the present opportunity is not availed of. Secondly, even if he is sure to receive the gift in future, today’s Rs. 100 can be invested so as to earn interest, say, at 8 percent so that. one year after the Rs. 100 of today will become Rs. 108 whereas if he does not accept Rs. 100 today, he will get Rs. 100 only in the next year. Naturally, he would prefer the first alternative because he is likely to gain by Rs. 8 in future. Another way of saying the same thing is that the value of Rs. 100 after one year is not equal to the value of Rs. 100 of today but less than that. To find out how much money today is equal to Rs. 100 would earn if one decides to invest the money. Suppose the rate of interest is 8 percent. Then we shall have to discount Rs. 100 at 8 per cent in order to ascertain how much money today will become Rs. 100 one year after. The formula is:

V =
Rs. 100
 1 + i
          where,
          V = present value
          i = rate of interest.
          Now, applying the formula, we get

V =
Rs. 100
 1 + i
    
 =

100
 1.08
  If we multiply Rs. 92.59 by 1.08, we shall get the amount of money, which will accumulate at 8 per cent after one year.
92.59 x 1.08 = 99.0072
                     = 1.00
The same reasoning applies to longer periods. A sum of Rs. 100 two years from now is worth:

V =
Rs. 100

=
Rs. 100

=
Rs. 100
(1+i)2
(1.08)2
1.1664

          Similarly, we can also check by computing how much the cumulative interest will be after two years. The principle involved in the above discussion is called the discounting principle and is stated as follows: “If a decision affects costs and revenues at future dates, it is necessary to discount those costs and revenues to present values before a valid comparison of alternatives is possible.”

5. Equi-marginal Principle
This principle deals with the allocation of the available resource among the alternative activities. According to this principle, an input should be allocated in such a way that the value added by the last unit is the same in all cases. This generalisation is called the equi-marginal principle.
          Suppose a firm has 100 units of labour at its disposal. The firm is engaged in four activities, which need labour services, viz., A, B, C and D. It can enhance any one of these activities by adding more labour but sacrificing in return the cost of other activities. If the value of the marginal product is higher in one activity than another, then it should be assumed that an optimum allocation has not been attained. Hence it would, be profitable to shift labour from low marginal value activity to high marginal value activity, thus increasing the total value of all products taken together. For example, if the values of certain two activities are as follows:
          Value of Marginal Product of labour
          Activity A = Rs. 20
          Activity B = Rs. 30
          In this case it will be profitable to shift labour from A to activity B thereby expanding activity B and reducing activity A. The optimum will be reach when the value of the marginal product is equal in all the four activities or, when in symbolic terms:
VMPLA = VMPLB = VMPLC = VMPLD
                Where the subscripts indicate labour in respective activities.
          Certain aspects of the equi-marginal principle need clarifications, which are as follows:
  • First, the values of marginal products are net of incremental costs. In activity B, we may add one unit of labour with an increase in physical output of 100 units. Each unit is worth 50 paise so that the 100 units will sell for Rs. 50. But the increased output consumes raw materials, fuel and other inputs so that variable costs in activity B (not counting the labour cost) are higher. Let us say that the incremental costs are Rs. 30 leaving a net addition of Rs. 20. The value of the marginal product relevant for our purpose is thus Rs. 20.
  • Secondly, if the revenues resulting from the addition of labour are to occur in future, these revenues should be discounted before comparisons in the alternative activities are possible. Activity A may produce revenue immediately but activities B, C and D may take 2, 3 and 5 years respectively. Here the discounting of these revenues will make them equivalent.
  • Thirdly, the measurement of value of the marginal product may have to be corrected if the expansion of an activity requires an alternative reduction in the prices of the output. If activity B represents the production of radios and it is not possible to sell more radios without a reduction in price, it is necessary to make adjustment for the fall in price.
  • Fourthly, the equi-marginal principle may break under sociological pressures. For instance, du to inertia, activities are continued simply because they exist. Similarly, due to their empire building ambitions, managers may keep on expanding activities to fulfil their desire for power. Department, which are already over-budgeted often, use some of their excess resources to build up propaganda machines (public relations offices) to win additional support. Governmental agencies are more prone to bureaucratic self-perpetuation and inertia.

Gaps between Theory of the Firm and managerial Economics
The theory of the firm is a body of theory, which contains certain assumptions, theorems and conclusions. These theorems deal with the way in which businessmen make decisions about pricing, and production under prescribed market conditions. It is concerned with the study of the optimisation process.
          For optimality to exist profit must be maximised and this can occur only when marginal cost equals marginal revenue. Thus, the optimum position of the firm is that which maximises net revenue. Managerial economics, on the other hand, aims at developing a managerial theory of the firm and for the purpose it takes the help of economic theory of the firm. However, there are certain difficulties in using economic theory as an aid to the study of decision-making at the level of the firm. This is because for the purposes of business decision-making it fails to provide sufficient analytical tools that are useful to managers. Some of the reasons are as follows:
  • Underlying all economic theory is the assumption that the decision-maker is omniscient and rational or simply that he is an economic man. Thus being omniscient means that he knows the alternatives that are available to him as well as the outcome of any action he chooses. The model of “economic man” however as an omniscient person who is confronted with a compete set of known or probabilistic outcomes is a distorted representation of reality. The typical business decision-maker usually has limited information at his disposal, limited computing ability and a limited number of feasible alternatives involving varying degrees of risk. Further, the net revenue function, which he is expected to maximise, and the marginal cost and marginal revenue functions, which he is expected to equate, require excessive knowledge of information, which is not known and cannot be obtained even by the most careful analysis. Hence, it is absurd to expect a manager to maximise and equalise certain critical functional relationships, which he does not know and cannot find out.
  • In micro-economic theory, the most profitable output is where marginal cost (MC) and marginal revenue (MR) are equal. In Figure 1.2, the most profitable output will be at ON where MR=MC. This is the point at which the slope of the profit function or marginal profit is zero. This is highlighted in Figure 1.3 where the most profitable output will be again at ON. In economic theory, the decision-maker has to identify this unique output level, which maximises profit.
 In real world, however, a complexity often arises, viz., certain resource limitations exist. As a result, it is not possible to attain the maximum output level (ON). In practical terms the maximum output possible as a result of resource limitations is, say, OM. Now the problem before the decision-maker is to find out whether the output, which maximises profit, is OM or some other level of output to the left of OM. It is obvious that economic theory is of no help for ON level of output because it is not relevant in view of the resource limitations. A managerial economist here has to take the aid of linear programming, which enables the manager to optimise or search for the best values within the limits set by inequality conditions.
·         Another central assumption in the economic theory of the firm is that the entrepreneur strives to maximise his residual share, or profit. Several criticisms of this assumption have been made:
o   The theory is ambiguous, as it doesn’t clarify. Whether it is short or long run profit that is to be maximised. For example, in the short run, profits could be maximised by firing all research and development personnel and thereby eliminating considerable immediate expenses. This decision would, however, have a substantial impact on long-run profitability.
o   Certain questions create some confusion around the concept of profit maximisation. Should the firm seek to maximise the amount of profit or the rate of profit? What is the rate of profit?  Is it profit in relation to total capital or profit in relation to shareholders’ equity?
o   There is no allowance for the existence of “psychic income” (Income other than monetary, power, prestige, or fame), which the entrepreneur might obtain from the firm, quite apart from his monetary income.
o   The theory does not recognise that under modern conditions, owners and managers are separate and distinct groups of people and the latter may not be motivated to maximise profits.
o   Under imperfect competition, maximisation is an ambiguous goal, because actions that are optimal for one will depend on the actions of the other firms.
o   The entrepreneur may not care to receive maximum profits but may simply want to earn “satisfactory profits”. This last point is particularly relevant from the behavioural science standpoint because it introduces a concept of satiation. The notion of satiation plays no role in classical economic theory. To explain business behaviour in terms of this theory, it is necessary to assume that the firm’s goals are not concerned with maximising profit, but with attaining a certain level or rate of profit, holding a certain share of the market or a certain level of sales. Firms would try to satisfy rather than maximise. But according to Simon the satisfying model damages all the conclusions that can be derived concerning resource allocation under perfect competition. It focuses on the fact that the classical theory of the firm is empirically incorrect as a description of the decision-making process. Based on this notion of satiation, it appears that one of the main strengths of classical economic theory has been seriously weakened.
·         Most corporate undertakings involve the investment of funds, which are expect to produce revenues over a number of years. The profit maximisation criterion provides no basis for comparing alternatives that can promise varying flows of revenue and expenditure over time.
·         The practical application of profit maximisation concept also has another limitation. It provides no explicit way of considering the risk associated with alternative decisions. Two projects generating similar expected revenues in the future and requiring similar outlays might differ vastly as regarding the degree of uncertainty with which the benefits to be generated. The greater the uncertainty associated with the benefits, the greater the risk associated with the project.
·         Baumol on the other hand is of the view that firms do not devote all their energies to maximising profit. Rather a company will seek to maximise its sales revenue as long as a satisfactory level of profit is maintained. Thus Baumol has substituted “Total sales revenue” for profits. Also, two decision criteria or objectives have been advanced viz., a satisfactory level of profit and the highest sales possible. In other words, the firm is no longer viewed as working towards one objective alone. Instead, it is portrayed as aiming at balancing two competing and non-consistent goals. Baumol’s model is based on the view that managers’ salaries, their status and other rewards often appear as closely related to the companies’ size in which they work and is measured by sales revenue rather than their profitability. As such, managers may be more concerned to increased size than profits. And the firm’s objective thus becomes sales maximisation rather than profits maximisation.
·         Empirical studies of pricing behaviour also give results that differ from those of the economic theory of firm as can be seen from the following examples:
o      Several studies of the pricing practices of business firms have indicated that managers tend to set prices by applying some sort of a standard mark-up on costs. They do not attempt to estimate marginal costs, marginal revenues or demand elasticities, even if these could be accurately measured.
o      For many firms, prices are more often set to attain, a particular target return on investment, say, 10 per cent, than to maximise short or long-run profits.
o      There is some evidence that firms experiencing
declining market shares in their industry strive more vigorously to increase their sales than do competing firms, which are experiencing steady or increasing market shares.
·         An alternative model to profit maximisation is the concept of
wealth maximisation, which assumes that firms seek to maximise the present value of expected net revenues over all periods within the forecasted future.
·         As pointed out by Haynes and Henry, a study of the
behaviour of actual firms shows that their decisions are not completely determined by the market. These firms have some freedom to develop decisions, strategies or rules, which become part of the decision-making system within the firm. This gap in economic theory has led to what has come to be known as ‘Behavioural Theory of the Firm’. This theory, however, does not replace the former but rather powerfully supplements it. The behavioural theory represents the firm as an adoptive institution. It learns from experience and has a memory. Organisational behaviour, is embodies into decision rules and standard operating procedures. These may be altered over long run as the firm reacts to “feedback” from experience. However, in the short run, decisions of the organisation are dominated by its rules of thumb and standard methods.

CONCLUSION
The various gaps between the economic theory of the firm and the actual decision-making process at the firm level are many in number. They do, however, stress that economic theory seriously needs major fixing up and substantial changes are in progress for creating better and different models. Thus the classical economic concepts like those of rational man is undergoing important changes; the notion of satisfying is pushing aside the aim of maximisation and newer lines and patterns of thoughts are being developed for finding improved applications to managerial decision-making. A strong emphasis is laid on quantitative model building, experimentation and empirical investigation and newer techniques and concepts, such as linear programming, game theory, statistical decision-making, etc., are being applied to revolutionise the approaches to problem solving in business and economics.
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