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UNIT I - INTRODUCTION: MANAGERIAL ECONOMICS

ECONOMICS

Economics is the study of how societies use scarce resources to produce valuable commodities

and distribute them among different people.

SCOPE OF ECONOMICS1. Consumption: Satisfaction of human wants is called consumption which forms one of the

important branches of economics. This tells how people behave in consumption of goods andservices in order to maximize their satisfaction.

2. Production: Goods and services have to be produced with the help of factors of production.

So, production is another branch of economics. It concerned with how maximum goods areproduced with minimum cost or how the scarce factors could be utilized economically for better

results.

3. Exchange: Goods and services cannot be produced at one place or at one point of time.Goods produced by one are exchanged for the goods produced by the others. So exchange forms

another branch of study in economics.

4. Distribution:Goods and services are produced with efforts, i.e., by combining the factors ofproduction. These efforts have to be paid for or rewarded. The land gets rent, the labor get

wages, the capital gets interest and the organizer gets profit. This branch of study is calleddistribution in economics.

5. Public Finance: This branch of study in economics studies about the sources of revenue

to the government and the principles governing the expenditure for the benefit of the people. Italso studies about public debt and financial administration.

ECONOMICS IS A SCIENCE OR AN ART

Economics as a Science: A science is a systematized body of knowledge ascertainable

by observation experimentation. It is a body of generalizations, principles, theories or laws whichtraces out a casual relationship between cause and effect. Economics is a systematized body of

knowledge in which economic facts are studied and analyzed in a systematic manner. Forinstance, economics is divided into consumption, production, exchange, distribution and public

finance which have their laws are theories on whose basis these departments are studied andanalyzed in a systematic manner. Hence economics is a science like any other science

which has its own theories and laws which establish a relation between cause and effect.Economics is also a science because its laws possess universal validity such as the law of

diminishing returns, the law of diminishing marginal utility the law of demand, Greshams law,etc. Again, economics is a science because of its self corrective nature. It goes on revising its

conclusions in the light of new facts based on observations. Economic theories or principles arebeing revised in the fields of macro economics, monetary economics, international economics,

public finance and economic development.


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Economics as an Art: Unlike natural science, there is no scope for experimentation in

economics because economics is related to man, his problems and activities. Economicphenomena are very complex as they related to man whose activities are bound by his tastes,

habits, and social and legal institutions of the society in which he lives. Economics is thus

concerned with human beings who act irrationally and there is no scope for experimentation ineconomics. Even though economics possess statistical, mathematical and econometricmethods of testing its phenomena but these are not so accurate as to judge the true

validity of economic laws and theories. As a result, exact quantitative predication is not possiblein economics.

Economics as both a Science and an Art: Economics is not only a science but also an art. It is a

science in its methodology and an art in its application. It has a theoretical aspect and is also anapplied science in its practical aspects.

FUNDAMENTAL ECONOMIC PROBLEMS

Economic Problem: Due to the scarcity of means and the multiplicity of ends, the economic

problem lies in making the best possible use of our resources so as to get maximum outputsatisfaction in the case of a consumer and maximum output or profit for a producer. Hence

economic problem consists in making decisions regarding the ends to be pursued and the goodsto be produced and the means to be used for the achievement of certain ends.

Fundamental problems facing the economy:

1. What to produce:The first major decision relates to the quantity and the range of

goods to be produced. Since resources are limited, we must choose between differentalternative collection of goods and services that may be produced. It also implies the

allocation of resources between the different types of goods. Example: Consumer goods andcapital goods.

2. How to produce: Having decided the quantity and the type of goods to be produced, we mustnext determine the techniques of production to be used. Example: labor intensive or capital

intensive.3. For whom to produce: This means how the national product is to distributed, i.e., who

should get how much. This is the problem of the sharing the national product.4. Are the Resources Economically Used? This is the problem of economic efficiency or

welfare maximization. There is to be no waste or misuse of resources since they are limited.5. Problem of Full employment: Fullest possible use must be made of the available resources.

In other words, an economy must endeavor to achieve full employment not only of labor but ofall its resources.

6. Problem of Growth: Another problem for an economy is to make sure that it keepsexpanding or developing so that it maintains conditions of stability. It is not to be static. Its

productive capacity must continue to increase. If it is an under developed economy, it mustaccelerate its process of growth.


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CAPITALIST SYSTEMCapitalism is that profit-oriented system which is characterized by private ownership of

objects of labor instruments of labor and means of labor. Production is mainly carried out withthe help of labor services rendered by the working class in return for wages and the class of

capitalists has the right to whatever output is produced within the system.

Characteristics of the capitalist system:1. Private ownership of means of production: Under the capitalist system anything whichhelps man in the production process like machinery, tools, land, raw-materials, etc. is owned by

the capitalist class.2. Production for the market: Under capitalism business firms produce mainly with the aim of

selling the output in the market. Wherever any good is produced for the market it is termed as acommodity and any economy in which production is undertaken with the sole object of

exchange is call a commodity economy.3. Price mechanism: In a capitalist economy neither an individual nor any institution takes

decisions in a planned manner concerning its day-to-day functioning. That is, there is noconscious effort to arrive at some kind of solution to its central problems.

4. Labor power as a commodity: In a capitalist economy, majority of the people ownonly on thing viz., their capacity to work or their labor power.

5. Exploitation of labor: Workers are exploited under capitalism. Very often due to the freedomgranted to the workers at a formal level, many people are wrongly given to believe that

the workers by bargaining in the free market are able to get a fair price in return for their laborpower.

6. Growing wealth of the capitalists: In a capitalist economy the wealth of the capitalist classincreases in a sustained manner.

7. Emergence of the working class: Under capitalism the increasing use of machineryleads to widespread unemployment and an increase in the rate of exploitation of workers

which implies a decline in the share of workers in the national income over time.8. Class contradiction: Hence, the two major classes found in a capitalist society are those

of the capitalists and the workers. The clash of interests of the capitalists and the workers takethe form of the class conflict with the further development of capitalism.

SOCIALISM

Under socialism not only is there social ownership of the means of production but alsothe functioning of the economy is such so as to maximize social benefit rather than private

benefit. Unlike capitalism in a socialist society the market mechanism does not play the alldominating role of determining the type and quantity of various commodities produces their

priority sequence and the necessary allocation of resources.Characteristics (or) Salient features of the socialist economic system:

1. Social ownership of the means of production: In a socialist society privateownership of the means of production is abolished in the various sectors of the economy.

2. Predominance of public sector: An important precondition for the establishment of socialismis the existence of the public sector which is founded on the principle of social ownership of the

means of production.3. Decisive role of economic planning:Economic planning under socialism plays exactly the

same role as is played by the price mechanism in a capitalist economy.


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4. Production guided by social benefit: In a socialist economy, however, income

inequalities are drastically reduced so that everyone has an adequate amount of disposableincome. While determining the pattern and size of output the planning commission has to see to

it that its decisions in this regard are such that they ensure the availability of commodities for all

in the market.5. Abolition of exploitation of labor: Once the development of human society reaches the stageof socialism. Exploitation of man by man comes to an end.

MIXED ECONOMY

According to Samuelson, a mixed economy is characterized by the existence of both public andprivate institutions exercising economic controls.

Characteristics of a mixed economy:

1. Private and state ownership of the means of production and profit induced private

business: In a mixed economy people enjoy right of property through constitutional provisions.2. Decisive role of market mechanism: Market mechanism has a predominant position in a

mixed economy. In such an economy markets exist not only for various products, but alsofor productive factors, such as labor and capital.

3. Interventionist role of the state: The market mechanism is a mixed economy may not beentirely free from state control. Often legislative measures are undertaken to provide a regulatory

system for industrial activity in the country.4. Public sector activities are supposedly guided by social benefit: Activities of the public

enterprises are considered to be guided by the social benefit. Thus performance of theseenterprises is often judged on the criterion of social benefit and thus most of this enterprise

ignore profit maximization goal.5. Supportive role of economic planning: The role of economic planning in basically

capitalistic economic framework is supportive. Hence planning in these economies is usuallyindicative in nature. Economic planning in developing economies, in which both private and

public sectors co-exists, has nothing to do with socialism.

ENGINEERING ECONOMICSIt is the application of economic principles to engineering problems. For example, in comparing

the comparative costs of two alternative capital projects.

IMPORTANCE OF ENGINEERING ECONOMICS:1. Engineering economics is concerned with the monetary consequences (or) financial analysis

of the projects, products and processes that engineers design.2. Engineers are required to use economic concepts in the major fields such as increasing

production, improving productivity, reducing human efforts, increasing wealth by maximizingprofit, controlling and reducing cost.

3. Engineering economics provides has very important role to play in all engineering decisions.4. Engineering economics provides a number of tools and techniques to solve engineering

problems related to product-mix, output level, pricing the product, investment, quantum ofadvertisement, etc.


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5. Engineering economics helps in understanding the market conditions, general economicenvironment in which the firm is working.

6. Engineering economics provide basis for resource allocation problem.7. Engineering economics deals with identification of economic choices, and is concerned with

the decision making of engineering problems of economic nature.

APPLICATIONS OF ENGINEERING ECONOMICS1. Selection of location and site for a new plant-It is concerned with comparing the cost of

establishment and operation of various locations and sites.2. Production Planning and Control.

3. Selection of equipment and their replacement analysis.4. Selection of a material handling system.

5. Determination of plant capacity: It is associated with investment of funds such as initialoutlay and operating expenses which determines the capacity of a plant. The capacity is a

measure of ability to produce goods and services or rate of output.6. Determination of wage structure of the workers.

7. Selection of choice between a concrete structure and a steel structure, between variousinsulation thickness, and between prices at which to sell a product.

8. It can be applied by a major corporation to analyze plans for a new manufacturingfacility or a new research and development (R&D) thrust.

CHARACTERISTICS OF ENGINEERING ECONOMICS

1. Engineering economics is a traditional and important part of engineering practice.2. Engineering economics is concerned with application of economic principles in technical and

managerial decision making.3. Engineering economics embarrasses both micro and macroeconomic principles when applied

to engineering problems. For example, the study of demand analysis is mostly concerned withindividual or household as a small unit of study. Whereas, the study of impact of taxes on raw-

materials will influence engineers to look for alternative materials for manufacturing ordesigning a product or processes which is of course a macro economic issue. The demand

analysis is microeconomic principle.4. Engineering economics also take in its fold certain concepts and principles from other fields

such as statistics, accounting, management, etc.5. Engineering economics aids decision making aspect of an engineer and it avoids the

abstract nature of economic theory.6. Engineering economics is mostly an application tool, whereas economics is a social science

with broad characteristics.7. Economic theory conveniently ignores the significant backgrounds which are common to

individual firms but engineering economics take in to consideration the individual firmsenvironment of decision making.

8. Engineering economics provides an analytical and scientific approach resulting in qualitativedecisions.

ADVANTAGES OF ENGINEERING ECONOMICS

1. Better decision making on the part of engineers.


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2. Efficient use of resources results in better output and economic advancement.3. Cost of production can be reduced.

4. Alternative courses of action using economic principles may result in reduction of prices ofgoods and services.

5. Elimination of waste can result in application of engineering economics.

6. Competitive strength on the part of the firm in adopting engineering economics.7. More capital will be made available for investment and growth.8. Improves the standard of living with the result of better products, more wages and salaries,

more output, etc. From the firm applying economics.

MANAGERIAL ECONOMICSManagerial Economics has been described as economics applied to decision-making. It may be

viewed as a special branch of economics bridging the gulf between pure economic theoryand managerial practice.

CHIEF CHARACTERISTICS

1. Managerial Economics is micro-economic in character. This is because the unit of study is afirm; it is the problems of a business firm which are studied in it. Managerial Economics does

not deal with the entire economy as a unit of study.2. Managerial Economics largely uses that body of economic concepts and principles which is

known as Theory of the Firm or Economics of the Firm. In addition, it also seeks to applyProfit Theory which forms part of Distribution Theories in Economics.

3. Managerial Economics is pragmatic: It avoids difficult abstract issues of economic theory butinvolves complications ignored in economic theory to face the overall situation in which

decisions are made. Economic theory appropriately ignores the variety of backgrounds andtraining found in individual firms but Managerial Economics considers the particular

environment of decision-making.4. Managerial Economics belongs to normative economics rather than positive economics (also

sometimes known as descriptive economics). In other words, it is prescriptive rather thandescriptive. The main body of economic theory confines itself to descriptive hypothesis,

attempting to generalize about the relations among different variables without judgment aboutwhat is desirable or undesirable.

5. Macro-economics is also useful to Managerial Economics since it provides an intelligentunderstanding of the environment in which the business must operate. This understanding

enables a business executive to adjust in the best possible manner with external forces overwhich he has no control but which play a crucial role in the well-being of his concern.

SCOPE OF MANAGERIAL ECONOMICS1. Demand Analysis and Forecasting: A major part of managerial decision-making

depends on accurate estimates of demand. Before production schedules can be prepared andresources employed, a forecast of future sales is essential.

2. Cost Analysis: A study of economic costs, combined with the data drawn from the firmsaccounting records, can yield significant cost estimates that are useful for management decisions.


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3. Production and Supply Analysis: Production analysis mainly deals with different productionfunction and their managerial uses. Supply analysis deals with various aspects of supply of a

commodity. Certain important aspects of supply analysis are: Supply schedule, curves andfunction. Law of supply and its limitations, Elasticity of supply and Factors influencing supply.

4. Pricing Decisions, Policies and Practices: The important aspects dealt with under this area

are: Price Determination in various Market Forms, Pricing Methods, Differential Pricing,Product-line Pricing and Price Forecasting.5. Profit Management: Business firms are generally organized for the purpose of making

profits and, in the long run, profits provide the chief measure of success. In this connection, animportant point worth considering is the element of uncertainty existing about profits because of

variations in costs and revenues which, in turn, are caused by factors both internal and external tothe firm.

6. Capital Management: Capital management implies planning and control of capitalexpenditure. The topics dealt with are: Cost of Capital, Rate of Return and Selection of projects.

BASIC ECONOMIC TOOLS IN MANAGERIAL ECONOMICS

1. Opportunity Cost Principle: By the opportunity cost of a decision is meant thesacrifice of alternatives required by that decision. Thus, it should be clear that opportunity

costs require ascertainment of sacrifices. If a decision involves no sacrifice, its opportunity costis 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 thesacrifices of alternatives required by that decision. If there are no sacrifices, there is no cost.

2. Incremental Principle: Incremental concept involves estimating the impact of decisionalternatives on costs and revenues, emphasizing the changes in total cost and total revenue

resulting from changes in prices, products, procedures, investments or whatever may be atstake in the decision. The two basic components of incremental reasoning are: Incremental cost

and incremental revenue. Incremental cost may be defined as the change in total cost resultingfrom a particular decision. Incremental revenue is the change in total revenue resulting from a

particular decision.3. Principle of Time Perspective: The economic concepts of the long run and the short

run have become part of everyday language. Managerial economics are also concerned with theshort-run and long-run effects of decisions on revenues as well as costs. The really important

problem in decision-making is to maintain the right balance between the long-run and theshort-run considerations. 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 atfirst appeared.

4. Discounting Principle: One of the fundamental ideas in economics is that a rupeetomorrow is worth less than a rupee today. This seems similar to saying that a bird in hand is

worth two in the bush. If a decision affects costs and revenues at future dates, it is necessary todiscount 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 resources

among the alternative activities. According to this principle, an input should be so allocated thatthe value added by the last unit is the same in all cases. This generalization is called the equi-

marginal principle.


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RELATIONSHIP OF MANAGERIAL ECONOMICS WITH OTHER DISCIPLINES1. Managerial Economics and Economics: Managerial Economics has been described as

economics applied to decision-making. It may be viewed as a special branch of economicsbridging the gulf between pure economic theory and managerial practice. Economics has two

main divisions: micro-economics and macro-economics. Micro-economics has been defined as

that branch where the unit of study is an individual or a firm. Macro-economics, on the otherhand, is aggregative in character and has the entire economy as a unity of study.2. Managerial Economics and statistics: Managerial Economics employs statistical methods

for empirical testing of economic generalizations. These generalizations can be accepted inpractice only when they are checked against the data from the world of reality and are found

valid.3. Managerial Economics and Mathematics: Mathematics is yet another important tool-subject

closely related to Managerial Economics. This is because Managerial Economics is metricalin character, estimating various economics relationships, predicting relevant economic

quantities and using them in decision-making and forward planning.4. Managerial Economics and Accounting: Managerial Economics is also closely related

to accounting which is concerned with recording the financial operations of a businessfirms. Indeed, accounting information is one of the principal sources of data required by a

managerial economist for his decision-making purpose.5. Managerial Economics and Operations Research: The significant relationship between

managerial economics and operations research can be highlighted with reference to certainimportant problems of managerial economics which are solved with the help of or

techniques. The problems are: allocation problems, competitive problems, waiting line problemsand inventory problems.

DIFFERENCE BETWEEN MANAGERIAL ECONOMICS AND ECONOMICS

1. Managerial Economics involves application of economic principles to the problems ofthe firm. Economics deals with the body of the principles itself.

2. Managerial Economics is micro-economic in character; Economics is both macro-economicand micro-economic.

3. Managerial Economics, though micro in character, deals only with firms and has nothing to dowith an individuals economic problems. But micro-Economics as a branch of Economics deals

with both economics of the individual as well as economics of the firm.4. Under Micro-Economics as a branch of Economics, distribution theories, viz., wages, interest

and profit, are also dealt with but in Managerial Economics, mainly Profit Theory is used: otherdistribution theories have not much use in Managerial Economics. Thus, the scope of Economics

is wider than that of Managerial Economics.5. Economic theory hypothesizes economic relationships and builds economic models but

Managerial Economics adopts, modifies and reformulates economic models to suit thespecific conditions and serves the specific problem solving process. Thus Economics gives

the simplified model, whereas Managerial Economics modifies and enlarges it.6. Economic theory makes certain assumptions whereas Managerial Economics introduces

certain feedbacks such as objectives of the firm, multi-product nature of manufacture,behavioral constraints, environmental aspects, legal constraints, constraints on resource

availability, etc., thus embodying a combination of certain complexities assumed away in


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economic theory and then attempts to solve the real-life, complex business problems withthe aid of tool subjects, e.g., mathematics, statistics, econometrics, accounting, operations

research, marketing research and so on.

ROLE OF MANAGERIAL ECONOMISTS IN BUSINESS1. Decision Making and Forward Planning: Managerial economists play a vital role inmanagerial decision making and forward planning.

2. Inventory Schedules of the Firm: He plays an effective role in price fixation, location of aplant, quality improvement, etc. and inventory schedules of the firm.

3. Demand Forecasting: The most important role of the managerial economist relates todemand forecasting.

4. Economic Analysis: The managerial economists undertake an economic analysis of theindustry.

5. Price Fixation: Another role played by a managerial economist is to fixing prices for new aswell as existing products of a firm.

6. Environmental Issues: A managerial economist is also undertakes the analysis ofenvironmental issues.

7. Cost of the Firm: He is also responsible and playing a vital role in input cost of the firm.8. Governments Economic Policies: Lastly, managerial economist has also to keep in touch

with the governments economic policies and the central banks monetary policies annualbudgets of the government.

DECISION MAKING ENVIRONMENTS

The decisions are also categorized in terms of the degree of certainty that exists in a situation.Thus every decision making situation falls into one of the four categories that exist along

a certainty continuum namely Certainty, Risk, Uncertainty and Ambiguity1. Certainty: This is a state of certainty that exists only when the decision maker knows

the available alternatives and the conditions and consequences of those actions. Makingdecisions under certainty assumes that the decision maker has all the necessary information

about the problem situation.2. Risk: A state of risk exists when the decision maker is aware of all the alternatives,

but is unaware of their consequences. In this situation, the decision maker at best can makeguess as to which alternative to choose. The decision in order risk usually involves clear and

precise goals and good information, but future outcomes of the alternatives are just not known toa degree of certainty. However, sufficient information is available to allow the decision maker to

ascribe the probability of successful outcomes for each alternative.3. Uncertainty: Most significant decisions made in todays complex environment are formulate

under a state of uncertainty, where there is an unawareness of all the alternatives and soalso the outcomes even for the known alternatives. Such decisions demand creativity and the

willingness to take a chance in the face of such uncertainties. In such situations, decision makersdo not even have enough information to calculate degree of risk.

4. Ambiguity: The most difficult decision situation is the state of ambiguity, in which thedecision problems are not at all clear. The alternative courses of action are difficult to identify,


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and the information about consequences is not available. In this state, nothing is known for sureand the risk of failure is quite high.

PROFIT MAXIMIZATION AS BUSINESS OBJECTIVE

Profit maximization objective of the firm has been the traditional approach to the study of a firm

in equilibrium analysis. Profit maximization means the largest absolute amount of profits over atime period, both short-term. And long term. The short run is a period where adjustments cannotbe made quickly in matters of supply and demand. Long run however enables adjustment to

changed conditions. Profit can be defined as the difference between total revenue (TR) andtotal cost (TC).

Profit=TR-TC

CRITISIMS OF PROFIT-MAXIMISING THEORIES1. Separation of Ownership from Control: The rise of corporate firm of organization has

resulted in a separation of ownership and control. Ownership is vested with the shareholders andcontrol is wielded by the managers. It has not been empirically proved that shareholders are

more concerned with profitability than anything else.2. Difficulties in Pursuing Profit Maximization: The modern firm faces lot uncertainties. As a

result, short run profit maximizing behavior is subordinated to the more important objectiveof long-run survival of the firm, for example, the firms objective to pursue good-will in the

long-run may clash with short-run profit objective.3. Problems in the Measurement of Profit:There are some problems about the measurement

of profit as a measure of firms efficiency. Profit may be the result of imperfection in the marketand profits may be the reward of monopolistic exploitation. Worse still, profit measurement

process itself is dubious.4. Social responsibility of the firm: The firm is now-a-days not just an economic entity

concerned with production or sales alone. The firm owes a responsibility to offer good, wellpaid jobs for employees, to provide efficient services to customers. In short the firm has a

social responsibility beyond profit maximization.5. Deliberate limitation of profits: Firms may deliberately show lesser profits in the

short run in order to discourage laborers from asking for higher wages or to discourageentry of new firms. Limited profits may be shown to prevent the government from taking over

the business.6. Aversion for business expansion: Profit maximization requires business expansion and it

means additional risk and responsibility. Businessmen may be satisfied with the prevent level ofprofit and may not expand.

ARGUMENTS IN FAVOUR OF PROFIT MAXIMIZATION

1. Profit is indispensable for firms survival: The survival of all the profit-orientedfirms in the long run depends on their ability to make a reasonable profit depending on the

business conditions and the level of competition.2. Achieving other objectives depends on firms ability to make profit: Many other objectives

of business firms have been cited in economic literature, e.g., maximization of managerial utilityfunction, maximization of long-run growth, maximization of sales revenue, satisfying all the


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concerned parties, increasing and retaining market share, etc. the achievement of such alternativeobjectives depends wholly or partly on the primary objective of making profit.

3. Evidence against profit maximization objective not conclusive: Profit maximization is atime-honored objective of business firms. Although this objective has been questioned by many

researchers, the evidence against it is not conclusive or unambiguous.

4. Profit maximization objective has a greater predicting power: Compared to other businessobjectives, profit maximization assumption has been found to be a much more powerful premisein predicting certain aspects of firms behaviour.

5. Profit is a more reliable measure of firms efficiency: Thought not perfect, profit is the most

efficient and reliable measure of the efficiency of a firm.

ALTERNATIVE OBJECTIVE OF FIRMS

Baumols Theory of Sales Revenue Maximization

Prof. J. Baumol has postulated seller revenue maximization approach as an alternative to profitmaximization objective. The factors which explain the pursuance of this objective are following:

1. Financial institutions evaluate the success and strength of the firm in terms of rate of growth ofits sales revenue.

2. Empirical evidence shows that the stock earnings and salaries of top management arecorrelated more closely with sales than with profits.

3. Increasing sales revenue over a period of time gives prestige to the top management, butprofits are enjoyed only by the shareholders.

4. Growing sales means higher salaries and better terms. Hence sales revenue maximizationsresults in a healthy personnel policy.

5. It is seen that managers prefer a steady performance with satisfactory profits thanspectacular profits year after year. They will be criticized if spectacular profits decline. Hence

they may prefer a safe and steady performance with satisfactory profits but good sales.6. Large and increasing sales help the firm to obtain a bigger market share which gives it a

greater competitive power.

ASSUMPTIONS OF BAUMOLS SALE MAXIMIZATION MODELi. Sales maximization goal is subject to a minimum profit constrain.

ii. Advertisement is a major instrument of sales maximization i.e., advertisement will shift thedemand curve to the right.

iii. Advertisement costs are independent of production costs.iv. Price of the product is assumed to be constant.

IMPLICATIONS OF BAUMOLS THEORY

i. His theory is more consistent with observed behavior. In the traditional theory changes infixed costs do not influence output or prices except for fixing the breakeven point. But

according to Baumol a firm which experiences any increase in fixed costs will try to reducethem or pass them on to the consumer in the form of higher prices, through large scales.

ii. This theory also establishes that businessmen may consider non-price competition throughsales maximization to be the more advantageous alternative.


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iii. However, Baumols theory does not explain how the firms maximize their salesvolume within a profit constraint. Further it explains business behavior, without elaborating the

mechanism by which they try to find new alternative.

MARRIS THEORY OF MAXIMISATION OF FIRMS GROWTH RATE

According to Robin Marris, managers maximize firms balanced growth rate subject tomanagerial and financial constraints. He defines firms balanced growth rate (G) as, G= GD=GCWhere GD=growth rate of demand for firms product and GC=growth rate of capital supply

to the firm. In simple words, a firms growth rate is balance when demand for its product andsupply of capital to the firm increase at the same rate. The two growth rates are according to

Marris, translated into utility functions:(i) Managers utility function: The managers utility function (Um) and owners utility(Uo)

may be satisfied as follows. Um=f(salary, power, job security, prestige, status).

(ii) Owners utility function Owners utility function (Uo): Uo=f (output, capital, market-share, profit, public esteem), implies growth of demand for firms product and supply of capital.

Therefore, maximization of Uo means maximization of demand for firms product orgrowth of capital supply. According to Marris, by maximizing these variables, managers

maximize both their own utility function and that of the owners. The managers can do sobecause most of the variables (e.g., salaries, status, job security, power, etc) appearing in their

own utility function and those appearing in the utility function of the owners (e.g., profit, capitalmarket, share, etc) are positively and strongly correlated with a single variable, i.e., size of the

firm. Maximization of these variables depends on the maximization of the growth rate of thefirms. The managers, therefore, seek to maximize a steady growth rate.

Marriss theory, though more rigorous and sophisticated than Baumols sales revenuemaximization, has its own weaknesses. It fails to deal to deal satisfactorily with oligopolistic

interdependence & it ignores price determination which is the main concern of profitmaximization hypothesis.

Williamsons Theory of Maximization of Managerial Utility Function

Like Baumol and Marris, Willamson argues that managers have discretion to pursue objectivesother than profit maximization. The managers seek to maximize their own utility function subject

to a minimum level of profit. Managers utility function (U) is expresses as:U = f(S, M, ID)

where S= additional expenditure on staff, M= managerial emoluments, ID = discretionaryinvestments.

According to Williamsons theory managers maximize their utility function subject to asatisfactory profit. A minimum profit is necessary to satisfy the shareholders or else managers

job security is endangered. The utility functions which managers seek to maximize include bothquantifiable variables like salary and slack earnings, and non-quantitative variable such as

prestige power, status, job security, professional excellence, etc. The non-quantifiable variablesare expresses, in order to make them operational, in terms of expense preference defined as

satisfaction derived out of certain types of expenditures (such as slack payments), and readyavailability of funds for discretionary investments.


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Williamsons theory suffers from certain weakness. His model fails to deal with problem ofoligopolistic interdependence. Williamsons theory is said to hold only where rivalry between

firms is not strong. In case of strong rivalry, profit maximization is claimed to be a moreappropriate hypothesis. Thus, Williamsons managerial utility function too does not offer a more

satisfactory hypothesis than profit maximization.

CYERT-MARCH THEORY OF SATISFICING BEHAVIOURCyert-March theory is an extension of Simons theory or firms. Satisfying behaviour or

satisfying behaviour. Simon had argued that the real business world is full of uncertainly;accurate and adequate data are not readily available; where data are available managers have

little time and ability to process them; and managers work under a number of terms of rationalitypostulated under profit maximization hypothesis. Nor do the firms seek to maximize sales,

growth or anything else. Instead they seek to achieve a satisfactory profit a satisfactorygrowth, and so on. This behaviour of firms is termed as Satisfaction Behaviour. Cyert and

March added that, apart from dealing with an uncertain business world, managers have to satisfya variety of groups of people-managerial staff, labour, shareholders, customers, financiers, input

suppliers, accountants, lawyers, authorities etc. All these groups have their interest in the firms-often conflicting. The managers responsibility is to satisfy them all. Thus, according to the

Cyert-March, firms behavior is satisfying behaviour. The satisfying behaviour impliessatisfying various interest groups by sacrificing firms interest or objective. The

underlying assumption of Satisfying Behaviour is that a firm is a coalition of different groupsconnected with various activities of the firms, e.g., shareholders, managers, workers, input

supplier, customers, bankers, tax authorities, and so on. All these groups have some kind ofexpectations-high and low-from the firm, and the firm seeks to satisfy all of them in one way or

another in sacrificing some of its interest.In order to reconcile between the conflicting interests and goals, managers form an aspiration

level of the firm combining the following goals:(a) Production goal

(b) Sales and market share goals(c) Inventory goal

(d) Profit goal.These goals and aspiration level are set on the basis of the managers past experience and

their assessment of the future market conditions. The aspiration levels are modified andrevised on the basis of achievements and changing business environment. The behavioural

theory has, however, been criticized on the following grounds. First, though the behaviouraltheory deals realistically with the firms activity, it does not explain the firms behaviour under

dynamic conditions in the long run. Secondly, it cannot be used to predict exactly the futurecourse of firms activities; thirdly, this theory does not deal with the equilibrium of the

industry. Fourthly, like other alternative hypotheses, this theory too fails to deal withinterdependence of the firms and its impact on firms behaviour.

SOURCES OF BUSINESS RISK

1. Risk of Market Fluctuation: General economic conditions are rarely stable. Firms facebooms and depressions. Though with the help of certain forecasting techniques the firm can

somewhat hedge itself against cyclical fluctuation, but there is no way the firm can


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generally know with certainty the timing and volatility of changes. The firm is, therefore,unstable to completely prepare itself for these changes.

2. Risk of Industry Fluctuations: There may be fluctuations specific to the industry, which areleast as uncertain and may not always coincide with those of the overall market.

3. Competition risks: These are the risk arising from the policy changes of the rivals, which

include things like changes in prices, product line, advertisement expenditure, etc.4. Risk of technological change: This is also called the risk of obsolescence, which grows withadvancement of an economy. These risks arise from the possibility of newly installed machinery

becoming obsolete with the discovery of new and more economical process of production.5. Risk of taste fluctuation: In many cases, vagaries of consumer demand create uncertain

conditions. Successful product of one season may become discarded in the next season. Theserisks are most common in fashion and entertainment industries.

6. Risk of cost fluctuation: Unless contractually agreed upon, the future prices of labour,material etc. may change. Thus estimates of future expenditure are subject to uncertainty.

7. Risk of public policy: Government policy regarding business undergoes a change overtime, some of which cannot be precisely predicted. These relate to price control, foreign trade

policy, corporate taxation etc.

THE THREE CATEGORIES OF DECISION-MAKERS1. Risk-neutral: A decision-maker is risk-neutral if each added rupee of wealth gives him the

same additional utility.2. Risk-averse: A decision-maker is considered risk-averse if addition of each successive rupee

to his wealth gives him lesser utility than the earlier rupee.3. Risk-preferer: A decision-maker is considered as risk-preferer when addition of each

successive rupee to decision-makers wealth gives him greater utility each time.

DECISION MAKINGDecision making is the process of selection from a set of alternative courses of action

which is thought to fulfill the objective of the decision problem more satisfactorily than other.

FEATURES OF DECISION MAKING1. Selection process: Decision making is a selection process. The best alternative is selected out

of many available alternatives.2. Goal-oriented process: Decision making is goal-oriented process. Decisions are made to

achieve some goal or objective.3. End process: Decision making is the end process. It is preceded by detailed discussion and

selection of alternatives.4. Human and Rational process: Decision making is a human and rational process involving

the application of intellectual abilities. It involves deep thinking and foreseeing things.5. Dynamic process: Decision making is a dynamic process. An individual takes a number of

decisions each day.6. Situational: Decision making is situational: A particular problem may have different

decisions at different times, depending upon the situation.7. Continues or Ongoing process: Decision making is a continuous or ongoing process.

Managers have to take a series of decisions on particular problems.


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8. Freedom to the decision makers: Decision making implies freedom to the decision makersregarding the final choice. It also involves the using of resources in specified ways.

9. Positive or Negative: Decision may be positive or negative. A decision may direct others todo or not to do.

10. Gives happiness to an Endeavour: Decision making gives happiness to an Endeavour who

takes various steps to collect all the information which is likely to affect decisions.

STEPS IN DECISION MAKING PROCESS IN AN ORGANIZATION

1. Identification of problem: Decision making process begins with the identification of problemthat means recognition of a problem. The managers have to use imagination, experience, and

judgment in order to identify the real nature of the problem.2. Diagnosis and analysis of the problem: In order to diagnose the problem correctly, a

manager must obtain all pertinent facts and analyze them correctly. The most important part ofthe diagnosing problem is to find out the real cause or source of the problem. After

analyzing the problem next phase of the decision making is to analyze problem. This processinvolves classifying the problem and gathering information.

3. Search for alternatives: A problem can be solved in many ways. All possible ways cannot beequally satisfying. Managers are advice to limit him to the discovery of the alternatives

which are strategic or critical to the problem. The principle of limiting factor is given as Byrecognizing and overcoming that factor that stand critically in the way of a goal, the best

alternative course of action can be selected. Creative thinking is necessary to developalternatives such as decision makers past experience, practices followed by others, and using

creative techniques.4. Evaluation of alternatives: Evaluation is the process of measuring the positive and

negative consequences of each alternative. Some alternatives offer maximum benefit thanothers. An alternative is compared with the others. Management must set some criteria against

which the alternatives can be evaluated. Criteria to weigh the alternative courses of actionincludes Risk-Degree of risk involved in each alternative, Economy of effort- Cost, time and

effort involved in each alternative, Timing or Situation- Whether the problem is urgent &Limitation of resources- Physical, financial and human resources available with the organization.

5. Selecting an alternative: In this stage, decision makers can select the best alternatives.Optimum alternative is one which maximizes the results under given conditions.

6. Implementation and follow-up: Once an alternative is selected, it is put into action insystematic way. The future course of action is scheduled on the basis of selected alternatives.

When a decision is put into action, it may yield certain results. These results provide theindication whether decision making and its implementation is proper. The follow-up action

should be in the light of feedback received from the results.

RATIONAL DECISION MAKINGDecision making is the process of selection from a set of alternative courses of action

which is thought to fulfill the objective of the decision problem more satisfactorily than other.The concept of rationality is defined in terms of objective and intelligent action.

TYPES OF DECISION MAKING DEPENDING UPON RATIONALITY


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1. Major and supplementary decisions: Major decisions refer to the decisions withregard to the quality of the product, price of the product, developing a new product etc.

These decisions have direct bearing on the achievement of the goals of the concern and so thesedecisions should be made very carefully. Minor or supplementary decisions, on the other hand,

are made in the course of conversion of major decisions into action.

2. Organizational and personal decision: Organizational decisions are made by the executivein his capacity as manager in order to achieve the best interests of the organization. Thesedecisions can be delegated to the other members in the organization. Personal decisions, on the

other hand, are made by the manager in his personal capacity and not in his capacity as amember of the organization. These decisions are not delegated. These decisions relate to the

executives personal work.3. Basic and routine decisions: Basic decisions involve long range commitment and large

funds. Decisions with regard to selection of a location, selection of a product line, merger of thebusiness are known as basic decisions. As these decisions affect the entire organization, they are

considered as basic decisions. They are also now as vital decisions. Decisions that are taken tocarry out the day-today activities are called routine decisions. These decisions are repetitive in

nature. They have only a minor impact on the business. These decisions are made at middle andlower levels of management. For eg., purchase of sundry materials.

4. Group and individual decisions: If the decision is taken by one person, it is calledindividual decision. Group decisions are taken by a group of persons.

5. Policy and operating decisions: Policy decisions are made at top management levels. Thesedecisions are taken to determine the basic policies and goals of the organization. Operating

decisions are taken to execute the policy decisions. These decisions are taken at the middle andlower management levels and are related to routine activities of business.

6. Programmed decision: Programmed decision is otherwise called routine decision orstructured decision. The reason is that these types of decision are taken frequently and they

are repetitive in nature. Such decision is generally taken by middle or lower level managers,and has a short term impact. This decision is taken within the preview of the policy of the

organization.7. Non-Programmed decision: Non programmed structures are otherwise called strategic

decisions or basic decision or policy decision or unstructured decisions. This decision is taken bytop management people whenever the need arises. This decision deals with unique or unusual or

non-routine problems. Such problems cannot be tackled in a predetermined manner. There are noestablished methods or readymade answers for such problems.

8. Organizational decisions: Organizational decisions are decisions taken by an individual inhis official capacity to further the interest of the organization known as organizational decision.

These decisions are based on rationality, judgment and experience.9. Personal decisions: Personal decisions are decisions taken by an individual based on his

personal interest. it is oriented to the individuals goals. These decisions are based on self ego,self prestige etc.

10. Objectively rational decision: If the decision is really the correct behavior for maximizinggiven values in a given situation, then it is called objectively rational decision.

11. Subjectively rational decision: If a decision maximizes attainment relative to the actualknowledge of the subject, then it is called subjectively rational decision.


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12. Consciously rational decision: A decision is consciously rational to extend that headjustment of means to ends is a conscious process.

13. Economic model: Economic rationality implies that decision making tries to maximize thevalues in a given situation by choosing the most suitable course of action. A rational business

decision is one which effectively and efficiently assures the attainment of aims for which the

means are selected.

RATIONAL DECISION MAKING PROCESS

1. Clear and well defined goal: The decision makers has clear and well defined goal thathe is trying to maximize.

2. Uninfluenced by emotions: He is fully objective and rational uninfluenced by emotions.3. Identification of the problem: The decision makers can identify the problem clearly and

precisely.4. Alternative course of action: He must have clear understanding of alternative course of

action by which a goal can be reached under existing circumstances.5. Analyze and evaluate alternatives: He must have the ability to analyze and evaluate

alternatives in the light of the goals.6. Effectively satisfies goal achievement: He must have a desire to come to the best

solution by selecting the alternative that most effectively satisfies goal achievement.

ADMINISTRATIVE PROBLEMS IN DECISION MAKING1. The decisions taken by the management should be of sound one. The soundness of the

decisions refers to its quality and reliability. If the decisions taken are not sound then it will meanwaste of efforts and funds. The soundness of decision depends upon the sophistication of the

decision maker, the information available to him and the techniques that he can make use of.2. Another problem that is faced by the management is timing of decision. If it is not properly

timed, there is no use in taking a useful decision.3. The physical and psychological environments have their influence on decision making. If the

environment is satisfactory then there will be co-operation, proper understanding among themembers of the organization. This will provide better scope for research and analysis.

4. Effective communication of the decision is another important administrative problem of themanagement. Decisions taken should be clear, simple and unambiguous. Decision made should

be communicated to the concerned persons in the language understandable by the receiver.5. All members of an organization should be encouraged to give their opinion on various aspects

while arriving at important decisions. In most cases, top executives feel that it is below theirdignity to get their views. In such cases, decisions are taken by a few persons at the top

management level. But this is not a good practice because making decision by a few at the toplevel will create some problem in its implementation.

6. Another problem faced by the management is implementation of decision. Once a decision ismade, executive and his subordinates should take all possible steps to implement it. While

making decision, the manager may have consulted hired specialist but the finals decision will beof his own. Therefore, final responsibility lies on him. Implementation of decision involves

several steps which brings a number of problems. Manager should handle it very carefully sothat the problems can be tackled easily.

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