ENGINEERING ECONOMICS AND FINANCIAL ACCOUNTING

UNIT 1INTRODUCTION TO MANAGERIAL ECONOMICS:

Managers, in their day-to-day activities, are always confronted with several issues such as how much quantity is to be supplied; at what price; should the product be made internally; or whether it should be bought from outside; how much quantity is to be produced to make a given amount of profit and so on. Managerial economics provides us a basic insight into seeking solutions for managerial problems.ECONOMICS:

Economics deals with body of principles. It has both micro and macroeconomics. It deals about the individual, firm and whole economy.Micro economics:

It deals with theory of individual choice such as problems and decisions related to individual consumer and firms.Macro economics:

It deals with overall economy and the general economic equilibrium conditions. It is the study of ‘aggregate’ or total level of economics activity in a country.Management:Management is the science and art of getting things done through people in formally organized groups.Managerial economics:

It deals with application of economic principles to the problems of the firm i.e. it deals with problems of the firm and also the problems of the individuals in the firm alone. It is drawn from both of micro and macro economics. It refers to the firm’s decision making process.. It is called Business Economic or Industrial economics or Economics for firms. Definition of managerial economics:

It is the integration of economic theory with business practice for the purpose of facilitating decision making and forward planning.Decision making:

It is the process of selecting a particular course of action from among a number of alternatives.Forward planning:

It means establishing plans for the future. It goes along with decision making.

ECONOMICS-THEORY AND METHODOLOGY

BUSINESS MANAGEMENT-DECISION PROBLEMS

MANAGERIAL ECONOMICS-APPLICATION OF ECONOMICS TO SOLVE BUSINESS PROBLEMS

OPTIMAL SOLUTIONS TO BUSINESS PROBLEMS

NATURE / FEATURES / SIGNIFICANCE OF MANAGERIAL ECONOMICS:Close to micro economics: bcoz it is the study of individuals in business firms like consumers, suppliers, government etc.Macro touch: managerial decisions are affected by macro economic conditions of economy such as aggregate level of output, income, consumption, investment, price level, inflation and interest rate.Related to economic analysis: through the following 2 components

1. Mathematical economics: it is used to express economic theories in the firm of equation to give a functional relationship between economic variables.

Eg: To see the variables that affect the quantity demanded by the customers, the equation is Q = f (P, Y, PC, PS)

Where Q= quantity demandedP= price of commodityY= income of consumersPC &PS = price of related commodity i.e. price of complimentary and

supplementary or substitute commodities.2. Econometrics/ statistical economics: it applies statistical tools like regression

analysis to the equation.Eg: quantity demanded by consumer is related to price

Q = 100 – 2PQ= quantity demandedP= price of commodity

If the price is Rs. 5Q = 100 – 2(5) = 90 units

If the price is Rs. 2Q = 100 – 2(2) = 96 units

Interdisciplinary: managerial economic theory (techniques and tools) is drawn from various disciplines like statistics, mathematics, accounts, sociology and psychology. Therefore it is a integration of various disciplines.Managerial economics deals with application of economics: it deals with economic theory i.e. the principles of economics is applicable to business to take decision making. The theory applied to business management in the areas like Demand analysis, Production analysis, Market analysis etc.It is the study of allocation of the resources: it deals with problem of resource allocation like what to produce, how to produce and for whom to produce. It includes input allocation, output allocation and allocation of funds.It is perspective than descriptive: bcoz it is goal oriented to resolve certain business problems through the application of principles of economics and it does not try to explain concept of economics without their usuage of business situations.An integrating agent: It serves as an integral agent by co-ordinating the different areas by providing it with effective decisions.

It is normative in nature: A normative statement usually includes or implies the words ‘ought’ or ‘should’. They reflect people’s moral attitudes and are expressions of what a team of people ought to do. IT IS based on value judgments and express views of what is ‘good’ or ‘bad’, ‘right’ or ‘ wrong’. Prescriptive actions: It suggests the course of action from the available alternatives for optimal solution. If does not merely mention the concept, it also explains whether the concept can be applied in a given context on not. Applied in nature: ‘Models’ are built in ME help managers for decision-making in the areas like inventory control, optimization, project management etcProvides revenue to the government: ME insist the firms to contribute a good revenue to the government (excise duties, sales tax etc.Based on assumptions: Managerial economics is based on certain assumptions. The theory will not hold good if there is change in assumption. Therefore it is not properly applicable to universe.SCOPE OF MANAGERIAL ECONOMICS:The scope of managerial economics refers to its area of study. It covers two areas of decision making

a. Operational or Internal issuesb. Environmental or External issues

A. OPERATIONAL ISSUES:Operational issues refer to those, which wise within the business organization and they are under the control of the management. Those are:Demand Analysis and Forecasting:Demand analysis is helpful in making choice of commodity, finding the optimum level of production and determining the price of the product. It also highlights the factors which influence the demand for a product. Forecasting demand denotes an estimation of the level of demand of the product at a future period under given circumstances.Production and cost analysis:Cost analysis means a manager of a firm take business decision to see that the cost balances revenue in an optimum way. It deals with monetary terms. Production analysis deals with physical terms of the product. It expresses the relationship between the combination of input and output. Pricing decision, policies and practices: Pricing decisions is the core of ME. The success of the firm depends on accurate price decisions to compete in the market. It helps to explain how prices are determined under different types of market conditions. Resource Allocation:Managerial Economics is concerned with the problem of optimum allocation of scarce resources. Marginal analysis is applied to the problem of determining the level of output, which maximizes profit. In this respect linear programming techniques has been used to solve optimization problems.

5. Profit analysis:Profit making is the major goal of firms. Managerial economics deals with techniques of averting of minimizing risks. Profit theory guides in the measurement and management of profit.6. Capital or investment analyses:Capital is the foundation of business i.e. efficient allocation and management of capital is one of the most important tasks of the managers. Knowledge of capital theory can help very much in taking investment decisions. This involves, capital budgeting, analysis of cost of capital etc.B. Environmental or External Issues:It refers to general economic, social and political atmosphere within which the firm operates. It includes

a. The type of economic system in the country.b. The general trends in production, employment, income, prices, saving and investment.c. Trends in the working of financial institutions like banks, financial corporations,

insurance companiesd. Trends in foreign trade;e. Trends in labour and capital markets;f. Government’s economic policies viz. industrial policy monetary policy, fiscal policy,

price policy etc.MANAGERIAL ECONOMICS RELATIONSHIP WITH OTHER DISCIPLINES:Relationship with traditional economics:

Managerial economics EconomicsInvolves application of economic principles Involves body of principlesMicro in character Both micro and macroWithin micro economics it deals only with firms

Deals with problems of individual consumer, firm and overall economy

Lesser scope bcoz it covers only firms Wider scope bcoz it covers all areasME and micro economics: ME is micro in character. It make use of many of the concept provided under micro economic theory like demand and forecasting, cost and production analysis, pricing decisions etc.ME and macro economics: Macro economics focuses on overall economy and general economic equilibrium conditions. Its concept like national income, business cycle, fiscal and monetary policy, social accounting etc is used under ME.ME and accounting: Managerial Economics requires a proper knowledge of cost and revenue information for decision making. This information is effectively provided by cost and management accounting.ME and mathematics: The major problem of ME is how to maximize profit and to minimize cost through optimum use of its resources. Mathematical concepts and techniques (Geometry, Algebra and calculus) are widely used in economics logically to solve these problems. ME and Statistics: Statistical tools like probability and forecasting techniques are used in collecting data and analyzing them to take decisions during uncertainty. It make use of

correlation and multiple regressions in related variables like price and demand to estimate the extent of dependence of one variable on the other. ME and Operations Research: Operation research provides a scientific model of the system ( LPP, game theory, queuing model) and it helps managerial economists in the field of product development, material management, and inventory control, quality control, marketing and demand analysis. ME and the theory of Decision- making: The Theory of decision-making is developed to explain multiplicity of goals and lot of uncertainty which is useful to business firms to take quick decision in the case of multiple goals. ME and Computer science: Computers are used in data and accounts maintenance, inventory and stock control, supply and demand predictions. It helps reduce time and workload of managers.

TYPES OF FIRM:An organisation is a group of people working together to achieve a common goal.

The most important forms of business organisation are as follows:• Sole Proprietorship• Partnership• Joint Stock Company• Co-operative Society SOLE PROPRIETORSHIP CONCERN:

When the ownership and management of business are in control of one individual, it is known as sole proprietorship or sole tradership. It is seen everywhere, in every country. Eg: The grocery store, the vegetable store, stationery store, the STD/ISD booths etc.

It may be small or large. The individual entrepreneur supplies entire capital. He is the decision maker.

He is responsible for all good and bad things. i.e entire profit and loss belongs to himAdvantages:

Easy Formation: (easy to form sole tradership business bcoz no legal formalities is required for this business)).

Better Control: (The owner has full control over his business. Therefore effective control can be made:

Prompt Decision Making : (As the sole trader takes all the decisions himself the decision making becomes quick)

Flexibility in Operations : One man ownership makes it possible for change in operations at any time)

Retention of Business Secrets : (secrecy can be maintained since it is controlled by single individual)

Personal Attention to Consumer Needs : (proprietor take personal care of consumer needsbcoz of its functioning within a small geographical area)

Disadvantages:

Unlimited Liability :(the liability of business is to be recovered only from the personal assets of the owner not by anybody)

Expansion is prevented due to limited Financial Resources : (bcoz the ability to raise and borrow money by one individual is always limited)

Limited Capacity of Individual: (An individual has limited knowledge and skill. Therefore hasty decisions will be taken)

Uncertainty of duration : (bcoz the existence of a sole tradership business is linked with the life of the proprietor)

More risk: (bcoz entire loss has to be beared by single individual) PARTNERSHIP:

It is one where two or more persons with different ability and skills, may join together to carry on a business with a view to earn profit. These firms are governed by the Indian Partnership Act, 1932.

Advantages: Easy Formation: (A partnership can be formed without many legal formality and

expenses. Every partnership firm need not be registered) Larger Resources : (As compared to sole proprietorship, a partnership firm can pool

larger financial resources) Flexibility in operation: (There is flexibility of operation in partnership business due

to a limited number of partners) Better Management: (Partners take more interest in the affairs of business. They

often meet to discuss the affairs of business and can take prompt decision) Sharing of Risk: (loss is shared by all the partners) Better decisions: (bcoz of different skills and abilities of partners)

Disadvantages of partnership Firm : Instability: (The death, insolvency of a partner may bring about an unexpected end to

partnership) Unlimited Liability : (the liability of business is to be recovered only from the

personal assets of partners) Lack of Harmony : (Since every partner has equal right, there are greater

possibilities of friction and quarrel among the partners) Limited Capital : (As there is a restriction on the maximum number of partners to 20

the capital which can be raised is limited) JOINT STOCK COMPANY:

It is an artificial person created by law with a fixed capital, divisible into transferable shares. It is an association of persons who generally contribute money for some common purpose. The money so contributed is the capital of the company. The persons who contribute capital are its members. The proportion of capital to which each member is entitled is called his share, therefore members of a joint stock company are known as shareholders and the capital of the company is known as share capital. The total share capital is divided into a number of units known as ‘shares’. It is governed by the Indian Companies Act, 1956Eg: Tata Iron & Steel Co. Limited, Hindustan unilever Limited, Reliance Industries

Limited etc.

Characteristics: Artificial Person :( i.e. is created by law) Separate Legal Entity: (Being an artificial person, a company has an existence

independent of its members. It can own property, enter into contract and conduct any lawful business in its own name. It behaves like a human being)

Common Seal :( Every company has a common seal by which it is represented while dealing with outsiders)

Perpetual succession :( It is not affected by the death, insolvency or retirement of any of its members)

Limited Liability: (The liability of a member is limited i.e. during the winding up of the company, a shareholder is held liable only to the extent of unpaid value of his share and not liable for any other losses)

Transferability of Shares : (The members of a company are free to transfer the shares held by them to anyone else)

Formation : (A company comes into existence only when it has been registered after completing the formalities prescribed under the Indian Companies Act 1956)

Advantages of Joint Stock Company: Limited Liability :( In a Joint Stock Company the liability of its members is limited

to the extent of unpaid value of shares held by them) Continuity of existence: (It is not affected by the death or insolvency etc. of its

members) Benefits of large scale operation: (opens the scope for expansion) Professional Management: (contains different skills and efficient managers) Social Benefit: (A joint stock company offers employment to a large number of

people)Disadvantages of Joint Stock Company:

Formation is not easy: (due to number of legal formalities under the companies Act) Control by a Group: (controlled by a group of persons known as the Board of

Directors. Therefore delay in decision making exist) Excessive government control : (A company is expected to comply with the

provisions of several Acts. Non-compliance of these invites heavy penalty) TYPES:

On the basis of INCORPORATIONa. Chartered companies: These companies are established by a special sanction of head

of state having special powers and rules. Eg: British East Indian Co., Bank of England.

b. Statutory companies: Formed by special act of parliament or state legislative. Their objectives, powers and activities are determined by special law. Eg: RBI, SBI, IDBI ETC.

c. Registered companies: Established under Indian companies act. Eg: Bombay dyeing, TISCO etc.On the basis of LIABILITY

a. Unlimited liability companies: liability of the members is unlimited like partnership and sole proprietorship firm.

b. Limited liability companies: it is divided into 2Company limited by guarantee: liability of the shareholders is limited to specific amount guaranteed by them according to the specified ratio during winding up of the company.Company limited by shares: liability of the shareholders is limited to the unpaid value of the shares and not for anything else during winding up of the company.

On the basis of OWNERSHIPa. Public company: a public company is one wherein

There is no restriction in the transferability of sharesMaximum number of shareholders is not limited to 50Invite public to subscribe for its shares or debentures through prospectus.Eg: Bajaj auto, BHEL etc

b. Private company: a private company is one which is not a public company. i.e. is does not contain the features of public company.Eg: Reliance Industries limited, Tata, Godrej etc

FEATURES PUBLIC PRIVATETransferability of shares

There is no restriction in the transferability of shares

There is a restriction in the transferability of shares i.e. it takes place between 50 members.

Prospectus Invite public to subscribe for its shares or debentures through prospectus

Does not invite public to subscribe for its shares or debentures through prospectus.

Members Minimum – 7 maximum no limit

Minimum – 3 maximum - 50

Number of Directors 3 2Control Directly controlled by

governmentIndirectly controlled by government

c. Government Company: it is one of the types of public company. A company whose at least 51% of paid up capital is held by government is called government company.Eg: BHEL, Indian oil corporation, Telephone etc.

d. Holding company: a company which holds more than 50% of share capital of another company is called holding company. it has control over the board of directors of subsidiary company.

e. Subsidiary company: a company whose 50% of the share capital is holded by another company is called subsidiary company.

f. Forging Collaboration Company: it is an enterprise jointly owned, managed and controlled by both Indians and foreigners. It combines the resources of both the companies. Eg: HUL, Bajaj Alliance etc

g. Multinational companies: it operates in many countries i.e. it has branches in many countries and usually very large in size. Eg: Coke, Pepsi, Ponds, Broke bond etc

COOPERATIVE ENTERPRISES:A co-operative society is formed particularly to provide services to its members and to

the society. Individuals, producers, consumers, farmers etc. who are in need and wish to protect themselves form co-operatives.Features :

It is a body corporate that enjoys certain privileges like a joint stock company. Its primary objective is to render services to its members in particular and society in

general. Its management is mostly democratic in nature. Its major finance is raised through government loans, grants, subsidies and outside

donations.

OBJECTIVES / GOALS/ OF A FIRM: It is divided into two, main objective and alternative objectives. This can be explained with the following theories.

Main objective - profit maximisation theoryAlternative objectives - Baumol’s sales revenue maximisation theory

Marri’s growth maximisation model William’s model of managerial utility theory Behavioural theories

Simon’s satisficing model Cyert and march model

PROFIT MAXIMISATION THEORY OR THEORY OF FIRM:Assumption:

Firm has a single goal i.e. profit maximisation Firm has perfect knowledge of all relevant variables at the time of decision making Firm is a sole proprietary concern

Short run profit maximisation:It is defined as a period where adjustments to changed conditions are only partially

made not completely made.Eg: if demand for the product is increases, in short run a firm can meet the demand by

changing its man hours and optimum utilisation of its machinery.Long run profit maximisation:

It is defined as a period where adjustments to changed conditions are completely made.

Eg: if demand for the product is increases, in long run a firm can meet the demand by purchasing additional machinery and appointing more employees.

There is no exact time period for short run and long run. It varies according to the type of industry.

Eg: for furniture shop to meet demand in long run changes will be made within 3 months but for automobile it take few years to change.Relationship between short run and long run profit maximisation:

Long run consists of number of short run. But there is no match between short run and long run i.e. if the firm maximises its profit in the short run it is not able to maximises its profit in long run. The reason is,

Increased profit in short run insist he employees to demand higher wages in long run Increased profit in short run attract government to put higher tax in long run Decreased profit in short run (due to attract customer the firm may charge less price

for their product) may increases the profit in the long run.Determination of profit maximising output and price:

This is calculated either as a difference between TR and TC or MR and MC. Total cost: it is the total actual cost incurred on the production of goods and

services. Total revenue: it is the total revenue acquired on the sale of goods and services. Average cost and average revenue: it is not an actual cost. It is obtained by

dividing the total cost by total output. i.e. TC/ QSimilarly average revenue is obtained by dividing the total revenue by total sales. i.e. TR/ S

Marginal cost: it is defined as changes in TC as a result of producing one additional unit of a commodity. i.e. MC = Tcn – TCn-1

Marginal revenue: it is defined as changes in TR as a result of selling one additional unit of a commodity. i.e. MR = TRn – TRn-1

Eg: TC of producing 100 units is Rs. 2500 and TC of producing 101 units is Rs. 2550. Therefore

MC = 2500 – 2550 Rs.50

Economist Rule is TC = TR and MC = MR to have profit maximisation.

The figure shows TR and TC of different levels of output. OQ2 is the output which gives maximum profit when the gap between the TR and TC is maximum i.e. when the difference between the TR and TC is maximum; the output level OQ2 gives maximum profit where the slopes of the two curves are equal.

The slopes of TC and TR curves are MR and MC, it implies the profit is maximised at that level of output where MR = MC.

MR and MC meet at point E and the corresponding output is OM units. i.e. MR = MC Suppose if the output is less than OM, MR is greater than MC, the profit is higher but

it cannot be maximised (bcoz our rule is MR = MC). Now the firm increases its output to maximise its profit.

Suppose if the output is greater than OM, MR is less than MC, the firm is losing its profit. Now the firm decreases its output to maximise its profit.

Hence the most profitable position is OM, where MR = MC The maximum profit is represented by the shaded rectangle PQRS.

Critique of PM theory: Divorce of ownership from control: firm’s ownership is vested with shareholders and

their objective is to maximise profit, firm’s control is vested with managers and their objective is to maximise sales to have goodwill, job security good salary. Therefore manager objective is different from owner objective.

Difficulties in pursuing PM: Bcoz short run PM is not matching with long run PM. Problems in the measurement of profit: i.e. whether to measure as accounting profit or

economic profit Social responsibility of firm: apart from PM firm’s objective is to serve the society by

giving quality products at low cost. Deliberate limitations of profit: firm intentionally shows low profit even though it

earn higher profit to discourage their workers to demand higher wages.Advantages of PM theory: PM is essential for firm’s survival Achieving other objective depends on PM There is lot of evidence that is proven by the researcher relating to PM theory PM theory has a greater predicting power for the future status of the business

ALTERNATIVE OBJECTIVES OF A FIRM:

BAUMOL’S THEORY OF SALES REVENUE MAXIMISATION: Baumol pointed out that in a competitive market firm’s aim is to maximise

revenue through maximisation of sales.

According to him sales volume shows the growth of business and increases prestige of firm and also determines market leadership during competition.this cannot be shown by PM theory.

Owner’s goal is different from manager’s goal. Goal of manager is directly related with sales maximisation and not a profit.

Assumptions: Goal of a firm is sales maximisation keeping in view of profit constraint(it

means minimum level of profit to satisfy shareholders) Concept is applicable to oligopolistic firms(few number of firms that compete

with each other) Advertising is the major instrument to maximise sales i.e. ∂R/∂a > 0 Price of the product is constant Production cost is independent i.e. advertising cost is not included with it.

Profit constraint is shown by a line ∏ Sales maximiser will keep on selling till MR remains positive. So the sales

maximiser’s level of output would be OQ1, where MR =0 i.e. ∂(TR)/∂Q = 0. If minimum profit constraint (∏0) is above the level of profit (at point K1), the sales

maximiser is constrained to stop at OQ3 output where minimum profit constraint ∏0 is met.

If minimum profit constraint is below the level of output (at point K3) then sales maximiser will face no profit constraint and he would therefore produce OQ1 output to increase sales and also to have a profit constraint.

Advantages: SM increases good will of the firm It also strengthens firm’s competitive spirit Increases market position Manager’s performance is evaluated only through sales target not by profit.

MARRI’S GROWTH MAXIMISATION MODEL:

This theory says that the objective of owners and managers can be achieved only through growth maximization of the firm(G)G depends on 2 components:

Growth rate of demand of product (GD) Growth rate of capital of a firm (GC)

Hence the growth rate of a firm will be balanced only GD and GC grows at the same rate. i.e.

G = GD =GCConstraint of this model:

Managerial constraint: Marri says that skill, efficiency and sincerity of managers are essential for the firm’s growth, if not means we can’t able to achieve growth maximization.

Financial constraint: lack of appropriate allocation finance affects firm’s growth. It includes

Debt equity ratio = value of debt / total assets The exact proportion has to be made by the firm while issuing debt and equity to its shareholders.

Liquidity ratio = liquid assets / total assets Increase in liquidity affects firms growth rate and decrease in liquidity shows insolvency of a firm

Retained earnings ratio = retained earnings / total profit If it increases it won’t keep shareholders happy and if it decreases it will not help the firm during dangerous situations.

WILLIAM’S MODEL OF MANAGERIAL UTILITY:o Utility refers to capacity of a commodity to satisfy human want. Managerial

utility refers to satisfaction of a manager related to salary, job, status etco In william’s model manager are free to pursue their own self-interest once

they have achieved a level of profit that will pay satisfactory dividend to shareholders.

o Manager see the goal so as to maximize their own utility function or self-

interest.o Utility function of manager is divided into 2 types

Measurable factors = manager’s salaryNon–measurable factors = job security, status and job satisfaction

Therefore manager’s objective is shown as,UM = f(S, M, ∏d)

Where UM = manager’s utility, S = Salary, M =emoluments and ∏d = discretionary profit (Discretionary profit = actual profit – minimum profit – tax)

Therefore manager will maximize their utility function by minimizing the profit of shareholders. I.e. Increase in one will lead to decrease in others. If the profit of shareholder increases the job security of manager will be endangered.

BEHAVIOURAL THEORIES:It has 2 theories

SIMON’S SATISFICING MODEL:This model says that modern business faces a big challenge

because of lack of information and uncertainty. Due to this the firm can achieve only a satisficing level of profit and sales than maximum level of profit and sales.

According to Simon manager set an aspiration level then try to achieve it. If the performance exceeds the aspiration level their satisfaction is increased and vice versa.

CYERT AND MARCH MODEL:It is the extension of Simon model. According to this model

every firm need to have multi goals and multi face activities.Apart from dealing with inadequate information and

uncertainties, manager has to satisfy stake holders like employees, customers, shareholders, suppliers, financiers, accountant and government.

Stakeholders have conflicting goals. This model is also called satisficing model. Satisficing refers to satisfying all groups of people. Therefor a firm has to fix variety of goals like inventory goal, production goal, market share goal, profit goal, sales goal etc to satisfy all groups of people.

MANAGERIAL ANALYSIS/ DECISION ANALYSIS:DECISION MAKING:MEANING: It is the process of selecting a particular course of action from among a number of alternatives.TYPES:

Organisational DM: It is taken by executives and delegated to others in the organisation

Personal DM: it is also taken by executives but not delegated to others Routine DM: short term in nature. Strategic DM: long term decisions and should be taken carefully Programmed DM: it is structured, systematic and procedurally framed decisions Non – programmed DM: it is unstructured, unsystematic and not procedurally

framed decisions; Operating DM: decisions taken for lower level employees Individual DM: taken only for a single individual Group DM: taken for a particular group of employees.

PROCESS:

DEFINITION OF PROBLEM

ANALYSIS OF PROBLEM

DEVELOPING ALTERNATIVE SOLUTIONS FEEDBACK AND FOLLOW UP

DM UNDER DIFFERENT STATUS OF NATURE: DM under Certainity:

Manager has a complete knowledge of DM environment. 100% accuracy in prediction Exact result is known in advance Full information is provided Conditions of certainity is routine and repetitive in nature

Eg: allocation of resources to various product lines. DM under Risk:

Most of the organizational decisions are made under risk Information is incomplete Results / outcomes are not totally known Decision maker has to select the outcome which will produce best possible

resultsEg: probability of absenteeism

DM under Uncertainity: Probability of possible outcomes is Unknown. Lack of knowledge in prediction No past experience and no information is provided

Eg: marketing of new productDECISION ANALYSIS:

It is a logical and systematic way to address a wide variety os problems involving DM in an uncertain environment.TOOLS OF DA:

I. DECISION MODELS: it describes the steps involved in DM.1. Rational DM model:

- Identifying the problem- Generating alternative solutions- Evaluating the alternatives- Selecting the best solution- Implementing the solution

It includes 2 models Economic man model: This model says that people are economically rational.

They attempt to maximize outcomes in an orderly and sequential process i.e.

EVALUATION OF ALTERNATIVES

SELECTING THE BEST ONE

IMPLEMENTATION

people will select the decision that has greatest advantage from among the alternatives.

Simon’s bounded rationality model/ administrative man model/ normative model: It assumes people seek a kind of bounded rationality in decisions. This model is also called as satisficing model. i.e. people will select the alternative that is good enough and realistic.Steps:

- Various alternatives are identified and evaluated sequentially. i.e. if first solution fails next will be considered.

- Use of heuristics – it means selecting the alternative that has high probability of yielding satisfactory solution.

- Satisfied alternative is selected.2. Political DM model: It assumes that people bring preconceived bias into the decision

making situations. Self-interest may block people making most rational choice. Sometimes it is difficult to determine whether decision maker is operating rationally or politically.

II. DECISION TREE: it is used for identifying the available alternatives and the risk and outcome associated with each alternative.

PRINCIPLES OF MANAGERIAL ECONOMICS/ FUNDAMENTAL CONCEPT THAT AIDS DM OF A FIRM:Economic principles assist in rational judgment. They develop logical ability and strength of a manager. Some important principles of managerial economics are:

1. Incremental Principle and decision rule:

Incremental concept involves estimation of impact of decision alternative on cost and revenue resulting from changes in price, product, procedures, investment etc.

Incremental cost refers to changes in TC due to changes in total outputIC = C2 – C1 = ∆C Where IC = Incremental cost, C1 = old TC, C2 = new TC

Incremental revenue refers to changes in TR due to changes in total sales.IR = R2 – R1 = ∆RWhere IR = Incremental revenue, R1 = old TR, R2 = new TR

Eg: if the price of selling pen is reduced from Rs. 5 to Rs. 4,then sales increases from 1000 units to1500 units. Therefore incremental revenue is

IR = 6000 – 5000 = 1000 rupees IC and IR simply measure the difference between the old and new revenue and cost. Incremental principle states that a decision is profitable

- if revenue increases more than costs;- if costs reduce more than revenues- if increase in some revenues is more than decrease in others and - if decrease in some costs is greater than increase in others

2. Marginal principle and decision rule:

Marginal analysis implies judging the impact of a unit change in one variable on the other

Marginal cost refers to change in total cost as a result of producing one additional unit of a commodity.

MC = Tcn – TCn-1 Marginal revenue refers to change in total revenue as a result of selling one

additional unit of a commodity.MR = TRn – TRn-1Eg: TC of producing 100 units is Rs. 2500 and TC of producing 101 units is Rs. 2550. Therefore MC = 2500 – 2550 Rs.50Economist Rule is MC = MR to have profit maximisation

The decision of a firm to change the price would depend upon the resulting impact/change in marginal revenue.

3. Contribution analysis and decision rule:The contribution of a business decision is defined as the difference between

the incremental revenue and the incremental cost associated with that particular decision. It is applied to analyse the contribution made by a business to work out the net result of that business.it is the technique used to take decision regarding

- Whether to accept or reject project- Whether to introduce or not to introduce product- Whether to make or buy a raw materials etc

Eg: Suppose if the firm gets an order to produce a product and the revenue to the company for that order is Rs. 7000. The cost involved in producing that product is,

Material cost - Rs. 4000Labour - Rs. 3000O/H - Rs. 300Selling & advertising - Rs. 1400Total cost Rs. 8700

Profit is lesser that cost. Therefore based on some assumptions we will change the TC is known as IC

Material cost - Rs. 4000Labour - Rs. 2000O/H - Rs. 100Selling & advertising - Total cost Rs. 6100

Here the firm gets a profit of Rs. 900. Therefore the order is accepted.

4. Equi-marginal Principle and decision rule:

Equi-marginal utility states that a consumer will reach the stage of equilibrium when the marginal utilities of various commodities he consumes are equal.

It states that the consumer will spend his money-income on different goods in such a way that the marginal utility of each good is proportional to its price, i.e.,

MUx / Px = MUy / Py = MUz / Pz Where, MU represents marginal utility and P is the price of good.

Similarly, a producer who wants to maximize profit (or reach equilibrium) will use the technique of production which satisfies the following condition:

MRP1 / MC1 = MRP2 / MC2 = MRP3 / MC3 Where, MRP is marginal revenue product of inputs and MC represents MCIt states that the input should be allocated in sucha way that the value added by

the last unit is the same in all cases. Eg: Suppose a firm is involved in 4 activities A,B,C,D. Each activity is having 25 labour and

producing same level of output. If the firm increases the labour in B activity an increase in output will result is called “Marginal product of labour”. Likewise if the firm increases the labour in other activities it has to get the same level of output what is achieved in activity B is called Equi marginal principle. Thus a manager can make rational decision by allocating resources in a manner which

equalises the ratio of marginal returns and marginal cost.

5. Opportunity Cost Principle and decision rule:It means sacrifice of alternatives. If there is no sacrifice there is no cost. It

means that cost of using something in a particular venture is the benefit foregone by using it in its best alternative use.

Eg 1: Suppose if a firm is decided to start a new project. It has 4 options. The profit involved in 4 projects is A = 10000, B = 9000, C = 8000 and D = 7000.

Here the firm will choose project A and sacrifices others. The sacrificing cost of other project is known as opportunity cost.

Eg 2: Suppose a person decided to organize his own business by resigning his present job which gives salary of Rs.50000 per month. The opportunity lost (earning Rs. 50,000) will be the opportunity cost of running his own business.

6. Time Perspective Principle and decision rule:

Time plays an important role in economic especially in the field of pricing. It is introduced by Marshall. He perceived that market is formed on the bass of time period.

Short-run refers to a time period in which some factors are fixed while others are variable. The production can be increased by increasing the quantity of variable factors.

While long-run is a time period in which all factors of production can become variable. Entry and exit of seller firms can take place easily.

From consumers point of view, short-run refers to a period in which they respond to the changes in price, given the taste and preferences of the consumers, while long-run is a time period in which the consumers have enough time to respond to price changes by varying their tastes and preferences.

7. Discounting Principle and decision rule:

This principle values the money at different time periods i.e. a rupee received today is more worth than a rupee received tomorrow.

So we have to discount the future value of the money tom make it comparable with the present value of the money. i.e.

FV = PV*(1+r)t Where, FV is the future value, PV is the present value , r is the discount (interest) rate,

and t is the time between the future value and present value. This principle is useful in making effective decision regarding investment in various

projects.