PEM C4 - Students

11/1/2023
CHAPTER 4: Principles of economic management
Why do Managers need to know Economics?

• Contribute in building analytical models, which help to recognize the
structure of managerial problems
• Enhance analytical capabilities of business analyst
• Offer clarity to various concepts used in businessanalysis, which
enables the managers to avoidconceptual pitfalls
Ten Principles of Economics

• Resources are scarce
• Scarcity: the limited nature of society’s resources
• Society has limited resources
• Cannot produce all the goods and services people wish to have
• Economics
• The study of how society manages its scarce resources
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Ten Principles of Economics

• Economists study:
• How people decide what to buy,
how much to work, save, and spend
• How firms decide how much to produce,
how many workers to hire
• How society decides how to divide its resources between
national defense, consumer goods, protecting the environment,
and other needs
Summary of economics principles

• Fundamental lessons about individual decision making:
• People face trade-offs among alternative goals
• The cost of any action is measured in terms of
forgone opportunities
• Rational people make decisions by comparing
marginal costs and marginal benefits
• People change their behavior in response to the
incentives they face

• Fundamental lessons about interactions among people:
• Trade and interdependence can be mutually
beneficial
• Markets are usually a good way of coordinating
economic activity among people
• The government can potentially improve market
outcomes by remedying a market failure or by
promoting greater economic equality
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• Fundamental lessons about the economy as a whole:
• Productivity is the ultimate source of living standards
• Growth in the quantity of money is the ultimate source of
inflation
• Society faces a short-run trade-off between inflation and
unemployment
Basic principles for managerial decision making

• Time Perspective Principle
• Discounting Principle
• Opportunity Cost Principle
• Marginal Principle
• Equi - Marginal Principle
• Incremental Principle
Time Perspective Principle

• Short run & Long run time periods play an important role in Business
decisions
• Short run mean that period within which some of inputs cannot be
altered (fixed inputs). However in long run all inputs can be altered so
they are variable in long run
• Determination of time perspective is of great significance where
projections are involved
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Discounting Principle
• A pound now is worth more than a pound earned a year after
• To take decision regarding investment which will yield return over a
period of time it is necessary to find its present worth by using
discounting principle
• This principle helps to bring value of future pounds to present pounds
• PV=1/(1+i)
Opportunity Cost
• Related to alternative uses of scarce resources
• Opportunity cost of availing an opportunity is the expected
income foregone from second best alternative
• Difference between actual earning and its opportunity cost is
called economic gain.
Opportunity Cost - Illustration

Assume that through buying the switches, Baron Company
can use the released productive capacity to generate
additional income of $38,000 from producing a different
product. This lost income is an additional cost of continuing
to make the switches in the make-or-buy decision.
Net income
Make Buy Increase
(Decrease)
Total annual cost $225,000 $250,000 $(25,000)
Opportunity cost 38,000 0 38,000
Total cost $263,000 $250,000 $13,000
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Marginal Principle
• Refers to change (increase or decrease) in total of any quantity due to
a unit change in its determinant.
• The marginal value of a dependentvariable is the change in this
dependent variable associated with a 1-unit change ina particular
independent variable.
• MC = TCn - TCn-1
• MR = TRn - TRn-1
• Decision Rule for Profit Maximization: MR > MC
Equi - Marginal Principle

• Deals with allocation of resources among alternative activities
• According to this principle an input should be employed in different
activities in such proportion that the value added by last unit is the
same in all activities or marginal products from various activities are
equalized.
• MPA = MPB =MPC =…MPN
Incremental Principle
• Applied to business decisions which involve a large change in total
cost or total revenue
• Incremental cost can be defined as the change in total cost due to a
particular business decision i.e change in level of output, investment,
etc.
• Includes both fixed & variable cost but does not include cost already
incurred i.e sunk cost
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Incremental Principle
• Incremental revenue is a change in total revenue resulting from a
change in level of output, price, etc
• A business decision worthwhileness is always determined on the
basis of criterion that incremental revenue should exceed incremental
cost
• Decision rule: TC < TR
Types of Incremental Analysis

Common types of decisions involving incremental
analysis:
1. Accept an order at a special price
2. Make or buy component parts or finished products
3. Sell or process further
4. Repair, retain, or replace equipment
5. Eliminate an unprofitable business segment or product
How Incremental Analysis Works

Important concepts used in incremental analysis

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11/1/2023

CHAPTER 4: Principles of economic management

Why do Managers need to know Economics?

Ten Principles of Economics

Ten Principles of Economics

Summary of economics principles

Summary of economics principles

Summary of economics principles

Basic principles for managerial decision making

Time Perspective Principle

Opportunity Cost - Illustration

Equi - Marginal Principle

Types of Incremental Analysis

How Incremental Analysis Works

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