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UNIT I INTRODUCTION
Managerial Economics - Relationship with other disciplines - Firms: Types, objectives
and goals - Managerial decisions - Decision analysis.
ECONOMICS
Economics is the study of how societies use scarce resources to produce valuable
commodities and distribute them among different people.
SCOPE OF ECONOMICS
1. 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 and services 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 are produced 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 of production. 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 called distribution 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. It also 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 which traces 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. For instance, economics is divided into consumption, production,
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exchange, distribution and public finance which have their laws are theories on whose
basis these departments are studied and analyzed 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, Gresham’s 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 are being
revised in the fields of macro economics, monetary economics, international economics,
public finance and economic development.
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. Economic
phenomena 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 in economics. Even though economics possess statistical, mathematical
and econometric methods 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 possible in 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 an applied 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 output satisfaction 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 goods to be produced and the means to be used for the achievement of
certain ends.
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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 different
alternative 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 and capital goods.
2. How to produce: Having decided the quantity and the type of goods to be
produced, we must next 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 of all its resources.
6. Problem of Growth: Another problem for an economy is to make sure that it
keeps expanding 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 must accelerate its process of growth.
TYPES OF ECONOMIC SYSTEM
1) CAPITALIST SYSTEM
Capitalism 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
with the 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 which helps man in the production process like machinery, tools, land, rawmaterials, etc. is owned by the capitalist class.
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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 a commodity 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 no conscious 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
own only 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 freedom granted 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 labor power.
6. Growing wealth of the capitalists: In a capitalist economy the wealth of the
capitalist class increases in a sustained manner.
7. Emergence of the working class: Under capitalism the increasing used of
machinery leads 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 take the form of the class conflict with the further development of capitalism.
2) SOCIALISM
Under socialism not only is there social ownership of the means of production but also
the 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 all dominating role of determining the type and quantity of various commodities
produces their priority sequence and the necessary allocation of resources.
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Characteristics (or) Salient features of the socialist economic system:
1. Social ownership of the means of production: In a socialist society private
ownership 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 socialism is 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.
4. Production guided by social benefit: In a socialist economy, however, income
inequalities are drastically reduced so that everyone has an adequate amount of
disposable income. 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 stage of socialism. Exploitation of man by man comes to an end.
3) MIXED ECONOMY
According to Samuelson, a mixed economy is characterized by the existence of both
public and private 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 also for productive factors, such as labor and capital.
3. Interventionist role of the state: The market mechanism is a mixed economy
may not be entirely 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
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of these enterprises 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 usually indicative in nature. Economic planning in developing economies,
in which both private and public sectors co-exists, has nothing to do with socialism.
4) LAISEZ FAIR ECONOMY
Laisez fair economy is an economic environment in which transactions between private
parties are free from government restrictions, tariffs, and subsidies, with only enough
regulations to protect property rights etc.
ENGINEERING ECONOMICS
It 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 maximizing profit, 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 of advertisement, etc.
5. Engineering economics helps in understanding the market conditions, general
economic environment 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.
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APPLICATIONS OF ENGINEERING ECONOMICS
1. 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 initial outlay 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
various insulation thicknesses, and between prices at which to sell a product.
8. It can be applied by a major corporation to analyze plans for a new
manufacturing facility 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 with individual 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 or designing 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.
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7. Economic theory conveniently ignores the significant backgrounds which are
common to individual firms but engineering economics take in to consideration the
individual firms’ environment of decision making.
8. Engineering economics provides an analytical and scientific approach resulting
in qualitative decisions.
ADVANTAGES OF ENGINEERING ECONOMICS
1. Better decision making on the part of engineers.
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 of goods 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 ECONOMICS
Managerial 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 theory and managerial practice.
CHIEF CHARACTERISTICS OF MANAGERIAL ECONOMICS
1. Managerial Economics is micro-economic in character. This is because the unit
of study is a firm; 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 apply Profit Theory which forms part of Distribution Theories in
Economics.
3. Managerial Economics is pragmatic. It avoids difficult abstract issues of
economic theory but involves complications ignored in economic theory to face the
overall situation in which decisions are made. Economic theory appropriately ignores the
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variety of backgrounds and training 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 than descriptive. The main body of economic theory confines itself to
descriptive hypothesis, attempting to generalize about the relations among different
variables without judgment about what is desirable or undesirable.
5. Macro-economics is also useful to Managerial Economics since it provides an
intelligent understanding 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 over which he has no control but which play a crucial role in the wellbeing of his concern.
SCOPE OF MANAGERIAL ECONOMICS
1. Demand Analysis and Forecasting: A major part of managerial decisionmaking depends on accurate estimates of demand. Before production schedules can be
prepared and resources employed, a forecast of future sales is essential.
2. Cost Analysis: A study of economic costs, combined with the data drawn from
the firm’s accounting records, can yield significant cost estimates that are useful for
management decisions.
3. Production and Supply Analysis: Production analysis mainly deals with
different production function 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 and function. 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, an important point worth considering is the element of uncertainty existing
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about profits because of variations in costs and revenues which, in turn, are caused by
factors both internal and external to the firm.
6. Capital Management: Capital management implies planning and control of
capital expenditure. 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 the
sacrifice 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 cost is nil. For decision-making, opportunity costs are the only relevant
costs. The opportunity cost principle may be stated as under: The cost involved in any
decision consists of the sacrifices of alternatives required by that decision. If there are no
sacrifices, there is no cost.
2. Incremental Principle: Incremental concept involves estimating the impact of
decision alternatives 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 at stake 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 resulting from 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 the short-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 the short-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 at first appeared.
4. Discounting Principle: One of the fundamental ideas in economics is that a
rupee tomorrow is worth less than a rupee today. This seems similar to saying that a bird
in hand is worth two in the bush. “If a decision affects costs and revenues at future dates,
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it is necessary to discount those costs and revenues to present values before a valid
comparison of alternatives is possible.”
5. Equi-marginal Principle: This principle deals with the allocation of the
available resources among the alternative activities. According to this principle, an input
should be so allocated that the value added by the last unit is the same in all cases. This
generalization is called the equi-marginal principle.
RELATIONSHIP OF MANAGERIAL ECONOMICS WITH OTHER
DISCIPLINES
1. Managerial Economics and Economics: Managerial 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 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 other hand, 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 in practice 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 metrical in 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 business firms. 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 certain important problems of managerial economics which are solved with the help of
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or techniques. The problems are: allocation problems, competitive problems, waiting line
problems and inventory problems.
DIFFERENCE BETWEEN MANAGERIAL ECONOMICS AND ECONOMICS
1. Managerial Economics involves application of economic principles to the
problems of the firm. Economics deals with the body of the principles itself.
2. Managerial Economics is micro-economic in character; Economics is both
macro-economic and micro-economic.
3. Managerial Economics, though micro in character, deals only with firms and
has nothing to do with an individual’s 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: other distribution 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 the specific 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 economic theory and then attempts to solve the real-life, complex
business problems with the aid of tool subjects, e.g., mathematics, statistics,
econometrics, accounting, operations research, marketing research and so on.
FIRM
Firm is a business organization, such as a corporation, limited Liability Company or
partnership. Firms are typically associated with business organizations that practice law,
but the term can be used for a wide variety or business operation units.
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It can be defined as “An Organization
owned by one or jointly by few or many
persons, which is engaged in productive activity of any kind for the motive of profit or
other well defined objective”.
TYPES OF FIRM
1) Private Sector
2) Joint Sector
a) Partnership firms
b) Joint family firms
c) Cooperative firms
d) Joint stock firms

Public limited

Private limited
3) Public Sector
a) Departmental organizations
b) Statutory corporation
c) Government companies
Goals and Objectives of the Firm
“Goals are general guidelines that explain what the firm wants to achieve in its
community. They are usually long-term and represent global visions such as “protect
public health and safety.”
“Objectives define strategies or implementation steps to attain the identified goals of the
organization. Unlike goals, objectives are specific, measurable, and have a defined
completion date. They are more specific and outline the “who, what, when, where, and
how” of reaching the goals.”
PROFIT MAXIMIZATION THEORY (The neoclassical theory)
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 a time period, both short-term. And long term. The short run is a period
where adjustments cannot be made quickly in matters of supply and demand. Long run
however enables adjustment to changed conditions.
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Profit can be defined as the difference between total revenue (TR) and total cost (TC).
Profit=TR-TC
ARGUMENTS IN FAVOUR OF PROFIT MAXIMIZATION
1. Profit is indispensable for firm’s survival: The survival of all the profit-oriented
firms 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 firm’s ability to make profit: Many
other objectives of business firms have been cited in economic literature, e.g.,
maximization of managerial utility function, maximization of long-run growth,
maximization of sales revenue, satisfying all the concerned parties, increasing and
retaining market share, etc. the achievement of such alternative objectives depends
wholly or partly on the primary objective of making profit.
3. Evidence against profit maximization objective not conclusive: Profit
maximization is a time- 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 business objectives; profit maximization assumption has been found to be a much
more powerful premise in predicting certain aspects of firm’s behavior.
5. Profit is a more reliable measure of firm’s efficiency: Thought not perfect,
profit is the most efficient and reliable measure of the efficiency of a firm.
CRITISIMS OF PROFIT-MAXIMISING THEORIES
1. 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 and control 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 objective of long-run survival of the firm, for example, the firm’s
objective to pursue ‘good-will’ in the long-run may clash with short-run profit objective.
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3. Problems in the Measurement of Profit: There are some problems about the
measurement of profit as a measure of firm’s efficiency. Profit may be the result of
imperfection in the market and profits may be the reward of monopolistic exploitation.
Worse still, profit measurement process itself is dubious.
4. Social responsibility of the firm: he firm is now-a-days not just an economic
entity concerned with production or sales alone. The firm owes a responsibility to offer
good, well paid 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 labors from asking for higher wages or to discourage
entry 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 of profit and may not expand.
The Transactions Cost Theory of the Firm
The Transactions Cost Theory of the Firm focuses on problems of asymmetric
information involved in transactions. The firm, according to this theory, comes into
existence because it successfully minimizes ‘make’ inputs costs (through vertical
integration) and ‘buy’ inputs costs (using available markets). The more specific the inputs
that the firm needs are the more likely it is that it would produce them internally and/or
acquire them through joint ventures and alliances. The weakness of this theory is that it
does not take into consideration agency costs or firm evolution, neither does it explain
how vertical integration should take place in the face of investments in human assets,
with unobservable value, that cannot be transferred.
The Principal–Agent Theory of the Firm
The Principal–Agent Theory of the Firm extends the neoclassical theory by adding agents
to the firm. The theory is concerned with friction due to asymmetric information between
owners of firms and their stakeholders or managers and employees; the friction between
agent and principal, requires precise measurement of agent performance and the
engineering of incentive mechanisms. The weaknesses of the theory are many: it is
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difficult to engineer incentive mechanisms, it relies on complicated incomplete contracts
(borderline unenforceable), it ignores transaction costs (both external and internal), and it
does not allow for firm evolution.
The Evolutionary Theory of the Firm
The Evolutionary Theory of the Firm places emphasis on production capabilities and
process as well as product innovation. The firm, according to this theory, possesses
unique resources, tied semi-permanently to the firm, and capabilities; the firm’s resources
can be classified into four categories: financial, physical, human and organizational. The
theory sees the firm as a reactor to change and a creator of change for competitive
advantage. The firm, as a creator of change, may cause creative destruction, which in turn
may give birth to new industries and enable sectors of, or entire, economies to grow.
Although many countries have established architectures to support entrepreneurial
endeavors, a weakness of the theory remains: process and product innovation (especially
the latter) are mostly due to serendipity and as a result ‘entrepreneurship’ is a very
expensive factor of production; in the pursuit of profit and general wellbeing, it cannot be
easily programmed within a firm or a nation.
DECISION MAKING
Decision 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.
CHARACTERISTICS OF DECISION-MAKING
The following are the characteristics of decision-making:
1. Decision-making is a selection process. The best alternative is selected out of
many available alternatives. If there is only one alternative, there is no decision-making.
2. Decision-making is the end process. Decision-making is preceded by detailed
discussion and selection of alternatives.
3. Decision-making is the application of intellectual abilities to a great extent. An
intelligent man alone can take a good decision.
4. Decision gives happiness to an Endeavour who takes various steps to collect all
the information which is likely to affect a decision.
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5. Decision-making is a dynamic process. An individual takes a number of
decisions each day.
.
6. Decision-making is situational. An individual takes decision according to the
situations prevailing. Different decisions may be taken to solve the same problem. The
reason is that the situation is changed from time to time.
7. Decision is taken to achieve the objectives of an organization.
8. Decision-maker has the freedom to take a decision which involves the using of
resources in specified ways.
9. Decision-making involves the evaluation of available alternatives through
critical appraisal methods.
10. A decision may be negative or positive. A decision may direct others to do or
not to do.
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 Ambiguity
1. 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.
Making decisions 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 make guess 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 to a 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 today’s complex environment
are formulated under a state of uncertainty, where there is an unawareness of all the
alternatives and so also the outcomes –even for the known alternatives. Such decisions
demand creativity and the willingness to take a chance in the face of such uncertainties.
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In such situations, decision makers do not even have enough information to calculate
degree of risk.
4. Ambiguity: The most difficult decision situation is the state of ambiguity, in
which the decision problems are not at all clear. The alternative courses of action are
difficult to identify, and the information about consequences is not available. In this state,
nothing is known for sure and the risk of failure is quite high.
STEPS IN DECISION MAKING PROCESS IN AN ORGANIZATION
1. Identification of problem: Decision making process begins with the
identification of problem that 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 of the 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 process involves classifying the problem and gathering information.
3. Search for alternatives: A problem can be solved in many ways. All possible
ways cannot be equally 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 “By recognizing 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 develop alternatives 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
than others. 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 action includes 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.
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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 in systematic 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 the indication 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 MAKING
Decision 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
1. Major and supplementary decisions: Major decisions refer to the decisions
with regard 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 these decisions 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 executive in his capacity as manager in order to achieve the best interests of the
organization. These decisions 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 a member 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 the business 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 to carry out the day-today activities are called routine
decisions. These decisions are repetitive in nature. They have only a minor impact on the
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business. These decisions are made at middle and lower levels of management. For eg.,
purchase of sundry materials.
4. Group and individual decisions: If the decision is taken by one person, it is
called individual decision. Group decisions are taken by a group of persons.
5. Policy and operating decisions: Policy decisions are made at top management
levels. These decisions 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 and lower management levels and are related to routine
activities of business.
6. Programmed decision: Programmed decision is otherwise called routine
decision or structured 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 by top 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 no established methods or readymade answers for
such problems.
8. Organizational decisions: Organizational decisions are decisions taken by an
individual in his 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 individual’s goals. These decisions are
based on self ego, self prestige etc.
10. Objectively rational decision: If the decision is really the correct behavior for
maximizing given values in a given situation, then it is called objectively rational
decision.
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11. Subjectively rational decision: If a decision maximizes attainment relative to
the actual knowledge of the subject, then it is called subjectively rational decision.
12. Consciously rational decision: A decision is consciously rational to extend
that he adjustment of means to ends is a conscious process.
13. Economic model: Economic rationality implies that decision making tries to
maximize the values 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 that he 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 MAKING
1. 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 mean waste 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
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understanding among the members of the organization. This will provide better scope for
research and analysis.
4. Effective communication of the decision is another important administrative
problem of the management. 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 their dignity 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 top level will create some problem in its implementation.
6. Another problem faced by the management is implementation of decision.
Once a decision is made, 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 be of 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 so that the problems can be tackled easily.
Important Part – A (Q&A)
1. 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 and services 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 are produced 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 of production. These efforts have to be paid for or rewarded. The land gets
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rent, the labor get wages, the capital gets interest and the organizer gets profit. This
branch of study is called distribution 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. It also studies about public debt and financial administration.
6. 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 an applied science in its practical aspects
7. Capitalism: Capitalism 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 with the 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.
8. 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 no conscious effort to arrive at some kind of solution to its central
problems.
9. Exploitation of labor: Workers are exploited under capitalism. Very often due
to the freedom granted 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 labor power.
10. 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 take the form of the class conflict with the further development of
capitalism.
11. Socialism: Under socialism not only is there social ownership of the means of
production but also the 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 all dominating role of determining the type and quantity of
various commodities produces their priority sequence and the necessary allocation of
resources.
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12. Mixed Economy: According to Samuelson, a mixed economy is
characterized by the existence of both public and private institutions exercising economic
controls.
13. 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. Making decisions under certainty assumes that the decision maker has all the
necessary information about the problem situation.
14. 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 make guess 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 to a degree of certainty. However, sufficient information
is available to allow the decision maker to ascribe the probability of successful outcomes
for each alternative.
15. Uncertainty: Most significant decisions made in today’s complex
environment are formulated under a state of uncertainty, where there is an unawareness
of all the alternatives and so also 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 makers do not even have enough information to
calculate degree of risk.
16. Ambiguity: The most difficult decision situation is the state of ambiguity, in
which the decision problems are not at all clear. The alternative courses of action are
difficult to identify, and the information about consequences is not available. In this state,
nothing is known for sure and the risk of failure is quite high.
17. Organizational and personal decision: Organizational decisions are made
by the executive in his capacity as manager in order to achieve the best interests of the
organization. These decisions 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 a member of the organization. These decisions are not
delegated. These decisions relate to the executives personal work.
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18. Policy and operating decisions: Policy decisions are made at top
management levels. These decisions 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 and lower management levels and are related to routine
activities of business.
19. Programmed decision: Programmed decision is otherwise called routine
decision or structured 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
20. Organizational decisions: Organizational decisions are decisions taken by an
individual in his official capacity to further the interest of the organization known as
organizational decision. These decisions are based on rationality, judgment and
experience.
University exam questions
Part - A
1) Define opportunity cost
2) What is time value of money?
3) List any two differences between managerial economics and economics.
4) What are the various phases of decision making?
5) Define normative economics.
6) What do you understand by the concept of discounting principle?
7) Define managerial economics.
Part – B
1)
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2)
3)
4)
5)
6)
7)
8)
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