Chapter 1

An Introduction to Managerial Economics: Nature and Scope

Short Answer Questions

1. Define managerial economics.

2. What are the differences between microeconomics and macroeconomics?
3. What is the purpose of studying managerial economics?
4. How does a firm makes use of managerial economics to
(a) decide on the price of the product.
(b) estimate the demand for the product.
5. How does a firm makes use of managerial economics to
(a) choose the technique of production.
(b) determine its advertising expenditures.

Answers to Short Answer Questions

Answer 1: Economics is concerned with the optimum utilization of the resources of

the economy to satisfy human wants. But while wants are unlimited, the resources, in
more simple terms, the factors of production like land, labour, capital and natural
resources are limited. The crux of the problem is that the limited resources have to be
utilized to satisfy the unlimited human wants. This gives rise to the economic
problem of scarcity. Hence given the limited resources, a choice has to be made at
every stage. The three economic problems of what to produce, how to produce and
for whom to produce have to be tackled by every economy. Knowledge of economics
is crucial in finding a viable solution to these problems.

Managerial economics is that discipline which requires application of economics in

the complex business decision-making process to formulate and achieve the rational
managerial objectives.

Answer 2: Microeconomics is that branch of economics which analyzes the market

behaviour and decision-making process of the individual consumers and firms and
also the interactions between individual buyers and sellers. Microeconomics focuses
on the demand, supply and equilibrium and also the determination of price and output
in individual markets.

Macroeconomics, on the other hand, is the study of how the national economy as a
whole grows and the changes which occur over time. Thus, it analyses the big or the
macro picture. Hence, the basic concerns of macroeconomics are to measure as to
how well an economy is performing, as to how the economy works and then to try to
improve the performance of the economy. Thus, macroeconomics deals with the big

Managerial Economics by Vanita Agarwal 1 Copyright 2013 Dorling Kindersley (India) Pvt. Ltd
 issues like price stability or inflation and full employment or unemployment.

Microeconomics and macroeconomics are both intertwined. By improving their

knowledge of certain phenomena, economists can help individuals and nations in
making more efficient decisions in allocating the resources. It is important to note that
what microeconomics takes as given, the total output, the total employment and the
total expenditure on the goods and services, macroeconomics takes it as one of its
most important variables. On the other hand, what macroeconomics takes as given,
the distribution of the total output, the total employment and the total expenditure
among the goods and services of the different firms and the different industries,
microeconomics takes it as a variable to be determined.

Answer 3: It was not long ago that the business scenario was dominated by a few
business houses that were in complete control of the industrial sector in India. The
impact could be seen even in the other sectors of the economy like finance.

Once the economy started growing and the complexities of business increased, it
became necessary to apply economics with its different theories, concepts and tools to
solve the diverse economic problems faced by the firm. It was then realized that
knowledge of economics would be more appropriate in solving these problems
relating to the consumer, the market and various other aspects. It was felt that a
manager should be equipped with the tools of economics if he has to be successful.
Hence, it was realized that the knowledge of economics is increasingly relevant for a
manager. It was obvious that a professionally trained manager could certainly
perform better than one who lacked the necessary knowledge.

Answer 4. Managerial economics can be applied by a firm in making its business

decisions.
(a) When a firm is planning on its production, it has to determine the price of the
product. This will depend on the structure of the market. If there exists perfect
competition then the firm will be just a price taker. However, if there is monopoly
then the firm will have some control over the price. Hence, the determination of
the price involves an understanding of the different market structures.
(b) The firm will have to forecast and estimate the demand for the product to be able
to decide on the level of output of the product. The managers will have to foresee
and provide for future increases in the demand for the product. This involves an
understanding of the nature of demand and the ability to forecast demand.

Answer 5: Managerial economics can be applied by a firm in making its business

decisions. These decisions include the following:
(a) The manager will have to make the crucial decision as to whether to use a labour
intensive technology or a capital intensive technology. The decision will, to some
extent, depend on which factor of production is more readily available and is in
abundance in the economy. This involves an understanding of the cost and
production analysis.

Managerial Economics by Vanita Agarwal 2 Copyright 2013 Dorling Kindersley (India) Pvt. Ltd
 (b) Under imperfect competition often, to sell its product, a firm may have to resort to
advertising. It will have to decide on the amount of expenditure to incur on
advertising, the medium of information to be used whether television, newspapers
and others such decisions. This involves an understanding of the optimum
advertising expenditure under monopoly, monopolistic competition and
oligopoly.

Long Answer Questions

1. What is managerial economics? Discuss.

2. The three economic problems of what to produce, how to produce and for
whom to produce have to be tackled by every economy. Comment.
3. How are microeconomics and macroeconomics related to managerial
economics? Analyse.
4. What are the crucial business decisions that a firm has to make? How can a
firm apply managerial economics in making these decisions? Discuss.
5. To resolve the three basic economic problems of what, how and for whom to
produce what are the areas of micro and macroeconomics that a manager
should be familiar with?

Answers to Long Answer Questions

Answer 1: Economics is concerned with the optimum utilization of the resources of the
economy to satisfy the human wants. But while wants are unlimited, the resources or in
more simpler terms, the factors of production like land, labour, capital and natural
resources are limited. The crux of the problem is that the limited resources have to be
utilized to satisfy the unlimited human wants. This gives rise to the economic problem of
scarcity. Hence given the limited resources, a choice has to be made at every stage. The
three economic problems of what to produce, how to produce and for whom to produce
have to be tackled by every economy. Knowledge of economics is crucial in finding a
viable solution to these problems.

Managerial economics is that discipline which requires application of economics in the

complex business decision-making process to formulate and achieve the rational
managerial objectives.

Answer 2: Every economy has to tackle the three economic problems of what to
produce, how to produce and for whom to produce.

As far as the problem of what to produce is concerned it involves various decisions.

Firstly, the decision has to be made as to which goods are to be produced and once that
decision has been made then it has to be decided as to what quantities of those goods
should be produced.

Managerial Economics by Vanita Agarwal 3 Copyright 2013 Dorling Kindersley (India) Pvt. Ltd
 The second basic economic problem of how to produce involves the selection of the
technique of production. A technique of production relates to the combination of the
factors of production used to produce a good. The technique may be labour intensive,
using more of labour or it may be capital intensive using more of capital. It is important
to note that the more advanced techniques are generally more productive but they are
more capital intensive. While making the decision on how to produce a good, it is
imperative that the manager should utilize in an efficient manner the scarce resources,
using labour intensive techniques in an economy where labour is in abundance, and
capital intensive techniques in an economy where capital is in abundance.

The third basic economic problem of for whom to produce relates to the distribution of
the national product between the members of the society. This problem occurs because
while on the one hand, wants are unlimited, on the other hand, the resources are scarce.
Therefore, the crucial decision has to be made as to the distribution of the national
product.

Answer 3: As already discussed, since our resources are limited in comparison to our
wants and needs, both individuals and nations will have to make decisions as to the goods
and services they can purchase and the ones they have to forgo.

So, due to the problem of scarcity, individuals and economies have to make decisions in
the allocation of their resources. Economics seeks to study as to why we make these
decisions and how we can allocate our resources most efficiently. Managerial economics
involves the organization and allocation of a firms limited resources to achieve its
objectives. Managerial economics is the application of economics to business decisions to
achieve the firms desired objectives using its limited resources.

Managerial economics can be thought of as applied microeconomics though to some

extent macroeconomics is also relevant at some stages. It focuses on those topics of
microeconomics which are of more interest and importance to managers in their day to
day decision making. If applied rationally, the principles relating to, for example, the
behaviour of the firms and consumers in the economy can be of immense help to the
manager in making his decisions and in achieving the objectives of the firm.

The principles of managerial economics can be used by the firm in many ways. It can
help the firm in an efficient allocation of resources. In case there is a change in the price
of a factor, say capital, the firm can make use of the principles of managerial economics
to decide whether to substitute by other inputs, for example the cheaper factor labour, in
the production of a good.

Economics is a tool in the hands of the manager which helps in sharpening his skills and
in making efficient decisions.

Answer 4: Managerial economics can be applied by a firm in making its business

decisions. These decisions include the following:

Managerial Economics by Vanita Agarwal 4 Copyright 2013 Dorling Kindersley (India) Pvt. Ltd
 (a) Decision regarding the price: When a firm is planning on its production, it has
to determine the price of the product. This will depend on the structure of the
market. If there exists a perfect competition then the firm will be just a price
taker. However, if there is monopoly then the firm will have some control over
the price. Hence, the determination of the price involves an understanding of the
different market structures.
(b) Forecasting and estimation of the demand for the product: The firm will have
to forecast and estimate the demand for the product to be able to decide on the
level of output of the product. The managers will have to foresee and provide for
future increases in the demand for the product. This involves an understanding of
the nature of demand and the ability to forecast demand.
(c) Choice relating to the technique of production: The manager will have to make
the crucial decision as to whether to use a labour intensive technology or a capital
intensive technology. The decision will, to some extent, depend on which factor
of production is more readily available and is in abundance in the economy. This
involves an understanding of the Cost and Production Analysis.
(d) Advertising expenditures: Under imperfect competition often, to sell its product,
a firm may have to resort to advertising. It will have to decide on the amount of
expenditure to incur on advertising, the medium of information to be used
whether television, newspapers and others such decisions. This involves an
understanding of the optimum advertising expenditure under Monopoly,
Monopolistic Competition and Oligopoly.
(e) Decision relating to investment: In the long run, a firm has to decide on whether
to expand the production of the product. Hence, it has to incur capital expenditure.
This involves an understanding of the theory of capital budgeting.

Answer 5: As far as the problem of what to produce is concerned, it involves various

decisions. Firstly, the decision has to be made as to which goods are to be produced and
once that decision has been made then it has to be decided as to what quantities of those
goods should be produced. For example, the problem may relate to as to whether to
produce more of capital goods or more of consumer goods, depending on the objectives
of the economy. Once this choice has been made, the next question would arise as to, for
example, in the context of consumer goods, whether to produce more of necessities or of
luxuries. To resolve this, it is imperative for a manager to have knowledge of the
objectives of a business firm, the decision rules and the optimization process. Also a
manager should be able to conduct an analysis of demand and also be able to forecast
demand. He should also be in a position to understand the behaviour of a consumer.

The second basic economic problem of how to produce involves the selection of the
technique of production. A technique of production relates to the combination of the
factors of production used to produce a good. The technique may be labour intensive,
using more of labour or it may be capital intensive using more of capital. Hence, the
choice relating to the technique of production is a crucial decision which the manager has
to make. For this, it is necessary that he is able to evaluate the process of production and
the attached costs and then make the relevant decisions. Also he should be able to make
decisions relating to investment and capital budgeting.

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 The third basic economic problem of for whom to produce relates to the distribution of
the national product between the members of the society. In a free enterprise economy,
this will depend on the remuneration that these factors will earn from their ownership of
the different factors that they own. The owner of labour will earn wages, the owner of
land will earn rent, the owner of capital will earn interest and the entrepreneur will earn
profits. Hence to understand the distribution of the national product, the manger should
be able to understand as to how wages, rent, interest and profit are determined.
Knowledge of the market structures, general equilibrium analysis and welfare economics
will guide him as to the role he can play in the welfare of the society. It is also necessary
for him to understand the role of the government and as to how it is able to influence the
economy through taxes, subsidies and various government expenditures.

All this constitutes a part of microeconomics. But to get the complete picture, it is equally
important for a manager to have some knowledge of the economys total output,
employment and price level. Knowledge about national income and its determination will
help managements apply macroeconomics in evolving their strategic business policies
and decisions.

The manager should have a thorough knowledge of the theories of economic growth if
has to play an important role in the growth and development of the economy. A manager
deals not only with the economy of the country in which he resides but he also deals with
the other economies of the world. For this, he should have a thorough knowledge of the
international scenario relating to the theory of international trade, trade policy, foreign
exchange, balance of payments and the international monetary system.

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