Economic For Managers PDF

Introduction to Economics and Managerial Economics 1
Notes
Unit 1: Introduction to Economics and

Managerial Economics
Structure:
1.1 Introduction to Economics
1.2 History of Economic Thoughts
1.3 Meaning and Definitions of Economics
1.4 Problem of Choice
1.5 Fundamental Economic Concepts
1.6 Nature of Economics
1.7 Scope of Economics
1.8 Micro and Macro-Economics
1.9 Concept of Managerial Economics
1.10 Meaning and Definitionsof Managerial Economics
1.11 Nature of Managerial Economics
1.12 Scope of Managerial Economics
1.13 Roles and responsibilities of a Managerial Economist
1.14 Relationship to economic theory, decision sciences, statistics, accounting
1.15 Functional areas of Business
1.16 Objectives of Business Firms
1.17 Profit as Business Objective
1.18 Theories of Profit
1.19 Alternative objectives of Business firms
1.20 Making a Reasonable Profit
1.21 A profitable Approach
1.22 Summary
1.23 Check Your Progress
1.24 Questions and Exercises
1.25 Key Terms
1.26 Check Your Progress: Answers
1.27 Case Study
1.28 Further Readings
1.29 Bibliography
Objectives
After studying this unit, you should be able to understand:
l Overview of Problem of choice
l Concept of Economics and Managerial Economics
l Nature and scope of economics
l Concept of Micro and Macro-Economics
Amity Directorate of Distance and Online Education
2 Managerial Economics
Notes l Definition, nature and scope of Managerial Economics

l Roles and responsibilities of a managerial economist
l Relationship to economic theory, decision sciences, statistics,
accounting and functional areas of business
l Objectives of Business Firms: Profit as Business Objective
l Concept of Theories of profit
l Making a reasonable profit – A profitable Approach
1.1 Introduction to Economics

Economics is a social science that analyzes production, distribution and
consumption of goods and services. Economics aims to explain how economies work and
how economic agents interact. Economic analysis is applied throughout society, in
business, finance and government, but also in crime, education, the family, health, law,
politics, religion, social institutions, war and science. At the turn of the 21st century, the
expanding domain of economics in the social sciences has been described as economic
imperialism.
Modern Economics makes two assumptions about people’s desires for material
goods and services. First, they are Insatiable. No matter how many goods and services
people have, they still want more. Today, even the poorest Indians have more goods and
services than could have possibly been imagined by people living 200 years ago. Yet,
we still desire more and more. Second, they are Rational. People’s desires are not to
be questioned.
In order to satisfy their desires for consumer goods, the people in the society must
engage in production. To produce, people begin with natural resources. Nature provides
land, minerals, trees, water, fish, animals and so forth. Usually the people must do
something to these natural resources to satisfy their desires harvest the fruits and
vegetables, dig the minerals, cut the trees, catch the fish and so forth.
The productive contribution made by the people is called labour. However, with natural
resources and labour alone, the society will not be able to satisfy the desires of the people
very well. From earliest times, people have learned that they could satisfy their desires
better by taking some of the natural resources and converting them into a form that will
not meet desires today but which will allow greater production in the future. Thus, wood
and iron are used to make a hammer. The hammer is not desired by anyone for its own
sake, but it allows people to build more of those things they do desire.
1.2 History of Economic Thoughts

Economics is the discipline that concerns itself with economies from how
organizations produce goods and services, to how they consume them. It has influenced
world economics at many important junctions throughout history and is a vital part of the
everyday lives. The statements that guide the study of economics have changed
dramatically throughout history.
Adam Smith is widely credited for creating the field of economics; however, he was
inspired by French writers, who shared his hatred of mercantilism. In fact, the first
methodical study of how economies work was undertaken by these French physiocrats.
Smith took many of their ideas and expanded them into a thesis about how economies
should work, as opposed to how they do work.

Smith believed that competition was self-regulating and that governments should Notes
take no part in business through tariffs, taxes or any other means, unless it was to protect
free-market competition. Many economic theories today are, at least in part, a reaction
to Smith's pivotal work in the field.
Karl Marx and Thomas Malthus had decidedly poor reactions to Smith's treatise.
Malthus predicted that growing populations would outstrip the food supply. He was proven
wrong, however, because he didn't foresee technological innovations that would allow
production to keep pace with a growing population. Nonetheless, his work shifted the focus
of economics to the scarcity of things, versus the demand for them.
This increased focus on scarcity led Karl Marx to declare that the means of
production were the most important components in any economy. Marx took his ideas
further and became convinced that a class war was going to be initiated by the inherent
instabilities he saw in capitalism. However, Marx underestimated the flexibility of
capitalism. Instead of creating a clear owner and worker class, investing created a mixed
class where owners and workers hold the interests of both classes, in balance. Despite
his overly rigid theory, Marx did accurately predict one trend: businesses grew larger and
more powerful, in accordance to the degree of free-market capitalism allowed.
Leon Walras, a French economist, gave economics a new language in his book
"Elements of Pure Economics." Walras went to the roots of economic theory and made
models and theories that reflected what he found there. General equilibrium theory came
from his work, as well as the tendency to express economic concepts statistically and
mathematically, instead of just in prose. Alfred Marshall took the mathematical modeling
of economies to new heights, introducing many concepts that are still not fully understood,
such as economies of scale, marginal utility and the real-cost paradigm.
It is nearly impossible to expose an economy to experimental rigor; therefore,
economics is on the edge of science. Through mathematical modeling, however, some
economic theory has been rendered testable.
John Maynard Keynes' mixed economy was a response to charges levied by Marx,
long ago, that capitalist societies aren't self-correcting. Marx saw this as a fatal flaw,
whereas Keynes saw this as a chance for government to justify its existence. Keynesian
economics is the code of action that the Federal Reserve follows, to keep the economy
running smoothly.
The economic policies of the last two decades all bear the marks of Milton Friedman's
work. As the U.S. economy matured, Friedman argued that the government had to begin
removing the redundant controls it had imposed upon the market, such as antitrust
legislation. Rather than growing bigger on the increasing gross domestic product (GDP),
Friedman thought that governments should focus on consuming less of an economy's
capital, so that more remained in the system. With more capital in the system, it would
be possible for the economy to operate without any government interference.
Economic thought has diverged into two streams: theoretical and practical.
Theoretical economics uses the language of mathematics, statistics and computational
modeling to test pure concepts that, in turn, help economists understand the truths of
practical economics and shape them into governmental policy. The business cycle, boom
and bust cycles and anti-inflation measures, are outgrowths of economics; understanding
them helps the market and government adjust for these variables.

Notes 1.3 Meaning and Definitions of Economics

Economics is the science that deals with the production, allocation and use of goods
and services. It is important to study how resources can best be distributed to meet the
needs of the greatest number of people.
Resources include the time and talent people have available, the land, buildings,
equipment and other tools on hand and the knowledge of how to combine them to create
useful products and services.Important choices involve how much time to devote to work,
to school and to leisure, how many dollars to spend and how many to save, how to combine
resources to produce goods and services and how to vote and shape the level of taxes
and the role of government.
Definition of Economics (wealth)
According to Adam smith Economics “An Inquiry into the Nature and Causes of
the Wealth of Nations”.
According to J. B Say Economics is the science which treats wealth. F.A Walker
made it clear that economics is that body of knowledge which relates to wealth.
Definition of Economics (welfare)
According to Alfred Marshall, Economics as “a study of mankind in the ordinary
business of life; it examines that part of individual and social action which is most closely
connected with the attainment and with the use of the material requisites of well-being.
Thus it is on one side a study of wealth; and on the other and more important side, a
part of the study of man.”
Definition of Economics (growth)
Paul Samuelson, Nobel laureate in Economics in 1970, defines economics as
“the study of how a person or society meets its unlimited needs and wants through the
effective allocation of resources”.
1.4 Problem of Choice

Since are live in a world of scarcity, a society can produce only a small portion of
goods and services that its people want. Therefore, scarcity of resources gives rise to
the fundamental economic problem of choice. As a society cannot produce enough goods
and services to satisfy all the wants of its people, it has to make choices.
A decision to produce one good requires a decision to produce less of some other
good. So choice involves sacrifice. Thus every society is faced with the basic problem
of deciding what it is willing to sacrifice to produce the goods it wants the most.
For instance, the more roads a country decided to construct the fever resources will
there be for building schools. So the problem of choice arises when there are alternative
ways of producing other goods. The sacrifice of the alternative (school buildings) in the
production of a good (roads) is called the opportunity cost.
There are a number of problems that can arise from choices that are made by people,
whether they are individuals, firms or government. Choices or alternatives (or opportunity
cost) are illustrated in terms of a production possibility curve.
A production possibility curve shows all possible combinations of two goods that
a society can produce within a specified time period whose resources are fully and
efficiently employed.

PP1 is the production possibility curve in Fig. which shows the problem of choice Notes
between two goods X and Y in a country. Good X is measured on the horizontal axis
and Good Y on the vertical axis. PP cue shows all combinations of X and Y good that
can be produced by the country with all its resources fully and efficiently employed.
If the country chooses to produces more of X good, it would have to sacrifice the
production of some quantity of Y good. The sacrifice of some quantity of Y good is the
opportunity cost of producing some extra quantity of good X.
The PP1 curve is downward sloping because to produce more of good X involves
producing less of Y good in a fully employed economy. Moving from point B to D on the
PP{ curve means that for producing XX, more quantity of good X, YY quantity of good
Y has to be sacrificed.
Both point’s B and D represent efficient use of country’s resources. Point R which
is inside the bounder of PP curve implies inefficient use of resources. Point K which is
outside the boundary of PPX curve is an unattainable combination because the country
does not possess sufficient resources to produce two combination of X and Y goods.
1.5 Fundamental Economic Concepts

Economics is the study the production and distribution of goods and services; it is
the study of human efforts to satisfy unlimited wants with limited resources. The
fundamental economic concepts include:
a) Wants: Simply the desires of citizens. Wants are different from needs as we
will see below. Wants are a means of expressing a perceived need. Wants are
broader than needs.
b) Needs: These are basic requirements for survival like food and water and shelter.
In recent years we have seen a perceived shift of certain items from wants to
needs. Telephone service, to many, is a need. I would argue, however, that they
are wrong.
c) Scarcity: the fundamental economic problem facing all societies. Essentially
it is how to satisfy unlimited wants with limited resources. This is the issue
that plagues all government and peoples. How do we conquer the issue of
scarcity? Many people have thought they had the answer (see Marx, Smith,
Keynes, etc.) but the issue of scarcity still exists.
In modern times the importance of the study of economics is infinite. It is not only
provides us knowledge, but also helps to solve the different problems in real life. The
importance of economic concepts in different areas of human life is discussed below:
Notes a) In the daily life of people: People are confronted with manifold wants in their
daily life. But the resources to satisfy those wants are limited. By studying
economics we can know the use of limited resources to satisfy alternative wants
on the basis of priority.
b) In the proper use of resources: We can learn about the use of resources
with the knowledge of economics. Study of economics helps us to understand
about how to produce the maximum output by the proper use of limited
resources.
c) In state management: The knowledge of economics is indispensable to
manage the economic and development activities of a state. For this reason
the politicians and the govt. officers need to have proper knowledge of the
currency system, banking system, tax system, industrial and trade policy,
budgeting etc. The knowledge of economics helps in managing the state affairs.
d) To social workers: Economic causes lie at the roots of maximum social
problems. The social workers need to have knowledge of economics to diagnose
and solve the problems of poverty, unemployment, illiteracy, excessive growth
of population, lack of housing and medical facilities etc.
e) To the labor leaders: The leaders of the workers should have the knowledge
of economics for improving their bargaining capacity in respect of the formation
of trade unions, the increase of wage and other benefits, the improvement of
their working conditions etc. In economic planning: It is necessary to have sound
knowledge of the economic problems and the available resources for the
formulation and implementation of economic plans for the country. For this
reason the knowledge of economics is indispensable.
f) Acquisition of knowledge of international issues: The knowledge of
economics is necessary to know and understand the socio economic events
of different countries, international relationship, commerce etc.
1.6 Nature of Economics

Economics is the science that deals with production, exchange andconsumption of
various commodities in economic systems. It shows how scarceresources can be used
to increase wealth and human welfare. The central focus ofeconomics is on scarcity of
resources and choices among their alternative uses.The resources or inputs available to
produce goods are limited or scarce. Thisscarcity induces people to make choices among
alternatives, and the knowledgeof economics is used to compare the alternatives for
choosing the best amongthem. For example, a farmer can grow paddy, sugarcane, banana,
cotton etc. inhis garden land. But he has to choose a crop depending upon the availability
ofirrigation water.
Two major factors are responsible for the emergence of economic problems.They
are: i) the existence of unlimited human wants and ii) the scarcity ofavailable resources.
The numerous human wants are to be satisfied through thescarce resources available in
nature. Economics deals with how the numeroushuman wants are to be satisfied with
limited resources. Thus, the science ofeconomics centers on want - effort -
satisfaction.Economics not only covers the decision making behaviour of individuals but
also the macro variables of economies like national income, public finance,international
trade and so on.
Adam smith (1723 - 1790), in his book “An Inquiry into Nature and Causes of Wealth
of Nations” (1776) defined economics as the science of wealth. He explained how a nation’s

wealth is created. He considered that the individual in the society wants to promote only Notes
his own gain and in this, he is led by an “invisible hand” to promote the interests of the
society though he has no real intention to promote the society’s interests. Criticism: Smith
defined economics only in terms of wealth and not in terms of human welfare. Ruskin
and Carlyle condemned economics as a ‘dismal science’, as it taught selfishness which
was against ethics. However, now, wealth is considered only to be a mean to end, the
end being the human welfare. Hence, wealth definition was rejected and the emphasis
was shifted from ‘wealth’ to ‘welfare’.
Alfred Marshall (1842 - 1924) wrote a book “Principles of Economics” (1890) in which
he defined “Political Economy” or Economics is a study of mankind in the ordinary
business of life; it examines that part of individual and social action which is most closely
connected with the attainment and with the use of the material requisites of well being”.
The important features of Marshall’s definition are as follows: a) According to Marshall,
economics is a study of mankind in the ordinary business of life, i.e., economic aspect
of human life. b) Economics studies both individual and social actions aimed at promoting
economic welfare of people. c) Marshall makes a distinction between two types of things,
viz. material things and immaterial things. Material things are those that can be seen,
felt and touched, (E.g.) book, rice etc. Immaterial things are those that cannot be seen,
felt and touched. (E.g.) skill in the operation of a thrasher, a tractor etc., cultivation of
hybrid cotton variety and so on. In his definition, Marshall considered only the material
things that are capable of promoting welfare of people. Criticism: a) Marshall considered
only material things. But immaterial things, such as the services of a doctor, a teacher
and so on, also promote welfare of the people.b) Marshall makes a distinction between
(i) those things that are capable of promoting welfare of people and (ii) those things that
are not capable of promoting welfare of people. But anything, (E.g.) liquor, that is not
capable of promoting welfare but commands a price, comes under the purview of
economics. c) Marshall’s definition is based on the concept of welfare. But there is no
clear-cut definition of welfare. The meaning of welfare varies from person to person, country
to country and one period to another. However, generally, welfare means happiness or
comfortable living conditions of an individual or group of people. The welfare of an individual
or nation is dependent not only on the stock of wealth possessed but also on political,
social and cultural activities of the nation.
1.7 Scope of Economics

Scope means province or field of study. In discussing the scope of economics, we
have to indicate whether it is a science or an art and a positive science or a normative
science. It also covers the subject matter of economics.
i) Economics - A Science and an Art

a) Economics is a science: Science is a systematized body of knowledge
thattraces the relationship between cause and effect. Another attribute of
science isthat its phenomena should be amenable to measurement. Applying
thesecharacteristics, we find that economics is a branch of knowledge where
thevarious facts relevant to it have been systematically collected, classified
andanalyzed. Economics investigates the possibility of deducing generalizations
asregards the economic motives of human beings. The motives of individuals
andbusiness firms can be very easily measured in terms of money. Thus,
economicsis a science.

Notes b) Economics is also an art: An art is a system of rules for the attainment of
agiven end. A science teaches us to know; an art teaches us to do. Applying
thisdefinition, we find that economics offers us practical guidance in the solution
ofeconomic problems. Science and art are complementary to each other
andeconomics is both a science and an art.
ii) Positive and Normative Economics
Economics is both positive and normative science.

a) Positive science: It only describes what it is and normative science
prescribeswhat it ought to be. Positive science does not indicate what is good
or what isbad to the society. It will simply provide results of economic analysis
of aproblem.
b) Normative science: It makes distinction between good and bad. It
prescribeswhat should be done to promote human welfare. A positive statement
is based onfacts. A normative statement involves ethical values. For example,
“12 per centof the labour force in India was unemployed last year” is a positive
statement,which could is verified by scientific measurement. “Twelve per cent
unemployment is too high” is normative statement comparing the fact of 12
percent unemployment with a standard of what is unreasonable. It also suggests
howit can be rectified. Therefore, economics is a positive as well as
normativescience.
iii) Methodology of Economics
Economics as a science adopts two methods for the discovery of its laws
andprinciples, viz., (a) deductive method and (b) inductive method.
a) Deductive method: Here, we descend from the general to particular, i.e.,
westart from certain principles that are self-evident or based on strict
observations.Then, we carry them down as a process of pure reasoning to the
consequencesthat they implicitly contain. For instance, traders earn profit in
their businessesis a general statement which is accepted even without verifying
it with thetraders. The deductive method is useful in analyzing complex
economicphenomenon where cause and effect are inextricably mixed up.
However, thedeductive method is useful only if certain assumptions are valid.
(Traders earnprofit, if the demand for the commodity is more).
b) Inductive method: This method mounts up from particular to general, i.e.,
webegin with the observation of particular facts and then proceed with the help
ofreasoning founded on experience so as to formulate laws and theorems on
thebasis of observed facts. E.g. Data on consumption of poor, middle and
richincome groups of people are collected, classified, analyzed and
importantconclusions are drawn out from the results.
1.8 Micro and Macro-Economics
Microeconomics
Microeconomics is a branch of economics that studies the behavior of how the

individual, modern household and firms make decisions to allocate limited resources. It
applies to markets where goods or services are being bought and sold. Microeconomics
examines how these decisions and behaviours affect the supply and demand for goods
and services.

Microeconomics also deals with the effects of national economic policies on the Notes
aforesaid aspects of the economy. One of the goals of microeconomics is to analyze
market mechanisms that establish relative prices amongst goods and services and
allocation of limited resources amongst many alternative uses. Microeconomics analyzes
market failure, where markets fail to produce efficient results and describes the theoretical
conditions needed for perfect competition. Significant fields of study in microeconomics
include general equilibrium, markets under asymmetric information, choice under
uncertainty and economic applications of game theory. Also considered is the elasticity
of products within the market system. Microeconomics focuses on supply and demand
and other forces that determine the price levels seen in the economy. For example,
microeconomics would look at how a specific company could maximize its production
and capacity so it could lower prices and better compete in its industry.
This is in contrast to macroeconomics, which involves the sum total of economic
activity, dealing with the issues of growth, inflation and unemployment. Supply and demand
is an economic model of price determination in a market. It concludes that in a competitive
market, the unit price for a particular good will vary until it settles at a point where the
quantity demanded by consumers (at current price) will equal the quantity supplied by
producers (at current price), resulting in an economic equilibrium of price and quantity.
The four basic laws of supply and demand are:
i) If demand increases and supply remains unchanged, then it leads to higher
equilibrium price and quantity.
ii) If demand decreases and supply remains unchanged, then it leads to lower
equilibrium price and quantity.
iii) If supply increases and demand remains unchanged, then it leads to lower
equilibrium price and higher quantity.
iv) If supply decreases and demand remains unchanged, then it leads to higher
price and lower quantity.
Graph shows the demand and supply relationship
Macroeconomics
Macroeconomics is the field of economics that studies the behavior of the economy
as a whole and not just on specific companies, but entire industries and economies. This
looks at economy-wide phenomena, such as Gross National Product (GNP) and how it
is affected by changes in unemployment, national income, rate of growth and price levels.
For example, macroeconomics would look at how an increase/decrease in net
exports would affect a nation’s capital account or how GDP would be affected by
Notes unemployment rate. While these two studies of economics appear to be different, they
are actually interdependent and complement one another since there are many overlapping
issues between the two fields. For example, increased inflation (macro effect) would cause
the price of raw materials to increase for companies and in turn affect the end product’s
price charged to the public.
The bottom line is that microeconomics takes a bottoms-up approach to analyzing
the economy while macroeconomics takes a top-down approach. Regardless, both micro-
and macroeconomics provide fundamental tools for any finance professional and should
be studied together in order to fully understand how companies operate and earn revenues
and thus, how an entire economy is managed and sustained.
National output is the total value of everything a country produces in a given time
period. Everything that is produced and sold generates income. Therefore, output and
income are usually considered equivalent and the two terms are often used
interchangeably. Output can be measured as total income, or, it can be viewed from the
production side and measured as the total value of final goods and services or the sum
of all value added in the economy
The amount of unemployment in an economy is measured by the unemployment
rate, the percentage of workers without jobs in the labour force. The labour force only
includes workers actively looking for jobs. People who are retired, pursuing education,
or discouraged from seeking work by a lack of job prospects are excluded from the labour
force. Unemployment can be generally broken down into several types based related to
different causes. Classical unemployment occurs when wages are too high for employers
to be willing to hire more workers.
Economists measure these changes in prices with price indexes. Inflation can occur
when an economy becomes overheated and grows too quickly. Similarly, a declining
economy can lead to deflation. Central bankers, who control a country’s money supply,
try to avoid changes in price level by using monetary policy. Raising interest rates or
reducing the supply of money in an economy will reduce inflation. Inflation can lead to
increased uncertainty and other negative consequences. Deflation can lower economic
output. Central bankers try to stabilize prices to protect economies from the negative
consequences of price changes.
Meaning of Macroeconomics
Macroeconomics is the subdivision of economics that studies the behavior and

performance of an economy as a whole. It focuses on the aggregate changes in the
economy such as unemployment, growth rate, gross domestic product and inflation.
Macroeconomics analyzes all aggregate indicators and the microeconomic factors
that influence the economy. Government and corporations use macroeconomic models
to help in formulating of economic policies and strategies.
Definitions of Macroeconomics
According to Blaug, Mark (1985), “Macroeconomics is a branch of economics

dealing with the performance, structure, behavior, and decision-making of an economy as
whole, rather than individual markets. This includes national, regional, and global
economies”.
The Economist's Dictionary of Economics defines Macroeconomics as "The study
of whole economic systems aggregating over the functioning of individual economic units.

It is primarily concerned with variables which follow systematic and predictable paths of Notes
behaviour and can be analyzed independently of the decisions of the many agents who
determine their level. More specifically, it is a study of national economies and the
determination of national income."
According to Shawn Grimsley, “Macroeconomics is the study of economics
involving phenomena that affects an entire economy, including inflation, unemployment,
price levels, economic growth, economic decline and the relationship between all of these”.
Microeconomics vs. Macroeconomics
There are differences between microeconomics and macroeconomics, although, at

times, it may be hard to separate the functions of the two. First and foremost, both of
these terms mentioned are sub-categories of economics itself. As the names of ‘micro’
and ‘macro’ imply, microeconomics facilitates decisions of smaller business sectors and
macroeconomics focuses on entire economies and industries. These two economies are
mutually dependent and together, they develop the strategy for the overall growth of an
organization. They are the two most important fields in economics and are necessary for
the rise in the economy.
Microeconomics focuses on the market’s supply and demand factors that determine
the economy’s price levels. In other words, microeconomics concentrates on the ‘ups’
and ‘downs’ of the markets for services and goods and how the price affects the growth
of these markets. An important aspect of this economy is also to examine market failure,
i.e. when the markets do not provide effectual results. In our present time, microeconomics
has become one of the most important strategies in business and economics. Its main
importance is to analyze the economy forces, consumer behavior and methods of
determining the supply and demand of the market.
Distinguish between Microeconomics and Macroeconomics
Microeconomics Macroeconomics
1. Microeconomics is the study of decisions 1. Macroeconomics is the field of
that people and businesses make economics that studies the behavior of
regarding the allocation of resources and the economy as a whole and not just
prices of goods and services. on specific companies, but entire
industries and economies.
2. Micro Economics studies the problems of 2. Macro Economics studies economic
individual economic units such as a firm, problems relating to an economy viz.,
an industry, a consumer etc. National Income, Total Savings etc.
3. Micro Economic studies the problems of 3. Macro Economics studies the problems
price determination, resource allocation of economic growth, employment and
etc. income determination etc.
4. While formulating economic theories, 4. In Macro Economics, economic
Micro Economics assumes that other variables are mutually inter-related
things remain constant. independently.
5. Micro economics study is what will be 5. Macro economics study what will be
the consequence of increase in salary of the consequence of higher inflation on
an individual will have on his or her growth of the economy or how rise in
purchasing power. gross domestic product will help in
generating employment opportunities.

Notes The Concept of Macroeconomics
Macroeconomics is a branch of economics dealing with the performance, structure,

behavior and decision-making of the entire economy. This includes a national, regional,
or global economy.
Macroeconomists study aggregated indicators such as GDP, unemployment rates
and price indices to understand how the whole economy functions. Macroeconomists
develop models that explain the relationship between such factors as national income,
output, consumption, unemployment, inflation, savings, investment, international trade and
international finance. In contrast, microeconomics is primarily focused on the actions of
individual agents, such as firms and consumers and how their behavior determines prices
and quantities in specific markets. While macroeconomics is a broad field of study, there
are two areas of research that are emblematic of the discipline: the attempt to understand
the causes and consequences of short-run fluctuations in national income (the business
cycle) and the attempt to understand the determinants of long-run economic growth
(increases in national income). Macroeconomic models and their forecasts are used by
both governments and large corporations to assist in the development and evaluation of
economic policy and business strategy.
Basic Macroeconomic Concepts
Macroeconomics encompasses a variety of concepts and variables, but three are

central topics for macroeconomic research. Macroeconomic theories usually relate the
phenomena of output, unemployment, inflation, Economic Growth, Business Cycle and
International Economics. Outside of macroeconomic theory, these topics are also
extremely important to all economic agents including workers, consumers and producers.
1. Output and Income
National output is the total value of everything a country produces in a given time
period. Since everything that is produced and sold produces income, output and income
are usually considered to be equivalent and the two terms are often used interchangeable.
Output can be measured as total income, or, it can be viewed from the production side
and measured as the total value of final goods and services or the sum of all value added
in the economy. Macroeconomic output is usually measured by Gross Domestic Product
(GDP) or any one of the other national accounts. Economists interested in long-run
increases in output study economic growth. Advances in technology, increases in
machinery and other capital and better education and human capital all lead to increased
economic output overtime. However, output does not always increase consistently.
Business cycles can cause short-term drops in output called recessions. Economists look
for macroeconomic policies that prevent economies from slipping into recessions and that
lead to faster long-term growth.
2. Unemployment
The amount of unemployment in an economy is measured by the unemployment
rate, the percentage of workers without jobs in the labour force. The labour force only
includes workers actively looking for jobs. People who are retired, pursuing education,
or discouraged from seeking work by a lack of job prospects are excluded from the labour
force. Unemployment can be generally broken down into several types based related to
different causes. Classical unemployment occurs when wages are too high for employers
to be willing to hire more workers. Wages may be too high because of minimum wage
laws or union activity. Consistent with classical unemployment, frictional unemployment
occurs when appropriate job vacancies exist for a worker, but the length of time needed

to search for and find the job leads to a period of unemployment. Structural unemployment Notes
covers a variety of possible causes of unemployment including a mismatch between
workers’ skills and the skills required for open jobs. Large amounts of structural
unemployment can occur when an economy is transitioning industries and workers find
their previous set of skills is no longer in demand. Structural unemployment is similar
to frictional unemployment since both reflect the problem of matching workers with job
vacancies, but structural unemployment covers the time needed to acquire new skills not
just the short term search process. While some types of unemployment may occur
regardless of the condition of the economy, cyclical unemployment occurs when growth
stagnates. Okun’s law represents the empirical relationship between unemployment and
economic growth. The original version of Okun’s law states that a 3% increase in output
would lead to a 1% decrease in unemployment.
3. Inflation and deflation
A general price increase across the entire economy is above the full employment
level as called inflation. When prices decrease, there is deflation. Economists measure
these changes in prices with price indexes. Inflation can occur when an economy becomes
overheated and grows too quickly. Similarly, a declining economy can lead to deflation.
Central bankers, who control a country’s money supply, try to avoid changes in price level
by using monetary policy. Raising interest rates or reducing the supply of money in an
economy will reduce inflation. Inflation can lead to increased uncertainty and other negative
consequences. Deflation can lower economic output. Central bankers try to stabilize prices
to protect economies from the negative consequences of price changes.
In order to proceed with this examination it is necessary to envisage the
macroeconomics system or social organization of the greater community or nation in a
form that can be easily understood and appreciated. This is done by means of a
macroeconomics model, which is a general expression of the system that is useful for
purposes of discussion. The model can take a number of different forms including block
diagrams, algebraic equations, mechanical analogy, electronic analogy, Leontief Matrix,
etc. A suitable model for use in representing the macroeconomic system is shown in the
illustration for a closed macroeconomics system without including “The Rest of The World”.
Money circulates around this model and goods, services, valuable legal documents etc.
pass in return between the 6 entities or agents also sometimes called sectors that
comprise the basic structure of the system. The system flows of money, goods etc.,
continuously try to self-adjust, in order to attain a condition of equilibrium.
4. Economic growth
Growth economics studies factors that explain economic growth – the increase in
output per capita of a country over a long period of time. The same factors are used to
explain differences in the level of output per capita between countries, in particular why
some countries grow faster than others and whether countries converge at the same rates
of growth. Much-studied factors include the rate of investment, population growth and
technological change. These are represented in theoretical and empirical forms as in the
neoclassical and endogenous growth model and in growth accounting.
5. Business cycle
The economics of a depression were the spur for the creation of “macroeconomics”
as a separate discipline field of study. During the Great Depression of the 1930s, John
Maynard Keynes authored a book entitled “The General Theory of Employment”, Interest
and Money outlining the key theories of Keynesian economics. Keynes contended that
aggregate demand for goods might be insufficient during economic downturns, leading to
unnecessarily high unemployment and losses of potential output.
Notes Over the years, the understanding of the business cycle has branched into various
schools, related to or opposed to Keynesianism. The neoclassical synthesis refers to the
reconciliation of Keynesian economics with neoclassical economics, stating that
Keynesianism is correct in the short run, with the economy following neoclassical theory
in the long run.
6. International economics
International trade studies determinants of goods-and-services flows across
international boundaries. It also concerns the size and distribution of gains from trade.
Policy applications include estimating the effects of changing tariff rates and trade quotas.
International finance is a macroeconomic field which examines the flow of capital across
international borders and the effects of these movements on exchange rates. Increased
trade in goods, services and capital between countries is a major effect of contemporary
globalization.
Significance of Macro Economics
The significances of macroeconomics are summarized as follows:

1. It helps to understand the problems faced by the various countries.
2. It facilitates to understand the functioning of the economic system.
3. It helps in formulation of economic policies.
4. It assists in dealing with the problem of allocation of goods and services.
5. It helps in understanding the business cycle.
6. Its effects and helps in formulating ways of reducing or minimizing the negative
effects through formulation of monetary and fiscal policies.
7. It helps in understanding the importance of savings.
8. It helps in analyzing the effects of inflation and deflation.
9. Businesses use macroeconomic analysis to determine whether expanding
production will be welcomed by the market.
10. It helps to analyse the GDP and economic growth of any Nation.
1.9 Concept of Managerial Economics

Managerial economics is a branch of economics that applies microeconomic analysis
to decision methods of businesses or other management units. It bridges economic theory
and economics in practice. If there is a unifying theme that runs through most of managerial
economics it is the attempt to optimize business decisions given the firm's objectives
and given constraints imposed by scarcity, for example through the use of operations
research and programming. Managerial economics is an evolutionary science. It is a
journey with continuing understanding and application of economic knowledge theories,
models, concepts and categories in dealing with the emerging business or managerial
situations and problems in a dynamic economy.
Managerial economics is pragmatic. It is concerned with analytical tools and
techniques of economics that are useful for decision making in business. Managerial
economics is, however, not a branch of economic theory but a separate discipline by itself,
having its own selection of economic principles and methods. In essence, managerial
economics rests on the edifice of economics. Knowledge of economics is certainly useful
to business people. Businessmen/business managers must know the fundamentals of
economics and economic theories for a meaningful analysis of business situations.

Managerial economics is a specialized discipline of management studies which deals Notes

with application of economic theory and techniques to business management. Managerial
economics is evolved by establishing links on integration between economic theory and
decision sciences along with business management in theory and practice for the optimal
solution to business/managerial decision problems. This means, managerial economics
pertains to the overlapping area of economics along with the tools of decision sciences
such as mathematical economics, statistics and econometrics as applied to business
management problems.
1.10 Meaning and Definitions of Managerial Economics

Meaning of Managerial Economics
Managerial economics is the study of allocation of resources available to a business
firm or an organization. This is concerned with the art of economizing, i.e., making rational
choices to yield maximum return out of minimum resources and efforts by making the
best selection among alternative courses of action.
Definitions of Managerial Economics
According to W. W. Haynes, “Managerial Economics is economics applied in
decision-making. It is a special branch of economics bridging the gap between the
economic theory and managerial practice. Its stress is on the use of the tools of economic
analysis in clarifying problems in organizing and evaluating information and in comparing
alternative courses of action”.
According to Spencer & Siegelman, “Managerial Economics is the integration of
economic theory with business practice for the purpose of facilitating decision-making and
forward planning by management”.
According to Joel Dean, “The purpose of Managerial Economics is to show how
economic analysis can be used in formulating business policies”.
Importance / Significance of Managerial Economics
The importance of managerial economics can be summarized as follows:

i) Problem solving: Managerial Economics involves an application of economic
theory especially, microeconomic analysis to practical problem solving in real
business life. It is essentially applied microeconomics.
ii) Market structure: A managerial economist determines how the competition and
market structure affect the product’s sales level and price.
iii) Market pricing: In a perfectly competitive market, the managerial economist
realizes companies accept market pricing based on supply and demand.
iv) Nash’s equilibrium: If the firm is part of an oligopoly, i.e., the company and
just a handful of others control the majority of the market; an economist uses
principles from Nash’s equilibrium which states that the firm must engage in
pricing strategy to undercut its competitors.
v) Optimal allocation of resources: It is concerned with firm’s behaviour in
optimal allocation of resources. It provides tools to help in identifying the best
course among the alternatives and competing activities in any productive sector
whether private or public.
vi) Management problems: Managerial economics incorporates elements of both
micro and macroeconomics dealing with management problems in arriving at
optimal decisions.
Notes vii) Economic methodology: It uses analytical tools of mathematical economics

and econometrics with two main approaches to economic methodology involving
‘descriptive’ as well as ‘prescriptive’ models.
viii) Optimizing models: Descriptive models are data based in describing and
exploring economic relationships of reality in simplified abstract sense.
Prescriptive models are the optimizing models to guide the decision makers
about the most efficient way of realizing the set goal.
ix) Economic entities: It may serve as a managerial insight. Managers have to
acquire the insight of both micro-economics and macroeconomics as the former
analyses the behaviour of individual economic entities such as consumer and
producers, while the later exposes issues pertaining to their behaviour in the
economy as a whole.
x) Alternative strategies: Managerial economics is the base for constructing an
optimizing model for profit maximization goal of the firm. In a prescriptive model,
the set of alternative strategies towards attainment of the objective function in
operation terms within specified constraints may be derived with the help of
descriptive models in background.
xi) Traditional economics: It differs from traditional economics in one important
respect that it is directly concerned in dealing with real people in real business
situations.
xii) Broader knowledge: Managerial economics becomes more meaningful when
coordinated with other discipline of management with a broader knowledge,
techniques/ methods, dogmas and theories involved using sharp common sense
in practical decision making.
xiii) Decision making: Managerial economics has a pivotal place in allied business
disciplines concerned into the arena of decision making.
xiv) Business activity: Managerial economics as an applied economic science
deals/helps in analyzing the firm’s markets, industry trends and macro forces
which are directly relevant to the concerned business activity.
xv) Quality: Managerial economics helps the manager to understand the intricacies
of the business problems which make the problem solving easier and quicker,
arrive at correct and appropriate decisions, improve the quality of such decisions
and so on.
xvi) Research/investigation: Most managerial decisions are made under conditions
of varying degrees of uncertainty about the future. To reduce this element of
uncertainty, it is essential to have homework of research/investigation on the
problem solving before the action is undertaken.
xvii) Business-problems: Managerial economics deals with practical business-
problems relating to production, pricing and sale. These problems are
theoretically analyzed by traditional economics.
1.11 Nature of Managerial Economics

Managerial economics is the integration of economic principles with business
management practices. The subject matter of business economics apparently pertains
to economic analysis that can be helpful in solving business problems, policy and planning.
But, one cannot make good use of economic theory in business practices unless one
masters the basic contents, principles and logic of economics.

Economics in essence pertains to an understanding of life’s principal pre-occupation. Notes

It is a religion of the day-in living for the want satisfying activity. Economics, as a social
science, studies human behaviour as a relationship between numerous wants and scarce
means having alternative uses.
Managerial economics is essentially applied economics in the field of business
management. It is the economics of business or managerial decisions. It pertains to all
economic aspects of managerial decision making.
Managerial economics is confined only to a part of business management. It is
primarily addressed to the analysis of economizing aspects of business problems and
decision making by a business firm or an organization. It is not directly concerned with
the managerial problems and actions involving implementation, control, conflict resolution
and other management strategies in day-to-day operations of the business. It draws heavily
on traditional economics, as well as decision science in analyzing the business problems
and the impact of alternative courses of action on the efficient allocation of resources or
optimization.
Managerial economics is however, not a branch of economic theory but a separate
discipline by itself having its own selection of economic principles and methods. In
essence, managerial economics rests on the edifice of economics. Knowledge of
economics is certainly useful to business people. Businessmen/business managers must
know the fundamentals of economics and economic theories for a meaningful analysis
of business situation.
Managerial economics is, by and large, the application of knowledge of economic
concepts, methods and tools of analysis to the managerial/business decision making
process, involved within the firm or organization in conducting the business or productive
activity. The relation of managerial economics to economic theory is somewhat like that
of medicine to biology.
It deals with the application of economic principles and methodologies to the decision
making process, within the firm under the given situation. It seeks to establish rules and
principles to facilitate the attainment of the chosen economic goals of business
management, such as minimization of costs, maximization of revenues and profits, and
so on. It follows that certain economic theories are directly useful in business analysis
and practice of decision making as well as forward planning of management. Managerial
economics deals with this kind of knowledge and principles. It is a collection of those
methods/analytical techniques that have direct application to business management.
Managerial economics, thus, attempts to bridge the gap between the purely analytical
problems dealt with in economic theory and decisions problems faced in real business.
It seeks to provide powerful tools of analysis and reasoning approaches for managerial/
business policy making.
Decision making is an art as well as science. Many managerial decisions are
addressed in a routine manner. Rules of thumb or the tried-and-true decision rules are,
however, invalidated by the changes in routine situations. Dynamic changes in business
situations need that decisions are to be addressed in a proactive manner. In proactive
decision-making, many alternatives have to be explored; conditions and assumptions have
to be reviewed and structured in a perspective manner. Managerial economics offers an
understanding of business and economic perspectives, jargons, tools, technique and
tactics that will facilitate manager’s development as a proactive decision-maker a decision
maker who addresses dynamic business situations in a critical, comprehensive and careful
manner, right in time, using formal analytical tools and skills that are guided by the
knowledge, judgement, experience and intuition.
Notes 1.12 Scope of Managerial Economics

The scope of business economics is usually restricted to the understanding of the
business behaviour and problems of a firm at a micro level in the context of the prevailing
business environment. The methodology of business economics involves micro economic
analysis in analyzing the behaviour and problems of the business unit in particular. Micro
economic analysis understands the business environment in the economy. It is positive
as well as normative science. As a positive science, it deals with empirical studies of
business phenomenon such as demand cost, production, etc. As a normative science,
it discusses policy objectives and business practices with a critical approach and suggest
for the socially desirable course of business actions. Managerial economics is the
incorporation of economic principles with business practice. The subject-matter of
business economics, as such, should pertain to economic analysis that can be helpful
in solving business problems, policy and planning. But, one cannot make good use of
economic theory in business practices unless he masters the basic contents, principles,
and logic of economics. Managerial economics is pragmatic. It is concerned with analytical
tools that are useful for decision making in business.
Managerial function is to allocate given business resources possessed by the firm
for achieving predetermined business goals. Managerial economics is an evolving science.
It is a newly developing subject with the popularity of management studies. Hence, there
is no demarcation or any uniform pattern of its subject-matter and scope. Managerial
economics has picked-up relevant concepts, techniques, tools and theories from micro
and macro economics applicable to business issues and problems of decision-making.
The scope of managerial economics also can be concentrated on the following areas:
i) Demand analysis and forecasting: The demands for the firm’s product would
change in response to change in price, consumer’s income, his taste etc. which
are the determinants of demand. A study of the determinants of demand is
necessary for forecasting future demand of the product.
ii) Cost analysis: Estimation of cost is an essential part of managerial problems.
The factors causing variation of cost must be found out and allowed for it
management to arrive at cost estimates. This will helps for more effective
planning and sound pricing practices.
iii) Pricing decisions: The firms aim to profit which depends upon the correctness
of pricing decisions. The pricing is an important area of managerial economics.
Theories regarding price fixation helps the firm to solve the price fixation
problems.
iv) Profit analysis: Business firms working for profit and it is an important measure
of success. But the firms are working under conditions of uncertainty. Profit
planning become necessary under the conditions of uncertainty.
v) Capital budgeting: The business managers have to take very important
decisions relating to the firm’s capital investment. The manager has to calculate
correctly the profitability of investment and to properly allocate the capital.
Success of the firm depends upon the proper analysis of capital project and
selecting the best one.
vi) Production and supply analysis: Production analysis is narrower in scope
than cost analysis. Production analysis is proceeds in physical terms while cost
analysis proceeds in monitory term. Important aspects of supply analysis are;
supply schedule, curves and functions, law of supply, elasticity of supply and
factors influencing supply.

1.13 Roles and responsibilities of a Managerial Economist Notes

The role of managerial economist can be summarized as follows:
1. Demand analysis and forecasting
2. Cost and production analysis
3. Pricing decisions, policies and practices
4. Profit management
5. Capital management
1. Demand Analysis and Forecasting
A business firm is an economic organization, which transforms productive resources
into goods that are to be sold in a market. A major part of managerial decision-making
depends on accurate estimates of demand. This is because before production schedules
can be prepared and resources are employed, a forecast of future sales is essential. This
forecast can also guide the management in maintaining or strengthening the market
position and enlarging profits. The demand analysis helps to identify the various factors
influencing demand for a firm’s product and thus provides guidelines to manipulate demand.
Demand analysis and forecasting, thus, is essential for business planning and occupies
a strategic place in managerial economics. It comprises of discovering the forces
determining sales and their measurement.
2. Cost and Production Analysis
A study of economic costs, combined with the data drawn from the firm’s accounting
records, can yield significant cost estimates. These estimates are useful for management
decisions. The factors causing variations in costs must be recognized and thereby should
be used for taking management decisions. This facilitates the management to arrive at
cost estimates, which are significant for planning purposes. An element of cost uncertainty
exists in this because all the factors determining costs are not always known or
controllable. Therefore, it is essential to discover economic costs and measure them for
effective profit planning, cost control and sound pricing practices. Production analysis is
narrower in scope than cost analysis.
3. Pricing Decisions, Policies and Practices
Pricing is a very important area of managerial economics. In fact price is the origin
of the revenue of a firm. As such the success of a business firm largely depends on the
accuracy of price decisions of that firm.
4. Profit Management
Business firms are generally organized with the purpose of making profits. 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 about profits. This uncertainty
occurs because of variations in costs and revenues. These are caused by factors such
as internal and external. If knowledge about the future were perfect, profit analysis would
have been a very easy task. However, in a world of uncertainty, expectations are not always
realized. Thus profit planning and measurement make up the difficult area of managerial
economics.
5. Capital Management
Among the various types and classes of business problems, the most complex and
troublesome for the business manager are those relating to the firm’s capital investments.
Capital management implies planning and control and capital expenditure. In this
Notes procedure, relatively large sums are involved and the problems are so complex that their
disposal not only requires considerable time and labor but also top-level decisions.
1.14 Relationship to economic theory, decision sciences, statistics,

accounting
Managerial Economics and Economic Theory
Managerial Economics is economics applied to decision making. It is a special
branch of economics, bridging the gap between pure economic theory and manage-rial
practice. Economics has two main branches micro-economics and macro-economics.
Micro-economics
‘Micro’ means small. It studies the behaviour of the individual units and small groups
of units. It is a study of particular firms, particular households, individual prices, wages,
incomes, individual industries and particular commodities. Thus micro-economics gives
a microscopic view of the economy.
The roots of managerial economics spring from micro-economic theory. In price
theory, demand concepts, elasticity of demand, marginal cost marginal revenue, the short
and long runs and theories of market structure are sources of the elements of micro-
economics which managerial economics draws upon. It makes use of well-known models
in price theory such as the model for monopoly price, the kinked demand theory and the
model of price discrimination.
Macro-economics
‘Macro’ means large. It deals with the behaviour of the large aggregates in the
economy. The large aggregates are total saving, total consumption, total income, total
employment, general price level, wage level, cost structure, etc. Thus macro-economics
is aggregative economics.
It examines the interrelations among the various aggregates, and causes of
fluctuations in them. Problems of determination of total income, total employment and
general price level are the central problems in macro-economics.
Macro-economies is also related to managerial economics. The environment, in which
a business operates, fluctuations in national income, changes in fiscal and monetary
measures and variations in the level of business activity have relevance to business
decisions. The understanding of the overall opera-tion of the economic system is very
useful to the managerial economist in the formulation of his poli-cies.Macro-economic
contributes to business forecasting. The most widely used model in modern forecasting
is the gross national product model.
Managerial Economics and Theory of Decision sciences
Managerial economics depends on economic theory for theoretical framework for
analyzing the problems of business decision-making. In the other hand, decision sciences
provide tools and techniques for constructing decision models and for evaluating the effect
and results of alternative courses of action i.e., alternative business strategies1. Business
economics uses optimization techniques including differential calculus, linear and other
types of mathematical programming for deriving decision rules which assist managers for
achieving the objectives of business firms.The theory of decision making is relatively a
new subject that has significance for managerial economics. In the process of
management such as planning, organizing, leading and controlling, decision making is
always essential. Decision making is an integral part of today’s business management.

A manager faces a number of problems connected with his/her business such as Notes
production, inventory, cost, marketing, pricing, investment and personnel.
Economist are interested in the efficient use of scarce resources hence they are
naturally interested in business decision problems and they apply economics in
management of business problems. Hence managerial economics is economics applied
in decision making.
Managerial Economics and Statistics
Statistics is important to managerial economics. It provides the basis for the empirical
testing of theory. It provides the individual firm with measures of appropriate func-tional
relationship involved in decision making. Statistics is a very useful science for business
execu-tives because a business runs on estimates and probabilities.
Statistics supplies many tools to managerial economics. Suppose forecasting has
to be done. For this purpose, trend projections are used. Similarly, multiple regression
technique is used. In managerial economics, measures of central tendency like the mean,
median, mode, and measures of dispersion, correlation, regression, least square,
estimators are widely used.
Statistical tools are widely used in the solution of managerial problems. For e.g.
sampling is very useful in data collection. Managerial economics makes use of correlation
and multiple regressions in business problems involving some kind of cause and effect
relationship.
Managerial Economics and Accounting
Managerial economics is closely related to accounting. It is recording the finan-cial
operation of a business firm. A business is started with the main aim of earning profit.
Capital is invested / employed for purchasing properties such as building, furniture, etc
and for meeting the current expenses of the business.
Goods are bought and sold for cash as well as credit. Cash is paid to credit sellers.
It is received from credit buyers. Expenses are met and incomes derived. This goes on
the daily routine work of the business. The buying of goods, sale of goods, payment of
cash, receipt of cash and similar dealings are called business transactions.
The business transactions are varied and multifarious. This has given rise to the
necessity of recording business transaction in books. They are writ-ten in a set of books
in a systematic manner so as to facilitate proper study of their results.
There are three classes of accounts:
(i) Personal account,
(ii) Property accounts and
(iii) Nominal accounts.
Man-agement accounting provides the accounting data for taking business decisions.
The accounting tech-niques are very essential for the success of the firm because profit
maximization is the major objective of the firm.

Notes 1.15 Functional Areas of Business

Various functional areas of business are given below:
1. Management
The primary role of managers in business is to supervise other people’s performance.
Most management activities fall into the following categories:
Planning: Managers plan by setting long-term goals for the business, as well short-
term strategies needed to execute against those goals.
Organizing: Managers are responsible for organizing the operations of a business
in the most efficient way, enabling the business to use its resources effectively.
Controlling: A large percentage of a manager’s time is spent controlling the activities
within the business to ensure that it’s on track to achieve its goals. When people or
processes stray from the path, managers are often the first ones to notice and take
corrective action.
Leading: Managers serve as leaders for the organization, in practical as well as
symbolic ways. The manager may lead work teams or groups through a new process
or the development of a new product. The manager may also be seen as the leader of
the organization when it interacts with the community, customers, and suppliers.
2. Operations
Operations are where inputs (factors of production) are converted to outputs (goods
and services). Operations are like the heart of a business, pumping out goods and services
in a quantity and of a quality that meets the needs of the customers. The operations
manager is responsible for overseeing the day-to-day business operations, which can
encompass everything from ordering raw materials to scheduling workers to produce
tangible goods.
3. Marketing
Marketing consists of all that a company does to identify customers’ needs and
design products and services that meet those needs. The marketing function also includes
promoting goods and services, determining how the goods and services will be delivered,
and developing a pricing strategy to capture market share while remaining competitive.
In day’s technology-driven business environment, marketing is also responsible for building
and overseeing a company’s Internet presence (e.g., the company Web site, blogs, social
media campaigns, etc.). Today, social media marketing is one of the fastest growing
sectors within the marketing function.
4. Accounting
Accountants provide managers with information needed to make decisions about the
allocation of company resources. This area is ultimately responsible for accurately
representing the financial transactions of a business to internal and external parties,
government agencies, and owners/investors. Financial Accountants are primarily
responsible for the preparation of financial statements to help entities both inside and
outside the organization assess the financial strength of the company. Managerial
accountants provide information regarding costs, budgets, asset allocation, and
performance appraisal for internal use by management for the purpose of decision-making.
5. Finance
Although related to accounting, the finance function involves planning for, obtaining,
and managing a company’s funds. Finance managers plan for both short- and long-term

financial capital needs and analyze the impact that borrowing will have on the financial Notes
well-being of the business. A company’s finance department answers questions about how
funds should be raised (loans vs. stocks), the long-term cost of borrowing funds, and the
implications of financing decisions for the long-term health of the business.
1.16 Objectives of Business Firms

The important goals or objectives of a business firm can be summarized as follows:
1. Profit Maximization
Profit means different things to different people. To an accountant “Profit” means the
excess of revenue over all paid out costs including both manufacturing and overhead
expenses. For all practical purpose, profit or business income means profit in accounting
sense plus non-allowable expenses.
Economist’s concept of profit is of “Pure Profit” called ‘economic profit’ or “Just profit”.
Pure profit is a return over and above opportunity cost, i. e. the income that a businessman
might expect from the second best alternatives use of his resources.
Profit maximization is a process that companies undergo to determine the best output
and price levels in order to maximize its return. The company will usually adjust influential
factors such as production costs, sale prices, and output levels as a way of reaching
its profit goal. There are two main profit maximization methods used, and they are Marginal
Cost-Marginal Revenue Method and Total Cost-Total Revenue Method. Profit maximization
is a good thing for a company, but can be a bad thing for consumers if the company
starts to use cheaper products or decides to raise prices.
The monopolist's profit maximizing level of output is found by equating its marginal
revenue with its marginal cost, which is the same profit maximizing condition that a
perfectly competitive firm uses to determine its equilibrium level of output. Indeed, the
condition that marginal revenue equal marginal cost is used to determine the profit
maximizing level of output of every firm, regardless of the market structure in which the
firm is operating.
Profit Maximization under different viewpoints
1. Total revenue - total cost viewpoint

Notes Profit Maximization - The Total Approach

To obtain the profit maximizing output quantity, we start by recognizing that profit
is equal to total revenue (TR) minus total cost (TC). Given a table of costs and revenues
at each quantity, we can either compute equations or plot the data directly on a graph.
The profit-maximizing output is the one at which this difference reaches its maximum.
In the accompanying diagram, the linear total revenue curve represents the case in which
the firm is a perfect competitor in the goods market, and thus cannot set its own selling
price. The profit-maximizing output level is represented as the one at which total revenue
is the height of C and total cost is the height of B; the maximal profit is measured as
CB. This output level is also the one at which the total profit curve is at its maximum.
If, contrary to what is assumed in the graph, the firm is not a perfect competitor
in the output market, the price to sell the product at can be read off the demand curve
at the firm's optimal quantity of output.
2. Marginal revenue-marginal cost viewpoint
Profit maximization using the marginal approach

An alternative perspective relies on the relationship that, for each unit sold, marginal
profit (Mp) equals marginal revenue (MR) minus marginal cost (MC). Then, if marginal
revenue is greater than marginal cost at some level of output, marginal profit is positive
and thus a greater quantity should be produced, and if marginal revenue is less than
marginal cost, marginal profit is negative and a lesser quantity should be produced. At
the output level at which marginal revenue equals marginal cost, marginal profit is zero
and this quantity is the one that maximizes profit. Since total profit increases when
marginal profit is positive and total profit decreases when marginal profit is negative, it
must reach a maximum where marginal profit is zero - or where marginal cost equals
marginal revenue - and where lower or higher output levels give lower profit levels. In
calculus terms, the correct intersection of MC and MR will occur when:
dMR dMC
<
dQ dQ
Case in which maximizing revenue is equivalent

In some cases a firm's demand and cost conditions are such that marginal profits
are greater than zero for all levels of production up to a certain maximum. In this case
marginal profit plunges to zero immediately after that maximum is reached; hence the
Mp = 0 rule implies that output should be produced at the maximum level, which also
happens to be the level that maximizes revenue. In other words the profit maximizing
quantity and price can be determined by setting marginal revenue equal to zero, which

occurs at the maximal level of output. Marginal revenue equals zero when the total revenue Notes
curve has reached its maximum value. An example would be a scheduled airline flight.
The marginal costs of flying one more passenger on the flight are negligible until all the
seats are filled. The airline would maximize profit by filling all the seats. The airline would
determine the conditions by maximizing revenues.
Changes in total costs and profit maximization
A firm maximizes profit by operating where marginal revenue equal marginal costs.
A change in fixed costs has no effect on the profit maximizing output or price. The firm
merely treats short term fixed costs as sunk costs and continues to operate as before.
This can be confirmed graphically. Using the diagram illustrating the total cost–total
revenue perspective, the firm maximizes profit at the point where the slopes of the total
cost line and total revenue line are equal. An increase in fixed cost would cause the total
cost curve to shift up by the amount of the change. There would be no effect on the total
revenue curve or the shape of the total cost curve. Consequently, the profit maximizing
point would remain the same. This point can also be illustrated using the diagram for the
marginal revenue–marginal cost perspective. A change in fixed cost would have no effect
on the position or shape of these curves.
Markup pricing
In addition to using methods to determine a firm's optimal level of output, a firm that
is not perfectly competitive can equivalently set price to maximize profit (since setting
price along a given demand curve involves picking a preferred point on that curve, which
is equivalent to picking a preferred quantity to produce and sell). The profit maximization
conditions can be expressed in a "more easily applicable" form or rule of thumb than the
above perspectives use. The first step is to rewrite the expression for marginal revenue
as MR = ∆ TR/ ∆ Q =(P ∆ Q+Q ∆ P)/ ∆ Q=P+Q ∆ P/ ∆ Q, where P and Q refer to the
midpoints between the old and new values of price and quantity respectively. The marginal
revenue from an "incremental unit of quantity" has two parts: first, the revenue the firm
gains from selling the additional units or P ∆ Q. The additional units are called the marginal
units. Producing one extra unit and selling it at price P brings in revenue of P. Moreover,
one must consider "the revenue the firm loses on the units it could have sold at the higher
price" that is, if the price of all units had not been pulled down by the effort to sell more
units. These units that have lost revenue are called the infra-marginal units. That is, selling
the extra unit results in a small drop in price which reduces the revenue for all units sold
by the amount Q( ∆ P/ ∆ Q). Thus MR = P + Q( ∆ P/ ∆ Q) = P +P (Q/P)(( ∆ P/ ∆ Q) = P
+ P/(PED), where PED is the price elasticity of demand characterizing the demand curve
of the firms' customers, which is negative. Then setting MC = MR gives MC = P + P/
PED so (P - MC)/P = - 1/PED and P = MC/[1 + (1/PED)]. Thus the optimal markup rule
is:
(P - MC)/P = 1/ (- PED)
or
P = [PED/(1 + PED)] × MC.
In words, the rule is that the size of the markup is inversely related to the price
elasticity of demand for the good. The optimal markup rule also implies that a non-
competitive firm will produce on the elastic region of its market demand curve. Marginal
cost is positive. The term PED/(1+PED) would be positive so P>0 only if PED is between
-1 and - ∞ that is, if demand is elastic at that level of output. The intuition behind this
result is that, if demand is inelastic at some value Q1 then a decrease in Q would increase

Notes P more than proportionately, thereby increasing revenue PQ; since lower Q would also
lead to lower total cost, profit would go up due to the combination of increased revenue
and decreased cost. Thus Q1 does not give the highest possible profit.
Profit Maximization as a Decision Criterion
Profit maximization is considered as the goal of financial management. In this
approach, actions that Increase profits should be undertaken and the actions that decrease
the profits are avoided. Thus, the Investment, financing and dividend also be noted that
the term objective provides a normative framework decisions should be oriented to the
maximization of profits. The term ‘profit’ is used in two senses. In one sense it is used
as an owner-oriented.
In this concept it refers to the amount and share of national Income that is paid to
the owners of business. The second way is an operational concept i.e. profitability. This
concept signifies economic efficiency. It means profitability refers to a situation where
output exceeds Input. It means, the value created by the use of resources is greater that
the Input resources. Thus in all the decisions, one test is used i.e. select asset, projects
and decisions that are profitable and reject those which are not profitable. The profit
maximization criterion is criticized on several grounds. Firstly, the reasons for the
opposition that are based on misapprehensions about the workability and fairness of the
private enterprise itself. Secondly, profit maximization suffers from the difficulty of applying
this criterion in the actual real-world situations. The term ‘objective’ refers to an explicit
operational guide for the internal investment and financing of a firm and not the overall
business operations.
Limitations of Profit Maximization Objective
1) Ambiguity: The term ‘profit maximization’ as a criterion for financial decision
is vague and ambiguous concept. It lacks precise connotation. The term ‘profit’
is amenable to different interpretations by different people. For example, profit
may be long-term or short-term. It may be total profit or rate of profit. It may
be net profit before tax or net profit after tax. It may be return on total capital
employed or total assets or shareholders equity and so on.
2) Timing of Benefits: Another technical objection to the profit maximization
criterion is that It Ignores the differences in the time pattern of the benefits
received from Investment proposals or courses of action. When the profitability
is worked out the bigger the better principle is adopted as the decision is based
on the total benefits received over the working life of the asset, Irrespective of
when they were received. The following table can be considered to explain this
limitation.
3) Quality of Benefits: The technical limitation of profit maximization criterion is
that it ignores the quality aspects of benefits which are associated with the
financial course of action. The term ‘quality’ means the degree of certainty
associated with which benefits can be expected. Therefore, the more certain
the expected return, the higher the quality of benefits. As against this, the more
uncertain or fluctuating the expected benefits, the lower the quality of benefits.
The profit maximization criterion is not appropriate and suitable as an operational
objective. It is unsuitable and inappropriate as an operational objective of
Investment financing and dividend decisions of a firm. It is vague and ambiguous.
It ignores important dimensions of financial analysis viz. risk and time value of
money. An appropriate operational decision criterion for financial management
should possess the following quality:

a) It should be precise and exact. Notes

b) It should be based on bigger the better principle.
c) It should consider both quantity and quality dimensions of benefits.
d) It should recognize time value of money.
2. Wealth Maximization
Wealth maximization is a process that increases the current net value of business
or shareholder capital gains, with the objective of bringing in the highest possible return.
The wealth maximization strategy generally involves making sound financial investment
decisions which take into consideration any risk factors that would compromise or
outweigh the anticipated benefits.
Wealth Maximization Decision Criterion
Wealth maximization decision criterion is also known as Value Maximization or Net
Present-Worth maximization. In the current academic literature value maximization is
widely accepted as an appropriate operational decision criterion for financial management
decision. It removes the technical limitations of the profit maximization criterion. It possess
total three requirements of a suitable operational objective of financial courses of action.
These three features are exactness, quality of benefits and the time value of money.
i) Exactness: The value of an asset should be determined In terms of returns it
can produce. Thus, the worth of a course of action should be valued In terms
of the returns less the cost of undertaking the particular course of action.
Important element in computing the value of a financial course of action is the
exactness in computing the benefits associated with the course of action. The
wealth maximization criterion is based on cash flows generated and not on
accounting profit. The computation of cash inflows and cash outflows is precise.
As against this the computation of accounting is not exact.
ii) Quality and Quantity and Benefit and Time Value of Money: The second
feature of wealth maximization criterion is that. It considers both the quality and
quantity dimensions of benefits. Moreover, it also incorporates the time value
of money. As stated earlier the quality of benefits refers to certainty with which
benefits are received In future.
The more certain the expected cash inflows the better the quality of benefits
and higher the value. On the contrary the less certain the flows the lower the
quality and hence, value of benefits. It should also be noted that money has
time value. It should also be noted that benefits received in earlier years should
be valued highly than benefits received later.
The operational implication of the uncertainty and timing dimensions of the
benefits associated with a financial decision is that adjustments need to be
made in the cash flow pattern. It should be made to incorporate risk and to
make an allowance for differences in the timing of benefits. Net present value
maximization is superior to the profit maximization as an operational objective.
iii) Comparison of value of cost: It involves a comparison of value of cost. The
action that has a discounted value reflecting both time and risk that exceeds
cost is said to create value. Such actions are to be undertaken. Contrary to
this actions with less value than cost, reduce wealth should be rejected. It is
for these reasons that the Net Present Value Maximization is superior to the
profit maximization as an operational objective.

Notes 3. Staff Maximization
In modern businesses, when large corporations are basically run by the professional
managers, there is a separation of the ownership from the control. According to Berle
and Means, when the managers control the business, instead of satisfying the profitability
interest of the owners the shareholders, they may seek to satisfy or justify their own utility
or worth for the concern by having a more than necessary larger staff to be employed
in the organization. When the firm possesses a degree of monopoly power in the market,
the manager may trade off some profits for an expansion in the size of staff. This is referred
to as the utility-maximisation theory of managerial behaviour.
As long as there is the separation of ownership and control there will be managers
to most beneficial owner means the possibility of. Since the supervision itself is costly
activity therefore the business owners to managers for their own interests at the expense
of owners of some activities do not have to be completely eliminated motivation. With the
separation of ownership and control is the premise managers can seek some effective
combination of resources the combination of these goals is to meet their own utility not
realizing the owners profit or wealth maximization. For example managers may have to
sacrifice some profit to the owner to increase staff size especially in even if managers
is one hundred percent owned by interests to seize the managers handle is also very
difficult time. We can use the indifference curve shows this trade off. Williamsen uses
the constraint conditions include the minimum or the acceptable level of profit also
including the capital market constraint. Williamsen presented evidence that in some cases
such as applied to or a lump sum tax on profits made by the reaction his effectiveness
the biggest melt release than the classical theory to predict the behavior of managers.
On other occasions such as the change of demand and the sales tax reaction his model
as reliable as new air max classical profit maximization theory. Select manager behavior
theory is not easy experience found no change in this point. For example Williamsen
claimed the Alchain Kay Searl hypothesis was a special case of the model if the capital
market includes both shareholders also includes the manufacturer claims are applied to
the management performance of the constraint condition is lax, management personnel
more freedom to randomly exercise firm with monopoly power. Therefore although we fully
agree with the Alchain Kay Searl on non monetary motivation is discussed and their
general preference function to replace the profit function but we still think regulated
industries is just a general situation. The general situation is that because of the existence
of mixed with giant or barriers to entry sake product market competition is very weak.
However it can also be said that Professor Kay Searl theory is more general assumption.
Williamsen noted that have a narrow range of salaries and expenses preference tradeoffs
between choice and Alchian and Kay Searl provides a general preference function
constraint condition analysis in various acts including the product market and the capital
market lacks competition situation. The important thing is not the monopoly manufacturer
and a competitive firm exists between preference differences. If the price or exchange rate
differences between given words buy variety exists difference also is not at all surprising.
Review the knowable different multivariate function of the deformation of considerable. In
the 60 and 70's as though there is a competitive many researchers are looking for new
variables put into the utility function. Integration of these different variables profit is still
a Nike Air Max 90 Women’s important explanatory variable although it is found that firm
size is also very important. In addition researchers such as Mackay have been pointed
out and proved the owner does not actively participate in the management of the company
ownership structure is it decided to top management compensation factor. McKay
Roentgen's discovery the return and profit rate of positive correlation than its sales revenue
is stronger correlations. Satisfactory behavior based on firm behavior satisfactory behavior

theory manufacturers have to set their own minimum performance standards with the goal Notes
of satisfactory rate of profit. Can assume that once they reach the profit rate manufacturers
will wind down. Satisfactory manufacturer behavior theory of one meaning is if you can
get a satisfactory yield if, then does not always exist within a firm to predetermined levels
of yield cost minimum effort. Each vendor management team are faced with the possibility
of other management team can persuade shareholders that if they want to control their
vendors manufacturers will increase profitability.
4. Sales Maximization
Sales maximization is an approach to business where the company's primary

objective is to generate as much revenue as possible. Sales or revenue is the generation
of cash flow through the sale of goods and services. A goal of maximizing revenue does
not necessarily produce profits, because companies often sell products at a loss to
generate revenue.
Sales maximization objectives are typically intended to produce as much revenue
as possible in a short time frame. Companies often have this objective to build their
customer base, to steal customers from competitors, to drive quick cash flow and to sell
excess inventory. Companies use sales objectives for various reasons and at different
times. The launch of the business, near the end of a quarter or fiscal year, during typically
slow times, when the business is slumping and when excess inventory builds up are
common points at which a company may introduce sales maximization goals for a
temporary period. Sales maximization goals do pose significant risks to long-term profit
potential. Companies advertise to build the sense of worth customers have for their
products. Constantly cutting costs to drive revenue creates a price orientation in the
market. If a business mismanages sales objectives, it can restrict the success of long-
term profit maximization.
Professor Baumol (1982) argues that managers are more concerned with the
Maximisation of sales or sales revenue rather than profits. This is because:
1. Managers’ salaries or remuneration are tied to sales and not profits.
2. Larger sales revenue, i.e., bigger size of sales causes a firm to expand. When
the size of the firm increases, it provides better opportunities in the managerial
cadre for promotion and higher status.
3. Increasing sales enables the firm to capture more market and earn business
reputation. Baumol, further states that a firm gives priority to earn a minimum
level of profit; and, once this is realized, it would seek to maximize its sales.
5. Growth Maximization
Professors Penrose and Marris, consider growth maximisation to be the primary goal
of managers. This is because the firm increases the employment of managerial staff at
a rate which maximizes growth. With the growth of firm, the complexities of organization
increases, so the firm requires greater managerial services. Further, managers’ salaries,
perks, prestige, etc., are also linked with the growth of their firms. Marris presents a growth
model of the firm by tracing two basic relationships linking profitability (p) and growth (g):
1. Supply-growth relationship: g = f(p)
2. Demand-growth relationship: p = h(g)
(Here, f and h denote functions)

Notes 6. Managerial Utility Maximization
Williamson (1964) argued that corporate control or governance is largely in the hands
of managers who seek to maximize managerial utility for the obvious reasons of deriving
intrinsic satisfaction from their individual, business and social status. He identified the
following model of managerial behaviour:
U = f (S, DI, M)
Where, U = Managerial utility
S = Expenditure on staff
DI = Discretionary investment, and
M = Managerial slack.
On a comparative basis, therefore, such firms will entail higher operating costs than
the firms aiming at growth and/or profitability. Using Leibenstein (1966), concept of X-
efficiency, we may say that the firms aiming at managerial utility maximisation have an
element of X-inefficiency owing to non-necessary expenditure in their cost structure.
For some businessmen like J.R.D. Tata money is never the driving force; what
propelled him most is the joy of achievement. Profit was not JRD’s primary motivation.
He was more conscious about what the nation’s needs. Tata companies in India as such,
in their Articles of Association have accepted social obligations beyond the welfare of their
own employees as part of their business objectives.
1.17 Profit as Business Objective

The role of profit in business can be judged from the following points:
1. Sources of Income
Investors invest their money in the business with the sole purpose of earning profit,
since profit is a source of income, it is therefore provides the owners of business the mean
with which they and their family members can live a comfortable life.
2. Continuity of Business
The incentive of earning profit keeps the man engaged in business activities. A
business can only grow and gain strength if it earns profit. So earning of profit is necessary
for the continuity of business.
3. Expansion of Business
One of the roles of profit in business is that businessman retains and reinvests a
part of its profits in business undertaking stands on sound footing. It can expand and
diversify business not only from reinvestment of funds but also getting loans from external
sources for business.
4. Reward of Risk Bearing
Profit is the reward for bringing new products or processes to the market. It is a
reward for a risk successfully undertaken. Profit, therefore, is a reward for the future which
is uncertain.
5. Profit and Economic Development
Another role of profit in business is economic development. Profit and economic
development are closely related with each other. If the firms are not earning profit then

there is no economic progress in the country. If there is no economic development there Notes
is no profit to the business.
6. Profit Acts as Measure of Efficiency
Profit acts as an index of performance for business, if the business firms are earning
profits. It shows that the country is progressing satisfactorily
1.18 Theories of Profit
1. Risk-Bearing Theory of Profit
The main proponent of this theory is Prof. Hawley. According to Hawley, one of the
major functions of an entrepreneur is to bear risk that is associated first with the setting
up of the business and then with the management of the business.
The risks in a business are of two types:
(i) Risk involved in the selection of the field of business; and
(ii) Risk associated with the management of the business.
After investing capital in a particular busi-ness, the entrepreneur has to wait for a
long time before he can know if his selection of the field of business has been appropriate—
this long wait is a form of risk-bearing.
Again, while managing the business, the entrepreneur has to bear all the risks arising
out of unexpected changes in the demand and supply for the product.
There may be sudden changes in the demand for a good owing to changes in the
tastes, habits and incomes of the buyers, changes in the availability and prices of the
substitute products, etc.
Also, there may be unexpected changes in the supply of the good owing to changes
in the availability of the factors of produc-tion and changes in production techniques, etc.
Therefore, that the entrepreneur has to bear the risks associated with the unexpected
changes in demand and supply of the product and also the risks associated with the
consequent changes in the price of the product, total revenue and profit of the firm. The
greater the ability of the entrepreneur to bear all these risks, the higher would be his level
of profit. This is the main contention of the risk-bearing theory.
Critical Evaluation of the Theory:
The arguments that may be advanced in favour of the theory are:
(i) The theory attracts our attention to the fact that one of the main functions of
the entrepre-neurs is to bear the risks.
(ii) The theory focuses also on the fact that a very few persons come forward to
play the role of entrepreneurs because here they would have to bear the risks.
That is why the supply of entrepreneurial services is very limited.
Arguments against the Theory:
Let us now come to the arguments against the theory. These are:
(i) Risk-bearing is not the only function of an entrepreneur who has to perform many
vital functions. For example, the entrepreneur has to innovate at regular intervals
new products, new markets and improved methods of production and business.

Notes He may augment his revenue and reduce his expenditures through such
innovations and, consequently, his profit level would go up. Therefore, profit may
also be considered as a reward for effecting innovations. Again, the
entrepreneurs, all of them, have not the same ability to face risks and to perform
other activi-ties.
Therefore, owing to differences in such ability, some entrepreneurs may earn
rent of abil-ity. Similarly, if the entrepreneur is able to establish a monopolistic
dominance in the market, then also his income, i.e., profit, would include the
added income acquired through monopoly power. Therefore, profit cannot be
explained only as a reward for risk-bearing.
(ii) The entrepreneur has surely to bear risks and his profit, at least some part of
it, may be considered to be a reward for risk-bearing. However, risk is a
subjective concept. We cannot measure risk in an objective, cardinal manner.
That is why it is not possible to establish a functional relationship between risk
and profit.
(iii) The exponents of the risk-bearing theory of profit did not distinguish between
insurable risk and non-insurable risk. But if we are to obtain a good estimate
of the amount of risk- bearing, it is essential to remember this distinction. For,
the entrepreneurs actually do not bear the burden of insurable risks it is borne
by the insurance companies.
Therefore, they cannot be considered as risks. According to Prof. Knight, the
entrepreneurs bear the burden of non-insurable risks and he has called these non-insurable
risks by the name of uncertainty. The entrepreneur should obtain profit as a reward for
bearing this uncertainty.
2. Uncertainty-Bearing Theory of Profit
Prof. F. H. Knight (1885-1973) has developed the uncertainty-bearing theory of profit.

He says that we may distinguish between insurable risks and non-insurable risks. This
distinction is important. For, the entrepreneurs actually do not bear the burden of insurable
risks it is borne by the insurance companies. Therefore, they cannot be considered as
risks for the entrepreneurs.
For example, we know from experience that factory premises are exposed to the
risk of fire. We also know why there may be fire in a factory premise, and so, we may
adopt necessary measures for prevention of fire.
In spite of all this, there remains the risk of fire, and, once the insurance companies
agree to bear this risk, it no longer remains a risk. In other words, according to Knight,
insurable risks should not be considered as risks and there is no question of the
entrepreneurs bearing this risk.
However, the entrepreneurs bear the burden of non-insurable risks for there is no
insurance company to bear these risks on their behalf. Prof. Knight has called these risks
the uncertainties.
He tells us that the entrepreneur should get profit as a reward for bearing the
uncertainties of the business world. The more prudently an entrepreneur bears the
uncertainties, the more should be the amount of profit to reward him with.
The following arguments are advanced in favour of the uncertainty-bearing theory of
profit:

(i) The theory attracts our attention to the fact that not all types of risk are to be Notes
borne by the entrepreneur. He actually bears the non-insurable risks. The
insurable risks are taken care of by the insurance agencies.
(ii) The theory tells us that, like all other productive services, uncertainty-bearing
is also a productive service. The entrepreneur supplies this productive service
and profit is the price of this service.
(iii) Since, in general, people are averse to uncertainty-bearing, the supply of
entrepreneurs in the real world is very small. This impression is also obtained
from the theory.
Arguments against the Theory:
The following arguments are advanced against the theory:
(i) Uncertainty-bearing is not the only function of an entrepreneur. The innovation
of new products, new markets or new production and business techniques are
also among the main tasks of an entrepreneur.
Therefore, along with the function of uncertainty-bearing, that of innovation may
also be the source of profit. Again, the rent of ability and monopolistic dominance
may also be the sources of profit. Similarly, a firm may earn profit owing to
its goodwill in the market. Therefore, we cannot say that profit arises only as
a reward for uncertainty-bearing.
(ii) Uncertainty is something subjective it has no objective, cardinal measure. In
the case of organisation and management of a particular business, different
entrepreneurs may have different perceptions of the degree of uncertainty
involved. Therefore, it is almost impossible to build up a functional relation
between uncertainty and profit.
3. Rent Theory of Profit
An American economist, Francis A. Walker (1840-97), is the exponent of the rent

theory of profit. Walker says that an entrepreneur acquires profit because of his ability
to perform. Walker argues like this. In a certain production process, if an entrepreneur
uses land, labour and capital owned by his own self, then the residual part of his revenue,
after payment is made to all these factors of production, is profit.
Now, at any particular price of the product, some entrepreneurs may have this profit
equal to zero. They are called the marginal entrepreneurs. Any such mar-ginal entrepreneur
can have nothing in excess of the wage, interest and rent earned by his own labour, capital
and land.
Therefore, if an entrepreneur’s ability to perform is more than that of a marginal
entrepreneur, then his cost of production would be smaller, and he would be able to earn
a positive profit. In fact, the greater the efficiency of a particular entrepreneur than that
of a marginal entrepreneur, the more would be the amount of profit earned by him.
There is some similarity between profit and rent. For, in the Ricardian theory of rent
also, we have seen that rent is zero on marginal land and the less the cost of production
and more the productivity on a plot of land, the more would be the rent enjoyed by its
owners. Because of this similarity between profit and rent, Walker’s theory is called the
rent theory of profit.
Like the other theories of profit, Walker’s theory cannot satisfactorily explain as to
why the firm and its entrepreneur should get profit. However, the theory attracts our

Notes attention to the similarity between profit and rent. But we should remember that rent is
not the only element of profit.
Walker has argued that profit of the marginal entrepreneur is zero and the profits
earned by an intra-marginal entrepreneur are all rent.
This contention of Walker may be correct if:
(i) An entrepreneur may supply his services only in his present business and he
has no alternative employment to go to; and
(ii) The supply of entrepreneurial services or the number of entrepre-neurs is
completely fixed.
However, in the real world, we always see that the entrepreneurs can supply their
services to many alternative areas and from the point of view of a particular business,
supply of entrepre-neurial services is not completely fixed—the supply can increase if the
reward increases. There-fore, in any particular business, the minimum supply price of
entrepreneurial services is not zero.
Loosely speaking, the minimum supply price of an entrepreneur in his present
business would be equal to the maximum amount of reward that he may avail of in an
alternative field of engagement, other things (i.e., risk or harassment factors) remaining
the same. The minimum supply price of the entrepreneur’s services in his present
engagement is called his normal profit.
If an entrepreneur is able to earn profits in excess of his normal profit, then this excess
is a surplus and this surplus is called pure or economic profit. The amount of pure profit
an entre-preneur may earn would depend upon the efficiency of his performance.
The more his effi-ciency, the more he would be able to earn as pure profit. Therefore,
pure profit which is the excess over normal profit, is of the nature of the rent of ability.
However, we have to remember here that the profit of a firm also includes what is known
as windfall or chance income.
Therefore, the pure profit is a surplus which includes the rental surplus as also the
surplus due to the windfall or chance factors. Therefore, pure profit is a mixed surplus.
4. Innovation Theory of Profit
The innovation theory of profit was developed by Prof. Joseph A. Schumpeter (1883-
1950). According to Schumpeter, the main function of an entrepreneur is to innovate. Here
we have to remember first the distinction which Schumpeter had made between invention
and innovation.
Invention is the discovery of a law of nature by a scientist. On the other hand, if
an entrepreneur manufactures a new product or introduces a new production technique
by using the newly discovered law of nature, and thereby makes the commercial use of
the invention possible, then this is called innovation.
For example, the scientists have discovered or invented the laws of science that are
behind the manufacture of the goods like electric lights or fans, radio sets, television sets,
refrigerators and such other goods. But the entrepreneurs have innovated these goods.
Innovation is the commercial use of the laws of science that have been discovered by
the scientists.
Schumpeter has said that if the entrepreneur can innovate new techniques of
production and sale, if he can innovate a new product or a new model of an old product
and if he can find new markets for selling the product, then Only, he will be able to play
the role of a pioneer in the business world and increase the amount of profit. We may Notes
call this increase in profit the innovation-induced profit.
Criticisms of the Theory:
Schumpeter’s innovation theory of profit has explained nicely how an entrepreneur
may increase the amount of profit by means of innovations. But this theory cannot fully
explain why profit arises or why the entrepreneurs should earn profit.
For example, we know that an entre-preneur should obtain profit as a reward for
bearing risk or uncertainty, for his ability to estab-lish monopolistic dominance, and for
many other reasons. But Schumpeter did not consider these factors that might work behind
the emergence of profit.
5. Dynamic Theory of Profit
According to J. M. Clark (1884-1963), an American economist, profit can emerge

only in a dynamic society. That is why his theory is called the dynamic theory of profit.
We have to remember here the distinction between a dynamic society and a static society.
The society which is constantly changing and where the socio-economic factors like
population and labour force, saving and investment, volume of capital, tastes and choices
of the people, the standard of education, health and culture, etc. are always changing,
is called a dynamic society.
On the other hand, the society where these changes do not occur, is called a static
society. According to Clark, changes do not occur in a static society. That is why here
there is no risk or uncertainty. In such a society, everything goes on according to routine
and everyone has a prior information of what will happen and when.
So here the entrepreneur bears no uncertainty while organising a production process,
and he should not get profit as a reward. Therefore, Clark concludes that profit does not
arise in a static society. The entrepreneur obtains a price for his product in this society,
which would just cover only his cost (including normal profit).
The dynamic society, on the other hand, goes through changes. There the tastes,
habits and fashion, the availability of factors of production and the methods and techniques
of production are all changing. That is why, in such a society, the entrepreneur has to
bear uncertainty. The more successful he is in managing the uncertainties, the higher
would be the profit level acquired by him.
It is clear in the above analysis that in a dynamic society, the entrepreneur has to
be innovative, for innovations lead to changes and changes inspire innovations. On the
other hand, in a static society, innovations do not occur, for such a society does not
experience changes. That is why the dynamic theory of profit is considered to be a more
general form of Schumpeter’s innovation theory.
Critical Estimates
The dynamic theory attracts our attention to the fact that dynamism is urgently
necessary for the social and economic progress of a society. If the society is dynamic,
the entrepreneurs would earn profit and, if they can earn profit, the supply of
entrepreneurship increases and, consequently, production in the society increases.
But the dynamic theory of profit also is not a complete theory. Because, this theory
also does not explain all the causes of the emergence of profit. For example, this theory
does not mention that profit may also arise because of the monopoly power of the firm.

Notes 6. Monopoly Power Theory of Profit
Many economists think that if there is perfect competition in the markets, there
cannot be any profit, because absence of competition creates opportunities in the markets
to acquire profit. As we know, under perfect competition, the buyers and sellers are
assumed to possess full knowledge about the conditions prevailing in the markets.
That is why if the firms in an industry happen to earn more than normal profit in
the short run, then in the long run, number of firms and the supply of the product would
be increasing and the price of the product would be decreasing till all the existing firms
would earn just the amount of normal profit. A firm under perfect competition is one of
a large number of firms.
That is why it can sell more or less any amount of its product at the market-
determined price. The entrepreneur, here, is not required to take an individual initiative
to increase the demand for his product and his sales. Therefore, here the entrepreneur
performs his routine activities and for this he gets no more than the normal profit.
On the other hand, if the entrepreneur possesses monopoly power in the market,
then he would have to exert individual initiative in giving leadership in the market. Now,
in order to maintain his monopoly power and to increase this power, he would have to
exercise necessary efforts.
The entrepreneur here has to bear risk and uncertainty, and he would have to expand
the dominance of his firm in the market through innovations. If the entrepreneur can perform
his job successfully, then he can increase the demand for his product and get a higher
price. Consequently, the amount of pure profit earned by him may increase.
Criticisms:
We may argue in favour of this theory that it has rightly emphasized the role of
monopoly power in the emergence of profit. But this also cannot be a complete theory
of profit.
For we know that even a monopolistic firm can earn less than normal profit or negative
pure profit, i.e., we may have p < AC at his MR = MC point. Therefore, the existence
of monopoly elements in the market may be a necessary condition for the emergence
of profit but it is not a sufficient condition.
7. Labour Exploitation Theory of Profit
According to the great philosopher and classical economist, Karl Marx (1818-1883),
labour is the only factor of production which can produce surplus value. The capitalists
acquire profit by expropriating this surplus value. Marx has said that labour is the only
productive factor.
Labour is given a rate of wage which is much smaller than the net value produced
by it with the help of machines, raw materials, etc. The surplus value is defined as the
difference between the net value produced by labour and what it actually gets as wage.
This surplus value is the profit of the entrepreneur who represents the capitalists.
There would be an increase in the productivity of labour when this profit is converted into
capital and invested again, for now the labour would be able to use more of capital goods
or machines.As the productivity of labour increases, the surplus value created by labour
also increases for the rate of wage of the workers generally does not increase, or, increases
at a much smaller rate. Thus exploitation of labour goes on increasing at an increasing
rate and, along with it, the stock of capital also increases.

Criticisms Notes
In the labour exploitation theory of profit, the role of labour in the creation of surplus
value and the subject of labour exploitation have been rightly emphasised. However, many
economists think that, like labour, the other factors of production, like land and capital,
are also productive.
Besides, Marx has said that it is the capitalists that acquire profit, i.e., he thinks
that capitalists are identical with entrepreneurs, although, in modern economic system,
entrepreneurs and capitalists may be separate persons.
Lastly, Marx does not consider the fact that sometimes the entrepreneurs may have
to bear risks and uncertainties. Therefore, Marx’s theory, too, cannot be considered to
be a complete theory of profit.
8. Marginal Productivity Theory of Profit
We already know how the marginal productivity (MP) theory of factor pricing may
be applied to the determination of the rates of wage and interest. We shall now see how
far the theory is relevant in determining the rate of profit. The MP theory says that the
price of a factor would be equal to the value of its marginal product (VMP).
Therefore, according to the MP theory, the rate of profit would be equal to the VMP
of entrepreneurship or entrepreneurial services. According to definition, the MP of
entrepreneurship is the increment in total output obtained as a result of use of the marginal
unit of entrepreneurial services.
It may be noted here that if we talk of one marginal unit of entrepreneur in place
of one marginal unit of entrepreneurial services, then there would be confusion since a
business firm may have one, or, at best, a few entrepreneurs, and entrepreneur is not
a continuous variable.
Therefore, while examining the relevance of the MP theory in the area of profit, we
should talk not of entrepreneurs, but of entrepreneurial services, the quantity used of which
may be measured, say, in units of time as quantity used of labour is expressed in hours.
Then we would be able to say: if the VMP of entrepreneurial services is greater than
the rate of profit determined in the market, then the entrepreneur would go on increasing
the amount of entrepreneurial services used till the VMP of these services diminishes owing
to the law of diminishing returns, to become equal to the rate of profit.
Criticisms
In the above discussion, we have seen that the MP theory may be applied to the
determination of the rate of profit (of course, the demand side). But this theory also has
defects like those of the other theories. Some-of these defects we shall mention below.
The MP theory, in general, assumes that there is perfect competition in both the
product and the factor markets. Therefore, the theory assumes that there is perfect
competition in the market for entrepreneurial services. That is, the buyers and sellers of
these services are large in number and the sellers are selling homogeneous entrepreneurial
services.
However, this assumption is not realistic at all. First, services of all the entrepreneurs
cannot be homogeneous. Some of the entrepreneurs may be more efficient and some
may be less. Second, the sellers of these services are not large in number in the real
world.
Notes Also, the existence of perfect competition in the market for these services implies
that the price or, the rate of profit is determined by the market forces of demand and
supply. But, by definition, there is nothing like a predetermined rate of pure or economic
profit. This profit is a residual earning.
A major defect of the MP theory is that it does not determine the price of a factor
it only analyses the demand side of the market and enables us to obtain only the demand
curve for the concerned factor of production. This defect of the theory does equally apply
in the case of profit also. That is, the theory explains the demand side of the market
for entrepreneurial services, not the supply side.
Lastly, another defect of the MP theory as applied to profit is that the theory cannot
explain all the elements of profit. For example, windfall profit, as we know, is an element
of profit. Since the windfall profit has no relation whatsoever with the productivity of
entrepreneurial services, this element of profit is beyond the scope of the MP theory to
explain.
1.19 Alternative objectives of Business firms

The traditional theory does not distinguish between owners and managers’ interests.
The recent theories of firm, which are also called managerial and behavioral theories of
firm, assume owners and managers to be separate entities in large corporations with
different goals and motivation. In this section, some important alternative objectives of
business firms, especially of large business corporations are also discussed.
1. Baumol’s Hypothesis of Sales Revenue Maximization
According to Baumol, “maximization of sales revenue is an alternative to profit
maximization objective“. The reason behind this objective is to clearly distinct ownership
and management in large business firms. This distinction helps the managers to set their
goals other than profit maximization goal. Under this situation, managers maximize their
own utility function. According to Baumol, the most reasonable factor in managers utility
functions is maximization of the sales revenue.
The factors, which help in explaining these goals by the managers, are following:
Salary and other earnings of managers are more closely related to seals revenue
than to profits.
Banks and financial corporations look at sales revenue while financing the
corporation.
Trend in sale revenue is a good indicator of the performance of the business firm.
It also helps in handling the personnel problems.
Increasing sales revenue helps in enhancing the prestige of managers while profits
go to the owners.
Managers find profit maximization a difficult objective to fulfill consistently over time
and at the same level. Profits may fluctuate with changing conditions.
Growing sales strengthen competitive spirit of the business firm in the market and
vice versa.
So far as empirical validity of sales revenue maximization objective is concerned,
realistic evidences are unsatisfying. Most empirical studies are, in fact, based on
inadequate data because the necessary data is mostly not available. If total cost function
intersects the total revenue (TR) function before it reaches its highest point, Baumol’s

theory fails. It is also argued that, in the long run, sales maximization and profit Notes
maximization objective can be merged into one. In the long run, sales maximization lends
to yield only normal levels of profit, which turns out to be the maximum under competitive
conditions. Thus, profit maximization is not inequitable with sales maximization objective.
2. Marris’s Hypothesis of Maximization of Firm’s Growth Rate
According to Robin Marris, managers maximize firm’s growth rate subject to
managerial and financial constraints. Marris defines firms balanced growth rate (G) as
follows:
G = Gd = Gc
where,
Gd = growth rate of demand for firms product.
Gc = growth rate of capital supply to the firm.
In simple words, a firm’s growth rate is considered to be balanced when demand
for its product and supply of capital to the firm increase at the same rate. The two growth
rates according to Marris, are translated into two utility functions such as:
Manager’s utility function
Owner’s utility function
The manager’s utility function (Um) and owner’s utility function (Uo) may be specified
as follows:
Um = f (salary, power, job security, prestige, status) and
Uo = f (output, capital, market-share, profit, public esteem).
Owner’s utility function (Uo) implies growth of demand for firms’ products and supply
of capital. Therefore, maximization of Uomans maximization of demand for a firm’s
products or growth of supply of capital.
According to Marris, by maximizing these variables, managers maximize both their
utility function and that of the owner’s. The, managers can do so because most of the
variables such as salaries status, job security, power, etc., appearing in their own utility
function and those appearing in the utility function of the owners such as profit, capital
market, share, etc. are positively and strongly correlated with the size of the firm. These
variables depend on the maximization of the growth rate of the firms. The managers,
therefore, seek to maximize a steady growth rate. Marris’s theory, though more accurate
and sophisticated than Baumol’s sales revenue maximization has its own weaknesses.
It fails to deal satisfactorily with the market condition of oligopolistic interdependence.
Another serious shortcoming is that it ignores price determination, which is the main
concern of profit maximization hypothesis. In tbe opinion of many economists, Marris’s
model too, does not seriously challenge the profit maximization hypothesis.
3. Williamson’s Hypothesis of Maximization of Managerial Utility Function
Like Baumol and Marris, Williamson argues that managers are very careful in
pursuing the objectives other than profit maximization The managers seek to maximize
their own utility function subject to a minimum level of profit. Managers’ utility function
(U) is expressed below:
U = f(S, M, ID)

Notes Where,
S = additional expenditure on staff
M = Managerial emoluments
ID = Discretionary investments
According to Williamson’s hypothesis, managers maximize their utility function
subject to a satisfactory profit. A minimum profit is necessary to satisfy the shareholders
and also to secure the job of managers. The utility functions which managers seek to
maximize include both quantifiable variables like salary and slack earnings anti non-
quantitative variable such as prestige power, status, job security, professional excellence,
etc. The non-quantifiable variables are expressed in order to make them work effectively
in terms of expense preference defined as satisfaction derived out of certain types of
expenditures. Like other alternative hypotheses, Williamson’s theory too suffers from
certain weaknesses. His model fails to deal with the problem of oligopolistic
interdependence. Williamson’s theory is said to hold only where rivalry between firms is
not strong. In case there is strong rivalry, profit maximization is claimed to be a more
appropriate hypothesis. Thus, Williamson’s managerial utility function too does not offer
a more satisfactory hypothesis than profit maximization.
4. Cyert-March Hypothesis of Satisfying Behavior
Cyert-March hypothesis is an extension of Simon’s hypothesis of firms’ satisfying
behavior Simon had argued that the real business world is full of uncertainties. Accurate
and adequate data are not readily available. If data are available, managers have little time
and ability to process them. Managers also work under a number of constraints. Under
such conditions it is not possible for the firms to act in terms of consistency assumed
under profit maximization hypothesis. Nor do the firms seek to maximize sales and growth.
Instead they seek to achieve a satisfactory profit or a satisfactory growth and so on. This
behavior of business firms is termed as satisfaction behavior.
Cyert and March added that, apart from dealing with uncertainty, managers need
to satisfy a variety of groups of people such as managerial staff, labor, shareholders,
customers, financiers, input suppliers, accountants, lawyers, etc. All these groups have
conflicting interests in the business firms. The manager’s responsibility is to satisfy all
of them. According to the Cyert-March, “firm’s behavior is satisfying behavior which implies
satisfying various interest groups by sacrificing firm’s interest or objectives.” The basic
assumption of satisfying behavior is that a firm is an association of different groups related
to various activities of the firms such as shareholders, managers, workers, input supplier,
customers, bankers, tax authorities, and so on. All these groups have some expectations
from the firm, which are needed to be satisfied by the business firms. In order to clear
up the conflicting interests and goals, managers form an objective level of the firm by taking
into consideration goals such as production, sales and market, inventory and profit.
These goals and objective level are set on the basis of the managers past experience
and their assessment of the future market conditions. The objective level is also modified
and revised on the basis of achievements and changing business environment. But the
behavioral theory has been criticized on the following grounds:
Though the behavioral theory deals with the activities of the business firms, it does
not explain the firm’s behavior under dynamic conditions in the long run.
It cannot be used to predict the firm’s activities in the future.
This theory does not deal with the equilibrium of the business industry.

This theory fails to deal with interdependence of the firms and its impact on firms Notes
behavior.
5. Rothschild’s Hypothesis of Long-Run Survival and Market Share Goals
Rothschild suggested another alternative objective and alternative to profit
maximization to a business firm. According to Rothschild, the primary goal of the firm
is long-run survival. Some other economists have suggested that attainment and retention
of a market share constantly, is an additional objective of the business firms. The
managers, therefore, seek to secure their market share and long-run survival. The firms
may seek to maximize their profit in the long run though it is not certain.
The evidence related to the firms to maximize their profits in the long run, is not
certain. Some economists argue that if management is kept separate from the ownership,
the possibility of profit maximization is reduced. This means that only those firms with
the objective of profit maximization can survive in the long run. A business firm can achieve
all other subsidiary goals easily by maximizing its profits. The motive of business firms
behind entry-prevention is also to secure a constant share in the market. Securing constant
market share also favors the main objective of business firms of profit maximization.
1.20 Making a Reasonable Profit

As we know that objectives of business firms can be various. There is no unanimity
among the economists and researchers on the objective of business firms.
One thing is, however, certain that the survival of a firm depends on the profit it can
make.
So whatever the goal of the firm-sales maximization, maximisation of firms, growth,
maximisation of managers’ utility function, long- run survival, market share, or entry-
prevention-it has to be a profitable organisation.
Maximisation of profit in technical sense of the term may not be practicable, but
profit has to be there in the objective function of the firms. The firms may differ on ‘how
much profit’ but they set a profit target for themselves. Some firms set their objective at
a ‘standard profit’, some at a ‘target profit’ and some at a ‘reasonable profit’. ‘A reasonable
profit’ is the most common objective.
Reasons for Aiming at “Reasonable Profits”
For a variety of reasons, modern large corporation aims at making a reasonable profit
rather than maximising the profit.
Joel Dean has listed the following reasons:
1. Preventing entry of competitors:
Profit maximisation under imperfect market conditions generally leads to a high ‘pure
profit’ which is bound to attract competitors, particularly in case of a weak monopoly.
The firms therefore adopt a pricing and a profit policy that assures them a reasonable
profit and, at the same time, keeps potential competitors away.
2. Projecting a favourable public image:
It often becomes necessary for large corporations to project and maintain a good
public image, for if public opinion turns against it and government officials start raising
their eyebrows on profit figures, corporations may find it difficult to sail smoothly. So most

Notes firms set prices lower than that conforming to the maximum profit but high enough to ensure
a “reasonable profit”.
3. Restraining trade union demands:
High profits make trade unions feel that they have a share in the high profit and
therefore they raise demands for wage-hike. Wage-hike may lead to wage-price spiral and
frustrate the firm’s objective of maximising profit. Therefore, profit restrain is sometimes
used as a weapon against trade union activities.
4. Maintaining customer goodwill:
Customer’s goodwill plays a significant role in maintaining and promoting demand
for the product of a firm. Customer’s goodwill depends largely on the quality of the product
and its ‘fair price’. What consumers view as fair price may not commensurate with profit
maximisation. Firms aiming at better profit prospects in the long run, sacrifice short-run
profit maximisation in favour of a “reasonable profit”.
5. Other factors:
Some other factors that put restraint on profit maximisation include
(a) Managerial utility function being preferable to profit maximisation for executives,
(b) Congenial relation between executive levels within the firm,
(c) Maintaining internal control over management by restricting firm’s size and profit,
and
(d) Forestalling the anti-trust suits.
1.21 A Profitable Approach

When firms voluntarily exercise restraint on profit maximization and choose to make
only a ‘reasonable profit’, the questions that arise are:
(i) What form of profit standards should be used, and
ii) How should reasonable profit be determined?
(i) Forms of Profit Standards:
Profit standards may be determined in terms of:

(a) Aggregate money terms,
(b) Percentage of sales, or
(c) Percentage returns on investment.
These standards may be determined with respect to the whole product line or for
each product separately. Of all the forms of profit standards, the total net profit of the
enterprise is more common to the other standards. But when purpose is to discourage
the potential competitors, then a target rate of return on investment is the appropriate
profit standard, provided competitors’ cost curves are similar.
The profit standard in terms of ‘ratio to sales is in eccentric standard’ because this
ratio varies widely from firm to firm, even if they all have the ‘same return on capital
invested’.

This is particularly so when there are differences in: Notes

(a) Vertical integration of production process,
(b) Intensity of mechanization,
(c) Capital structure, and
(d) Turnover
(ii) Setting the Profit Standard:
The following are the important criteria that are taken into account while setting the
standard for a “reasonable profit”.
(a) Capital-attracting standard:
An important criterion of profit standard is that it must be high enough to attract
external (debt and equity) capital. For example, if the firm’s stocks are being sold in market
at 5 times their current earnings, it is necessary that the firm earns a profit of 20 per
cent of the book investment.
There is however certain problems associated with this criterion:
(i) Capital structure of the firms (i.e., the proportions of bonds, equity and
preference shares) affects the cost of capital and thereby the rate of profit, and
(ii) Whether profit standard has to be based on current or long-run average cost
of capital as it varies widely from company to company and may at times prove
treacherous.
(b) ‘Plough-back’ standard:
In case a company intends to rely on its own sources for financing its growth, then
the most relevant standard is the aggregate profit that provides for an adequate “plough-
back” for financing a desired growth of the company without resorting to the capital market.
This standard of profit is used when maintaining liquidity and avoiding debt are main
considerations in profit policy.
Plough-back standard is however socially less acceptable than capital-attracting
standard. From society’s point of view, it is more desirable that all earnings are distributed
to stockholders and they should decide the further investment pattern. This is based on
a belief that market forces allocate funds more efficiently and an individual is the best
judge of his resource use.
On the other hand, retained earnings which are under the exclusive control of the
management are likely to be wasted on low-earning projects within the company. But one
cannot say for certain as to which of the two allocating agencies-market or management-
is generally superior. It depends on “the relative abilities of management and outside
investors to estimate earnings prospects.”
(c) Normal earnings standard:
Another important criterion for setting standard of reasonable profit is the ‘normal’
earnings of firms of an industry over a normal period. Companies own normal earnings
over a period of time often serve as a valid criterion of reasonable profit;
(i) Attracting external capital,
(ii) Discouraging growth of competition, and
(iii) Keeping stockholders satisfied. When average of ‘normal’ earnings of a group
of firms is used, then only comparable firms and normal periods are chosen.

Notes In short, none of these standards of profits is perfect, A standard is therefore chosen
after giving due consideration to the prevailing market conditions and public attitudes. In
fact, different standards are used for different purposes because no single criterion satisfies
all conditions and all the people concerned.
1.22 Summary
Economics is the science that deals with the production, allocation and use of goods
and services. It is important to study how resources can best be distributed to meet the
needs of the greatest number of people.
Scope means province or field of study. In discussing the scope of economics, we
have to indicate whether it is a science or an art and a positive science or a normative
science. It also covers the subject matter of economics.
Science is a systematized body of knowledge that traces the relationship between
cause and effect. Another attribute of science is that its phenomena should be amenable
to measurement.
An art is a system of rules for the attainment of a given end. A science teaches
us to know; an art teaches us to do. Applying this definition, we find that economics offers
us practical guidance in the solution of economic problems. Science and art are
complementary to each other and economics is both a science and an art.
A business firm is an economic organization, which transforms productive resources
into goods that are to be sold in a market. A major part of managerial decision-making
depends on accurate estimates of demand. This is because before production schedules
can be prepared and resources are employed, a forecast of future sales is essential.
Business firms are generally organized with the purpose of making profits. 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 about profits. This uncertainty
occurs because of variations in costs and revenues. These are caused by factors such
as internal and external.
Managerial Economics is economics applied to decision making. It is a special
branch of economics, bridging the gap between pure economic theory and manage-rial
practice. Economics has two main branches micro-economics and macro-economics.
‘Micro’ means small. It studies the behaviour of the individual units and small groups
of units. It is a study of particular firms, particular households, individual prices, wages,
incomes, individual industries and particular commodities. Thus micro-economics gives
a microscopic view of the economy.
‘Macro’ means large. It deals with the behaviour of the large aggregates in the
economy. The large aggregates are total saving, total consumption, total income, total
employment, general price level, wage level, cost structure, etc. Thus macro-economics
is aggregative economics.
Operations are where inputs (factors of production) are converted to outputs (goods
and services). Operations are like the heart of a business, pumping out goods and services
in a quantity and of a quality that meets the needs of the customers. The operations
manager is responsible for overseeing the day-to-day business operations, which can
encompass everything from ordering raw materials to scheduling workers to produce
tangible goods.

Marketing consists of all that a company does to identify customers’ needs and Notes
design products and services that meet those needs. The marketing function also includes
promoting goods and services, determining how the goods and services will be delivered,
and developing a pricing strategy to capture market share while remaining competitive.
Accountants provide managers with information needed to make decisions about the
allocation of company resources. This area is ultimately responsible for accurately
representing the financial transactions of a business to internal and external parties,
government agencies, and owners/investors.
Profit means different things to different people. To an accountant “Profit” means the
excess of revenue over all paid out costs including both manufacturing and overhead
expenses. For all practical purpose, profit or business income means profit in accounting
sense plus non-allowable expenses.
Profit maximization is considered as the goal of financial management. In this
approach, actions that Increase profits should be undertaken and the actions that decrease
the profits are avoided. Thus, the Investment, financing and dividend also be noted that
the term objective provides a normative framework decisions should be oriented to the
maximization of profits.
Wealth maximization is a process that increases the current net value of business
or shareholder capital gains, with the objective of bringing in the highest possible return.
The wealth maximization strategy generally involves making sound financial investment
decisions which take into consideration any risk factors that would compromise or
outweigh the anticipated benefits.
Sales maximization is an approach to business where the company's primary
objective is to generate as much revenue as possible. Sales or revenue is the generation
of cash flow through the sale of goods and services. A goal of maximizing revenue does
not necessarily produce profits, because companies often sell products at a loss to
generate revenue.
1.23 Check Your Progress
I. Fill in the Blanks

1. __________ is called as the 'founding father of modern economics'?
2. If the price elasticity is between 0 and 1, demand is _______________
3. A good with a vertical demand curve has a demand with ____________________
4. The price elasticity of demand can range between ____________________
5. If the price elasticity is between 0 and 1, demand is ____________________
II. True or False

1. “An Enquiry into the Nature and Causes of Wealth of Nations” is the book of
economist by Adam Smith.
2. When economists say, "There is no such thing as a free lunch," they mean
that all economic decisions involve trade-offs.
3. The expected value of a variable is the sum of all possible values which this
variable can take, weighted with the probability that the variable takes each
value.

Notes 4. If the opportunity cost of going to prison for a person falls, this person is less
likely to commit a criminal act.
5. Social responsibility goes beyond making profits to include protecting and
improving society's welfare.
III. Multiple Choice Questions

1. Who is credited with brining the term "the invisible hand"• in economics?
(a) Adam Smith
(b) John Maynard Keynes
(c) F. Hayek
(d) Samuelson
2. Macroeconomics as a separate branch came to be studied after the
contributions of which economist?
(a) Adam Smith
(b) John Maynard Keynes
(c) F. Hayek
(d) Samuelson
3. The price elasticity of demand depends on –
(a) The units used to measure price but not the units used to measure
quantity.
(b) The units used to measure price and the units used to measure quantity.
(c) The units used to measure quantity but not the units used to measure
price.
(d) Neither the units used to measure price nor the units used to measure
quantity
4. The price elasticity of demand measures –
(a) The slope of a budget curve.
(b) How often the price of a good changes.
(c) The responsiveness of the quantity demanded to changes in price.
(d) How sensitive the quantity demanded is to changes in demand
5. The price elasticity of demand can range between
(a) Negative one and one.
(b) Zero and infinity.
(c) Zero and one.
(d) Negative infinity and infinity
6. If the price elasticity is between 0 and 1, demand is –
(a) Inelastic
(b) Elastic
(c) Perfectly elastic
(d) Unit elastic
7. Demand is inelastic if –
(a) A large change in quantity demanded results in a small change in price.
(b) The price elasticity of demand is greater than 1.

(c) The quantity demanded is very responsive to changes in price. Notes

(d) The price elasticity of demand is less than 1.
8. Income elasticity of demand is defined as the responsiveness of:
(a) Quantity demanded to a change in income
(b) Quantity demanded to a change in price
(c) Price to a change in income
(d) Income to a change in quantity demanded
1.24 Questions and Exercises
I. Short Answer Questions

1. Define the term of Economics.
2. What is economic concept?
3. What is Micro Economics?
4. What is Macro-Economics?
5. What is Managerial Economics?
6. Define Managerial Economics?
7. Define the term profit.
8. What is Business firm?
II. Extended Answer Questions

1. Explain in details about Problem of Choice.
2. Discuss fundamental economic concepts.
3. Explain nature of economics.
4. Discuss scope of economics.
5. Distinguish between Micro and Macro-Economics.
6. Explain nature of Managerial Economics.
7. Discuss scope of Managerial Economics.
8. Explain roles and responsibilities of a managerial economist.
9. Discuss objectives of Business Firms.
10. Explain various Theories of profit.
1.25 Key Terms

l Economics: Economics is the science that deals with the production, allocation
and use of goods and services. It is important to study how resources can best
be distributed to meet the needs of the greatest number of people.
l Economics is a science: Science is a systematized body of knowledge that
traces the relationship between cause and effect. Another attribute of science
is that its phenomena should be amenable to measurement.
l Economics is also an art: An art is a system of rules for the attainment of
a given end. A science teaches us to know; an art teaches us to do. Applying
this definition, we find that economics offers us practical guidance in the solution
of economic problems. Science and art are complementary to each other and
economics is both a science and an art.
Notes l Profit Management: Business firms are generally organized with the purpose
of making profits. 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 about profits. This uncertainty occurs because of variations
in costs and revenues. These are caused by factors such as internal and
external.
l Managerial Economics: Managerial Economics is economics applied to
decision making. It is a special branch of economics, bridging the gap between
pure economic theory and manage-rial practice. Economics has two main
branches micro-economics and macro-economics.
l Micro-economics: ‘Micro’ means small. It studies the behaviour of the individual
units and small groups of units. It is a study of particular firms, particular
households, individual prices, wages, incomes, individual industries and
particular commodities. Thus micro-economics gives a microscopic view of the
economy.
l Macro-economics: ‘Macro’ means large. It deals with the behaviour of the large
aggregates in the economy. The large aggregates are total saving, total
consumption, total income, total employment, general price level, wage level,
cost structure, etc. Thus macro-economics is aggregative economics.
l Operations: Operations are where inputs (factors of production) are converted
to outputs (goods and services). Operations are like the heart of a business,
pumping out goods and services in a quantity and of a quality that meets the
needs of the customers.
l Marketing: Marketing consists of all that a company does to identify customers’
needs and design products and services that meet those needs. The marketing
function also includes promoting goods and services, determining how the goods
and services will be delivered and developing a pricing strategy to capture market
share while remaining competitive.
l Accounting: Accountants provide managers with information needed to make
decisions about the allocation of company resources. This area is ultimately
responsible for accurately representing the financial transactions of a business
to internal and external parties, government agencies, and owners/investors.
l Profit: Profit means different things to different people. To an accountant “Profit”
means the excess of revenue over all paid out costs including both
manufacturing and overhead expenses. For all practical purpose, profit or
business income means profit in accounting sense plus non-allowable
expenses.
l Profit Maximization: Profit maximization is considered as the goal of financial
management. In this approach, actions that Increase profits should be
undertaken and the actions that decrease the profits are avoided. Thus, the
Investment, financing and dividend also be noted that the term objective provides
a normative framework decisions should be oriented to the maximization of
profits.
l Wealth Maximization: Wealth maximization is a process that increases the
current net value of business or shareholder capital gains, with the objective
of bringing in the highest possible return. The wealth maximization strategy
generally involves making sound financial investment decisions which take into
consideration any risk factors that would compromise or outweigh the
anticipated benefits.

l Sales Maximization: Sales maximization is an approach to business where Notes

the company's primary objective is to generate as much revenue as possible.
Sales or revenue is the generation of cash flow through the sale of goods and
services. A goal of maximizing revenue does not necessarily produce profits,
because companies often sell products at a loss to generate revenue.
1.26 Check Your Progress: Answers

I. Fill in the Blanks
1. Adam Smith
2. Inelastic
3. Zero elasticity
4. Zero and infinity.
5. Inelastic
II. True or False
1. True
2. True
3. True
4. False
5. True
III. Multiple Choice Questions
1. (a) 2. (b)
3. (d) 4. (c)
5. (b) 6. (a)
7. (d) 8. (a)
1.27 Case Study

Analyse the case and answer the questions appended.
A closed economy has market clearance equations built over several decades.
Domestically, the economy acquired wealth over the years. The policy makers looked at
the domestic markets and found that product markets are almost perfect and that technical
rate of substitution has been advantageous. The economic fundamentals were strong
enough to open up the economy. There was opposition attributing to inconsistency from
“outside” The debate were on the following questions.
1) What are the macro economic fundamentals?
2) Could market equations remain the same after “opening up” of the economy?
3) What if the economy is closed for some more time?
1.28 Further Readings

1. Paul A. Samuelson, William D. Nordhaus, Sudip Chaudhuri and Anindya Sen,
Economics, 19thedition, Tata McGraw Hill, New Delhi, 2010.
2. William Boyes and Michael Melvin, Textbook of economics, Biztantra,11th
Edition, 2015.

Notes 3. N. Gregory Mankiw, Principles of Economics, 7th edition, Cengage, New Delhi,
2014
4. Richard Lipsey and Alec Charystal, Economics, 12th edition, Oxford, University
Press, New Delhi, 2015.
5. Karl E. Case and Ray C. fair, Principles of Economics, 14th edition, Pearson,
Education Asia, New Delhi, 2016.
1.29 Bibliography
1. Managerial Economics- Theory and Applications, Dr. D.M Mithani, Himalaya
Publications.
2. Managerial Economics, D.N Dwivedi, 6th ed., Vikas Publication.
3. Managerial Economics, H. L Ahuja, S. Chand, 2011
4. Indian Economy, K P M Sundharam and Dutt, 64th Edition, S Chand
Publication.
5. Business Environment Text and Cases by Justin Paul, 3rd Edition, McGraw-
Hill Companies.
6. Managerial Economics- Principles and worldwide applications, Dominick
Salvatore, Oxford Publication, 6e, 2010
7. Managerial Economics, Atmanand, Excel BOOKS, 2/e, 2010
8. Managerial Economics, Yogesh Maheshwari, PHI, 2/e, 2011
9. Managerial Economics: Case study solutions- Kaushal H, 1/e., Macmillan, 2011
10. Paul A. Samuelson, William D. Nordhaus, Sudip Chaudhuri and Anindya Sen,
Economics, 19thedition, Tata McGraw Hill, New Delhi, 2010.
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Introduction to Economics and Managerial Economics 1

Unit 1: Introduction to Economics and

Notes l Definition, nature and scope of Managerial Economics

1.1 Introduction to Economics

1.2 History of Economic Thoughts

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Notes 1.3 Meaning and Definitions of Economics

1.4 Problem of Choice

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1.5 Fundamental Economic Concepts

1.6 Nature of Economics

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1.7 Scope of Economics

i) Economics - A Science and an Art

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ii) Positive and Normative Economics

Economics is both positive and normative science.

1.8 Micro and Macro-Economics

Microeconomics is a branch of economics that studies the behavior of how the

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Macroeconomics is the subdivision of economics that studies the behavior and

According to Blaug, Mark (1985), “Macroeconomics is a branch of economics

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Microeconomics vs. Macroeconomics

There are differences between microeconomics and macroeconomics, although, at

Distinguish between Microeconomics and Macroeconomics

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Notes The Concept of Macroeconomics

Macroeconomics is a branch of economics dealing with the performance, structure,

Basic Macroeconomic Concepts

Macroeconomics encompasses a variety of concepts and variables, but three are

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Significance of Macro Economics

The significances of macroeconomics are summarized as follows:

1.9 Concept of Managerial Economics

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Managerial economics is a specialized discipline of management studies which deals Notes

1.10 Meaning and Definitions of Managerial Economics

Importance / Significance of Managerial Economics

The importance of managerial economics can be summarized as follows:

Notes vii) Economic methodology: It uses analytical tools of mathematical economics

1.11 Nature of Managerial Economics

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Economics in essence pertains to an understanding of life’s principal pre-occupation. Notes

Notes 1.12 Scope of Managerial Economics

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1.13 Roles and responsibilities of a Managerial Economist Notes

1.14 Relationship to economic theory, decision sciences, statistics,

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Amity Directorate of Distance and Online Education

Notes 1.15 Functional Areas of Business

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1.16 Objectives of Business Firms

Profit Maximization under different viewpoints

1. Total revenue - total cost viewpoint

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Notes Profit Maximization - The Total Approach

2. Marginal revenue-marginal cost viewpoint

Profit maximization using the marginal approach

Case in which maximizing revenue is equivalent

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Amity Directorate of Distance and Online Education