Basic Concepts of Managerial Economics
Basic Concepts of Managerial Economics
The future is always uncertain. Management takes many decisions and prepares plans for the future with a realistic understanding. In this, management is helped by some basic concepts and techniques in taking the right decisions. These concepts are as follows-
(1) Principle of Opportunity Cost- Opportunity cost means the cost of predetermined opportunities. The opportunity of a product or service means the expected revenue to be earned when that product or service is put to alternative use. According to Benham- “The opportunity cost of something is the other better option instead of being produced by the same elements or by an equivalent group of elements.” According to W.W. Haynes, “The opportunity cost of a decision means the sacrifice of options required by that decision.” W.W. Hennis has explained the meaning of the concept of opportunity cost with the help of the following examples-
1. The opportunity cost of funds invested in one’s own business is the interest (or profit corrected for the rest at risk) that could have been earned from the same funds on other activities.
2. The opportunity cost of the time invested by him in his own business is the salary he would have earned from other occupations (with correction for the relative psychological income in the two occupations).
3. The opportunity cost of using a machine to manufacture one product is the sacrifice of income which is possible from other products.
4. The opportunity cost of using a machine which is useless for any other purpose is zero because its use does not result in any sacrifice of 90 10 other opportunities.
It is clear from the above examples that opportunity cost requires the measurement of sacrifices. If a decision involves sacrifice, then there will be no opportunity cost. In this connection it is also important to note that opportunity cost is not recorded in the books of accounts but it has an important place in business decisions.
(II) Principle of incremental cost – Incremental cost is the specific cost which has to be incurred on taking up a business and does not have to be incurred until the business is not taken up. According to Hennis, Mile and Paul, “It involves the assessment of the effects of alternative decisions on costs and revenues with emphasis on the changes in total cost and total revenue that result from changes in prices, products, producers, investments or whatever else is at stake in the decision.” Therefore, it can be said that incremental cost is that cost in total cost which is caused by a change in the level of activity.
There are two basic concepts involved in this analysis- the concept of incremental cost and the concept of incremental revenue. Incremental cost refers to the change in total cost and incremental revenue refers to the change in total revenue that occurs as a result of a decision. According to W.W. Hennis, it will be profitable if-
1.It increases revenue more than costs.
2.It reduces some costs more than it increases others.
3.It increases some revenues more than it reduces others.
4.It reduces costs more than revenue.
