Principles of Managerial Economics

Opportunity cost 

Opportunity cost is the next-best choice available to someone who has picked between several mutually exclusive choices. It is a key concept in economics. It is a calculating factor used in mixed markets which favour social change instead of purely individualistic economics. It has been described as expressing "the basic relationship between scarcity and choice." The notion of opportunity cost plays a crucial part in ensuring that scarce resources are used efficiently. Thus, opportunity costs are not restricted to monetary or financial costs: the real cost of output forgone, lost time, swag, pleasure or any other benefit that provides utility should also be considered opportunity costs.

§  A person who has $15 can either buy a CD or a shirt. If he buys the shirt the opportunity cost is the CD and if he buys the CD the opportunity cost is the shirt. If there are more choices than two, the opportunity cost is still only one item, never all of them.

§  A person who invests $10,000 in a stock denies herself or himself the interest that could have accrued by leaving the $10,000 in a bank account instead. The opportunity cost of the decision to invest in stock is the value of the interest.

§  A person who sells stock for $10,000 denies himself or herself the opportunity to sell the stock for a higher price (say $12,000) in the future, inheriting an opportunity cost equal to the future price of $12,000 (and not the future price minus the sale price). Note that in this case, the opportunity cost can only be determined in hindsight.

§  An organization that invests $1 million in acquiring a new asset instead of spending that money on maintaining its existing asset portfolio incurs the increased risk of failure of its existing assets. The opportunity cost of the decision to acquire a new asset is the financial security that comes from the organization's spending the money on maintaining its existing asset portfolio.

§  If a city decides to build a hospital on vacant land it owns, the opportunity cost is the value of the benefits forgone of the next best thing that might have been done with the land and construction funds instead. In building the hospital, the city has forgone the opportunity to build a sports center on that land, or a parking lot, or the ability to sell the land to reduce the city's debt, since those uses tend to be mutually exclusive. Also included in the opportunity cost would be what investments or purchases the private sector would have voluntarily made if it had not been taxed to build the hospital. The total opportunity costs of such an action can never be known with certainty, and are sometimes called "hidden costs" or "hidden losses" as what has been prevented from being produced cannot be seen or known. Even the possibility of inaction is a lost opportunity. In this example, to preserve the scenery as-is for neighboring areas, perhaps including areas that it itself owns.

Opportunity cost is assessed in not only monetary or material terms, but also in terms of anything which is of value. For example, a person who desires to watch each of two television programs being broadcast simultaneously, and does not have the means to make a recording of one, can watch only one of the desired programs. Therefore, the opportunity cost of watching Dallas could be enjoying Dynasty. Of course, if an individual records one program while watching the other, the opportunity cost will be the time that that individual spends watching one program versus the other. In a restaurant situation, the opportunity cost of eating steak could be trying the salmon. For the diner, the opportunity cost of ordering both meals could be twofold - the extra $20 to buy the second meal, and his reputation with his peers, as he may be thought gluttonous or extravagant for ordering two meals. A family might decide to use a short period of vacation time to visit Disneyland rather than doing household improvements. The opportunity cost of having happier children could therefore be a remodeled bathroom.

If Adam can visit Kate in Western Australia for 3 days of a long weekend, or 7 days of a regular week but have to go to the beach while she goes to the office, then "Seeing Kate" on the days when she must work is the opportunity cost of being in Australia at all on work days. This is a more colloquial stretch of an example.

Marginal and Incremental Principle

This principle states that a decision is said to be rational and sound if given the firm’s objective of profit maximization, it leads to increase in profit, which is in either of two scenarios-

·         If total revenue increases more than total cost.

·         If total revenue declines less than total cost.

Marginal analysis implies judging the impact of a unit change in one variable on the other. Marginal generally refers to small changes. Marginal revenue is change in total revenue per unit change in output sold. Marginal cost refers to change in total costs per unit change in output produced (While incremental cost refers to change in total costs due to change in total output).The decision of a firm to change the price would depend upon the resulting impact/change in marginal revenue and marginal cost. If the marginal revenue is greater than the marginal cost, then the firm should bring about the change in price.

Incremental analysis differs from marginal analysis only in that it analysis the change in the firm's performance for a given managerial decision, whereas marginal analysis often is generated by a change in outputs or inputs. Incremental analysis is generalization of marginal concept. It refers to changes in cost and revenue due to a policy change. For example - adding a new business, buying new inputs, processing products, etc. Change in output due to change in process, product or investment is considered as incremental change. Incremental principle states that a decision is profitable if revenue increases more than costs; if costs reduce more than revenues; if increase in some revenues is more than decrease in others; and if decrease in some costs is greater than increase in others.

Two basic concepts of incremental principle are:

1.     Incremental costs

2.     Incremental revenues

Incremental Costs:   It may be defined as the change in the total cost resulting in the form of a particular decision.

Incremental Revenues: It is the change in total revenues resulting from a particular decision.

                The incremental principle may be stated as – under decision is a profitable one, if

·         Its incremental revenue is more than costs

·         It decreases some costs more  than it increases others

·         It increases some revenues more than it deceases others

·         It reduces cost more than the revenue.

Time Perspective Principle

According to this principle, a manger/decision maker should give due emphasis, both to short-term and long-term impact of his decisions, giving apt significance to the different time periods before reaching any decision. Short-run refers to a time period in which some factors are fixed while others are variable. The production can be increased by increasing the quantity of variable factors. While long-run is a time period in which all factors of production can become variable. Entry and exit of seller firms can take place easily. From consumers point of view, short-run refers to a period in which they respond to the changes in price, given the taste and preferences of the consumers, while long-run is a time period in which the consumers have enough time to respond to price changes by varying their tastes and preferences.

Discounting Principle

According to this principle, if a decision affects costs and revenues in long-run, all those costs and revenues must be discounted to present values before valid comparison of alternatives is possible. This is essential because a rupee worth of money at a future date is not worth a rupee today. Money actually has time value. Discounting can be defined as a process used to transform future dollars into an equivalent number of present dollars. For instance, $1 invested today at 10% interest is equivalent to $1.10 next year.

FV = PV*(1+r)^t

Where, FV is the future value (time at some future time), PV is the present value (value at t0, r is the discount (interest) rate, and t is the time between the future value and present value.

Until recently it has been common practice in economic evaluations to “discount” both future costs and benefits, but recently discounting benefits has become controversial. Discounting makes current costs and benefits worth more than those occurring in the future because there is an opportunity cost to spending money now and there is desire to enjoy benefits now rather than in the future. The reason why current spending incurs an opportunity cost relative to delayed spending is that a monetary investment yields a real rate of return and therefore there is a cost to spending money in the present.

For example, if £100 were invested with a nominal return of 10%, in one year’s time it would be worth £110; if inflation was 4% this would result in a real return of £6 on every £100 invested. If for some reason £100 of healthcare spending were delayed for one year then (assuming prudent investment) we could expect that in one year’s time we would have £106 for healthcare investment.

To take into account the opportunity cost of investing now rather than waiting one year we have to discount future costs. Therefore, if two healthcare interventions both released £100 in savings but for one we had to wait a year, then, all other things being equal, we would adopt the intervention that saved £100 now. This is because the £100 released now, if invested, would produce an extra £6 in a year’s time (with a discount rate of 6%).

Failure to discount the future costs in economic evaluations can give misleading results. For example, an evaluation of cystic fibrosis screening revealed a cost of £80000 for detecting and terminating one affected pregnancy. This cost was compared with the future excess costs of treating an individual with cystic fibrosis, which was estimated to be £5000 a year over 25 years. As cystic fibrosis screening benefits (£125000) outweighed the costs (£80000) it was concluded that screening represented good value for money. However, if the averted costs had been discounted (at 6%) then these would have been only £63917, which alters the study’s results (though not if the discount rate were only 4%).

Discounting future costs is uncontroversial and until recently so was the process of discounting health related benefits. The main argument against discounting health benefits is that health, unlike wealth, cannot be invested to produce future gains.The Department of Health has thus recommended that health related benefits should not be discounted,though more recent advice suggests future health benefits should be discounted but at a very low rate of 1.5%-2%.

An important reason for discounting future costs and benefits is “time preference,” which refers to the desire to enjoy benefits in the present while deferring any negative effects of doing so. Examples of human behaviour which implicitly discount future health effects abound. For instance smoking and drinking give current pleasure while incurring future (discounted) detrimental health effects. Indeed, research has indicated that smokers value future health benefits at a lower rate than non-smokers. This desire to enjoy pleasurable benefits in the present time is often reflected in differential pricing of goods and services. Consider the hire of a video for home viewing. Despite the increased cost of newly released videos, many people are willing to pay the extra cost rather than wait until the price falls

Equi-marginal Principle

Marginal Utility is the utility derived from the additional unit of a commodity consumed. The laws of equi-marginal utility states that a consumer will reach the stage of equilibrium when the marginal utilities of various commodities he consumes are equal. According to the modern economists, this law has been formulated in form of law of proportional marginal utility. It states that the consumer will spend his money-income on different goods in such a way that the marginal utility of each good is proportional to its price, i.e.,

MUx / Px = MUy / Py = MUz / Pz

Where, MU represents marginal utility and P is the price of good.

Similarly, a producer who wants to maximize profit (or reach equilibrium) will use the technique of production which satisfies the following condition:

MRP1 / MC1 = MRP2 / MC2 = MRP3 / MC3

Where, MRP is marginal revenue product of inputs and MC represents marginal cost.

Thus, a manger can make rational decision by allocating/hiring resources in a manner which equalizes the ratio of marginal returns and marginal costs of various use of resources in a specific use.