Principles of Economics in Business Situations Essay
The behavior of this group of people is therefore a subject matter of study for economics. A Business Manager is responsible for leading this group of people in the direction of attainment of the objectives. In this capacity she has to take several decisions during the course of her day-to-day operations. An understanding and application of principles of economics would help the Business Manager to take appropriate decisions under various situations. Scope of Managerial Economics – Principle of Economics can help a Manager in taking decisions in various business situations.
These can be summarized with the help of the following diagram – Business Decisions are primarily centered around Production and Sales. In addition o this, the environment in which a business organization operates has an impact on the Business Decisions. Various topics in Economic Theory help Business Managers in their functions. (I) Sales, Marketing and Advertising – Sales, marketing and advertising related decision need an in-depth understanding of the Consumer Behavior.
We need to understand the reasons for consumption, factors affecting consumption, constraints faced by the consumers, the decision-making process of the consumer as regards price to be paid, quantity to be purchased, allocation of resources between different needs, etc. Theory of
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Cross Price Elasticity helps in identifying competitors which may not be essentially within the same product category – egg. Should soft-drinks manufacturers be seen as competitors for Tea? Theory of Consumer’s Equilibrium helps in understanding how a consumer allocates his income between different needs. Having understood the various factors that affect demand for a product and the decision-making process of a consumer helps easiness managers in devising more effective sales, marketing and advertising strategies. (it) Production – Production is perhaps the most important activity in a business organization.
A Business Manager has to take several decisions regarding production – egg. What to produce, what should be the plant capacity, what should be the capacity utilization, which technology to use, etc. While organizing of production activity, Business Managers have to take several factors into consideration, such as – could have various objectives such as profit minimization, sales minimization, minimization of market share, etc. Economics helps us to understand what impact these different objectives will have on key variables such as Sales, Production, Prices, Costs, Profits, etc.
Organization Economics, a branch of economics helps us in understanding relationship between firm objectives and internal dynamics of an organization. (b) Profit Minimization – In traditional theory we examine a firm that has profit minimization as its central objective. In order to maximize profits a firm has to minimize costs and maximize its revenues. Thus, a deeper understanding of the Costs and Revenues is required for achieving this objective. (c) Revenues – Revenues of a firm depend on the demand scenario and the competitive scenario in the market.
The understanding of the above two would be essential for a business manager to predict the revenues that the business will be able to generate. (d) Demand scenario – To decide on the plant capacity and capacity utilization, an understanding of quantity demanded in the market in different time periods is important (e) Market Structures – In addition to the quantity demanded, one has to understand the competitive scenario. How many players are competing for the given market demand? What is the market structure and how will it impact the firm’s own ales? F) Costs – In order to maximize profits, a firm needs to minimize costs. Costs are impacted by several factors. Primary among them are quantity of production and factor prices. (g) Technology – Technology has multi-dimensional impact on costs. On one hand technology determines what combination of various factors is to be used – egg. Capital-intensive technology or labor intensive technology. Technology also determines the levels of production possible – both in terms of optimum capacity as also in terms of range of capacities at which a plant can operate.
This in turn has an impact on the costs. – egg. The most efficient level of operation of a certain plant may be at 1000 units per day (where cost of production is lowest). However, it would be possible to operate the same plant within a range of 500 units per day to 1200 units per day (though may not be at same levels of efficiencies – I. E. It may result in higher costs). Thus while taking a decision to select technology for production; its impact on costs will have to be kept in mind. Quite often the most advanced technology may not be the best choice in terms of its impact on costs. H) Factor Pricing – Technology dictates a certain combination of factors that need to be used. One has to check whether it would be affordable for business to employ those factors in the given quantities. Often prohibitively high price of factors would dictate choice of technology. Thus, while taking important decisions regarding the production activity, understanding of Economics would be essential at every step. (iii) Business Environment – Finally, businesses operate in a given social, political and economic environment.
There is a symbiotic relationship between the business and its environment. A business organization, through its operations, causes an impact on the surrounding socio-economic conditions. So also, the socio-economic environment prevailing in the outer world has an impact on the business. From time to time, Business Managers are required to foresee the changes in the outer world, analyze their likely impact on their business and take necessary corrective actions. Events from the economic environment such as changes in government policies, tax inflation, etc. Business cycles and growth projections are some of the important events that directly or indirectly impact every business activity. Knowledge of macroeconomics is quite often required to be able to predict these events in the economy and understand the likely impact of these changes on business. Other Analytical Tools Apart from these, economics equips the Business Manager with important analytical tools that help him in performing his functions in the following aspects : (v) Fundamental Principles of Behavior – As pointed out earlier, a Business Manager deals with a group of human beings plating different roles – egg. Nonusers, suppliers, share-holders, workers, etc. Economics studies the fundamental motivating factors behind behavior of these different economics agents. This knowledge would hush help the Business Manager in influencing behavior of these economic agents in a manner that enables the business to achieve its objectives. (v) Decision Criterion – An important part of study of economics is to understand the decision criterion of different economic agents such as consumers, firms, workers, etc.
Economics aims at arriving at a logical method of arriving at a decision given the objectives that the economic agent has to achieve and the constraints within which she operates. This technique is helpful to a Business Manager in taking the numerous decisions that she is required to take during the course of her work. V’) Resource Allocation – The above techniques of decision-making studied in economics can be used for taking a wide range of decisions including those regarding allocation of resources, capital management, distribution and logistics, etc. – egg.
If a decision has to be taken for distributing a capital of RSI. 1 million between various used A, B and C, the technique of Marginal Analysis tells us that the Capital should be distributed in such a manner that the marginal returns from each use is equal. (vii) Designing of Management Information Systems (MIS) – The decision criteria tells what information would be squired so as to enable us to take the right decision. One can use this input in designing a proper MIS that is relevant and useful – egg. In the above case the MIS should be designed to give the manager information about marginal returns.
Instead, if the MIS gives information about average and total returns, it would not help in the decision-making process. (viii) Economic v/s Accounting Decisions – Economics introduces us to certain differences between good accounting decisions and good business decisions. It tells us how a result which may seemingly be good and proper in accounts may, in-fact be a wrong business decision – egg. T may not be taking into account opportunity costs or replacement costs. (xx) Cost-Benefit Analysis – Economics helps Business Managers in enlarging their scope of Cost-Benefit Analysis.
Economics informs us that the C-B Analysis should not be looked at from the narrow perspective of immediate increase in profitability to business. Along with this a more comprehensive Social Cost-Benefit Analysis is also essential to understand the long- term implications of business on the economy and the society. Such an understanding can also be leveraged to enhance the overall profitability of business – egg. Ability of business to generate employment in the economy can be used as leverage in extracting tax concessions from the government.
The methods of demand forecasting are Opinion survey methods and statistical methods. (1) Opinion survey methods(2) Consumers opinion survey(3) Expert opinion survey(4) Collective opinion survey(S) Test marketing or controlled experimentation method(6) End use method I I 1)Consumers opinion survey:- The consumer opinion survey can be either census or sample survey where the numbers of buyers are limited, census survey methods hold. In this case, the opinion of the entire universe is obtained.
On the other hand, where the number of buyers is large, universal survey is not feasible; hence, sample survey methods are used The results obtained through the sample surveys are blown up to the entire universe to obtain the forecasted demand However, it should be borne in mind that consumer opinion surveys are not perfectly reliable as there are consumers biases and based on the likely hood of some future changes that mayor may not materialize. Further, consumer opinion surveys are expensive and time taking. 2)Expert opinion method or Delphi method:-Expert opinion method is a variant f the consumers opinion survey method.
It was also popular as Delphi method and first used by Rand Corporation in USA for predicting the demand under conditions of intractable technological changes. It is used under conditions of nonexistence of data or when a new product is being launched. The fairest step in this method is the identification of experts and eliciting their opinions about the likely demand for the product. The experts may differ in their views in which case the firm has to pass on the opinions of one expert to the other, of course under strict anonymity and seek heir reactions.
This exercise should go on until a common line of thinking emerges. I I 3) Collective opinion surveyor sales force opinion survey method:- In this method, the firm will extract the opinions of the sales team, which is on the payrolls of the company about the future demand for the product. The sales personnel are very close to the consumers and dealers. They express their opinions about the future demand for the product. The opinions so gathered are tabulated and the demand forecasts will be arrived at. However, care be taken before forming an opinion about the future demand.
The opinions of the sales team should not be taken on the face value as an ambitious sales man gives an over estimate of the demand for the product while a skeptic fearing the fixation of higher sales targets always quotes a lesser figure. This can resolved by maintaining a track record of accomplishment of the previous targets and achievements of each member of the sales team and make necessary adjustments in the forecasted sales and arrive at a conclusion. This method is an inexpensive but more reliable method of demand forecasting.
I 4)Test marketing or controlled experimentation:- Firms resort to test marketing while munching a new product or likely to change the design or model of the existing products. This is also known as controlled experimentation method as the product is likely to be launched in a segmented market to identity its demand potential. The essential prerequisites of test marketing are that the product price, its design, quality, level of advertisement and sales promotion campaign should be equal in promotion to that of what the firm is likely to incur had it been released in the dilatation market.
Test marketing should be continued until the repurchase cycle commences. The geographical, economic, sociological and even the demo Topic eaters of the test marketing region should represent all the features of the national market. Test marketing can be under taken in a single market or different markets with different features of the product. Test marketing will no doubt be useful method as it ventilates the consumer preferences and facilitates the model or design changes if necessary but at the same time, it is an expensive proposition.
The forecasted sales in the test marketing area should not be taken on their face values. 5)End-use or input-output method end-use method applies for forecasting the demand for intermediate products. These are products used in the manufacture of some other final goods. The demand for the final product is an indicator of the demand for intermediate product, subject to the availability of the input/output coefficients. Once the demand for the final goods estimated, the demand for the intermediate product can be easily arrived at using the input-output coefficients.
The major problem of using this method is that one product is an intermediate product for producing not One commodity but several other commodities as in the case of iron and steel. In such cases. The input-output coefficient in all the uses and the estimated demand for all those products should be available, failing which the demand forecasts become useless. SOON AAA NAS- * I no. 3. 759 | Break-Even Method of Investment Analysis P. H. Guttering and N. L. Deleted* (3/12) * A break- even point defines when an investment will generate a positive return. Fixed costs are not directly related to the level of production. * Variable costs change in direct relation to volume of output. * Total fixed costs do not change as the level of production increases. Break-even analysis is a useful tool to study the relationship between fixed costs, variable costs and returns. A break-even point defines when an investment will generate a positive return and can be determined graphically or with simple mathematics. Break-even analysis computes the volume of production at a given price necessary to cover all costs.
Break-even price analysis computes the price necessary at a given level of production to cover all costs. To explain how break-even analysis works, it is necessary to define the cost items. Fixed costs, incurred after the decision to enter into a business activity is made, are not directly related to the level of production. Fixed costs include, but are not limited to, depreciation on equipment, interest costs, taxes and general overhead expenses. Total fixed costs are the sum of the fixed costs.
Variable costs change in direct relation to volume of output. They may include cost of goods sold or production expenses such as labor and power costs, feed, fuel, veterinary, irrigation and other expenses directly related to the production of the variable costs for the specified level of production or output. Average variable costs are the variable costs per unit of output or often divided by units of output. Total fixed costs are shown in Figure 1 by the broken horizontal line. Total iced costs do not change as the level of production increases.
Total variable costs of production are indicated by the broken line sloping upward, which illustrates that total variable costs increase directly as production increases. The total cost line is the sum of the total fixed costs and total variable costs. The total cost line parallels the total variable cost line, but it begins at the level of the total fixed cost line. The total income line is the gross value of the output. This is shown as a dotted line, starting at the lower left of the graph and slanting upward.
At any point, the total income line is equivalent to the number of units produced multiplied by the price per unit. The key point (break-even point) is the intersection of the total cost line and the total income line (Point P). A vertical line down from this point shows the level of production necessary to cover all costs. Production greater than this level generates positive revenue; losses are incurred at lower levels of production. I Figure 1: Graph form of break-even analysis.
I Mathematical Explanation graphic method of analysis helps the reader understand the concept of the break-even point. However, graphing the cost and income lines is laborious. The break-even point is found faster and more accurately with the following formula:: B-E = F / (S – V) where: B-E = break-even point (units of production), F = total fixed costs, V = variable costs per unit of production, S = savings or additional returns per unit of production, and The mathematical approach is best presented using examples. Example IA farmer wants to buy a new combine rather than hire a custom harvester.
The total fixed costs for the desired combine are $21 ,270 per year. The variable costs (not counting the operator’s labor) are $8. 75 per hour. The farmer can harvest 5 acres per hour. The custom harvester charges $16. 0 per acre. How many acres must be harvested per year to break-even? Fixed costs (F) = $21,270 savings (S) = $16/A variable costs (V) = $8. 75/her / 5 A/her = $1. 75/A B-E = $21,270 / ($16/A – $1. 75/A) = $21,270 / $14. 25/A = 1,493 Scrambled break- even analysis can be easily extended to consider other changes.
If the farm operator can save two additional bushels of wheat per acre more than the custom harvester, what would be the break-even point if wheat is worth $4/bushel? Additional income = $4/buy * 2 baa = $8/A B-E = $21,270/ ($16/A+ $8/A- $1. 75/A) = $21,270 / $22. 25/A = 956 Scrambled AAA farmer raising 1,200 acres of wheat per ear considers purchasing a combine. How much additional return (to land, capital labor, management and risk) would result? Additional return = (savings or additional income) – (fixed costs + variable costs) Additional profit = [ $16/AC + ($4/buy * 2 buy/AC) ] x 1200 A = $21,270 + [ ($8. 5/her / 5 A/her)x 1200 A] = = $5,thus, the farmer would generate another $5,430 in additional return by purchasing the combine. A farmer harvesting only 900 acres would probably choose not to buy the may want to evaluate the purchase of a smaller or used combine. Additional Situations additional situations are presented as follows:Problem 1 . If the fixed costs for the combine are $12,000 per year, no additional yield is expected, variable costs are $7 per hour and the farmer can combine 4 acres per hour, what is the new break-even point?
Problem 2. If 900 acres are harvested, what is the effect on the farmer’s profits? Solutions Fixed costs = $12,000 Savings = $16/A Variable costs = $7/her / 4 A/her = $1. 75/Problem 1: B-E = $12,000 / ($16/A – $1. 75/A) = $12,000 / $14. 25/A = 842 Scrollable 2: Additional profit = ($16/A x 900 A) – [$12,000 + ($7/her / 4 A/her x 900 A = $14,000 – $13,575 = $825 inseparability of Break-even Analysis main advantage of reek-even analysis is that it points out the relationship between cost, production volume and returns.
It can be extended to show how changes in fixed cost-variable cost relationships, in commodity prices, or in revenues, will affect profit levels and break-even points. Limitations of break-even analysis include: * It is best suited to the analysis of one product at a time; * It may be difficult to classify a cost as all variable or all fixed; and * There may be a tendency to continue to use a break-even analysis after the cost and income functions have changed. Break-even analysis is cost useful when used with partial budgeting or capital budgeting techniques.
The major benefit to using break-even analysis is that it indicates the lowest amount of business activity necessary to prevent losses. SOON B-NAS – Purpose – Various Aspects of Appraisal Managerial Analysis Technical Analysis – Institutional/organizational/ Social Analysis Financial Analysis – Economic analysis – Identifying Project Cost and Benefits – Commercial Analysis Pricing of Project Inputs and Output Appraisal Methods/Techniques – Pay Back Period Unit of Outlay Value Added – Capital-output Ratio Average Annual Proceeds Per Unit of Outlay –
Proceeds per Discounting Techniques – Net Present Worth (NP) Benefit-cost Ratio (BCC) – Internal Rate of Return (AIR) Sensitivity Analysis Net Benefit-Investment Ratio (N.B. = NICK Ratio) Choosing Among Mutually Exclusive/Alternate Domestic Resource Cost (Modified Bruno Ratio) I Purpose I Projects- 5. 1 The third phase in the project cycle is appraisal. If a project is well formulated and thoroughly appraised, a good follow-through on the subsequent stages of the project cycle will see to its goals being achieved.
Appraisal involves a careful checking of the basic data, assumptions and methodology used in project preparation, an in- PPTP review of the work plan, cost estimates and proposed financing, an assessment of the project’s organizational and management aspects, and finally the validity of the financial, economic and social benefits expected from the project. On the basis of such an assessment, a Judgment is reached as to whether the project is technically sound, financially Justified and viable from the point of view of the economy as a whole. 5. The Planning and Development Division, as per the Rules of Business, 1973 (up-dated Upton February, 1985) is responsible for the development of appropriate cost and physical standards for the effective technical and economic appraisal of projects. In the Planning and Development Division, there is a division of labor in technical section in consultation with other technical sections, wherever necessary. This covers engineering, commercial, organizational and managerial aspects, while the pre-sanction appraisal of the development projects from the financial, economic and social points of view is carried out by the Project Appraisal Section.
The rationale behind the project appraisal is to provide to the decision-makers financial and economic yardsticks for the selection/re]section of projects from among competing alternative proposals for investment. Go To Top Various Aspects of Appraisal 5. 3 Appraisal can be referred to as ex-ante, on-going and ex-post. In the Planning and Development Division, projects are examined from the technical, institutional/ organizational/ managerial, social, commercial, financial and economic points of view.
These aspects are briefly discussed in the following paragraphs:Go To Top Technical Analysis The analysis for determining the technical viability of the development reject is based on the technical data and information given in the PC-I form as well as the earlier experience of carrying out similar projects. The technical tests and yard-sticks to be used to determine the technical viability differ from project to project and from sector to sector. In cases where high level technology is involved and the country has little or no experience, foreign consultants are also employed to prepare the feasibility studies.
The technical analysis concerns the project’s input (supplies) and output (production) of real goods and services. For example, in an agricultural project, technical analysis will determine the potential yields in the project area, the co-efficient of production, potential cropping patterns, and the possibilities for multiple cropping. The technical analysis will also examine the marketing and storage facilities required for the successful operation of the project. The aspects like soil/ground water or collection of hydrological data may also be examined.
Knowledge about farmers in the project area, their current farming practices, and their social values to ensure realistic choices about technology is also examined. Go To Top Institutional/Organizational/Managerial Analysis A whole range of issues in project preparation revolves around the overlapping institutional, organizational and managerial aspects of the project, which clearly have an important effect on project implementation. The proposal should be examined to see that the project is manageable and a relationship has been developed amongst the project, region and the country.
The proposal may contain the replies of the probable questions: (a) are the authority and responsibility properly linked? (b) does the organizational set-up encourage delegation of authority? C) does the proposed organization take proper account of the customs and organizational procedures common in the country or, alternatively, does it introduce enough change in organizational structure to break the traditional organization forms? (d) What about training arrangements? Etc. Go To Top Social Analysis Social analysis is undertaken to examine the aspects like employment opportunities and income distribution.
The project analyst would also examine the effects of a project on particular groups/ regions. Go To Top Commercial Analysis The commercial aspects off project include he arrangements for marketing the output produced by the project and the arrangement for the supply of inputs needed to build and operate the project. On the output side, careful analysis of the proposed market for the project’s production It needs to be ensured that adequate input supplies are available for the efficient operation of the project.
Go To Top Financial Analysis Financial analysis involves assessment of financial impact, Judgment of efficient resource use, assessment of incentives, provision of a sound financing plan, coordination of financial contribution and assessment of financial management competence. The main objective of financial analysis is to determine the requirements of funds/timing and the expected returns on investment from the points of view of the various parties involved in the financing of the project. Under this analysis, Judgment is framed about the project’s financial efficiency, incentives, credit-worthiness and liquidity.
In financial analysis, cost and benefits are calculated using current market prices. Interest payments on borrowed capital and repayment of loans are not included. Taxes in the form of excise duties, customs duties, sales taxes are considered cost, while subsidies and non receipts are considered benefits and are fully accounted for in the analysis. Go To Top Economic Analyticities from the economic aspect assesses the desirability of an investment proposal in terms of its effect on the economy.
The question to be addressed here is whether the investment proposal contributes to the developmental objective of the country and whether this contribution is likely to be large enough to Justify the use of scarce resources such as capital, skilled labor, managerial talents etc. , that would be needed to implement and operate the project. In economic analysis, input and output prices are adjusted to reflect true social or economic values. These adjusted prices are often termed as shadow or accounting prices. The taxes and duties are treated as transfer payments and are excluded from the capital and operating cost.
The two main steps in economic analysis are: (a) the “pricing of project inputs and outputs” and (b) the “identification of project costs and benefits”. These steps are discussed below: Go To Top I (a) I Pricing of Project Inputs and Outputs I I In economic analysis, the valuation of inputs and outputs can be made keeping n view the following three rules: I) I Most of the inputs in economic analysis are valued at opportunity cost or on the principle of willingness to pay. Actually it is assumed that all inputs to the project are diverted away from alternative uses.
Each input has generally value in alternative use. But this use may be sacrificed so that the input can be used by the project. This sacrifice is a cost to the nation; it is an opportunity foregone because of the project. Every input to the project is valued at this opportunity cost-the value of the input in its best alternative use; I it) I For mom final goods and services, usually non-traded ones, the concept of opportunity cost is not applicable because it is consumption value that sets the economic value. This criterion is called “willingness to pay” or “value in use”. Ii) I The third rule of pricing inputs and outputs is that the analysis is done at present, I. E. Constant prices. This is because current price analysis entails the prediction of inflation rate which is difficult and unreliable. I I Identifying Project Costs and Benefits I I Proper identification of project costs and benefits is an important step. An improper identification of costs and benefits would lead to under – estimation of costs or over-estimation of benefits or vice versa. The identification of secondary expanded irrigation project may be offset by a fall in fish production and reduce income for thousands of fishermen.
Increased benefits due to the construction of a new highway may be equally matched by a reduction in the income of the railways due to decrease in passengers/goods. An important technique which is followed for correct quantification of costs and benefits is “with and without project” comparison of costs and benefits. Project analysis tries to identify and value costs and benefits that arise with the proposed project and to compare them with the situation as it would be without the project. The difference is the incremental net benefits arising from the project investment.
This approach is not the same as comparing the situation “before” and “after” the project. The “before” and “after” comparison fails to account for changes in production over the life of the project that would occur without the project and thus leads to an erroneous statement of benefits attributable to the project investment. A change in output can also occur without the project if reduction would actually fall in the absence of new investment. In some cases, an investment to avoid a loss might also lead to an increase in production so that the total benefits would arise partly from the loss avoided and partly from increased production.
Here are some special items which must carefully be handled while identifying and quantifying costs and benefits for financial and economic analyses: I) I Direct Transfer Payments I I Some entries in financial accounts really represent shifts in claims of goods and services from one entity in the society to another and do not reflect changes in the national income. The following four kinds of transfer payments are important which are not included in economic analysis: I I (a) I Taxes (Direct and Indirect) I I When a farmer pays a tax, his net benefit is reduced but it does not reduce national income.
It is a cost to the farmer and is not a cost from the stand-point of society as a whole. Thus, unlike financial analysis, in economic analysis, we would not treat the payment of taxes as a cost in project accounts. However, some taxes called user taxes are exempted from this rule. Governments often include payments for road improvements, water or power supply charges in property taxes and this element of property tax does represent a real cost to society. Highway and bridges tolls, if accurately set, also may be users taxes and represent real cost.
But taxes on gasoline and petrol do not represent users taxes. I (b) I Subsidies I I Subsidies are simply direct transfer payments, that flow in the opposite direction from taxes. If a farmer is able to purchase fertilizer at a subsidized price, that will reduce his costs and thereby increase his net benefit. But fertilizer used by the farmer is cost to the economy and in economic analysis must enter the full cost of fertilizer. Another form of subsidy is that which lowers the selling price of inputs below what otherwise would be their market price.
Market price may be maintained at a level higher than it otherwise would be by, say, levying an import duty on competing imports or forbidding competing imports altogether. The difference between the higher controlled price, set by such measures, and lower price for competing imports, that would prevail without such measures, does represent such indirect subsidy. I (c) I Credit Transactions I I Credit transactions are the other major form of direct transfer payment. Loan to