MG2452 Engineering Economics and Financial Accounting Notes [Unit - I ]
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UNIT –I
ECONOMICS
Economics is the study of how societies use scarce resources to produce valuable commodities and
distribute them among different people.
SCOPE OF ECONOMICS
1. Consumption: Satisfaction of human wants is called consumption which forms one of the
important branches of economics. This tells how people behave in consumption of goods and
services in order to maximize their satisfaction.
2. Production: Goods and services have to be produced with the help of factors of production. So,
production is another branch of economics. It concerned with how maximum goods are produced
with minimum cost or how the scarce factors could be utilized economically for better results.
3. Exchange: Goods and services cannot be produced at one place or at one point of time. Goods
produced by one are exchanged for the goods produced by the others. So, exchange forms another
branch of study in economics.
4. Distribution: Goods and services are produced with efforts, i.e., by combining the factors of
production. These efforts have to be paid for or rewarded. The land gets rent, the labor get wages,
the capital gets interest and the organizer gets profit. This branch of study is called distribution in
economics.
5. Public Finance: This branch of study in economics studies about the sources of revenue to the
government and the principles governing the expenditure for the benefit of the people. It also studies
about public debt and financial administration.
ECONOMICS IS A SCIENCE OR AN ART
Economics as a Science: A science is a systematized body of knowledge ascertainable by
observation experimentation. It is a body of generalizations, principles, theories or laws which traces
out a casual relationship between cause and effect.
Economics is a systematized body of knowledge in which economic facts are studied and analyzed in
a systematic manner. For instance, economics is divided into consumption, production, exchange,
distribution and public finance which have their laws are theories on whose basis these departments
are studied and analyzed in a systematic manner.
Hence economics is a science like any other science which has its own theories and laws which
establish a relation between cause and effect. Economics is also a science because its laws possess
universal validity such as the law of diminishing returns, the law of diminishing marginal utility the
law of demand, Gresham’s law, etc.
Again, economics is a science because of its self corrective nature. It goes on revising its conclusions
in the light of new facts based on observations. Economic theories or principles are being revised in
the fields of macro economics, monetary economics, international economics, public finance and
economic development.
Economics as an Art: Unlike natural science, there is no scope for experimentation in economics
because economics is related to man, his problems and activities. Economic phenomena are very
complex as they related to man whose activities are bound by his tastes, habits, and social and legal
institutions of the society in which he lives.
Economics is thus concerned with human beings who act irrationally and there is no scope for
experimentation in economics. Even though economics possess statistical, mathematical and
econometric methods of testing its phenomena but these are not so accurate as to judge the true
validity of economic laws and theories. As a result, exact quantitative predication is not possible in
economics.
Economics as both a Science and an Art: Economics is not only a science but also an art. It is a
science in its methodology and an art in its application. It has a theoretical aspect and is also an
applied science in its practical aspects
FUNDAMENTAL ECONOMIC PROBLEMS
Economic Problem: Due to the scarcity of means and the multiplicity of ends, the economic problem
lies in making the best possible use of our resources so as to get maximum output satisfaction in the
case of a consumer and maximum output or profit for a producer. Hence economic problem consists
in making decisions regarding the ends to be pursued and the goods to be produced and the means to
be used for the achievement of certain ends.
Fundamental problems facing the economy:
1. What to produce: The first major decision relates to the quantity and the range of goods to be
produced. Since resources are limited, we must choose between different alternative collection of
goods and services that may be produced. It also implies the allocation of resources between the
different types of goods. Example: Consumer goods and capital goods.
2. How to produce: Having decided the quantity and the type of goods to be produced, we must next
determine the techniques of production to be used. Example: labor – intensive or capital – intensive.
3. For whom to produce: This means how the national product is to distributed, i.e., who should get
how much. This is the problem of the sharing the national product.
4. Are the Resources Economically Used? This is the problem of economic efficiency or welfare
maximization. There is to be no waste or misuse of resources since they are limited.
5. Problem of Full employment: Fullest possible use must be made of the available resources. In
other words, an economy must endeavor to achieve full employment not only of labor but of all its
resources.
6. Problem of Growth: Another problem for an economy is to make sure that it keeps expanding or
developing so that it maintains conditions of stability. It is not to be static. Its productive capacity
must continue to increase. If it is an under – developed economy, it must accelerate its process of
growth.
CAPITALIST SYSTEM
Capitalism is that profit-oriented system which is characterized by private ownership of objects of
labor instruments of labor and means of labor. Production is mainly carried out with the help of labor
services rendered by the working class in return for wages and the class of capitalists has the right to
whatever output is produced within the system.
Characteristics of the capitalist system:
1. Private ownership of means of production: Under the capitalist system anything which helps man
in the production process like machinery, tools, land, raw-materials, etc. is owned by the capitalist
class.
2. Production for the market: Under capitalism business firms produce mainly with the aim of selling
the output in the market. Wherever any good is produced for the market it is termed as a commodity
and any economy in which production is undertaken with the sole object of exchange is call a
commodity economy.
3. Price mechanism: In a capitalist economy neither an individual nor any institution takes decisions in
a planned manner concerning its day-to-day functioning. That is, there is no conscious effort to
arrive at some kind of solution to its central problems.
4. Labor power as a commodity: In a capitalist economy, majority of the people own only on thing
viz., their capacity to work or their labor power.
5. Exploitation of labor: Workers are exploited under capitalism. Very often due to the freedom granted
to the workers at a formal level, many people are wrongly given to believe that the workers by
bargaining in the free market are able to get a fair price in return for their labor power.
6. Growing wealth of the capitalists: In a capitalist economy the wealth of the capitalist class increases
in a sustained manner.
7. Emergence of the working class: Under capitalism the increasing used of machinery leads to
widespread unemployment and an increase in the rate of exploitation of workers which implies a
decline in the share of workers in the national income over time.
8. Class contradiction: Hence, the two major classes found in a capitalist society are those of the
capitalists and the workers. The clash of interests of the capitalists and the workers take the form of
the class conflict with the further development of capitalism.
SOCIALISM
Under socialism not only is there social ownership of the means of production but also the
functioning of the economy is such so as to maximize social benefit rather than private benefit.
Unlike capitalism in a socialist society the market mechanism does not play the all dominating role
of determining the type and quantity of various commodities produces their priority sequence and the
necessary allocation of resources.
Characteristics (or) Salient features of the socialist economic system:
1. Social ownership of the means of production: In a socialist society private ownership of the
means of production is abolished in the various sectors of the economy.
2. Predominance of public sector: An important precondition for the establishment of socialism is
the existence of the public sector which is founded on the principle of social ownership of the means
of production
3. Decisive role of economic planning: Economic planning under socialism plays exactly the same
role as is played by the price mechanism in a capitalist economy.
4. Production guided by social benefit: In a socialist economy, however, income inequalities are
drastically reduced so that everyone has an adequate amount of disposable income. While
determining the pattern and size of output the planning commission has to see to it that its decisions
in this regard are such that they ensure the availability of commodities for all in the market.
5. Abolition of exploitation of labor: Once the development of human society reaches the stage of
socialism. Exploitation of man by man comes to an end.
MIXED ECONOMY
According to Samuelson, a mixed economy is characterized by the existence of both public and
private institutions exercising economic controls.
CHARACTERISTICS OF A MIXED ECONOMY:
1. Private and state ownership of the means of production and profit induced private business:
In a mixed economy people enjoy right of property through constitutional provisions.
2. Decisive role of market mechanism: Market mechanism has a predominant position in a mixed
economy. In such an economy markets exist not only for various products, but also for productive
factors, such as labor and capital.
3. Interventionist role of the state: The market mechanism is a mixed economy may not be entirely
free from state control. Often legislative measures are undertaken to provide a regulatory system for
industrial activity in the country.
4. Public sector activities are supposedly guided by social benefit: Activities of the public
enterprises are considered to be guided by the social benefit. Thus performance of these enterprises is
often judged on the criterion of social benefit and thus most of this enterprise ignore profit
maximization goal.
5. Supportive role of economic planning: The role of economic planning in basically capitalistic
economic framework is supportive. Hence planning in these economies is usually indicative in
nature. Economic planning in developing economies, in which both private and public sectors co-
exists, has nothing to do with socialism.
ENGINEERING ECONOMICS
It is the application of economic principles to engineering problems. For example, in comparing the
comparative costs of two alternative capital projects.
IMPORTANCE OF ENGINEERING ECONOMICS:
1. Engineering economics is concerned with the monetary consequences (or) financial analysis of the
projects, products and processes that engineers design.
2. Engineers are required to use economic concepts in the major fields such as increasing production,
improving productivity, reducing human efforts, increasing wealth by maximizing profit, controlling
and reducing cost.
3. Engineering economics provides has very important role to play in all engineering decisions.
4. Engineering economics provides a number of tools and techniques to solve engineering problems
related to product-mix, output level, pricing the product, investment, quantum of advertisement, etc.
5. Engineering economics helps in understanding the market conditions, general economic
environment in which the firm is working.
6. Engineering economics provide basis for resource allocation problem.
7. Engineering economics deals with identification of economic choices, and is concerned with the
decision making of engineering problems of economic nature.
APPLICATIONS OF ENGINEERING ECONOMICS
1. Selection of location and site for a new plant-It is concerned with comparing the cost of
establishment and operation of various locations and sites.
2. Production Planning and Control.
3. Selection of equipment and their replacement analysis.
4. Selection of a material handling system.
5. Determination of plant capacity. It is associated with investment of funds such as initial outlay
and operating expenses which determines the capacity of a plant. The capacity is a measure of
ability to produce goods and services or rate of output.
6. Determination of wage structure of the workers.
7. Selection of choice between a concrete structure and a steel structure, between various insulation
thickness, and between prices at which to sell a product.
8. It can be applied by a major corporation to analyze plans for a new manufacturing facility or a
new research and development (R&D) thrust.
CHARACTERISTICS OF ENGINEERING ECONOMICS
1. Engineering economics is a traditional and important part of engineering practice.
2. Engineering economics is concerned with application of economic principles in technical and
managerial decision making.
3. Engineering economics embarrasses both micro and macroeconomic principles when applied to
engineering problems. For example, the study of demand analysis is mostly concerned with
individual or household as a small unit of study. Whereas, the study of impact of taxes on raw-
materials will influence engineers to look for alternative materials for manufacturing or designing a
product or processes which is of course a macro economic issue. The demand analysis is
microeconomic principle.
4. Engineering economics also take in its fold certain concepts and principles from other fields such
as statistics, accounting, management, etc.
5. Engineering economics aids decision making aspect of an engineer and it avoids the abstract
nature of economic theory.
6. Engineering economics is mostly an application tool, whereas economics is a social science with
broad characteristics.
7. Economic theory conveniently ignores the significant backgrounds which are common to
individual firms but engineering economics take in to consideration the individual firms’
environment of decision making.
8. Engineering economics provides an analytical and scientific approach resulting in qualitative
decisions.
ADVANTAGES OF ENGINEERING ECONOMICS
1. Better decision making on the part of engineers.
2. Efficient use of resources results in better output and economic advancement.
3. Cost of production can be reduced.
4. Alternative courses of action using economic principles may result in reduction of prices of goods
and services.
5. Elimination of waste can result in application of engineering economics.
6. Competitive strength on the part of the firm in adopting engineering economics.
7. More capital will be made available for investment and growth.
8. Improves the standard of living with the result of better products, more wages and salaries, more
output, etc. From the firm applying economics.
MANAGERIAL ECONOMICS
Managerial Economics has been described as economics applied to decision-making. It may be
viewed as a special branch of economics bridging the gulf between pure economic theory and
managerial practice.
CHIEF CHARACTERISTICS
1. Managerial Economics is micro-economic in character. This is because the unit of study is a firm;
it is the problems of a business firm which are studied in it. Managerial Economics does not deal
with the entire economy as a unit of study.
2. Managerial Economics largely uses that body of economic concepts and principles which is known
as “Theory of the Firm’ or ‘Economics of the Firm’. In addition, it also seeks to apply Profit Theory
which forms part of Distribution Theories in Economics.
3. Managerial Economics is pragmatic. It avoids difficult abstract issues of economic theory but
involves complications ignored in economic theory to face the overall situation in which decisions
are made. Economic theory appropriately ignores the variety of backgrounds and training found in
individual firms but Managerial Economics considers the particular environment of decision-making.
4. Managerial Economics belongs to normative economics rather than positive economics (also
sometimes known as descriptive economics). In other words, it is prescriptive rather than
descriptive. The main body of economic theory confines itself to descriptive hypothesis, attempting
to generalize about the relations among different variables without judgment about what is desirable
or undesirable.
5. Macro-economics is also useful to Managerial Economics since it provides an intelligent
understanding of the environment in which the business must operate. This understanding enables a
business executive to adjust in the best possible manner with external forces over which he has no
control but which play a crucial role in the well-being of his concern.
SCOPE OF MANAGERIAL ECONOMICS
1. Demand Analysis and Forecasting: A major part of managerial decision-making depends on
accurate estimates of demand. Before production schedules can be prepared and resources employed,
a forecast of future sales is essential.
2. Cost Analysis: A study of economic costs, combined with the data drawn from the firm’s
accounting records, can yield significant cost estimates that are useful for management decisions.
3. Production and Supply Analysis: Production analysis mainly deals with different production
function and their managerial uses. Supply analysis deals with various aspects of supply of a
commodity. Certain important aspects of supply analysis are: Supply schedule, curves and function.
Law of supply and its limitations, Elasticity of supply and Factors influencing supply.
4. Pricing Decisions, Policies and Practices: The important aspects dealt with under this area are:
Price Determination in various Market Forms, Pricing Methods, Differential Pricing, Product-line
Pricing and Price Forecasting.
5. Profit Management: Business firms are generally organized for the purpose of making profits
and, 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 because of variations in
costs and revenues which, in turn, are caused by factors both internal and external to the firm.
6. Capital Management: Capital management implies planning and control of capital expenditure.
The topics dealt with are: Cost of Capital, Rate of Return and Selection of projects.
BASIC ECONOMIC TOOLS IN MANAGERIAL ECONOMICS
1. Opportunity Cost Principle: By the opportunity cost of a decision is meant the sacrifice of
alternatives required by that decision. Thus, it should be clear that opportunity costs require
ascertainment of sacrifices. If a decision involves no sacrifice, its opportunity cost is nil. For
decision-making, opportunity costs are the only relevant costs. The opportunity cost principle may
be stated as under: The cost involved in any decision consists of the sacrifices of alternatives
required by that decision. If there are no sacrifices, there is no cost.
2. Incremental Principle: Incremental concept involves estimating the impact of decision
alternatives on costs and revenues, emphasizing the changes in total cost and total revenue resulting
from changes in prices, products, procedures, investments or whatever may be at stake in the
decision. The two basic components of incremental reasoning are: Incremental cost and
incremental revenue. Incremental cost may be defined as the change in total cost resulting from a
particular decision. Incremental revenue is the change in total revenue resulting from a particular
decision.
3. Principle of Time Perspective: The economic concepts of the long run and the short run have
become part of everyday language. Managerial economics are also concerned with the short-run and
long-run effects of decisions on revenues as well as costs. The really important problem in decision-
making is to maintain the right balance between the long-run and the short-run considerations. A
decision may be made on the basis of short-run considerations, but may as time elapses have long-
run repercussions which make it more or less profitable than it at first appeared.
4. Discounting Principle: One of the fundamental ideas in economics is that a rupee tomorrow is
worth less than a rupee today. This seems similar to saying that a bird in hand is worth two in the
bush. “If a decision affects costs and revenues at future dates, it is necessary to discount those costs
and revenues to present values before a valid comparison of alternatives is possible.”
5. Equi-marginal Principle: This principle deals with the allocation of the available resources
among the alternative activities. According to this principle, an input should be so allocated that the
value added by the last unit is the same in all cases. This generalization is called the equi-marginal
principle.
RELATIONSHIP OF MANAGERIAL ECONOMICS WITH OTHER DISCIPLINES
1. Managerial Economics and Economics: Managerial Economics has been described as
economics applied to decision-making. It may be viewed as a special branch of economics bridging
the gulf between pure economic theory and managerial practice. Economics has two main divisions:
micro-economics and macro-economics. Micro-economics has been defined as that branch where the
unit of study is an individual or a firm. Macro-economics, on the other hand, is aggregative in
character and has the entire economy as a unity of study.
2. Managerial Economics and statistics: Managerial Economics employs statistical methods for
empirical testing of economic generalizations. These generalizations can be accepted in practice oly
when they are checked against the data from the world of reality and are found valid.
3. Managerial Economics and Mathematics: Mathematics is yet another important tool-subject
closely related to Managerial Economics. This is because Managerial Economics is metrical in
character, estimating various economics relationships, predicting relevant economic quantities and
using them in decision-making and forward planning.
4. Managerial Economics and Accounting: Managerial Economics is also closely related to
accounting which is concerned with recording the financial operations of a business firms. Indeed,
accounting information is one of the principal sources of data required by a managerial economist for
his decision-making purpose.
5. Managerial Economics and Operations Research: The significant relationship between
managerial economics and operations research can be highlighted with reference to certain important
problems of managerial economics which are solved with the help of or techniques. The problems
are: allocation problems, competitive problems, waiting line problems and inventory problems.
DIFFERENCE BETWEEN MANAGERIAL ECONOMICS AND ECONOMICS
1. Managerial Economics involves application of economic principles to the problems of the firm.
Economics deals with the body of the principles itself.
2. Managerial Economics is micro-economic in character; Economics is both macro-economic and
micro-economic.
3. Managerial Economics, though micro in character, deals only with firms and has nothing to do
with an individual’s economic problems. But micro-Economics as a branch of Economics deals with
both economics of the individual as well as economics of the firm.
4. Under Micro-Economics as a branch of Economics, distribution theories, viz., wages, interest and
profit, are also dealt with but in Managerial Economics, mainly Profit Theory is used: other
distribution theories have not much use in Managerial Economics. Thus, the scope of Economics is
wider than that of Managerial Economics.
5. Economic theory hypothesizes economic relationships and builds economic models but
Managerial Economics adopts, modifies and reformulates economic models to suit the specific
conditions and serves the specific problem solving process. Thus Economics gives the simplified
model, whereas Managerial Economics modifies and enlarges it.
6. Economic theory makes certain assumptions whereas Managerial Economics introduces certain
feedbacks such as objectives of the firm, multi-product nature of manufacture, behavioural
constraints, environmental aspects, legal constraints, constraints on resource availability, etc., thus
embodying a combination of certain complexities assumed away in economic theory and then
attempts to solve the real-life, complex business problems with the aid of tool subjects, e.g.,
mathematics, statistics, econometrics, accounting, operations research, marketing research and so on.
ROLE OF MANAGERIAL ECONOMISTS IN BUSINESS
1. Decision Making and Forward Planning: Managerial economists play a vital role in managerial
decision making and forward planning.
2. Inventory Schedules of the Firm: He plays an effective role in price fixation, location of a plant,
quality improvement, etc. and inventory schedules of the firm.
3. Demand Forecasting: The most important role of the managerial economist relates to demand
forecasting.
4. Economic Analysis: The managerial economists undertake an economic analysis of the industry.
5. Price Fixation: Another role played by a managerial economist is to fixing prices for new as well
as existing products of a firm.
6. Environmental Issues: A managerial economist is also undertakes the analysis of environmental
issues.
7. Cost of the Firm: He is also responsible and playing a vital role in input cost of the firm.
8. Government’s Economic Policies: Lastly, managerial economist has also to keep in touch with
the government’s economic policies and the central bank’s monetary policies annual budgets of the
government.
DECISION MAKING ENVIRONMENTS
The decisions are also categorized in terms of the degree of certainty that exists in a situation. Thus
every decision making situation falls into one of the four categories that exist along a certainty
continuum namely Certainty, Risk, Uncertainty and Ambiguity
1. Certainty: This is a state of certainty that exists only when the decision maker knows the
available alternatives and the conditions and consequences of those actions. Making decisions under
certainty assumes that the decision maker has all the necessary information about the problem
situation.
2. Risk: A state of risk exists when the decision maker is aware of all the alternatives, but is
unaware of their consequences. In this situation, the decision maker at best can make guess as to
which alternative to choose. The decision in order risk usually involves clear and precise goals and
good information, but future outcomes of the alternatives are just not known to a degree of certainty.
However, sufficient information is available to allow the decision maker to ascribe the probability of
successful outcomes for each alternative.
3. Uncertainty: Most significant decisions made in today’s complex environment are formulated
under a state of uncertainty, where there is an unawareness of all the alternatives and so also the
outcomes –even for the known alternatives. Such decisions demand creativity and the willingness to
take a chance in the face of such uncertainties. In such situations, decision makers do not even have
enough information to calculate degree of risk.
4. Ambiguity: The most difficult decision situation is the state of ambiguity, in which the decision
problems are not at all clear. The alternative courses of action are difficult to identify, and the
information about consequences is not available. In this state, nothing is known for sure and the risk
of failure is quite high.
PROFIT MAXIMIZATION AS BUSINESS OBJECTIVE
Profit maximization objective of the firm has been the traditional approach to the study of a firm in
equilibrium analysis. Profit maximization means the largest absolute amount of profits over a time
period, both short-term. And long term. The short run is a period where adjustments cannot be
made quickly in matters of supply and demand. Long run however enables adjustment to changed
conditions. Profit can be defined as the difference between total revenue (TR) and total cost (TC).
Profit=TR-TC
CRITISIMS OF PROFIT-MAXIMISING THEORIES
1. Separation of Ownership from Control: The rise of corporate firm of organization has resulted
in a separation of ownership and control. Ownership is vested with the shareholders and control is
wielded by the managers. It has not been empirically proved that shareholders are more concerned
with profitability than anything else.
2. Difficulties in Pursuing Profit Maximization: The modern firm faces lot uncertainties. As a
result, short run profit maximizing behaviour is subordinated to the more important objective of
long-run survival of the firm, for example, the firm’s objective to pursue ‘good-will’ in the long-run
may clash with short-run profit objective.
3. Problems in the Measurement of Profit: There are some problems about the measurement of
profit as a measure of firm’s efficiency. Profit may be the result of imperfection in the market and
profits may be the reward of monopolistic exploitation. Worse still, profit measurement process
itself is dubious.
4. Social responsibility of the firm: he firm is now-a-days not just an economic entity concerned
with production or sales alone. The firm owes a responsibility to offer good, well paid jobs for
employees, to provide efficient services to customers. In short the firm has a social responsibility
beyond profit maximization.
5. Deliberate limitation of profits: Firms may deliberately show lesser profits in the short run in
order to discourage labourers from asking for higher wages or to discourage entry of new firms.
Limited profits may be shown to prevent the government from taking over the business.
6. Aversion for business expansion: Profit maximization requires business expansion and it means
additional risk and responsibility. Businessmen may be satisfied with the prevent level of profit and
may not expand.
ARGUMENTS IN FAVOUR OF PROFIT MAXIMIZATION
1. Profit is indispensable for firm’s survival: The survival of all the profit-oriented firms in the
long run depends on their ability to make a reasonable profit depending on the business conditions
and the level of competition.
2. Achieving other objectives depends on firm’s ability to make profit: Many other objectives of
business firms have been cited in economic literature, e.g., maximization of managerial utility
function, maximization of long-run growth, maximization of sales revenue, satisfying all the
concerned parties, increasing and retaining market share, etc. the achievement of such alternative
objectives depends wholly or partly on the primary objective of making profit.
3. Evidence against profit maximization objective not conclusive: Profit maximization is a time-
honored objective of business firms. Although this objective has been questioned by many
researchers, the evidence against it is not conclusive or unambiguous.
4. Profit maximization objective has a greater predicting power Compared to other business
objectives, profit maximization assumption has been found to be a much more powerful premise in
predicting certain aspects of firm’s behaviour.
5. Profit is a more reliable measure of firm’s efficiency: Thought not perfect, profit is the most
efficient and reliable measure of the efficiency of a firm.
ALTERNATIVE OBJECTIVE OF FIRMS
Baumol’s Theory of Sales Revenue Maximization
Prof. J. Baumol has postulated seller revenue maximization approach as an alternative to profit
maximization objective. The factors which explain the pursuance of this objective are following:
1. Financial institutions evaluate the success and strength of the firm in terms of rate of growth of its
sales revenue.
2. Empirical evidence shows that the stock earnings and salaries of top management are correlated
more closely with sales than with profits.
3. Increasing sales revenue over a period of time gives prestige to the top management, but profits
are enjoyed only by the shareholders.
4. Growing sales means higher salaries and better terms. Hence sales revenue maximizations results
in a healthy personnel policy.
5. It is seen that managers prefer a steady performance with satisfactory profits than spectacular
profits year after year. They will be criticized if spectacular profits decline. Hence they may prefer a
safe and steady performance with satisfactory profits but good sales.
6. Large and increasing sales help the firm to obtain a bigger market share which gives it a greater
competitive power.
ASSUMPTIONS OF BAUMOL’S SALE MAXIMIZATION MODEL
i. Sales maximization goal is subject to a minimum profit constrain.
ii. Advertisement is a major instrument of sales maximization i.e., advertisement will shift the demand
curve to the right.
iii. Advertisement costs are independent of production costs.
iv. Price of the product is assumed to be constant.
IMPLICATIONS OF BAUMOL’S THEORY
i. His theory is more consistent with observed behavior. In the traditional theory changes in fixed costs
do not influence output or prices except for fixing the breakeven point. But according to Baumol a
firm which experiences any increase in fixed costs will try to reduce them or pass them on to the
consumer in the form of higher prices, through large scales.
ii. This theory also establishes that businessmen may consider non-price competition through sales
maximization to be the more advantageous alternative.
iii. However, Baumol’s theory does not explain how the firms maximize their sales volume within a
profit constraint. Further it explains business behavior, without elaborating the mechanism by which
they try to find new alternative.
MARRIS’ THEORY OF MAXIMISATION OF FIRM’S GROWTH RATE
According to Robin Marris, managers maximize firm’s balanced growth rate subject to managerial
and financial constraints. He defines firm’s balanced growth rate (G) as, G= GD=GC
Where GD=growth rate of demand for firms product and GC=growth rate of capital supply to the
firm.
In simple words, a firm’s growth rate is balance when demand for its product and supply of capital to
the firm increase at the same rate. The two growth rates are according to Marris, translated into
utility functions:
(i) Manager’s utility function: The manager’s utility function (Um) and owner’s utility(Uo) may be
satisfied as follows. Um=f(salary, power, job security, prestige, status).
(ii) Owner’s utility function Owner’s utility function (Uo): Uo=f (output, capital, market-share,
profit, public esteem), implies growth of demand for firms product and supply of capital.
Therefore, maximization of Uo means maximization of demand for firm’s product or growth of
capital supply. According to Marris, by maximizing these variables, managers maximize both their
own utility function and that of the owners. The managers can do so because most of the variables
(e.g., salaries, status, job security, power, etc) appearing in their own utility function and those
appearing in the utility function of the owners (e.g., profit, capital market, share, etc) are positively
and strongly correlated with a single variable, i.e., size of the firm. Maximization of these variables
depends 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 rigorous and sophisticated than Baumol’s sales revenue maximization,
has its own weaknesses. It fails to deal to deal satisfactorily with oligopolistic interdependence & it
ignores price determination which is the main concern of profit maximization hypothesis
WILLIAMSON’S THEORY OF MAXIMIZATION OF MANAGERIAL UTILITY
FUNCTION
Like Baumol and Marris, Willamson argues that managers have discretion to pursue objectives other
than profit maximization. The managers seek to maximize their own utility function subject to a
minimum level of profit. Manager’s utility function (U) is expresses as: U = f(S, M, ID)
Where S= additional expenditure on staff, M= managerial emoluments, ID= discretionary
investments.
According to Williamson’s theory managers maximize their utility function subject to a satisfactory
profit. A minimum profit is necessary to satisfy the shareholders or else manager’s job security is
endangered. The utility functions which managers seek to maximize include both quantifiable
variables like salary and slack earnings, and non-quantitative variable such as prestige power, status,
job security, professional excellence, etc. The non-quantifiable variables are expresses, in order to
make them operational, in terms of expense preference defined as ‘satisfaction derived out of certain
types of expenditures’ (such as slack payments), and ready availability of funds for discretionary
investments.
Williamson’s theory suffers from certain weakness. His model fails to deal with problem of
oligopolistic interdependence. Williamson’s theory is said to hold only where rivalry between firms
is not strong. In case of 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.
CYERT-MARCH THEORY OF SATISFICING BEHAVIOUR
Cyert-March theory is an extension of Simon’s theory or firms’. ‘Satisfying behaviour’ or satisfying
behaviour. Simon had argued that the real business world is full of uncertainly; accurate and
adequate data are not readily available; where data are available managers have little time and ability
to process them; and managers work under a number of terms of rationality postulated under profit
maximization hypothesis. Nor do the firms seek to maximize sales, growth or anything else. Instead
they seek to achieve a ‘satisfactory profit’ a ‘satisfactory growth’, and so on. This behaviour of
firms is termed as ‘Satisfaction Behaviour’.
Cyert and March added that, apart from dealing with an uncertain business world, managers have to
satisfy a variety of groups of people-managerial staff, labour, shareholders, customers, financiers,
input suppliers, accountants, lawyers, authorities etc. All these groups have their interest in the
firms-often conflicting. The manager’s responsibility is to ‘satisfy’ them all. Thus, according to the
Cyert-March, firm’s behaviour is ‘satisfying behaviour’. The ‘satisfying behaviour’ implies
satisfying various interest groups by sacrificing firm’s interest or objective. The underlying
assumption of ‘Satisfying Behaviour’ is that a firm is a coalition of different groups connected with
various activities of the firms, e.g., shareholders, managers, workers, input supplier, customers,
bankers, tax authorities, and so on. All these groups have some kind of expectations-high and low-
from the firm, and the firm seeks to satisfy all of them in one way or another in sacrificing some of
its interest.
In order to reconcile between the conflicting interests and goals, managers form an aspiration level of
the firm combining the following goals: (a) Production goal, (b) Sales and market share goals, (c)
Inventory goal, and (d) Profit goal. These goals and ‘aspiration level’ are set on the basis of the
managers’ past experience and their assessment of the future market conditions. The ‘aspiration
levels’ are modified and revised on the basis of achievements and changing business environment.
The behavioural theory has, however, been criticized on the following grounds. First, though the
behavioural theory deals realistically with the firm’s activity, it does not explain the firm’s behaviour
under dynamic conditions in the long run. Secondly, it cannot be used to predict exactly the future
course of firm’s activities; thirdly, this theory does not deal with the equilibrium of the industry.
Fourthly, like other alternative hypotheses, this theory too fails to deal with interdependence of the
firms and its impact on firm’s behaviour.
SOURCES OF BUSINESS RISK
1. Risk of Market Fluctuation: General economic conditions are rarely stable. Firms face booms
and depressions. Though with the help of certain forecasting techniques the firm can somewhat
hedge itself against cyclical fluctuation, but there is no way the firm can generally know with
certainty the timing and volatility of changes. The firm is, therefore, unstable to completely prepare
itself for these changes.
2. Risk of Industry Fluctuations: There may be fluctuations specific to the industry, which are least
as uncertain and may not always coincide with those of the overall market.
3. Competition risks: These are the risk arising from the policy changes of the rivals, which include
things like changes in prices, product line, advertisement expenditure, etc.
4. Risk of technological change: This is also called the risk of obsolescence, which grows with
advancement of an economy. These risks arise from the possibility of newly installed machinery
becoming obsolete with the discovery of new and more economical process of production.
5. Risk of taste fluctuation: In many cases, vagaries of consumer demand create uncertain
conditions. Successful product of one season may become discarded in the next season. These risks
are most common in fashion and entertainment industries.
6. Risk of cost fluctuation: Unless contractually agreed upon, the future prices of labour, material
etc. may change. Thus estimates of future expenditure are subject to uncertainty.
7. Risk of public policy: Government policy regarding business undergoes a change over time,
some of which cannot be precisely predicted. These relate to price control, foreign trade policy,
corporate taxation etc.
THE THREE CATEGORIES OF DECISION-MAKERS
1. Risk-neutral: A decision-maker is risk-neutral if each added rupee of wealth gives him the same
additional utility.
2. Risk-averse: A decision-maker is considered risk-averse if addition of each successive rupee to
his wealth gives him lesser utility than the earlier rupee.
3. Risk-preferer: A decision-maker is considered as risk-preferrer when addition of each successive
rupee to decision-makers wealth gives him greater utility each time.
DECISION MAKING
Decision making is the process of selection from a set of alternative courses of action which is
thought to fulfil the objective of the decision problem more satisfactorily than other.
FEATURES OF DECISION MAKING
1. Selection process: Decision making is a selection process. The best alternative is selected out of
many available alternatives.
2. Goal-oriented process: Decision making is goal-oriented process. Decisions are made to achieve
some goal or objective.
3. End process: Decision making is the end process. It is preceded by detailed discussion and
selection of alternatives.
4. Human and Rational process: Decision making is a human and rational process involving the
application of intellectual abilities. It involves deep thinking and foreseeing things.
5. Dynamic process: Decision making is a dynamic process. An individual takes a number of
decisions each day.
6. Situational: Decision making is situational. A particular problem may have different decisions at
different times, depending upon the situation.
7. Continues or Ongoing process: Decision making is a continuous or ongoing process. Managers
have to take a series of decisions on particular problems.
8. Freedom to the decision makers: Decision making implies freedom to the decision makers
regarding the final choice. It also involves the using of resources in specified ways.
9. Positive or Negative: Decision may be positive or negative. A decision may direct others to do or
not to do.
10. Gives happiness to an Endeavour: Decision making gives happiness to an Endeavour who
takes various steps to collect all the information which is likely to affect decisions.
STEPS IN DECISION MAKING PROCESS IN AN ORGANIZATION
1. Identification of problem: Decision making process begins with the identification of problem
that means recognition of a problem. The managers have to use imagination, experience, and
judgment in order to identify the real nature of the problem.
2. Diagnosis and analysis of the problem: In order to diagnose the problem correctly, a manager
must obtain all pertinent facts and analyze them correctly. The most important part of the diagnosing
problem is to find out the real cause or source of the problem. After analyzing the problem next
phase of the decision making is to analyze problem. This process involves classifying the problem
and gathering information.
3. Search for alternatives: A problem can be solved in many ways. All possible ways cannot be
equally satisfying. Managers are advice to limit him to the discovery of the alternatives which are
strategic or critical to the problem. The principle of limiting factor is given as “By recognizing and
overcoming that factor that stand critically in the way of a goal, the best alternative course of action
can be selected”. Creative thinking is necessary to develop alternatives such as decision makers past
experience, practices followed by others, and using creative techniques.
4. Evaluation of alternatives: Evaluation is the process of measuring the positive and negative
consequences of each alternative. Some alternatives offer maximum benefit than others. An
alternative is compared with the others. Management must set some criteria against which the
alternatives can be evaluated. Criteria to weigh the alternative courses of action includes Risk-
Degree of risk involved in each alternative, Economy of effort- Cost, time and effort involved in
each alternative, Timing or Situation- Whether the problem is urgent & Limitation of resources-
Physical, financial and human resources available with the organization.
5. Selecting an alternative: In this stage, decision makers can select the best alternatives. Optimum
alternative is one which maximizes the results under given conditions.
6. Implementation and follow-up: Once an alternative is selected, it is put into action in systematic
way. The future course of action is scheduled on the basis of selected alternatives. When a decision
is put into action, it may yield certain results. These results provide the indication whether decision
making and its implementation is proper. The follow-up action should be in the light of feedback
received from the results.
RATIONAL DECISION MAKING
Decision making is the process of selection from a set of alternative courses of action which is
thought to fulfil the objective of the decision problem more satisfactorily than other. The concept of
rationality is defined in terms of objective and intelligent action.
TYPES OF DECISION MAKING DEPENDING UPON RATIONALITY
1. Major and supplementary decisions: Major decisions refer to the decisions with regard to the
quality of the product, price of the product, developing a new product etc. These decisions have
direct bearing on the achievement of the goals of the concern and so these decisions should be made
very carefully. Minor or supplementary decisions, on the other hand, are made in the course of
conversion of major decisions into action.
2. Organizational and personal decision: Organizational decisions are made by the executive in his
capacity as manager in order to achieve the best interests of the organization. These decisions can be
delegated to the other members in the organization. Personal decisions, on the other hand, are made
by the manager in his personal capacity and not in his capacity as a member of the organization.
These decisions are not delegated. These decisions relate to the executives personal work.
3. Basic and routine decisions: Basic decisions involve long range commitment and large funds.
Decisions with regard to selection of a location, selection of a product line, merger of the business
are known as basic decisions. As these decisions affect the entire organization, they are considered
as basic decisions. They are also now as vital decisions. Decisions that are taken to carry out the
day-today activities are called routine decisions. These decisions are repetitive in nature. They have
only a minor impact on the business. These decisions are made at middle and lower levels of
management. For eg., purchase of sundry materials.
4. Group and individual decisions: If the decision is taken by one person, it is called individual
decision. Group decisions are taken by a group of persons.
5. Policy and operating decisions: Policy decisions are made at top management levels. These
decisions are taken to determine the basic policies and goals of the organization. Operating decisions
are taken to execute the policy decisions. These decisions are taken at the middle and lower
management levels and are related to routine activities of business.
6. Programmed decision: Programmed decision is otherwise called routine decision or structured
decision. The reason is that these types of decision are taken frequently and they are repetitive in
nature. Such decision is generally taken by middle or lower level managers, and has a short term
impact. This decision is taken within the preview of the policy of the organization.
7. Non-Programmed decision: Non programmed structures are otherwise called strategic decisions
or basic decision or policy decision or unstructured decisions. This decision is taken by top
management people whenever the need arises. This decision deals with unique or unusual or non-
routine problems. Such problems cannot be tackled in a predetermined manner. There are no
established methods or readymade answers for such problems.
8. Organizational decisions: Organizational decisions are decisions taken by an individual in his
official capacity to further the interest of the organization known as organizational decision. These
decisions are based on rationality, judgment and experience.
9. Personal decisions: Personal decisions are decisions taken by an individual based on his personal
interest. it is oriented to the individual’s goals. These decisions are based on self ego, self prestige
etc.
10. Objectively rational decision: If the decision is really the correct behavior for maximizing given
values in a given situation, then it is called objectively rational decision.
11. Subjectively rational decision: If a decision maximizes attainment relative to the actual
knowledge of the subject, then it is called subjectively rational decision.
12. Consciously rational decision: A decision is consciously rational to extend that he adjustment of
means to ends is a conscious process.
13. Economic model: Economic rationality implies that decision making tries to maximize the values
in a given situation by choosing the most suitable course of action. A rational business decision is
one which effectively and efficiently assures the attainment of aims for which the means are selected.
RATIONAL DECISION MAKING PROCESS
1. Clear and well defined goal: The decision makers has clear and well defined goal that he is
trying to maximize.
2. Uninfluenced by emotions: He is fully objective and rational uninfluenced by emotions.
3. Identification of the problem: The decision makers can identify the problem clearly and
precisely.
4. Alternative course of action: He must have clear understanding of alternative course of action by
which a goal can be reached under existing circumstances.
5. Analyze and evaluate alternatives: He must have the ability to analyze and evaluate alternatives
in the light of the goals.
6. Effectively satisfies goal achievement: He must have a desire to come to the best solution by
selecting the alternative that most effectively satisfies goal achievement.
ADMINISTRATIVE PROBLEMS IN DECISION MAKING
1. The decisions taken by the management should be of sound one. The soundness of the decisions
refers to its quality and reliability. If the decisions taken are not sound then it will mean waste of
efforts and funds. The soundness of decision depends upon the sophistication of the decision maker,
the information available to him and the techniques that he can make use of.
2. Another problem that is faced by the management is timing of decision. If it is not properly timed,
there is no use in taking a useful decision.
3. The physical and psychological environments have their influence on decision making. If the
environment is satisfactory then there will be co-operation, proper understanding among the
members of the organization. This will provide better scope for research and analysis.
4. Effective communication of the decision is another important administrative problem of the
management. Decisions taken should be clear, simple and unambiguous. Decision made should be
communicated to the concerned persons in the language understandable by the receiver.
5. All members of an organization should be encouraged to give their opinion on various aspects
while arriving at important decisions. In most cases, top executives feel that it is below their dignity
to get their views. In such cases, decisions are taken by a few persons at the top management level.
But this is not a good practice because making decision by a few at the top level will create some
problem in its implementation.
6. Another problem faced by the management is implementation of decision. Once a decision is
made, executive and his subordinates should take all possible steps to implement it. While making
decision, the manager may have consulted hired specialist but the finals decision will be of his own.
Therefore, final responsibility lies on him. Implementation of decision involves several steps which
brings a number of problems. Manager should handle it very carefully so that the problems can be
tackled easily.
