Steps in decision making:
• Establish objectives
• Specify the decision problem
• Identify the alternatives
• Evaluate alternatives
• Select the best alternatives
• Implement the decision
• Monitor the performance
Basic economic tools in managerial economics for decision making:
Economic theory offers a variety of concepts and analytical tools which can be of considerable assistance to the managers in his decision making practice. These tools are helpful for managers in solving their business related problems. These tools are taken as guide in making decision.
Following are the basic economic tools for decision making:
1) Opportunity cost
2) Incremental principle
3) Principle of the time perspective
4) Discounting principle
5) Equi-marginal principle
1) Opportunity cost principle:
By the opportunity cost of a decision is meant the sacrifice of alternatives required by that decision.
For e.g.
a) The opportunity cost of the funds employed in one’s own business is the interest that could be earned on those funds if they have been employed in other ventures.
b) The opportunity cost of using a machine to produce one product is the earnings forgone which would have been possible from other products.
c) The opportunity cost of holding Rs. 1000as cash in hand for one year is the 10% rate of interest, which would have been earned had the money been kept as fixed deposit in bank.
Its clear now that opportunity cost requires ascertainment of sacrifices. If a decision involves no sacrifices, its opportunity cost is nil.
For decision making opportunity costs are the only relevant costs.
2) Incremental principle:
It is related to the marginal cost and marginal revenues, for economic theory. Incremental concept involves estimating the impact of decision alternatives on costs and revenue, 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 decisions.
The two basic components of incremental reasoning are
1) Incremental cost
2) Incremental Revenue
The incremental principle may be stated as under :
“ A decision is obviously a profitable one if –
a) it increases revenue more than costs
b) it decreases some costs to a greater extent than it increases others
c) it increases some revenues more than it decreases others and
d) it reduces cost more than revenues”
3) Principle of Time Perspective
Managerial economists are also concerned with the short run and the long run effects of decisions on revenues as well as costs. The very important problem in decision making is to maintain the right balance between the long run and short run considerations.
For example,(illustration)
Suppose there is a firm with a temporary idle capacity. An order for 5000 units comes to management’s attention. The customer is willing to pay Rs 4/- unit or Rs.20000/- for the whole lot but not more. The short run incremental cost(ignoring the fixed cost) is only Rs.3/-. There fore the contribution to overhead and profit is Rs.1/- per unit (Rs.5000/- for the lot)
