Five Fundamental Concepts

Economics provides certain tools which are of immense help to a manager

for making scientific decisions. These are-

1) The opportunity cost and decision rule: this concept is related with the
alternative use of scarce resources. Resources both natural and man
made are scarce in relation to the demand for them. The scarcity and
alternative uses of resources gives rise to this concept.

Examples of OC
• The OC of funds employed in one’s own business is the amount of
interest which could have been earned if these funds are invested
some where else.
• When a product X is produces instead of product Y by a machine
which can produce both, the OC of producing X is the amount of Y
sacrificed.

Thus, the OC of availing an opportunity is the foregone income expected

from the second best opportunity of using the resources. The difference b/w
actual earning and its opportunity cost is called economic gain. OC assumes
great importance when the economic gain is neither insignificant nor very
large because then it requires a careful evaluation of the options available.
This concept is applied to all resources in business decisions. Given any two
options, the firm will analyze its cost and benefits and will take a decision.

2) Marginal Principle and decision rule: The term marginal refers to the
change (increase or decrease) in total quantity or value due to one unit
change in its determinant. Eg. Given the factor prices, the TC of
production of a commodity depends on the no. of units produced. In
this case, Marginal cost can be defined as the change in TC due to one
unit change in production. The MC is worked out as-

MC= TCn- TCn-1

Where, MC = marginal cost

TCn= total cost of producing n units
TCn-1= ttal cost of producing n-1 unit
Suppose, TC of producing 100 units of a commodity is Rs.2500 and TC of
producing 101 unit is 2550. Then,

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MC= 2550-2500
= Rs.50

Similarly, Total Revenue (TR) of a firm depends upon the number of units it
sells at some point of time. MR can be defined as the change in TR due to
sale of one additional unit of a product. Thus,

TR= TRn-TRn-1

Where, TR = Total Revenue

TRn= total revenue of producing n units
TRn-1= total revenue of producing n-1 unit

3) Incremental Principle and Decision Rule: this principle is applied to

business decisions which involve bulk production and a large increase
in Total Cost (TC) and Total revenue (TR). Such an increase in TC
and TR is termed as Incremental Cost and Incremental Revenue.
Incremental cost can be defined as the change in TC as a result of
change in the level of output. Incremental Revenue is defined as the
change in TR from a change in the level of output. While taking a
decision, a manager always determines the worthiness of a decision
on the basis of the criterion that the IR should exceed IC.

Eg. A firm gets an order which will fetch additional revenue of

Rs.2000. The cost of production of this order is:

Labor: 600
Material: 800
Overheads: 720
Selling &
Administrative expenses: 280
Full Cost Rs. 2400

If we compare the additional revenue with the cost the order seems
unprofitable. But if the order is accepted it would need some of the existing
facilities of the firm. Therefore, the addition to the TC will be less than
Rs.2400. Lets consider that the addition to the TC due to the new order is as
following-

Labor: 400

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 Material: 800
Overhead: 200
Total Incremental Cost: Rs.1400

Now, an analysis reveals that this order will earn a net profit of Rs.600.

There are three components of IC:

A) Present explicit cost
B) Opportunity cost
C) Future cost

A) Present explicit cost includes-

a) Fixed cost i.e. the cost of plant and building
b) Variable cost including cost of direct labor, material and overhead like
electricity and indirect labor.

B) Opportunity cost refers to the expected income forgone from the second
best use of the resources involved in the present decision.

C) Future cost includes depreciation and advertising cost.

The increase in TR due to a business3 decision is called IR. The use of

incremental concept in business decision in called Incremental Reasoning.

4) Contribution Analysis: the contribution of a business decision can be

defined as the difference between the IC and IR. This analysis is
generally applied to analyze the contribution made by a business
decision to overhead cost and revenue to work out the net result of a
business decision.
For using this analysis, it is important to know the IC and IR. Unit
contribution is the per unit difference of IC and IR. In case of a firm
with excess capacity, a new product can be introduced easily as it is
likely to add little to TC and significantly to TR. On the other hand, if
the firm has a backlog of orders for the existing product then the
new products if introduced will have to compete with the existing
products for the use of same production facilities. In such a case
choice between clearing the backlog of existing orders or
producing new product, will depend upon their respective
contribution. Production facilities will be allocated on the basis that
which product can contribute more.

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 Eg. A firm has a scarce resource, machine time availability and all the
other resources are in abundance. The firm has to make a choice
between 4 products; all need the use of same scarce machine hour. In
this case contribution (of the 3) per unit of machine hour will be
calculated and best use of machine hour will be evaluated.

Contribution Product wise of a Multi Product Plant

Machine
Incremental Time
cost per required
Product Price unit Contribution per unit
1 44 26 18 180 min
2 40 24 16 120
3 37 22 15 90
4 20 8 12 60

Col 4 shows that Product 1 is the best as its contribution per unit is
larger than that of other products. But this product consumes most of
the scarce machine time compared to other products. Therefore,
contribution per unit of machine hour should be calculated to make a
rational decision. This will give the following results-

Contribution
Product per unit
6 per
1 machine hour
2 8
3 10
4 12

This analysis shows that product 4 yields the highest contribution and
decision should be taken in its favor.

5) Equi Marginal Principle: the law of equi marginal utility states that a
utility maximizing consumer distributes his consumption expenditure
between various goods and services he consumes in such a way that

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 marginal utility derived from each unit of expenditure on various
goods and services is the same. This pattern of consumption
expenditure maximizes consumer’s total utility.
This law was applied by managers for allocation of resources between
their alternative uses with a view to maximize profit in case the firm
carries out more then one business activity. This principle says that
the available resources should be so allocated between the alternative
options that the marginal productivity gains (MP) from the various
activities are equalized.
Eg. Suppose a firm has a total capital of Rs.100 million which can be
spent on three projects A,B and C. Each of these projects requires a
unit expenditure of Rs.10 million. Suppose, the MP schedule of each
unit of expenditure on the three projects is as follows-

Unit of
Expenditure
(Rs.10
million) Marginal Productivity
Project Project Project
A B C
1st 50 (1) 40 (3) 35 (4)
2nd 45 (2) 30 (5) 30 (6)
3rd 37 (7) 20 (8) 20 (9)
4th 20 10 15
(10)
5th 10 0 12

Going by the equi marginal principle, the firm will allocate its total
resources (Rs.100 million) among the projects in such a way that the MP of
each project is the same i.e., MPA= MPB= MPC=….. MPN

Therefore, the firm will spend 1st, 2nd, 7th and 10th unit of finance on project
A, 3rd, 5th and 8th unit on project B and 4th, 6th and 9th unit on project C. A
profit maximizing firm will invest 40 million on project A and 30 million on
project B and C. This pattern will maximize firm’s productivity gains.
This principle can be applied where-
a) firms have limited investible resources
b) resources have alternative uses

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6) Time perspective in Business: All business decisions are taken within
a time perspective. The time perspective refers to the time period
extending from past to future. All business decisions do not have the
same time perspective. Some have short run outcome and therefore
involve short run time perspective. Eg. Decision to buy explosive for
manufacturing crackers. There are a large number of decisions which
have long run repercussions, eg. Investment in plant, building,
introduction of a new product etc.
The business decision makers must assess the time perspective of
business propositions in advance and make decisions accordingly.