Chapter 3
SOME FUNDAMENTAL
CONCEPTS USED IN
BUSINESS DECISIONS
Learning Objectives
 Opportunity cost and Decision Rule.
 Managerial Principle and Decision Rule
 Incremental principle and Decision Rule
 Concept of contribution analysis
 Equi-marginal principle in business decisions
 Time perspective in business decisions
Managerial Decision
Rule of
Thumb
Technique
Business
Decision
Sophisticated
Technique
Opportunity Cost
Opportunity Cost and
Economic Gain
Scarcity of
Resources
• Opportunity cost is the income
lost due to the best obtained
from the alternate use of a
particular resource.
• Opportunity cost concept can
be applied to all those business
decisions, which involve at
least two alternative benefit.
Alternative
Choices
Opportunity
Cost
• The difference between actual
earning and its opportunity
cost is called Economic
Profit(gain).
• Economic Profit is important
when opportunity cost is
neither insignificant nor large.
Marginal Principle and Decision Rule
Marginal Principle
Marginal
Utility in
Consumer
Analysis
• Marginal Concept : Change
in total quantity or value due to
unit change in it’s determinant.
• Marginal Cost(MC)
=TCn-TCn-1
• Marginal Revenue(MR)
=TRn-TRn-1
Marginal
Concept
Limitations in Decision
Making
• Marginal Concept can be used
where TC and TR is known for
each and every unit produced.
• Marginal Concept can be
applied to a situation in which
only the variable cost changes.
Marginal
Revenue in
Pricing
Theory
Marginal
Cost in
Production
Analysis
Incremental Principle and Decision Rule
Incremental principle is applied only in decisions
related to bulk production whose total cost and
total revenue are expected to increase.
Increase in the total cost and total revenue is
called incremental cost and incremental revenue,
respectively.
Incremental cost has three components:
• Current explicit costs
• Opportunity cost
• Future costs
Incremental reasoning is applied in business
decisions mainly while accepting or rejecting a
business proposal.
Contribution Analysis
Contribution
Incremental
Revenue
Incremental
Cost
Relevant incremental costs:
Current explicit costs
Opportunity costs
Future incremental costs
Relevant incremental revenues:
Explicit current revenue
Possible opportunity revenue
Possible future revenue
Equi-marginal Principle
The combination of equimarginal principle and
consumption theory gives
the law of equi-marginal
utility.
The principle states that the
inputs of the firm must be
allocated in such a way that
their marginal productivity
is same in each alternative
use.
This helps in equalizing the
gains from the marginal
productivity gains from
various activities.
This principle is applied by
the firms because they have
limited resources that have
alternative uses subjected to
diminishing marginal
productivity or returns.
Equi-marginal Principle
1. Under the condition of three projects –A, B and C –with
same cost
Rule : MPA
MPB
MPC
(MP=Marginal Productivity)
2. Under the condition of three projects –A, B and C –with
different cost(C)
Rule :
MPA
CA
MPB
CB
MPC
CC
Time Perspective in Business Decisions
Time Perspective
Relevant Past
Long
Run
Short
Run
Foreseeable Future
Projection
Summary
 Managerial decision involves rule of thumb technique and
sophisticated technique
 Opportunity cost is the income that can be obtained from the
second alternate use of a particular resource.
 Marginal Concept
: Change
in total
quantity or value due to unit
Understand
the concept
of managerial
change in it’s economics
determinant.
 Incremental principle is applied only in decisions related to bulk
production whose total cost or total revenue are expected to
increase.
 Contribution is difference between incremental revenue and
incremental cost
 The equi-marginal principle states that equi-marginal
productivity of inputs in all alternative uses must be the same.