Fundamental concepts I: incremental principle, marginalism, time perspective and discounting
Managerial Economics · Unit I · Topic 2 of 15 · 5 min read
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1. The incremental principle
The incremental concept compares the change in total revenue with the change in total cost that a decision causes. A decision is worth taking if it increases total profit.
- Incremental revenue (IR) = total revenue after the decision − total revenue before it.
- Incremental cost (IC) = total cost after the decision − total cost before it.
- Rule: accept the decision if IR > IC; reject if IR < IC.
Incremental reasoning covers any change: a new product, a new market, a special order, a new machine, a change in price. Only costs and revenues that change because of the decision count. Sunk costs (already spent and not recoverable) and fixed overheads that continue anyway are irrelevant.
Incremental versus marginal. Marginal cost and marginal revenue are the change caused by one more unit of output. Incremental cost and revenue refer to the change caused by a whole decision, which may involve many units or none (a change of method). So marginal is a special case of incremental. Marginal revenue per unit can be found from incremental figures: MR = ΔTR ÷ ΔQ.
2. Worked problems on the incremental principle
Problem 1 (special order). A firm has spare capacity. Its full cost per unit is Rs. 75 (variable Rs. 50, allocated fixed overhead Rs. 25). A buyer offers to take 1,000 units at Rs. 60 each. The order needs special packing of Rs. 2,000. Should it be accepted?
| Item | Rs. |
|---|---|
| Incremental revenue (1,000 × 60) | 60,000 |
| Incremental variable cost (1,000 × 50) | 50,000 |
| Special packing | 2,000 |
| Incremental cost | 52,000 |
| Incremental profit | 8,000 |
Accept. The order seems to lose Rs. 15 a unit on full cost, but the fixed overhead is incurred whether or not the order is taken, so it is not an incremental cost. Two cautions should be added in the answer: the low price must not spoil the regular market, and there must truly be spare capacity.
Problem 2 (February 2025 paper). The price of commodity X falls from Rs. 20 to Rs. 13 per unit. Sales rise from 4,000 to 7,000 units and total revenue rises from Rs. 80,000 to Rs. 90,000. Calculate incremental and marginal revenue.
- Incremental revenue = 90,000 − 80,000 = Rs. 10,000.
- Change in quantity = 7,000 − 4,000 = 3,000 units.
- Marginal revenue = 10,000 ÷ 3,000 = Rs. 3.33 per unit.
3. The time perspective
A decision must be judged over the right period. Marshall’s distinction is the base:
- Short run: a period in which some inputs (plant, machinery) are fixed and output can be changed only by varying the variable inputs. Costs divide into fixed and variable.
- Long run: a period long enough for all inputs to be varied, including the size of plant. All costs are variable.
The principle: a decision should take account of both its short-run and its long-run effects, and give each its proper weight. A price cut may raise sales this quarter but invite retaliation and lower prices next year. A low special-order price (Problem 1) may be profitable now but teach regular customers to wait for discounts. Charging the maximum the market will bear may yield profit in the short run but attract entrants and government attention in the long run. Joel Dean put it as the need to balance short-run and long-run considerations.
4. The discounting principle
A rupee today is worth more than a rupee in the future, because today’s rupee can be invested to earn interest, because the future is uncertain, and because people prefer present to future consumption. So future receipts and payments must be brought to their present value before they are compared.
Formula. Present value PV = FV ÷ (1 + r)n, where FV is the future amount, r the rate of interest (discount rate) and n the number of years.
| Amount receivable | When | Rate | Present value (Rs.) |
|---|---|---|---|
| 1,10,000 | 1 year | 10% | 1,00,000 |
| 1,21,000 | 2 years | 10% | 1,00,000 |
| 1,33,100 | 3 years | 10% | 1,00,000 |
Problem. A buyer offers Rs. 1,00,000 today or Rs. 1,15,000 after two years. The firm can earn 10%. PV of Rs. 1,15,000 = 1,15,000 ÷ 1.21 = Rs. 95,041. The present offer is better by Rs. 4,959.
The principle stated: if a decision affects costs and revenues at future dates, discount them to present values before deciding. This is the basis of the net present value method of capital budgeting in Unit V.
5. Other fundamental concepts often added
- Risk and uncertainty. Risk is measurable (insurable) chance of loss; uncertainty cannot be measured. Frank Knight, in Risk, Uncertainty and Profit (1921), treated profit as the reward for bearing uncertainty.
- Contribution. Selling price less variable cost; the amount each unit contributes towards fixed cost and profit. It is the incremental principle applied per unit, and the base of marginal costing (Unit IV).
How this is examined
The incremental principle comes as a 6-mark problem (February 2025: incremental and marginal revenue from a price fall) or folded into an essay on the fundamental concepts (February 2025: “Define managerial economics. Explain the fundamental concepts”). The syllabus asks for mathematical illustrations, so give at least one small sum under each concept. In a problem, set out the before and after figures, state the rule (IR > IC), and end with a one-line decision.
Now try the real questions: Managerial Economics past question papers.