IAI Actuarial Core Principles · Business Economics

Relationship between economics and business: formula sheet

Full chapter guide

Key formulas

Profit: Profit = Total Revenue − Total Cost; The basic objective measure used in business decisions.
Profit-maximising rule: Marginal Revenue (MR) = Marginal Cost (MC); Assumes the firm aims to maximise profit and that MC rises through MR from below. Studied in later topics.
Marginal principle: Do an activity while marginal benefit ≥ marginal cost; A general decision rule at the heart of business economics. Stop when extra cost exceeds extra benefit.
Opportunity cost: Opportunity cost = value of the best alternative given up; Use it, not just accounting cost, when comparing choices.
Profit-maximising rule (micro): Profit is maximised where MR = MC, with MC cutting MR from below; A core micro decision rule for output. MR is marginal revenue, MC is marginal cost.
Price elasticity of demand (micro): PED = % change in quantity demanded ÷ % change in price; Tells the firm how revenue responds to a price change. Usually negative; often quoted as an absolute value.
Aggregate demand (macro): AD = C + I + G + (X − M); Consumption, investment, government spending and net exports. Used to explain how the economy-wide demand environment changes.
Inflation rate (macro): Inflation rate = (P₁ − P₀) ÷ P₀ × 100; P is a price index at the end (1) and start (0) of the period.
Opportunity cost: Opportunity cost = value of the best alternative forgone; Count only the single best alternative, not all of them. Include implicit costs such as owner's time or own capital.
Economic cost: Economic cost = explicit cost + implicit cost; Explicit costs are actual payments. Implicit costs are the opportunity cost of resources the firm already owns.
Economic profit: Economic profit = total revenue − explicit costs − implicit costs; Accounting profit ignores implicit costs, so it is usually higher than economic profit.
Marginal cost: MC = change in total cost ÷ change in quantity; The extra cost of one more unit.
Marginal benefit rule: Do more while MB > MC; stop where MB = MC; If MB < MC, doing less raises net benefit. Use only forward-looking costs and benefits.
Profit: π = TR − TC; TC includes opportunity costs. Economic profit is profit after all of them.
Profit-maximising rule: MR = MC, with MC cutting MR from below; The second condition means profit is a maximum and not a minimum. In the short run the firm should also cover average variable cost, or it shuts down.
Marginal revenue and marginal cost: MR = ΔTR ÷ ΔQ; MC = ΔTC ÷ ΔQ; For a small change, use derivatives: MR = dTR/dQ and MC = dTC/dQ.
Wealth maximisation: Value = Σ Expected profit(t) ÷ (1 + r)^t, for t = 1 to n; r is a risk-adjusted discount rate. It captures timing and risk, which simple profit ignores.
Revenue maximisation: MR = 0; It is reached where TR is highest. This is the output at which Baumol's firm would stop if no minimum profit were required.
Investment decision rule: Invest if NPV > 0; NPV = present value of benefits − present value of costs, with the discount rate adjusted for risk.
Three basic economic questions: What to produce? How to produce? For whom to produce?; Every economic system answers these. Use them to structure comparison answers.
Market economy: Private ownership + price mechanism + profit motive; Prices coordinate decisions. Government role is limited, mainly law and order and property rights.
Planned economy: State ownership + central planning + administered prices; A central authority sets output targets. Prices do not mainly come from demand and supply.
Mixed economy: Private sector + public sector + regulation; Markets handle most allocation. The state provides public goods and corrects market failure.
Environment split (PEST-type grouping): Political, Economic, Social, Technological factors; A common checklist for the external environment. Legal and environmental factors are often added.

Quick revision

Business economics applies economic theory to business decisions.
Scarcity means limited resources against unlimited wants, so choices must be made.
Opportunity cost is the value of the best alternative given up.
Marginal analysis compares the extra benefit with the extra cost of one more unit or action.
Microeconomics studies individual consumers, firms and markets.
Macroeconomics studies the whole economy: output, inflation, unemployment and policy.
Incentives influence how people and firms behave.
Firms may pursue profit maximisation, growth, sales or survival, and objectives can conflict.
The business environment includes economic, political, legal, social and technological factors.
Economic systems differ in how resources are allocated: market, planned or mixed.
Positive statements describe what is; normative statements say what should be.

Common mistakes

Saying business economics is the same as economic theory. Fix: Stress that business economics applies theory to firm decisions and is prescriptive, while pure theory builds general explanations.
Claiming business economics is only about microeconomics. Fix: Say it is mainly micro in focus but uses macro factors such as inflation, interest rates and policy.
Treating micro as 'small firms' and macro as 'large firms'. Fix: Micro is about individual decision units and markets, whatever their size. Macro is about the economy as a whole.
Saying macro factors do not matter to a single firm. Fix: A firm cannot control macro conditions, but they shape its demand, costs and financing. It must plan around them.
Adding up the value of all alternatives to get opportunity cost. Fix: Opportunity cost is only the value of the single next best alternative.
Including sunk costs in the decision. Fix: Ignore costs that cannot change. Compare only future costs and benefits.
Treating accounting profit as the profit that firms maximise in economic theory. Fix: Subtract opportunity costs to get economic profit. Say that normal profit is a cost, so economic profit is zero at the break-even point.
Saying profit maximisation and wealth maximisation are the same. Fix: Profit maximisation is usually short-term and ignores risk and timing of cash flows. Wealth maximisation uses the present value of risk-adjusted future profits.
Treating a market economy as having no government role. Fix: Say the government role is limited, not absent. It still enforces contracts and property rights.
Calling India a pure market or pure planned economy. Fix: Describe India as a mixed economy with a large private sector, a public sector and substantial regulation.

Exam tips

Begin every answer with a clear one-line definition. Examiners look for it first.
In distinction questions, compare on at least two named points, not just one.
Always add a business example. Actuarial examples such as pricing or capital management fit well.
Divide scope into internal and external groups. It makes a long answer organised and easy to mark.
In MCQs, watch for absolute words such as only or never. Business economics is both micro and macro in its inputs.
Start by stating the level in your first sentence. It shows the examiner you have classified the factor correctly.
In written answers, always give the channel from the factor to the firm: demand, costs or finance. Lists of definitions score less than linked explanations.
Use the standard terms: elasticity, marginal cost, aggregate demand, interest rate, exchange rate. Keep them accurate.