Nature and Scope of Managerial Economics

1. Introduction Managerial economics is a special branch of economics evolved to bridge the gap between abstract theory and managerial practice. It deals with the use of economic concepts and principles for decision-making and forward planning through an uncertain future. Economic theory provides a number of concepts and analytical tools which are of considerable significance to the executives in their decision-making process in an uncertainty framework. But this does not mean that economic provides answers for all the problems faced by the firm or a business unit. In practice, many more skills are to be developed in solving the variety of problems faced by the firm. Only conceptual knowledge is of no use. The executives have to develop necessary skills to make use of their knowledge in the context of the firm. Managerial economics, therefore, refers to only those aspects of economics that are useful in the decision making process of the firm. The scope of managerial economics mainly confines to microeconomics and it generally does not extend to macroeconomics. This does not mean that macroeconomics is completely useless to a managerial economist. Even though the scope of managerial economic does not cover the area of macroeconomics, its understanding is absolutely essential for a potential business executive. Managerial economics is thus a science which deals with the application of economic theory to managerial practice. It lies on the borderline of economics and business management. It may be defined precisely as the study of the allocation of resources available to a firm among its activities. Briefly, managerial economics may be called ‘economics applied in decision making’. It is mainly concerned with classifying problems, organizing and evaluating information and ultimately comparing the alternative course of action. McNair and Meriam in their book Problems in Business Economics maintain that the managerial economics consists of the use of economic modes of

thought to analyze business situations. According to Milton H. Spencer and Louis Siegelman, managerial economics is the integration of economic theory with business practice for the purpose of facilitating decision making and forward planning by management. Managerial economics is highly pragmatic. It deals mainly with analytical tools that are useful in decision-making process. It avoids some of the abstract issues of economic theory, but has also certain complications that are neglected in theory. Managerial economics, therefore, considers particular environment of decision-making. William J. Baumol in his article, ‘What Can Economic Theory Contribute to managerial Economics?’, points out that it is not the final theorems of economics that are important to management but rather the methods of reasoning. Managerial economics borrows only the analytical tools of economic theory and gives very little importance to the final theorems of economics. Managerial economics is thus realistic in nature. It is applied to solve some of the problems faced by the firm. These problems generally relate to choices faced by the firm. These problems generally relate to choices and allocation of recourses which are essentially economic in character and are experienced by the managers. It should be remembered here that even though managerial economics helps a great deal in solving some of the ticklish problems of the firm by influencing decision-making process, the decision-making process is not only dependent on the tools and concepts of managerial economics; but there are several other factors which also significantly influences the decision-making process of the firm. In other words, managerial decision-making is influenced not only by economic factors but also by many other considerations. The other factors influencing the decisions made by the managers are:
i) ii) iii)

Human and behavioral consideration Technological forces Environmental factors

2. Scope/Areas of Managerial Economics The areas of business issues to which economic theories can be directly applied may be divided into followings: a) Demand Analysis and Forecasting b) Cost and Production Analysis c) Pricing Decision, Policies and Practices d) Profit Management e) Capital Management f) Linear Programming and the Theory of Games (a) Demand Analysis and Forecasting. Effective decision-making at

the fir level depends on accurate estimates of demand. Demand analysis aims at discovering the forces that determine sales. It has two main managerial purposes (i) forecasting sales, and (ii) manipulating demand. It is useful for business planning and hence occupies a pivotal place in managerial economics. The demand analysis mainly relates to the study of demand determinants, demand distinctions and demand forecasting. The Case of Wool production: a) During the late 1980s, wool prices increased considerably due to increased demand by China and the former Soviet Union. From 1977 to 1988, the price of wool for worsted clothing rose from $3.67 to $5.81 per pound. Expecting that wool prices would remain high, wool producers raised a lot more sheep. Did this result in a shift right in the supply curve for wool? b) At the same time the Chinese and Russians cut back on their purchases of wool because of lack of foreign currency (and in the case of Chain because of organizational problem). c) Australia is the world’s largest producer of wool and for a time Australia Wool Corporation propped up the price of wool by buying up any unsold Australian wool. Why was it necessary to prevent the price from falling?

(b)

Cost and Production Analysis. Cost estimates are also essential

for effective decision-making and production planning at the firm level. Profit planning, cost control and sound pricing practices call for an accurate cost and production analysis. Cost analysis is wider in scope than the production analysis. While production analysis is in physical terms, the cost analysis is in monetary terms. Cost analysis deals with cost concepts and classifications, cost-output relations, economies and diseconomies of scale, production functions and cost control. Production theory helps in determine the size of firm, size of the total output and the factor proportion, that is, the amount of capital and labor to be employed. (c) Pricing decisions, Policies and Practices. Pricing is an important

area of managerial economics. Success of a business firm largely depends on the accuracy of price decisions. Price determination under different markets, pricing methods and policies product line pricing and price forecasting are some of the topics studied in this area.

(d)

Profit management. Business firms are mainly profit-hunting

institutions. The success of the firm is always measured in terms of profits. Nature and management of profits, profits policies and techniques and profit planning are the important aspects covered under his area. (e) Capital Management. The most complex, troublesome and ticklish management implies planning and control of capital

problem faced by a business manager is the capital management. Capital expenditures. Cost of capital, rate of return selection projects are the important topics to be studied under capital management. (f) Linear Programming and the Theory of Games. Since managerial economics and operations research are closely connected with each other, managerial economics has started using such techniques of

operations research as Linear Programming and the Theory of Games. Recently, the Linear Programming and Theory of Games have been brought as a part of the study of managerial economics. 3. Managerial Economics and other Disciplines Managerial economics is closely related to other disciplines. It is intimately related to microeconomic theory, macroeconomic theory, the theory of decision-making, operations research, mathematics, statics and accounting. The management executive makes use of the concepts and methods form all these disciplines. Managerial Economics and Microeconomic Theory Managerial economics is mainly microeconomic in character. Microeconomic theory provides all important concepts and analytical tools to managerial economics. Managerial economic makes use of such micro economic concepts as the elasticity of demand, marginal cost, market structures, short and long-runs and so on. It also deals with monopoly price, the kinked demand theory and the price discrimination. While making use of some of these microeconomic concepts, managerial economics also neglects some of the important issues that occupy a pivotal place in economic theory. For instance, managerial economic is totally indifferent to the indifference curves which have helped in clarifying important aspects in economic theory such as separation of income and substitution effects of price change. Managerial economics tries to use only those concepts of microeconomic theory which command immediate applicability. Microeconomic theory mainly deals with the theory of firm and the theory of pricing. The main concepts and analytical apparatus of managerial economics are drawn from these two branches of macroeconomics theory. The study of microeconomic theory, therefore, constitutes an essential condition for the better understanding of the managerial economics.

Managerial Economics and Macroeconomic Theory Macroeconomic theory has comparatively less concern with the managerial economics. It is useful to managerial economics mainly in the area of forecasting. Macroeconomic theory being aggregative in character is immense importance in forecasting general business conditions. The general theory of income and employment, which is at the core of macroeconomics, has a direct impact upon the forecasting of general business conditions. Managerial economics makes use of such macroeconomic concepts as the National Income and Social Accounting, Propensity to Consume, Marginal Efficiency of Capital, the Multiplier, the Accelerator, Liquidity Preference, Business Cycles, Public Finance and Fiscal Policy; and so on. Since the decisions at a firm level are taken in the board framework of an economic system, it becomes essential conditions. It is in this context, macroeconomic theory is useful to managerial economics. In recent years, a new branch of study known as the Business Environment and Policy has come into vogue which has relevance to macro economic theory. Managerial economics is thus closely related to both micro and and

macroeconomic theory.

The

relation

of managerial

economics

economic theory is like the relation of engineering to physics. Managerial Economics and the Theory of Decision Making Managerial economics is also closely related to the theory of decisionmaking. The theory of decision-making is comparatively a new subject. It deals with the processes by which a particular course of action is selected from out of a number of alternatives available. It details the processes by which expectations under conditions of uncertainty framework are constituted. It takes into account of uncertainty the sociological and psychological factors influencing human behavior. In practice, the theory of decision-making and economic theory come in contrast with each other as they are based on a different set of assumptions. The case method

employed in managerial economics is a part and parcel of the theory of decision-making. Managerial Economics and Operations Research Operations research is one of the most important developments in the fields of management science. Even though the roots of operation all areas of administrations requiring planning and control in all areas of administration requiring planning and control. Operations research has been broadly defined as the application of mathematical techniques in solving the business problems. It deals with model building – the construction of theoretical models that helps the decision-making process. The origin of Operation Research can be traced back to the interdisciplinary research that took place in the United States and other Western countries to solve the complicated operational problems of planning and resource allocation in defense and key disciplines such as engineers, statisticians, mathematicians and other came together and developed models and other apparatus. Since then, these have grown into specialized fields known as Operations Research. Operations research has enhanced the utility of managerial economics in actual practice. Managerial economics has a very close connection with the operations research. The techniques of operations research are highly mathematical in character. One of the popular techniques evolved and very often used is the Linear or Mathematical Programming. It is applied to a variety of problems of choice. Managerial economics makes use of linear programming and other concepts of operations research for dealing with problems involving risk and uncertainty. Managerial Economics and Mathematics Mathematics is another subject with which managerial economics has a very close relation. Recent advancements have compelled the business executives to make use of mathematical concepts and techniques. Mathematics has almost become a part and parcel of the managerial economics. Managerial economics today has become metrical in character.

Professor Joel Dean in the early stages of the development of the managerial economics maintained that it is conceptual rather than metrical. But Professors Savage and Small contend that ‘managerial economics should be both conceptual and metrical ; for while measurement without theory can only lead to false precision, theory without measurement can rarely be operationally useful’. Mathematics is useful in managerial economics in estimating various economic relationships, measuring relevant economic quantities and employing them in decision-making and forward planning. Modern business executive therefore should have the knowledge of geometry, trigonometry, and algebra and also of integral and differential calculus. Managerial Economics and Statistics Statistics is also useful in many ways to managerial economics. Managerial economics obtains the basis for the empirical testing of theory from statistics. The importance of statistics to managerial economics also lies in the fact that it provides the individual firm with measures of the appropriate functional relationship involved in decision-making. Since management executives take their decisions in an uncertainly framework, the theory of probability evolved in statistics provides the logic for dealing with such uncertainty. Management executives are constantly confronted with the choice between models neglecting uncertainty and those that involve probability theory. Therefore, there exists a very close relation between statistics and managerial economics. Managerial Economics, Management Theory and Accounting Management theory and Accounting also exercise a profound influence on managerial economics. Since decision-making is mainly the function of management, the developments in management theory do influence managerial economics which helps the process of decision-making at the firm level. Modern management theorists now contend that satisfying is the objective of modern firms’ rather than maximizing as thought earlier. Managerial economics cannot afford to ignore these development and changing views of management theorists as they have important bearing on the decision-making process of the firm.

There also exists a very close relationship between managerial economics and accounting. Accounting refers to the recording of pecuniary transactions of the firm in certain prescribed books. The decision-making process of the firm depends heavily on accounting information. Language of business consists of accounting data and statements. Therefore, managerial economists have to get him acquainted with the concepts and practices of accounting. He should also know the interpretation and use of accounting data. Growing specialization in the form of Cost and Management Accounting has become much common in recent years. Managerial economist has to keep pace with the changing times. Accounting has in fact strengthened the applied bias of managerial economics.

Case Study:
Decision Making in Business and Military Strategy According to William E. Peacock, a former president of two St. Louis companies and Assistant Secretary of the Army, decision making in business has much in common with military strategy. Although business managers’ actions are restricted by laws and regulations to prevent unfair practices and the objective of managers, of course, is not to literally destroy the competition, there is much that they can learn from military strategists. Peacock points out that, down through history; military conflicts have produced a set of Darwinian basic principles that are an excellent guideline to business managers in meeting the competitions in the market place. Neglecting these principles can make the difference between business success and failure. In business as in war, it is crucial to have clear objective as to what the organization wants to accomplish and to explain this objective to all employees. The benefits of a simple marketing strategy that all employees can understand are clearly evidenced by the success of McDonald’s. Both business and warfare also require the development of a strategy for attacking. Being aggressive is important because few competitions are ever won by being passive. Furthermore, both business and warfare

require unity of command to pinpoint responsibility. Even in decentralized companies with informal lines of command, there are always key individuals who must make important decisions. Finally, in business as in war, the element of surprise and security (keeping your strategy secret) is crucial. For example, Lee Iacocca stunned the competition in 1964 by introducing the immensely successful Mustang. Furthermore, industrial espionage to discover a rival’s plans or steal a rival’s new technological breakthrough is becoming increasingly common. More than ever before, today’s business leaders must learn how to tap employees’ ideas and energy, manage large-scale rapid change, anticipate business conditions five or ten years down the road, and muster the courage to steer the firm in radical new directions when necessary. Above all, firms must think and act strategically in a world of increasing global competitions. 4. Characteristics/Features of Managerial Economics 1 Managerial economics basically uses the principles of micro economics that is micro economic in character; It studies the business units and only the problems of business firms are studied. 2 3 It uses price theory than the theory of distribution. It uses only profit theories, which is a part of the theory of distribution. Managerial economics is more normative in character. Traditional economics is descriptive in character. It does not care at all whether a thing is good or bad. For example, it explains that according to the law of demand price increases when demand increases, but does not say whether the increase in price is good or bad. On the other hand, since managerial economics is concerned with decision-making , it includes value judgment. 4 Managerial economics integrates the economic theory and business practice.

Nature of Profit Every business firm is organized with the objective of making profits. Profits are the primary measure of its success. The survival of any firm depends upon its ability to earn profits. The word profit has different meaning to businessman, workers and economists. The meaning of profit; to a layman, profit means all income that flow to the investors, to a business community, profit refers to the revenue of the firm minus the explicit and accounting cost, To an economist, profit is of pure profit also called economic profit. Profit is described as a reward for entrepreneurship for successfully managing the businessman faces certain risks which can be divided broadly into two categories. i) ii) Insurable risks Non-insurable risks

Insurable risk are those which can be calculated and insured against with the insurance companies. The entrepreneur does not bother much about these risks as they are covered by insurance companies. For example risk like due to fire, earthquake, floods, other natural calamities, loss due to theft, burglary, and robbery. Non-insurable risks are those which cannot be measured and insured against. These are to be necessarily borne by the entrepreneur himself. These are known as non-insurable risks and include the risk of competition, technical risks, business cycle risks, risk or development of new products and risks arising from government action through changes in economic policy. The non-insurable risks are described by the professor F.H. Knight. According to him- “Profit is a reward for assuming and successfully managing risks and for bearing uncertainties.”

Profit, according to some writers, is essentially a residual sum. It is the income received by an organizer. A firm makes profits when it receives a surplus after it has paid interest on capital, wages to laborers and rent for land. In other words, profit is the residual income which is equal to the difference between the total revenue and the total cost of production. Profits nay arise also on account of market imperfections and monopoly. They arise due to the monopolistic control which the organizer is able to acquire in the market due to certain peculiar conditions prevalent. Monopolistic control gives the entrepreneur complete control over the supply of a commodity and the price fixation in the absence of any competition. This situation contributes to the emergence of profits. Sometimes profits are due to mere luck. Few entrepreneurs flourish only due to their good luck. Few entrepreneurs flourish only due to their good luck. Apart from luck, sometimes profits many arise just by chance that appears in the business. For instance, during the World War some countries could get the chance of selling their commodities at a better and higher price in the market. Such profits are called the fortuitous gains. Professor Schumpeter, a noted German economist, is of the opinion that profits arise on account of economic innovation. Economic innovation implies the introduction of a new product, introduction of a new process, opening of a new market, invention of new methods of production, development of a new source of raw material and new methods of business organization. Innovation, according to Schumpeter, is the source of profits. Economic and Accounting Profit The two important concepts of profits that figure in business are: economic profit and accounting profit. In accounting sense profit is surplus of revenue over and above all paid-out costs. Accounting profit may be calculated as:

Accounting Profit = TR ─ (W + R + I + M) where, TR = Total Revenue, W R I M = Wages and salaries = Rent = Interest, and = Cost of materials

While calculating accounting profits, only explicit costs or book costs are considered. Economic profit takes into account also the implicit costs or opportunity costs. Opportunity cost is income forgone which a businessman could expect from the second best alternative use of his resources. For example, if an entrepreneur uses his capital in his own business, he forgoes interest which he might earn by purchasing debenture of other companies or by depositing his money with joint stock companies for a period. Furthermore, if an entrepreneur uses his labour in his own business, he forgoes his salary which he might earn by working as a manager in another firm. Similarly, by using productive assets (land and building) in his own business, he sacrifices his market rent. These foregone incomes are called opportunity costs. Economic profit or pure profit may be defined as a residual left after all contractual costs have been met, including insurable risk, depreciation, payment to shareholders. Thus, Economic Profit = Total Revenue ─ (Explicit cost + Implicit cost) Limitations: 1) Economic profit may exist only in short period; it does not exist the long-run especially under perfect competition. 2) It may not be possible to calculate the economic profit every year by a single firm. in

Problem related to profit of a business A business person who has a MBA degree invests Rs.200,000 in a retail shop. The projected income statement for the year as prepared by an accountant is shown as: Rs. Sales Less: Cost of goods sold Gross Profit Rs. 90,000 40,000 50,000

Less: Advertising Depreciation Utilities Property Tax Miscellaneous Expenses Total of Expenses Net Annual Profit  

10,000 10,000 3,000 2,000 5,000

30,000 20,000

In the above income and expenditure statement net accounting profit or business profit is Rs.20,000. The economists recognize other costs, defined as implicit costs. Implicit costs are not included in the accounting statements, but must be included in any rational decision making framework. There are two major implicit costs in the preceding example: i) The owner has Rs.200,000 invested in the business. Suppose the best alternative use for this money is a bank account paying a 5 percent interest rate. Therefore, this investment would return Rs.10,000 annually. This Rs.10,000 should be considered as the implicit or opportunity cost of having Rs.200,000 invested in the retain store. The second implicit cost includes the managers' time and talent. The annual wage return on an MBA degree from a reasonably

ii)

good business school may be Rs.60,000 per year. Thus, the income statement should be amended in the following way in order to determine economic profit. Rs. Sales Less: Cost of goods sold Gross Profit Rs. 90,000 40,000 50,000

Less: explicit costs Advertising Depreciation Utilities Property Tax Miscellaneous Expenses Total of Expenses Accounting Profit before implicit cost 10,000 10,000 3,000 2,000 5,000 30,000 20,000

Less: implicit costs Return on Rs.200,000 Foregone wages Total of implicit costs Net Economic profit/loss 10,000 60,000 70,000 (50,000)

Most decision makers are unaware of this concept. The concept of economic profit accounts for all costs and therefore is more useful management tools than the more normally defined concept of accounting profit.

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