Managerial Economics

Unit 1: Introduction to Managerial Economics

People have limited number of needs which must be satisfied if they are to survive as

human beings. Some are material needs, some are psychological needs and some others are

emotional needs. People’s needs are limited; however, no one would choose to live at the

level of basic human needs if they want to enjoy a better standard of living. This is because

human wants (desire for the consumption of goods and services) are unlimited. It doesn’t

matter whether a person belongs to the middle class in India or is the richest individual in

the World, he or she wants always something more. For example bigger a house, more

friends, more salary etc., Therefore the basic economic problem is that the resources are

limited but wants are unlimited which forces us to make choices. Economics is the study of

this allocation of resources, the choices that are made by economic agents. An economy is a

system which attempts to solve this basic economic problem. There are different types of

economies; household economy, local economy, national economy and international

economy but all economies face the same problem. The major economic problems are (i)
what to produce? (ii) How to produce? (iii) When to produce and (iv) For whom to

produce? Economics is the study of how individuals and societies choose to use the scarce

resources that nature and the previous generation have provided. The world’s resources

are limited and scarce. The resources which are not scarce are called free goods. Resources

which are scarce are called economic goods. Why Study Economics? A good grasp of

economics is vital for managerial decision making, for designing and understanding public

policy, and to appreciate how an economy functions. The students need to know how

economics can help us to understand what goes on in the world and how it can be used as a
practical tool for decision making. Managers and CEO’s of large corporate bodies, managers

of small companies, nonprofit organizations, service centers etc., cannot succeed in

business without a clear understanding of how market forces create both opportunities
and constraints for business enterprises.

5 Reasons For Studying Economics:

1. It is a study of society and as such is extremely important.

2. It trains the mind and enables one to think systematically about the problems of
business and wealth.

3. From a study of the subject it is possible to predict economic trends with some
precision.

4. It helps one to choose from various economic alternatives. Economics is the science

of making decisions in the presence of scarce resources. Resources are simply

anything used to produce a good or service to achieve a goal. Economic decisions

involve the allocation of scarce resources so as to best meet the managerial goal.

The nature of managerial decision varies depending on the goals of the manager. A

Manager is a person who directs resources to achieve a stated goal and he/she has the

responsibility for his/her own actions as well as for the actions of individuals, machines
and other inputs under the manager’s control.

Managerial economics is the study of how scarce resources are directed most efficiently to

achieve managerial goals. It is a valuable tool for analyzing business situations to take
better decisions.
The science of Managerial Economics has emerged only recently. With the growing

variability and unpredictability of the business environment, business managers have

become increasingly concerned with finding rational and ways of adjusting to an exploiting
environmental change.

The problems of the business world attracted the attentions of the academicians from 1950

onwards. Managerial economics as a subject gained popularity in the USA after the
publication of the book “Managerial Economics” by Joel Dean in 1951.

Managerial economics generally refers to the integration of economic theory with business

practice. Economics provides tools managerial economics applies these tools to the

management of business. In simple terms, managerial economics means the application of

economic theory to the problem of management. Managerial economics may be viewed as

economics applied to problem solving at the level of the firm.

It enables the business executive to assume and analyse things. Every firm tries to get

satisfactory profit even though economics emphasises maximizing of profit. Hence, it

becomes necessary to redesign economic ideas to the practical world. This function is being
done by managerial economics.

Definitions:

“Managerial Economics is the integration of Economic theory with business

practice for the purpose of facilitating decision making and forward planning by
the management”

Spencer and Siegelman

“Managerial economics is the use of economic modes of thought to analyse
business situation”

Mc Nair and Meriam

Managerial decision areas include:

 assessment of investable funds

 selecting business area
 choice of product
 determining optimum output
 sales promotion

Almost any business decision can be analyzed with managerial economics

techniques, but it is most commonly applied to:

 Risk analysis – various models are used to quantify risk and

asymmetric information and to employ them in decision rules to manage risk.
 Production analysis – microeconomic techniques are used to analyze production
efficiency, optimum factor allocation, costs, economies of scale and to estimate the
firm's cost function.
 Pricing analysis – microeconomic techniques are used to analyze various pricing
decisions including transfer pricing, joint product pricing, price discrimination, price
elasticity estimations, and choosing the optimum pricing method.
 Capital budgeting – investment theory is used to examine a firm's capital purchasing
decisions
Scope:
Managerial economics to a certain degree is prescriptive in nature as it suggests course of
action to a managerial problem. Problems can be related to various departments in a firm
like production, accounts, sales, etc.
1. Demand decision:
The foremost aspect regarding its scope is in demand analysis and forecasting. A
business firm is an economic unit which transforms productive resources into
saleable goods. Since all output is meant to be sold, accurate estimates of demand
help a firm in minimizing its costs of production and storage.

A firm must decide its total output before preparing its production schedule and
deciding on the resources to be employed. Demand forecasts serves as a guide to the
management for maintaining its market share in competition with its rivals, thereby
securing its profit. Thus, demand analysis facilitates the identification of the various
factors affecting the demand for a firm’s product. This, in turn helps the firm in
manipulating the demand for its output.

In fact, demand forecasts are the starting point for a firm’s planning and decision-
making. This deals with the basic tools of demand analysis i.e.; Demand
Determinants, Demand Distinctions and Demand Forecasting etc.

2. Production decision:

A firm’s profitability depends much on its costs of production. A wise manager

would prepare cost estimates of a range of output, identify the factors causing
variations in costs and choose the cost-minimising output level, taking also into
consideration the degree of uncertainty in production and cost calculations.
Production processes are under the charge of engineers but the business manager
works to carry out the production function analysis in order to avoid wastages of
materials and time. Sound pricing policies depend much on cost control.

The main topics discussed under cost and production analysis are:

Cost concepts, cost-output relationships, Economics and diseconomies of scale and

cost control

3. Theory of exchange or price theory

Another task before a business manager is the pricing of a product. Since a firm’s
income and profit depend mainly on the price decision, the pricing policies and all
such decisions are to be taken after careful analysis of the nature of the market in
which the firm operates. The important topics covered in this field of study are:
Market Structure Analysis, Pricing Practices and Price Forecasting.
 4. Profit Management:
Each and every business firms are tended for earning profit; it is profit which
provides the chief measure of success of a firm in the long period. Economists tell us
that profits are the reward for uncertainty bearing and risk taking. A successful
business manager is one who can form more or less correct estimates of costs and
revenues at different levels of output. The more successful a manager is in reducing
uncertainty, the higher are the profits earned by him. It is therefore, profit-planning
and profit measurement that constitutes the most challenging area of business
economics.

5. Capital Management:
Still another most challenging problem for a modern business manager is of
planning capital investment. Investments are made in the plant and machinery and
buildings which are very high. Therefore, capital management requires top-level
decisions. It means capital management i.e., planning and control of capital
expenditure. It deals with Cost of capital, Rate of Return and Selection of projects.

Basic Economics tools in Managerial Economics

Some of the important economics tools which are used widely in managerial
economics are as follows:
1. Opportunity Cost Principle:
This principle is of immense use in decision-making. It can be stated as; the cost involved in
any decision consists of the sacrifices of alternatives required by that decision. If there are
no sacrifices there are no costs.

The opportunity costs are measured by the sacrifices in terms of goods and services
involved in the decision. The opportunity cost of the funds employed in one’s own business
is the amount of interest income which could be earned had that been employed in other
ventures.

The opportunity cost of using a machine to produce one product is measured as the income
which could have been obtained by renting it out to somebody else. If a machine has only
one use, its opportunity cost is zero. In the same way, the opportunity cost of the time
which an entrepreneur devotes to his business is the salary he could earn by working with
some other firm of which he has knowledge. Thus, opportunity costs are the only relevant
principle for decision making.

2. Incremental Principle:
The economists make a use of the incremental principle in the theories of consumption,
production pricing and distribution. In price-determination, this principle states that a firm
would maximise its profits if it equates its marginal costs to its marginal revenue. In this
way, this principle guides a business manager that he should expand his business in each
direction only so long as the incremental benefit to his firm is more than the incremental
costs.

The moment the incremental benefit (marginal revenue) is equated to the incremental cost
(marginal cost); it is the point where the activity has to be limited. This principle focuses on
the changes in prices, products, procedures, investments or whatever may be at stake in a
business decision.

3. Principle of Time Perspective:

Another principle that is the principle of time perspective is useful in decision-making in
output, prices, advertising and expansion of business. Economists distinguish between the
short run and the long run in discussing the determination of price in a given market
because in the long run a firm must cover its full cost.

On the contrary, in the short-run it can afford to ignore some of its (fixed) costs. Modern
economists have started making use of an “intermediate run” between the short run and
the long run in order to explain pricing and output behaviour under what is called
oligopoly.

The principle of time perspective can be stated as under:

A decision should take into account both the short run and the long run effects on revenues
and costs and maintain a right balance between the long run and the short run
perspectives.

4. Discounting Principle:
Generally people consider a rupee tomorrow to be worth less than a rupee today. This is
also implied by the common saying that a bird in hand is worth two in the bush. Anybody
will prefer Rs. 100 today to Rs. 100 next year.
There are two main reasons for this:
(1) The future is uncertain and it is preferable to get Rs.100 today rather than a year after;

(2) Even if one is sure to receive Rs. 100 next year, one would do well to receive Rs. 100
now and invest it for a year and earn a rate of interest on Rs. 100 for one year.

What is the present worth (PW) of Rs. 100 obtainable after one year?

The relevant formula for finding this out is:

The principle of economics used in the calculations given above is called the discounting
principle. It can be explained as “If a decision affects costs and revenues at future dates, it is
necessary to discount those costs and revenues to obtain the present values of both before
a valid comparison of alternatives can be made”.

5. The Equi-Marginal Principle:

This principle states that an input should be allocated in such a way that the value added by
the last unit of the input is the same in all its uses. This generalized law is known as the
equi-marginal principle.

Example:
Let us suppose that a firm has got two workers to employ in three activities, say production
of bottled milk, butter, and cheese. The firm must allocate these workers in such a way that
the marginal productivity of the last worker employed in each of these activities is the
same.

To put it in more clear way, if the marginal worker given the duty of producing bottled
milk, adds output worth Rs. 20. Then the marginal worker employed on butter and cheese
production must also earn neither more nor less than Rs. 20 for the milk plant.
Otherwise the firm will not be making the best use of the employed labour. The Rs. 20
worth of additional output produced by the marginal worker is called ‘value -of marginal
product or VMP.’

According to the law of equi-marginal principle in short, it can be written as follows:

VMPA = VMPB = VMP8C
Where A, B and C indicate the activities A, B and C.

This is the equi-marginal principle is a very simple form. It needs to be corrected further
for practical use.

Firstly:
We must find the net value of the marginal products before we compare these. This is
because adding a worker to an activity also necessitates adding other inputs like machine,
time, electricity etc. And to find out the worker’s net marginal value product, we must
deduct from his VMP the value of the additional materials used in the process. Suppose the
value of these additional materials is Rs. 5, then the net VMP of the worker will be Rs. 20 –
Rs. 5 = Rs. 15.

Secondly:
Correction is needed with regard to the price of the output produced by the additional
worker. When more bottles of milk are produced these may have to be offered to
consumers at lower prices which means that the revenue earned by the firm from
additional bottles of milk would be less than that of the earlier bottles. If we subtract the
reduction in revenue from the VMP of the worker, we get the net marginal revenue product
of the worker.

Thirdly:
Equi-marginal principle is to discount the revenues made available to the firm from the sale
of the additional production in the future. Labour has to be paid today while the output of
labour has to be sold in future. If a year’s period is necessary for the sale of output we have
to discount the net product for one year before comparing the net products of labour in
each activity.

We must remember that the equi-marginal principle is workable only under only ideal
conditions. A business enterprise may also work under some non-economic pressures and
pulls. For example, an activity may be carried on simply because of inertia on the part of
management arising from well-set routines even though activities add less to the revenues
of a firm than others which have to be started for the first time. Other activities may be just
continued because the managers have a sentimental attachment to them.

To conclude the discussion, we can say that economic laws are significant in business
economics although these have to considerably refined and modified to suit the nature of
the business enterprise. But, there are definite gaps between the theory of the firm and
managerial economics.

Economic theory deals for generalized study and application to economic models while
managerial economics is downright practical science. Most of the assumptions of the
economic theory of the firm are abstract in nature, For example, the entrepreneur of a firm
is assumed to be a thoroughly calculating man who strives to maximize profit by equating
its marginal cost with marginal revenue.

But, now it has been observed that under imperfect competition firms has no compulsion
to maximize profit. Rather the firms tend to have nonprofit goals of a long-run nature such
as stability and liquidity of the firm which considerably modify their decision-making
processes and policy planning.

Role and Responsibility of managerial Economist

A managerial economist helps the management by using his analytical skills and highly
developed techniques in solving complex issues of successful decision-making and future
advanced planning.

The role of managerial economist can be summarized as follows:

1. He studies the economic patterns at macro-level and analysis its significance to the
specific firm he is working in.
2. He has to consistently examine the probabilities of transforming an ever-changing
economic environment into profitable business avenues.
3. He assists the business planning process of a firm.
4. He also carries cost-benefit analysis.
5. He assists the management in the decisions pertaining to internal functioning of a
firm such as changes in price, investment plans, type of goods /services to be
produced, inputs to be used, techniques of production to be employed, expansion/
 contraction of firm, allocation of capital, location of new plants, quantity of output to
be produced, replacement of plant equipment, sales forecasting, inventory
forecasting, etc.
6. In addition, a managerial economist has to analyze changes in macro- economic
indicators such as national income, population, business cycles, and their possible
effect on the firm’s functioning.
7. He is also involved in advicing the management on public relations, foreign
exchange, and trade. He guides the firm on the likely impact of changes in monetary
and fiscal policy on the firm’s functioning.
8. He also makes an economic analysis of the firms in competition. He has to collect
economic data and examine all crucial information about the environment in which
the firm operates.
9. The most significant function of a managerial economist is to conduct a detailed
research on industrial market.
10. In order to perform all these roles, a managerial economist has to conduct an
elaborate statistical analysis.
11. He must be vigilant and must have ability to cope up with the pressures.
12. He also provides management with economic information such as tax rates,
competitor’s price and product, etc. They give their valuable advice to government
authorities as well.
13. At times, a managerial economist has to prepare speeches for top management.

Importance of Managerial Economics

This section elaborates on the significance of the study of managerial economics.

Managerial economics does not give importance to the study of theoretical economic
concepts. Its main concern is to apply theories to find solutions to day-to-day practical
problems faced by a firm. The following points indicate the significance of the study of this
subject in its right perspective:
1. It gives guidance for identification of key variables in decision-makingprocess.
2. It helps the business executives to understand the various intricacies of business
and managerial problems and to take right decisions at the right time.
3. It provides the necessary conceptual, technical skills, toolbox of analysis and
techniques of thinking and other such modern tools and instruments like elasticity
of demand and supply, cost and revenue, income and expenditure, profit and volume
of production, etc to solve various business problems.
4. It is both a science and an art. In the context of globalisation, privatisation,
liberalisation and marketisation and a highly competitive dynamic economy, it helps
 in identifying various business and managerial problems, their causes and
consequence, and suggests various policies and programmes to overcome them.
5. It helps the business executives to become much more responsive, realistic and
competent to face the dynamic challenges in the modern business world.
6. It helps in the optimum use of scarce resources of a firm to maximise its profits.
7. It also helps in achieving other objectives a firm likes attaining industry leadership,
market share expansion and social responsibilities, etc.
8. It helps a firm in forecasting the most important economic variables like demand,
supply, cost, revenue, price, sales and profit, etc and formulate sound business
policies
9. It also helps in understanding the various external factors and forces which affect
the decision-making of a firm.
Thus, it has become a highly useful and practical discipline in recent years to analyse and
find solutions to various kinds of problems in a systematic and rational manner.

Questions:
1. Define managerial economics and explain its main characteristics.
2. Discuss the scope of managerial economics.
3. Explain the importance of managerial economics.
4. Discuss the functions of a managerial economist.

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