Introduction To Managerial Economics - Free Study Notes

Nature of Managerial Economics

Managerial Economics and Business economics are the two terms, which, at times have been used interchangeably. Of late, however, the term Managerial Economics has become more popular and seems to displace progressively the term Business Economics.

The prime function of a management executive in a business organization is decision making and forward planning. Decision Making means the process of selecting one action from two or more alternative courses of action whereas forward planning means establishing plans for the future. The question of choice arises because resources such as capital, land, labour and management are limited and can be employed in alternative uses. The decision making function thus becomes one of making choices or decisions that will provide the most efficient means of attaining a desired end, say, profit maximization. Once decision is made about the particular goal to be achieved, plans as to production, pricing, capital, raw materials, labour, etc., are prepared. Forward planning thus goes hand in hand with decision making.
A significant characteristic of the conditions, in which business organizations work and take decisions, is uncertainty. And this fact of uncertainty not only makes the function of decision making and forward planning complicated but adds a different dimension to it. If knowledge of the future were perfect, plans could be formulated without error and hence without any need for subsequent revision. In the real world, however, the business manager rarely has complete information and the estimates about future predicted as best as possible. As plans are implemented over time, more facts become known so that in their light, plans may have to be revised, and a different course of action adopted. Managers are thus engaged in a continuous process of decision making through an uncertain future and the overall problem confronting them is one of adjusting to uncertainty.
In fulfilling the function of decision making in an uncertainty framework, economic theory can be pressed into service with considerable advantage. Economic theory deals with a number of concepts and principles relating, for example, to profit, demand, cost, pricing production, competition, business cycles, national income, etc., which aided by allied disciplines like Accounting. Statistics and Mathematics can be used to solve or at least throw some light upon the problems of business management. The way economic analysis can be used towards solving business problems. Constitutes the subject matter of Managerial Economics.

Definition of Managerial Economics

According to McNair and Meriam, "Managerial Economics consists of the use of economic modes of thought to analyse business situation."
Spencer and Siegelman have defined Managerial Economics as "The integration of economic theory with business practice for the purpose of facilitating decision making and forward planning by management."
We may, therefore define Managerial Economics as the discipline which deals with the application of economic theory to business management. Managerial Economics thus lies on the borderline between economics and business management and serves as a bridge between economics and business management.
Chart 1 – Economics, Business Management and Managerial Economics.

Application of Economics to Business Management

The application of economics to business management or the integration of economic theory with business practice, as Spencer and Siegelman have put it, has the following aspects :-

1. Reconciling traditional theoretical concepts of economics in relation to the actual business behavior and conditions. In economic theory, the technique of analysis is one of model building whereby certain assumptions are made and on that basis, conclusions as to the behavior of the firms are drown. The assumptions, however, make the theory of the firm unrealistic since it fails to provide a satisfactory explanation of that what the firms actually do. Hence the need to reconcile the theoretical principles based on simplified assumptions with actual business practice and develops appropriate extensions and reformulation of economic theory, if necessary.
2. Estimating economic relationships, viz., measurement of various types of elasticities of demand such as price elasticity, income elasticity, cross-elasticity, promotional elasticity, cost-output relationships, etc. The estimates of these economic relationships are to be used for purposes of forecasting.
3. Predicting relevant economic quantities, eg., profit, demand, production, costs, pricing, capital, etc., in numerical terms together with their probabilities. As the business manager has to work in an environment of uncertainty, future is to be predicted so that in the light of the predicted estimates, decision making and forward planning may be possible.
4. Using economic quantities in decision making and forward planning, that is, formulating business policies and, on that basis, establishing business plans for the future pertaining to profit, prices, costs, capital, etc. The nature of economic forecasting is such that it indicates the degree of probability of various possible outcomes, i.e. losses or gains as a result of following each one of the strategies available. Hence, before a business manager there exists a quantified picture indicating the number o courses open, their possible outcomes and the quantified probability of each outcome. Keeping this picture in view, he decides about the strategy to be chosen.
5. Understanding significant external forces constituting the environment in which the business is operating and to which it must adjust, e.g., business cycles, fluctuations in national income and government policies pertaining to public finance, fiscal policy and taxation, international economics and foreign trade, monetary economics, labour relations, anti-monopoly measures, industrial licensing, price controls, etc. The business manager has to appraise the relevance and impact of these external forces in relation to the particular business unit and its business policies.

Characteristics of Managerial Economics

It would be useful to point out certain chief characteristics of Managerial Economics, in as much it’s they throw further light on the nature of the subject matter and help in a clearer understanding thereof.

1. Managerial Economics is micro-economic in character.
2. Managerial Economics largely uses that body of economic concepts and principles, which is known as 'Theory of the firm' or 'Economics of the firm'. In addition, it also seeks to apply Profit Theory, which forms part of Distribution Theories in Economics.
3. Managerial Economics is pragmatic. It avoids difficult abstract issues of economic theory but involves complications ignored in economic theory to face the overall situation in which decisions are made. Economic theory appropriately ignores the variety of backgrounds and training found in individual firms but Managerial Economics considers the particular environment of decision making.
4. Managerial Economics belongs to normative economics rather than positive economics (also sometimes known as Descriptive Economics). In other words, it is prescriptive rather than descriptive. The main body of economic theory confines itself to descriptive hypothesis, attempting to generalize about the relations among different variables without judgment about what is desirable or undesirable. For instance, the law of demand states that as price increases. Demand goes down or vice-versa but this statement does not tell whether the outcome is good or bad. Managerial Economics, however, is concerned with what decisions ought to be made and hence involves value judgments.

Production and Supply
Production analysis is narrower in scope than cost analysis. Production analysis frequently proceeds in physical terms while cost analysis proceeds in monetary terms. Production analysis mainly deals with different production functions and their managerial uses.
Supply analysis deals with various aspects of supply of a commodity. Certain important aspects of supply analysis are supply schedule, curves and function, law of supply and its limitations. Elasticity of supply and Factors influencing supply.

Pricing Decisions, Policies and Practices
Pricing is a very important area of Managerial Economics. In fact, price is the ness of the revenue of a firm and as such the success of a business firm largely depends on the correctness of the prices decisions taken by it. The important aspects dealt with under this area are :- Price Determination in various Market Forms, Pricing methods, Differential Pricing, Product-line Pricing and Price Forecasting.

Profit Management
Business firms are generally organized for the purpose of making profits and, in long run, profits provide the chief measure of success. In this connection, an important point worth considering is the element of uncertainty exiting about profits because of variations in costs and revenues which, in turn, are caused by torso both internal and external to the firm. If knowledge about the future were fact, profit analysis would have been a very easy task. However, in a world of certainty, expectations are not always realized so that profit planning and measurement constitute the difficult are of Managerial Economics. The important acts covered under this area are :- Nature and Measurement of Profit, Profit Testing and Techniques of Profit Planning like Break-Even Analysis.

Capital Management
Of the various types and classes of business problems, the most complex and able some for the business manager are likely to be those relating to the firm’s investments. Relatively large sums are involved, and the problems are so complex that their disposal not only requires considerable time and labour but is a term for top-level decision. Briefly, capital management implies planning and trolls of capital expenditure. The main topics dealt with are :- Cost of Capital, Rate return and Selection of Project.

The various aspects outlined above represent the major uncertainties which a ness firm has to reckon with, viz., demand uncertainty, cost uncertainty, price certainty, profit uncertainty, and capital uncertainty. We can, therefore, conclude the subject matter of Managerial Economic consists of applying economic cripples and concepts towards adjusting with various uncertainties faced by a ness firm.

Managerial Economics and Other Subjects

Yet another useful method of throwing light upon the nature and scope of Managerial Economics is to examine its relationship with other subjects. In this connection, Economics, Statistics, Mathematics and Accounting deserve special mention.

Managerial Economics and Economics
Managerial Economics has been described as economics applied to decision making. It may be viewed as a special branch of economics bridging the gulf between pure economic theory and managerial practice.
Economics has two main divisions :- (i) Microeconomics and (ii) Macroeconomics. Microeconomics has been defined as that branch of economics where the unit of study is an individual or a firm. Macroeconomics, on the other hand, is aggregate in character and has the entire economy as a unit of study.
Microeconomics, also known as price theory (or Marshallian economics) is the main source of concepts and analytical tools for managerial economics. To illustrate various micro-economic concepts such as elasticity of demand, marginal cost, the short and the long runs, various market forms, etc., all are of great significance to managerial economics. The chief contribution of macroeconomics is in the area of forecasting. The modern theory of income and employment has direct implications for forecasting general business conditions. As the prospects of an individual firm often depend greatly on general business conditions, individual firm forecasts depend on general business forecasts.

A survey in the U.K has shown that business economists have found the following economic concepts quite useful and of frequent application :-

1. Price elasticity of demand,
2. Income elasticity of demand,
3. Opportunity cost,
4. The multiplier,
5. Propensity to consume,
6. Marginal revenue product,
7. Speculative motive,
8. Production function,
9. Balanced growth, and
10. Liquidity preference.

Business economics have also found the following main areas of economics as useful in their work :-

1. Demand theory,
2. Theory of the firm-price, output and investment decisions,
3. Business financing,
4. Public finance and fiscal policy,
5. Money and banking,
6. National income and social accounting,
7. Theory of international trade, and
8. Economics of developing countries.

Managerial Economics and Management Accounting
Managerial Economics is also closely related to accounting, which is concerned with recording the financial operations of a business firm. Indeed, accounting information is one of the principal sources of data required by a managerial economist for his decision making purpose. For instance, the profit and loss statement of a firm tells how well the firm has done and the information it contains can be used by managerial economist to throw significant light on the future course of action - whether it should improve or close down. Of course, accounting data call for careful interpretation. Recasting and adjustment before they can be used safely and effectively.
It is in this context that the growing link between management accounting and managerial economics deserves special mention. The main task of management accounting is now seen as being to provide the sort of data which managers need if they are to apply the ideas of managerial economics to solve business problems correctly; the accounting data are also to be provided in a form so as to fit easily into the concepts and analysis of managerial economics.

Uses of Managerial Economics

Managerial economics accomplishes several objectives.
First, it presents those aspects of traditional economics, which are relevant for business decision making it real life. For the purpose, it calls from economic theory the concepts, principles and techniques of analysis which have a bearing on the decision making process. These are, if necessary, adapted or modified with a view to enable the manager take better decisions. Thus, managerial economics accomplishes the objective of building suitable tool kit from traditional economics.
Secondly, it also incorporates useful ideas from other disciplines such a psychology, sociology, etc., if they are found relevant for decision making. In fact managerial economics takes the aid of other academic disciplines having a bearing upon the business decisions of a manager in view of the carious explicit and implicit constraints subject to which resource allocation is to be optimized.
Thirdly, managerial economics helps in reaching a variety of business decisions.

1. What products and services should be produced?
2. What inputs and production techniques should be used?
3. How much output should be produced and at what prices it should be sold?
4. What are the best sizes and locations of new plants?
5. How should the available capital be allocated?

Fourthly, managerial economics makes a manager a more competent model builder. Thus he can capture the essential relationships which characterize a situation while leaving out the cluttering details and peripheral relationships.
Fifthly, at the level of the firm, where for various functional areas functional specialists or functional departments exist, e.g., finance, marketing, personal production, etc., managerial economics serves as an integrating agent by coordinating the different areas and bringing to bear on the decisions of each department or specialist the implications pertaining to other functional areas. It thus enables business decision making not in watertight compartments but in an integrated perspective, the significance of which lies in the fact that the functional departments or specialists often enjoy considerable autonomy and achieve conflicting coals.
Finally, managerial economics takes cognizance of the interaction between the firm and society and accomplishes the key role of business as an agent in the attainment of social and economic welfare. It has come to be realized that business part from its obligations to shareholders has certain social obligations. Managerial economics focuses attention on these social obligations as constraints subject to which business decisions are to be taken. In so doing, it serves as an instrument in rehiring the economic welfare of the society through socially oriented business decisions.

Role and Responsibilities of Managerial Economist

A managerial economist can play a very important role by assisting the Management in using the increasingly specialized skills and sophisticated techniques which are required to solve the difficult problems of successful decision making and forward planning. That is why, in business concerns, his importance is being growingly recognized. In developed countries like the U.S.A., large companies employ one or more economists. In our country (India) too, big industrial houses have come to recognize the need for managerial economists, and there are frequent advertisements for such positions. Tatas and Hindustan Lever employ economists. Indian Petrochemicals Corporation Ltd., a Government of India undertaking, also keeps an economist.

Let us examine in specific terms how a managerial economist can contribute to decision making in business.
In this connection, two important questions need be considered :-

1. What role does he play in business, that is, what particular management problems lend themselves to solution through economic analysis?
2. How can the managerial economist best serve management, that is, what are the responsibilities of a successful managerial economist?

Role of Managerial Economist

One of the principal objectives of any management in its decision making process is to determine the key factors which will influence the business over the period ahead. In general, these factors can be divided into two category, viz., (i) External and (ii) Internal. The external factors lie outside the control management because they are external to the firm and are said to constitute business environment. The internal factors lie within the scope and operations of a firm and hence within the control of management, and they are known as business operations.
To illustrate, a business firm is free to take decisions about what to invest, where to invest, how much labour to employ and what to pay for it, how to price its products and so on but all these decisions are taken within the framework of a particular business environment and the firm’s degree of freedom depends on such factors as the government’s economic policy, the actions of its competitors and the like.

Environmental Studies
An analysis and forecast of external factors constituting general business conditions, e.g., prices, national income and output, volume of trade, etc., are of great significance since every business from is affected by them.
Certain important relevant questions in this connection are as follows :-

1. What is the outlook for the national economy? What are the most important local, regional or worldwide economic trends? What phase of the business cycle lies immediately ahead?
2. What about population shifts and the resultant ups and downs in regional purchasing power?
3. What are the demands prospects in new as well as established markets? Will changes in social behavior and fashions tend to expand or limit the sales of a company’s products, or possibly make the products obsolete?
4. Where are the market and customer opportunities likely to expand or contract most rapidly?
5. Will overseas markets expand or contract, and how will new foreign government legislation’s affect operation of the overseas plants?
6. Will the availability and cost of credit tend to increase or decrease buying? Are money or credit conditions ahead likely to be easy or tight?
7. What the prices of raw materials and finished products are likely to be?
8. Is competition likely to increase or decrease?
9. What are the main components of the five-year plan? What are the areas where outlays have been increased? What are the segments, which have suffered a cut in their outlay?
10. What is the outlook regarding government’s economic policies and regulations?
11. What about changes in defense expenditure, tax rates, tariffs and import restrictions?
12. Will Reserve Bank’s decisions stimulate or depress industrial production and consumer spending? How will these decisions affect the company’s cost, credit, sales and profits?

Reasonably accurate answers to these and similar questions can enable management to chalk out more wisely the scope and direction of their own business plans and to determine the timing of their specific actions. And it is these questions which present some of the areas where a managerial economist can make effective contribution.
The managerial economist has not only to study the economic trends at the macro level but must also interpret their relevance to the particular industry / firm where he works. He has to digest the ever growing economic literature and advise top management by means of short, business like practical notes.
In a mixed economy like India, the managerial economist pragmatically interprets the intentions of controls and evaluates their impact. He acts as a bridge between the government and the industry, translating the government’s intentions and transmitting the reactions of the industry. In fact, government policies charge out of the performance of industry, the expectations of the people and political expediency.

Business Operations
A managerial economist can also be helpful to the management in making decisions relating to the internal operations of a firm in respect of such problems as price, rate of operations, investment, expansion or contraction.
Certain relevant questions in this context would be as follows :-

1. What will be a reasonable sales and profit budget for the next year?
2. What will be the most appropriate production Schedules and inventory policies for the next six months?
3. What changes in wage and price policies should be made now?
4. How much cash will be available next month and how should it be invested?

Specific Functions
A further idea of the role of managerial economists can be seen from the following specific functions performed by them as revealed by a survey pertaining to Britain conducted by K.J.W. Alexander and Alexander G. Kemp :-

1. Sales forecasting.
2. Industrial market research.
3. Economic analysis of competing companies.
4. Pricing problems of industry.
5. Capital projects.
6. Production programs.
7. Security/investment analysis and forecasts.
8. Advice on trade and public relations.
9. Advice on primary commodities.
10. Advice on foreign exchange.
11. Economic analysis of agriculture.
12. Analysis of underdeveloped economics.
13. Environmental forecasting.

The managerial economist has to gather economic data, analyze all pertinent information about the business environment and prepare position papers on issues facing the firm and the industry. In the case of industries prone to rapid technological advances, he may have to make a continuous assessment of the impact of changing technology. He may have to evaluate the capital budget in the light of short and long-range financial, profit and market potentialities. Very often, he may have to prepare speeches for the corporate executives.
It is thus clear that in practice managerial economists perform many and varied functions. However, of these, marketing functions, i.e., sales forecasting and industrial market research, has been the most important. For this purpose, they may compile statistical records of the sales performance of their own business and those relating to their rivals, carry our analysis of these records and report on trends in demand, their market shares, and the relative efficiency of their retail outlets. Thus while carrying out their functions; they may have to undertake detailed statistical analysis. There are, of course, differences in the relative importance of the various functions performed from firm to firm and in the degree of sophistication of the methods used in carrying them out. But there is no doubt that the job of a managerial economist requires alertness and the ability to work under pressure.

Economic Intelligence
Besides these functions involving sophisticated analysis, managerial economist may also provide general intelligence service supplying management with economic information of general interest such as competitors prices and products, tax rates, tariff rates, etc. In fact, a good deal of published material is already available and it would be useful for a firm to have someone who understands it. The managerial economist can do the job with competence.

Participating in Public Debates
Many well-known business economists participate in public debates. Their advice and views are being sought by the government and society alike. Their practical experience in business and industry ads stature to their views. Their public recognition enhances their stature in the organization itself.

Indian Context
In the indian context, a managerial economist is expected to perform the following functions :-

1. Macro-forecasting for demand and supply.
2. Production planning at macro and micro levels.
3. Capacity planning and product-mix determination.
4. Economics of various productions lines.
5. Economic feasibility of new production lines/processes and projects.
6. Assistance in preparation of overall development plans.
7. Preparation of periodical economic reports bearing on various matters such as the company’s product-lines, future growth opportunities, market pricing situation, general business, and various national/international factors affecting industry and business.
8. Preparing briefs, speeches, articles and papers for top management for various Chambers, Committees, Seminars, Conferences, etc.
9. Keeping management informed o various national and international developments on economic/industrial matters.

With the adoption of the New Economic Policy, in 1991, the macro-economic Environment in India is changing fast at a pace that has been rarely witnessed before. And these changes have tremendous implications for business. The managerial economist has to play a much more significant role. He has to constantly gauge the possibilities of translating the rapidly changing economic scenario into viable business opportunities. As India marches towards globalization, he will have to interpret the global economic events and find out how his firm can avail itself of the carious export opportunities or of establishing plants abroad either wholly owned or in association with local partners.

Responsibilities of Managerial Economist

Having examined the significant opportunities before a managerial economist to contribute to managerial decision making, let us now examine how he can best serve the management. For this, he must thoroughly recognize his responsibilities and obligations.
A managerial economist can serve management best only if he always keeps in mind the main objective of his business, viz., to make a profit on its invested capital. His academic training and the critical comments from people outside the business may lead a managerial economist to adopt an apologetic or defensive attitude towards profits. Once management notices this, his effectiveness is almost sure to be lost. In fact, he cannot expect to succeed in serving management unless he has a strong personal conviction that profits are essential and that his chief obligation is to help enhance the ability of the firm to make profits.
Most management decisions necessarily concern the future, which is rather uncertain. It is, therefore, absolutely essential that a managerial economist recognizes his responsibility to make successful forecasts. By making best possible forecasts and through constant efforts to improve upon them, he should aim at minimizing, if not completely eliminating, the risks involved in uncertainties, so that the management can follow a more orderly course of business planning. At times, he will have to reassure the management that an important trend will continue; in other cases, he may have to point out the probabilities of a turning point in some activity of importance to management. In any case, he must be willing to make considered but fairly positive statements about impending economic developments, based upon the best possible information and analysis and stake his reputation upon his judgment. Nothing will build management confidence in a managerial economist more quickly and thoroughly than a record of successful forecasts, well-documented in advance and modestly evaluated when the actual results become available.
A few corollaries to the above proposition need also be emphasized here.
First, he has a major responsibility to "alert management at the earliest possible moment" in case he discovers an error in his forecast. By promptly drawing attention to changes in forecasting conditions, he will not only assist management in making appropriate adjustment in policies and programs but will also be able to strengthen his own position as a member of the management team by keeping his fingers on the economic pulse of the business.
Secondly, he must establish and maintain many contacts with individuals and data sources, which would not be immediately available to the other members of the management. Extensive familiarity with reference sources and material is essential, but it is still more important that he knows individuals who are specialists in particular fields having a bearing on his work. For this purpose, he should join professional associations and take active part in them. In fact, one of the best means of determining the caliber of a managerial economist is to evaluate his ability to obtain information quickly by personal contacts rather than by lengthy research from either readily available or obscure reference sources. Within any business, there may be a wealth of knowledge and experience but the managerial economist would be really useful if he can supplement the existing know-how with additional information and in the quickest possible manner.
Again, if a managerial economist is to be really helpful to the management in successful decision making and forward planning, he must be able to earn full status on the business team. He should be ready and even offer himself to take up special assignments, be that in study teams, committees or special projects. For, a managerial economist can only function effectively in an atmosphere where his success or failure can be traced not only to his basic ability, training and experience, but also to his personality and capacity to win continuing support for himself and his professional ideas. Of course, he should be able to express himself clearly and simply and must always try to minimize the use of technical terminology in communicating with his management executives. For, it is well-known that if management does not understand, it will almost automatically reject. Further, while intellectually he must be in tune with industry’s thinking the wider national perspective should not be absents from his advice to top management.