MANAGERIAL ECONOMICS

Whats Economics about?

Science of making decisions to allocate scarce resources to alternative uses. Three fundamental questions: What? How? To whom? Microeconomics vs Macroeconomics. Microeconomics: Studies decision making and interactions of individual agents; Concentrates on Demand, Supply and Markets. Macroeconomics: Studies the evolution of the aggregate economy, as a result of individual decisions and interactions; Concentrates on Product, Unemployment and Inflation.
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A market economy

Why Managerial Economics?

MANAGERIAL ECONOMICS

The prime function of a management executive in a business organization is decision-making and forward planning. Decisionmaking 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.

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.
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The Fundamentals of Managerial Economics

Identify objectives and constraints; Conduct marginal analysis; Use economic profits; Understand markets; Recognize the time value of money.

Identify objectives and constraints The role of objectives: Choices are made to achieve objectives; Objectives of the unit and objectives of the sub-units. Resources are scarce: Impose constraints; Limit possibilities. Conduct marginal analysis Why and how marginal analysis: Decide on the basis of marginal benefits and marginal costs. Examples: Discrete decisions: How many machines to buy? Continuous decisions: How much for advertising?
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How many machines to buy?

Use economic profits Accounting profits Economic profits: Opportunity costs. Example: Operation of a small pizzeria. Objective: maximize shareholders value. Operation of a small pizzeria (I) Mike runs a small pizzeria in his hometown. He owns the building. Annual revenues are 100,000 euros. Annual costs are 20000.Annual profit is 80000 euros. This is not the economic profit!

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Operation of a small pizzeria (II) Mike could have a job earning 30,000.Mike could have rented the space for 100,000. The economic profit is just: 80,000-30000-100000 = -50,000 CONCLUSION: Mike should close the pizzeria, rent the space andget the alternative job.

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Understand markets It takes two to tango: demand and supply. Conflicting interests between buyers and sellers. Rivalry among buyers: Auctions. Rivalry among sellers: Mobile communications. Government and the markets Understanding markets is key for good management decisions.

Recognize the time value of money Many decisions have monetary implications throughout a long period of time (R&D is a typical example). This raises specific problems. 1 today is worth more that 1 one year from now.
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What is Managerial Economics?

Douglas - Managerial economics is .. the application of economic principles and methodologies to the decisionmaking process within the firm or organization.

Pappas & Hirschey - Managerial economics applies economic theory and methods to business and administrative decision-making. Salvatore - Managerial economics refers to the application of economic theory and the tools of analysis of decision science to examine how an organisation can achieve its objectives most effectively. Howard Davies and Pun-Lee Lam It is the application of economic analysis to business problems; it has its origin in theoretical microeconomics.
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Characteristics Of Managerial Economics

Managerial Economics micro-economic in character. 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. Managerial Economics is pragmatic (practical). 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. 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.
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SCOPE OF MANAGERIAL ECONOMICS

Managerial economics is concerned with the application of economic concepts and analysis to the problem of formulating rational managerial decisions. There are four groups of problem in both decisionsmaking and forward planning. Its scope is mainly lies in MICRO & MACRO economics, other areas are Resource Allocation Inventory and queuing problem Pricing Problem Investment Problem
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Resource Allocation: Scare resources have to be used with utmost efficiency to get optimal results. These include production programming and problem of transportation etc. How does resource allocation take place within a firm? Naturally, a manager decides how to allocate resources to their respective uses within the firm, the resource allocation decision outside the firm is primarily done through the market. Thus, one important insight you can draw about the firm is that within it resources are guided by the manager in a manner that achieves the objectives of the firm. Inventory and queuing problem: Inventory problems involve decisions about holding of optimal levels of stocks of raw materials and finished goods over a period. These decisions are taken by considering demand and supply conditions. Queuing problems involve decisions about installation of additional machines or hiring of extra labor in order to balance the business lost by not undertaking these activities.

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Pricing Problem: Fixing prices for the products of the firm is an important decision-making process. Pricing problems involve decisions regarding various methods of prices to be adopted. Investment Problem: Forward planning involves investment problems. These are problems of allocating scarce resources over time. For example, investing in new plants, how much to invest, sources of funds, etc.

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Study of managerial economics essentially involves the analysis of certain major subjects like: The business firm and its objectives Demand analysis, estimation and forecasting Production and Cost analysis Pricing theory and policies Profit analysis with special reference to breakeven point Capital budgeting for investment decisions Competition.
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MANAGERIAL ECONOMICS AND OTHER DISCIPLINES

Microeconomic Theory: As stated in the introduction, the roots of managerial economics spring from micro-economic theory. Price theory, demand concepts and theories of market structure are few elements of micro economics used by managerial economists. It has an applied bias as it applies economic theories in order to solve real world problems of enterprises. Macroeconomic Theory: This field has little relevance for managerial economics but at least one part of it is incorporated in managerial economics i.e. national income forecasting. The latter could be an important aid to business condition analysis, which in turn could be a valuable input for forecasting the demand for specific product groups.

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Operations Research: This field is used in managerial economics to find out the best of all possibilities. Linear programming is a great aid in decision making in business and industry as it can help in solving problems like determination of facilities on machine scheduling, distribution of commodities and optimum product mix etc. Theory of Decision Making: Decision theory has been developed to deal with problems of choice or decision making under uncertainty, where the applicability of figures required for the utility calculus are not available. Economic theory is based on assumptions of a single goal whereas decision theory breaks new grounds by recognizing multiplicity of goals and persuasiveness of uncertainty in the real world of management.

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Statistics: Statistics helps in empirical testing of theory. With its help, better decisions relating to demand and cost functions, production, sales or distribution are taken. Managerial economics is heavily dependent on statistical methods.
Management Theory and Accounting: Maximization of profit has been regarded as a central concept in the theory of the firm in microeconomics. In recent years, organization theorists have talked about satisfying instead of maximizing as an objective of the enterprise. Accounting data and statements constitute the language of business. In fact the link is so close that managerial accounting has developed as a separate and specialized field in21 itself.

Managerial Economist Role And Responsibilities

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
(i) external The external factors lie outside the control management because they are external to the firm and are said to constitute business environment (ii) internal. The internal factors he within the scope and operations of a firm and hence within the control of management, and they are known as business operations.
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Environmental Studies An analysis and forecast of external factors constituting general business conditions, e.g., prices, national income and output, volume of trade, etc., Certain important relevant questions in this connection are as follows:

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? What about population shifts and the resultant ups and downs in regional purchasing power? 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 companys products, or possibly make the products obsolete? Where are the market and customer opportunities likely to expand or contract most rapidly? Will overseas markets expand or contract, and how will new foreign government legislations affect operation of the overseas plants?

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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? What the prices of raw materials and finished products are likely to be? Is competition likely to increase or decrease? 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? What is the outlook regarding governments economic policies and regulations? What about changes in defense expenditure, tax rates, tariffs and import restrictions? Will Reserve Banks decisions stimulate or depress industrial production and consumer spending? How will these decisions affect the companys cost, credit, sales and profits?

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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: What will be a reasonable sales and profit budget for the next year? What will be the most appropriate production Schedules and inventory policies for the next six months? What changes in wage and price policies should be made now? How much cash will be available next month and 25 how should it be invested?

Specific Functions A further idea of the role managerial economists can play

Sales forecasting Industrial market research. Economic analysis of competing companies. Pricing problems of industry. Capital projects. Production programs. Security/investment analysis and forecasts. Advice on trade and public relations. Advice on primary commodities. Advice on foreign exchange. Economic analysis of agriculture. Analysis of underdeveloped economics. Environmental forecasting.

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Indian Context
In the Indian context, a managerial economist is expected to perform the following functions: Macro-forecasting for demand and supply. Production planning at macro and micro levels. Capacity planning and product-mix determination. Economics of various productions lines. Economic feasibility of new production lines/processes and projects. Assistance in preparation of overall development plans. Preparation of periodical economic reports bearing on various matters such as the companys product-lines, future growth opportunities, market pricing situation, general business, and various national/international factors affecting industry and business. Preparing briefs, speeches, articles and papers for top management for various Chambers, Committees, Seminars, Conferences, etc. Keeping management informed o various national and international developments on economic/industrial matters.
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What is the purpose of economic analysis?

Why do we want to apply economic analysis to business problems?
For the academic economist: to understand, to make predictions about firms behavior The positive approach to theory: What is? For the businessperson: to assist decision-making, to provide decision-rules which can be applied The normative approach to theory: What should be? These purposes are different, they can lead to misunderstanding, and economists are not always honest about the limitations of their approach for practical purposes.

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What are these limitations?

If the aim is prediction, unrealistic assumptions are acceptable and may be needed;
for instance, the firm may be assumed to behave as if its managers had perfect knowledge of its environment

If the aim is to produce decision-rules which can be applied by practising managers, unrealistic assumptions will produce decision-rules which are not operational
for instance, set output and price by MC=MR
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How Can Managerial Economics Assist Decision-Making? 1. Adopt a general perspective, not a sample of one
2. Simple models provide stepping stone to more complexity and realism 3. Thinking logically has value itself and can expose sloppy thinking

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Why Managerial Economics?

A powerful analytical engine. A broader perspective on the firm.

what is a firm? what are the firms overall objectives? what pressures drive the firm towards profit and away from profit

The basis for some of the more rigourous analysis of issues in Marketing and Strategic Management.
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Links between Managerial Economics and Industrial Economics

In managerial economics, the emphasis is upon the firm, the environment in which the firm finds itself, and the decisions which individual firms have to take.
In industrial economics (or industrial organization), the emphasis is (or was) upon the behavior of the whole industry, in which the firm is simply a component.
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What is Industrial Organization?

It studies how the performance of an industry is related to its structure, that is, to the number and size of firms it contains. It is the study of markets for goods and of the firms which produce them. It is the study of industry. It is more concerned with why markets are structured the way they are and behave the way they do.
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Questions Asked in Industrial Organization:

Why are some markets monopoly-like while others are competitive?

How can industry performance and structure be measured or analyzed?

How does the performance of individual firms affect the structure and performance of the industry in which they operate? If industry performance seems deficient but remediable, which government policies are likely to help more than they cost?
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The Structure-Conduct-Performance Paradigm:

Basic Conditions: factors which shape the market of the industry, e.g. demand, supply, political factors

Structure: attributes which give definition to the supply-side of the market, e.g. economies of scale, barriers to entry, industry concentration, product differentiation, vertical integration.
Conduct: the behavior of firms in the market, e.g. pricing behavior advertising, innovation. Performance: a judgement about the results of market behaviour, e.g. efficiency, profitability, fairness/income distribution, economic growth. How can the government improve the performance in an industry?
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Links between Managerial Economics and Management Science

Managerial economics: is often concerned with finding optimal solutions to decision problems.However, the primary purpose of using models is to predict how firms will behave, not to advise them what ought to do. Managers are assumed to find the optimal solutions for themselves and that is how predictions are made.

Management science: is essentially concerned with techniques for the improvement of decision-making and hence it is essentially normative;firms are not assumed to find the optimal solutions for themselves. They are found by the researchers who then present them as prescriptions for what the firm should do.
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