Notes on Managerial Economics: Introduction, Definition, Nature, Relation and Contribution

Notes on Managerial Economics:- 1. Introduction to Managerial Economics 2. Definition of Managerial Economics 3. Nature 4. Managerial Economics and Relation with Other Subjects 5. Contribution.

Contents:

1. Introduction to Managerial Economics
2. Definition of Managerial Economics
3. Nature of Managerial Economics
4. Managerial Economics and Relation with Other Subjects
5. Contribution of Economics to Managerial Economics

---

Note #  1. Introduction to Managerial Economics:

Managerial economics is a combination of economics and management. Managerial economics is also called Business Economics. Currently, the term managerial economics has become more popular and seems to displace progressively the term business economics.

One of the major functions of management in a business organization is decision making and forward planning. Decision making is selecting one action from the available alternatives. Forward planning is to forecast the future developments in the economy and formulate plans for production and distribution of goods and services.

Decision making and selecting one option from the available alternatives arises, as factors of production, land, labor, capital and organization, are limited and can be employed in alternative uses and can be substituted for one another to some extent.

The decision-making function, thus, is useful in finalizing an optimal solution in attaining the desired goal. The desired goal may be the maximization of profit. The decision is made, regarding production, pricing, capital, raw materials, labor, etc., depending on the objective to be achieved. Thus, forward planning and decision making go hand in hand.

Business organizations take decisions in uncertainty. Whatever the firm’s forecast or prediction may go wrong at any moment, as the business environment is influenced by changes in the domestic and global policies and developments.

In making a decision in an uncertain situation, economic theory alone is not adequate. Though economic theory deals with a number of concepts and principles relating to production, supply, cost, demand, pricing, profit, competition, business cycles, national income, etc., it should be aided by allied disciplines like accounting, statistics and mathematics, political science and public administration, sociology etc. Economic theory with the tools from other disciplines like statistics is useful in solving the problems of business management. This is the subject-matter of managerial economics.

---

Note # 2. Definition of Managerial Economics:

Managerial economics is economics applied in decision making. It is a special branch of economics bridging the gap between abstract theory and managerial practice. Managerial economics is concerned with choice. It deals with selection of one best alternative among the several alternatives available. According to McNair and Merriam, “managerial economics consists of the use of economic modes of thought to analyze business situations.”

Spencer and Seligman 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. As the definitions explain, managerial economics is the discipline which deals with the application of economic theory to business management.

---

Note # 3. Nature of Managerial Economics:

It would be useful to point out certain chief characteristics of managerial economics, as they throw further light on the nature and the subject-matter, which help in a clearer understanding the subject.

First, managerial economics is micro-economic in character. This is because the unit of study is a firm; it is the problems of a business firm which are studied in it. Managerial economics does not deal with the entire economy as a unit of study.

Secondly, managerial economics largely uses that body of economics concepts and principles which are useful for the firm. Hence, managerial economics is also known as theory of the firm. In addition, it also talks about profit maximization, which is part of distribution theory in economics.

Thirdly, managerial economics is realistic. It avoids difficult abstract issues of economic theory. It takes in to consideration the important elements which are useful in decision making.

Fourthly, managerial economics is normative in nature, rather than positive. Managerial economics is also described as normative micro-economics of the firm. In other words, it is prescriptive rather than descriptive, unlike Economics. Economic theory, on the other hand, is both positive and normative.

Economics is concerned with what decisions ought to be made and involves value judgments. Economics talks about the aims and objectives of a firm and tells how best to achieve these aims in different situations. Hence, it is both prescriptive and descriptive.

Fifthly, macro-economics is also useful to managerial economics since it provides an intelligent understanding of the environment in which the business must operate, this understanding enables a business executive to adjust in the best possible manner with external forces over which he has no control.

The important topics of macro-economics that are useful in managerial decision making are business cycles, National income accounting, and economic policies of the government like those relating to taxation, foreign trade anti-monopoly measures, labor legislations, etc.,

---

Note # 4. Managerial Economics and Relation with Other Subjects:

Yet another useful method of throwing light upon the nature and scope of managerial economics is to examine its relationship with the subjects. In this connection, economics, statistics, mathematics and accounting deserve special mention.

i. 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 gap between pure economic theory and managerial practice.

Economics has two main divisions; micro-economics and macro-economics. Micro-economics has been defined as that branch where the unit of study is an individual or a firm. Macro-economics, on the other hand, is aggregative in character and has the entire economy as a unit of study.

Micro-economics, also known as price theory for Marshallian economics, is the main source of concepts and analytical tools for managerial economics. To illustrate, various micro-economics concepts such as elasticity of demand, marginal cost, the short and the long runs, various market forms, etc., are all of great significance to managerial economics.

The chief contribution of macro-economics 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.

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

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 10. Liquidity preference

Business economists 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

Thus, it is obvious that managerial economics is very closely related to economics.

ii. Managerial Economics and Statistics:

Statistics is important to managerial economics in several ways:

First, managerial economics calls for the marshalling of quantitative data and reaching useful measure of appropriate functional relationships involved in decision-­making. For instance, in order to base its pricing decisions on demand and cost considerations, a firm should have statistically derived or calculated demand and cost functions.

Secondly, managerial economics employs statistical methods for empirical testing of economic generalizations. These generalizations can be accepted in practice only when they are checked against the data from the world of reality and are found valid.

Finally, managers do not usually have exact information about the variables affecting decisions and have got to deal with the uncertainty of future events. Theory of probability, upon which statistics is based, provides the logic for dealing with such uncertainty.

iii. Managerial Economics and Mathematics:

Mathematics is yet another important tool-subject closely related to managerial economics. This is because managerial economics is metrical in character, estimating various economic relationships, predicting relevant economic quantities and using them in decision-making and forward planning.

A knowledge of geometry, trigonometry and algebra is not only essential but certain mathematical tools and concepts such as logarithms and exponentials, vectors, determinants and matrix algebra and above all, calculus, differential as well as integral, are the handmaids.

Further, operations research which is closely related to managerial economics is mathematical in character. It provides and analyses data and develops models, benefiting from the experiences for experts drawn from different disciplines, viz., psychology, sociology, statistics and engineering.

iv. Managerial Economics and 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 adjustments before they can be used safely and effectively.

It is in this context that 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.

v. Managerial Economics and Operations Research:

During the Second World War and the years thereafter, a good deal of interdisciplinary research was done in the U.S.A. as well as other western countries to solve the complex operational problems of planning and resource allocation in defiance and basic industries.

Mathematicians, statisticians, engineers and others teamed up together and developed models and analytical tools which have since grown into a specialized subject known as operations research (OR). Much of the development of techniques and concepts, such as linear programming, inventory models, game theory, etc., is due to the work of the operations researchers.

The significant relationship between managerial economics and operations research can be highlighted with reference to certain important problems of managerial economics which are solved with the help of OR techniques. They are allocation problems, competitive problems, waiting line problems and inventory problems.

The essence of an allocation problem is that men, machines and other resources are scarce, relatively to the number and nature of the jobs required to be done. The examples are production programming and transportation problems.

Competitive problems deal with situations where managerial decision-making is to be made in the face of competitive action. That is, one of the factors to be considered “What will competitors do if certain steps are taken?” price reduction, for example, will not lead to increased market share if rivals follow suit.

Waiting line problems arise when a firm wants to know how many machines it should install in order to ensure that the amount of work-in-progress waiting to be machined is neither too small nor too large. Such situations arise when a post office, bank or LIC wants to know how many cash desks or counter clerks it should employ in order to balance the business lost through long queues against the cost of installing more equipment or hiring more labour.

Inventory problems deal with the question — “What is the optimum level of stocks of raw-materials, components or finished goods for the firm to hold?”

Conclusion:

To conclude, managerial economics is closely related to certain subjects, viz., economics, statistics, mathematics and accounting. A trained managerial economist integrates concepts and methods from all these subjects bringing them to bear on business problems of a firm. In particular, operations research and management accounting are getting very close to managerial economics, and there appears to be a trend towards their integration.

The usefulness of managerial economics lies in borrowing and adopting the tool­kit from economic theory, incorporating relevant ideas from other disciplines to achieve better business decisions, serving as a catalytic agent in the course of decision-­making by different functional departments/specialists at the firm’s level and finally accomplishing a social purpose through orienting business decisions towards social obligations.

---

Note # 5. Contribution of Economics to Managerial Economics:

Economic theory offers a variety of concepts and analytical tools which can be of considerable assistance to the manager in his decision-making practices. This is not to say that economics has all the answers. In fact, actual problem solving in business has found that there exists a wide disparity between the economic theory of firm and actual observed practice necessitating the use of many skills and tools which are not available in the traditional economist’s kit.

1. Basic Economic Tools in Managerial Economics:

The most significant contribution of economics to managerial economics lies in certain principles which are basic to the entire gamut of managerial economics.

The basic principles may be identified as:

(a) Opportunity cost principle

(b) Incremental principle

(c) Principle of time perspective

(d) Discounting principle

(e) Equi-marginal principle

2. Opportunity Cost Principle:

By the opportunity cost of a decision is meant the sacrifice of alternatives required by that decision.

This can best be understood with the help of a few illustrations:

(a) The opportunity cost of the funds employed in one’s own business is the interest that could be earned on those funds had they been employed in other ventures.

(b) The opportunity cost of the time an entrepreneur devotes to his own business is the salary he could earn by seeking employment.

(c) The opportunity cost of using a machine to produce one product is the earnings forgone which would have been possible from other products.

(d) The opportunity cost of using a machine that is useless for any other purpose is zero since its use requires no sacrifice of other opportunities.

(e) If a machine can produce either X or Y, the opportunity cost of producing a given quantity of X is therefore the quantity of Y which it would have produced. If that machine can produce 10 units of X or 20 units of Y, the opportunity cost of 1X is 2Y.

(f) Suppose we have no information about quantities produced, but have information about their prices. In this case, the opportunity costs can be computed in terms of the ratio of their respective prices, say Px/Py.

(g) The opportunity cost of holding Rs.500 as cash in hand for one year is the 10% rate of interest, which would have been earned had the money been kept as fixed deposit in a bank.

Thus, it should be clear that opportunity costs require ascertainment of sacrifices. If a decision involves no sacrifice, its opportunity cost is nil.

For decision-making, opportunity costs are the only relevant costs. The opportunity cost principle may be stated as under the cost involved in any decision consists of the sacrifices of alternatives required by that decision, if there are no sacrifices, there is no cost. In macro sense, the opportunity cost of more guns in an economy is less butter. Continued diversion of funds to defence spending amounts to a heavy tax on alternative spending on growth and development.

3. Incremental Principle:

Incremental concept is closely related to the marginal costs and marginal revenues of economic theory. Incremental concept involves estimating the impact of decision alternatives on costs and revenues, emphasizing the changes in total cost and total revenue resulting from changes in prices, products, procedures, investments or whatever may be at stake in the decision.

The two basic components of incremental reasoning are – incremental cost and incremental revenue. Incremental cost may be defined as the change in total cost resulting from a particular decision; incremental revenue is the change in total revenue resulting from a particular decision.

The incremental principle may be stated as under:

“A decision is obviously a profitable one if – (a) it increases revenue more than costs; (b) it decreases some costs to a greater extent than it increases others; (c) it increases some revenues more than it decreases others; and (d) it reduces costs more than revenues.”

Some businessmen take the view that to make an overall profit, they must make a profit on every job, and the result is that they refuse orders that do not cover full cost (labour, materials and overhead) plus a provision for profit. Incremental reasoning indicates that this rule may be inconsistent with profit maximization in the short run. A refusal to accept business below full cost may mean rejection of a possibility of adding more to revenue than to cost. The relevant cost is not the full cost but rather the incremental cost.

4. Principle of Time Perspective:

The economic concepts of the long run and the short run have become part of everyday language. Managerial economists are also concerned with the real important problem in decision-making, which is to maintain the right balance between the long-run and the short-run considerations. A decision may have long-run repercussions which make it more or less profitable than it at first appeared.

5. Discounting Principle:

One of the fundamental ideas in economics is that a rupee tomorrow is worth less than a rupee today. This seems similar to saying that a bird in hand is worth two in the bush. A simple example would make this point clear. Suppose a person is offered a choice to make between a gift of Rs.100 today or Rs.100 next year. Naturally he will choose the Rs.100 today. This is true for two reasons. First the future is uncertain and there may be uncertainty in getting Rs.100 if the present opportunity is not availed of.

Secondly, even if he is sure to receive the gift in future, today’s Rs.100 can be invested so as to earn interest, say, at 8 per cent so that one year after the Rs.100 of today will become Rs.108 whereas if he does not accept Rs.100 today, he will get Rs.100 only one year hence. Naturally, he would prefer the first alternative because he is likely to gain by Rs.8 in future. Another way of saying the same thing is that Rs.100 one year hence is not equal to Rs.100 of today but less than that.

But then how much money today is equal to Rs.100 one year hence? To find it out, we shall have to find out the relevant rate of interest which one would earn if one decides to invest the money. Suppose the rate of interest is 8 per cent. Then we shall have to discount Rs.100 at 8 percent in order to ascertain how much money today will become Rs.100 one year after. The formula is –

Again, we can check by computing how much the cumulative interest will be after two years.

The principle can be called the discounting principle and may be stated as – “If a decision affects costs and revenues at future dates, it is necessary to discount those costs and revenues to present values before a valid comparison of alternatives is possible.”

6. Equi-Marginal Principle:

This principle deals with the allocation of the available resources among the alternative activities. According to this principle, an input should be so allocated that the value added by the last unit is the same in all cases. This generalization is called the equi-marginal principle.

Suppose a firm has 100 units of labour at its disposal. The firm is engaged in four activities which need labour services, viz., A, b, C and D. It can enhance any one of these activities by adding more labour but only at the cost of other activities.

It should be clear that if the value of the marginal product is higher in one activity than in another, an optimum allocation has not been attained. It would, therefore, be profitable to shift labour from low marginal value activity to high marginal value activity, thus increasing the total value of all products taken- Labour is Rs.20 in activity A while that in activity B, it is Rs.30- It is profitable to shift labour from activity A to activity b thereby expanding activity b and reducing activity A. The optimum will be reached when the value of the marginal product is equal in all the four activities or, symbolically expressed, when –

VMP_LA = VMP_LB = VMP_LC = VMP_LD

Whereby the subscripts indicate labour in the respective activities.