Introduction to Managerial Economics

In MS-3, you have been exposed to the socio-economic environment. Given the environment, the management thinks and lakes or makes decision. Almost all such decisions, in one way or the other, relate to economics variables like demand, price, supply, stock, input, output, finance, profit and the like. In the name of Managerial Economics, we will now concentrate on the economic decision variables and the Economic decision process. Traditionally, the problem of optimal decision by firms and individuals has been studied in microeconomics theory. Managerial Economics as a separate discipline owes its origin Lo the growing disenchantment with economic theory in providing solutions to the problems faced by business. This does not mean that Managerial Economics provides ready-made solutions to business problems. What it provides is a tool-box of analysis and a technique of thinking which can be helpful in conceptualizing the problems faced by management of a business firm. Thus, Managerial Economics is supposed to enrich the conceptual and technical skill of a manager facing business decision problems.

Economic Analysis 

The concern of Economics is with the economic problem and its identification ‚ Description, explanation and solution, if possible. An economic problem is a problem of choice and valuation. The problem of choice arises because limited means (resources) with alternative uses are to be unlisted to satisfy ends (wants) which are unlimited and of varying degree of importance . Had resources like men, materials, machines, money, time, energy etc. not been scarce, there would have been no problem of choice, scarcity is at the root of all economic problems of choice. We have to choose between ends) between means, between use of means and satisfaction of ends. Because of scarcity of resources, we have to constantly match ends to means; this is called ‘economic activity’. The optimal economic activity is to maximize the attainment of ends, given the means and their scarcities or to minimize the use of resources, given the ends and their priorities.

Decision-making by management is truly economic in nature because it involves choice, From among a set of alternative-alternative course of action. A manager in any function at any level in any organization, always exercises choice the name of : decision-making. A finance manager chooses the sources and uses of funds. A production manager chooses the product-mix. A personnel manager chooses the staffing . pattern. A sales manager chooses the market segments. A purchase manager chooses the quality of materials. Such examples can be multiplied to suggest chat each and every - manager chooses one thing or the other from among a set of alternatives. A manager’s choice is dictated by his objectives and constraints. The optimal decision-making is an au of optimal economic choice, considering objectives and constraints. This justifies an evaluation of managerial decisions through concepts, precepts, tools and techniques of economic analysis.

Economic analysis may be of various types and forms:
  1. Micro vs. Macro Analysis: in micro economic analysis the problem of choice is analysed focusing on single individual entities like a consumer, a producer, a seller, an F- investor, a commodity, a factor, a market and the like. In macro-economic analysis, the problem is approached from the angle of totality or aggregates like national income national consumption, national investment, general price level etc.
  2. Partial is. General Equilibrium Analysis: The optimal economic choice defines the state of equilibrium. To attain the state of stable equilibrium, the economic problem may be analyzed part by part —one at a time — assuming “other things remaining the same”. This is partial equilibrium analysis. For example, given the price. The cost budget, the technology and the input requirement [he purchase manager has to decide on the quantity and quality of the material she purchases. By contrast, this assumption. - of “given?’ or “other things remaining equal” may be relaxed and interdependence or : interactions among variables may be allowed. This is general equilibrium analysis.
  3. Static, Comparative Static vs Dynamic Analysis: This has reference to the time dimension of the analysis of the problem. A problem may be analyzed:
    • at a point of Lime, allowing no change (Static)
    • at a point of time, allowing once-for-aIl change (Comparative Static)
    • over a period of lime, allowing successive changes (Dynamic) .
  1. Positive vs. Normative Analysis: In positive economic analysis, the problem is t analysed in objective terms based on principles and theories. In normative economic analysis, the problem is analysed based on value judgement (norms) and, therefore, the policy prescriptions are explicitly stated.
You nay note that the distinctions stated above are not water Light There may be considerable movement from the one to the other, and same overlapping. By and Large, Managerial Economics is primarily micro. partial equilibrium type, comparative static, and positivist in approach, though occasionally we may make reference to elements of macro economics, general equilibrium. dynamic and normative policy issues. In fact, a manager has to keep his economic perspective wide open, but for analysis of his decision problem, he must approach his decision environment with a defined set of assumptions. and methodologies. The manager himself is a micro economic entity and the firm where; he functions is a microeconomic unit; and, therefore, microeconomics is relatively more relevant for his tool kit.

Business Decisions

A decision is not a solution by itself is only an attempt towards a solution. A decision may solve an existing problem but it may also create a new problem. Business decisions are often classified into categories depending upon the managerial function to which they relate it. From this standpoint, we may talk about.
  1. Financial Decisions: Such decisions may relate to costing, budgeting, accounting. : auditing, tax. Planning. Portfolio composition, capital structure, dividend distribution and the like.
  2. Production Decisions; such decisions may relate to quantity and quality of product, Choice of technology, product-mix, plant location and layout, production scheduling, maintenance, pollution control etc.
  3. Personnel Decisions: Such decisions may relate to recruitment’, selection, induction, training, placemen, promotion, transfer, retirement or retrenchment of staff.
  4. Marketing Decisions: Such decisions may relate to sales volume, sales force, sales promotion, market research, customer service, packaging, advertisement, new product positioning etc.
  5. Miscellaneous Decisions: this category may relate to all residuary items like purchasing, inventory control, information system, data processing, public relations etc.
In the realm of each decision area, one can further distinguish between
  • Scientific and intuitive decisions
  • Strategic and tactical decisions
  • Certain and uncertain decisions
  • Major and minor decisions
  • Hard and soft decisions, and so on,
The point to note is that whatever may be the functional nature or type, all managerial. decisions involve some degree of choice and (hey arc, therefore, essentially economic in nature. Managerial Economics is, therefore, offered as one of the foundation courses for graduating in any functional area of management.

Managerial Economics

You should now be in a position to form some idea about the intent and content of managerial economics as a discipline. Managerial Economics concentrates on the . decision process, decision model and decision variables at the firm level. The firm is viewed as a microeconomic unit located within an industry which exists in the context of a given socio-economic environment of business. The executives and the functional managers are stationed within the firm; these managers, either individually or jointly think make and execute decisions. Their operation reflects the behavior and culture of the firm.

Managerial Economics is concerned with the economic behavior or the firm. To start with, it assumes that the firm maximizes profit. Profit is defined as the difference between revenue and costs. The flow of revenue k determined by the demand Conditions in the market, whereas the costs arc influenced by the supply condition. Demand and supply interact with each other to determine prices-commodity prices in the product market and input prices in the factor market. Much would, of course depend on the nature of the market structure—perfect or imperfect, free or regulated, buyers’ or sellers’ etc. The firm or the managers on behalf of the firm placed in the Context of a market environment, decide its economic strategy (in view of its objectives and constraints) and tactics. The tactical decisions are reflected in the course of operational decision variables like price. Output, input etc. Such operation through economic decision variables affects the firm’s level of profit. The firm can then evaluate its performance in terms of the rate of return on investment—intended and achieved. The firm will thus be in a position to estimate the element of risk and uncertainty it is subject to. In its decision-making process, the firm’s strategy is to minimize such risks and uncertainties through forecasting and forward planning.

You may appreciate that analytical riguor is very important in our subject of Managerial Economics. At each stage of analysis of any economics decision variable you should. therefore, be careful about the assumptions. Concepts, techniques. Logic of reasoning. conclusions arid their applicability hi the real world business situation.

Related Disciplines

By its nature, Managerial Economics draws heavily on other disciplines like Economics, Accountancy Mathematics, Statistics, Operations Research, Psychology and Organizational Behavior. Lets us state briefly the contributions made by each of these disciplines to Managerial Economics.
  1. Economics and Econometric: We have already stated that economic theory contributes concepts, precepts tools and techniques of analysis to Managerial Economics. In Elle preceding section on Economic Analysis you have been told about the form of analysis which we would like to borrow from economy theory. The additional point which you may note now is that Economics also tells us the art of constructing “Models” — a system or relation among variables. In Managerial Economics, we use various types of models: schematic models (diagrams), analog models (flowcharts) and mathematical models like econometric models and stochastic models. Most of these models are rooted in economic logic. Economics in particular is a combination of economics logic and statistical techniques. In our Course the empirically estimated functions that we will be using are basically economist estimates.
  2. Mathematics and Statics: Most of the decision models that we have mentioned, above are formulated in terms of mathematical symbols and relations. Mathematics gives up precision which is important in decisions, Decisions have to be precise. To the extent that the economic decisions are measurable and quantifiable, the use of mathematics is welcome. However, as managers, you must remember that symbols and numbers alone do nor suffice; what you need additionally is the logic of reasoning behind those numbers and symbols. Scientific decisions arrived through the use of mathematical tools and statistical techniques should have an intuitive appeal and logical support, otherwise the manager will be in trouble. Regression, for example, may help the manager to forecast his sales based on past record, but the manager must make sure chat the user of his product has not undergone any change in his tastes and preferences. That way, an econometric model may prove a better aid than pure mathematics and statistics.
  3. Operations Research (OR): OR was developed during the inter-war period and h is inter-disciplinary in character— a combined effort of scientists, economists , mathematicians, statisticians in formulating models lo solve specific problems of allocation, transportation, inventory building etc. There are linear programming as- well as goal programming models which are very useful for managerial decisions. ______ Managerial Economics, therefore, uses some of these models.. However, in our course material here, we will make only passing reference to linear programming techniques, because elsewhere you will have a detailed exposure to those programming techniques. In this course, we Will confine ourselves mostly to the calculus (Lagrange Multiplier) techniques of optimsation in specific situations. This is an alternative to linear programming methods of optimization .
  4. Accountancy: Decision-making requires data and a good deal of it is provided by the accounting sync. The information on costs, inventories, receivables, revenue and profits is provided by the accountant. of course, the economist may modify these data to arrive at optimal economic decisions. There are a number of concepts and techniques which are common to the accountant and the economist. In managerial economics. We make use of both keeping (he distinction between accountancy and economics in (he forefront. For example, we will be referring to the ‘accounting profit’ and economic profit or ‘break-even Output’ of the accountant and the ‘shut-down output of the economist. Accountancy does provide the data support, but in the tradition of Economics, managerial economics stresses the logic of reasoning behind those data and uses the data under a set of assumptions.
  5. Psychology and Organization Behavior (OB): Managerial economics analyses the individual behavior of microeconomic units like a buyer, seller, an investor1 a worker and an employer. Psychology makes a direct contribution towards understanding the behavioral aspects like attitude and motivation of any individual decision-making unit. In fact, there is a new branch of discipline called Psychological Economics which analyses subjects like buyers’ behavior directly relevant for marketing management. lately, the economists have developed the behavioral models of firm drawing heavily from the organizational behavior area. Organization psychology and Micro Economics together provide the basis of such behavior models to explain the economic behavior of a firm. These behavior models attempt an integration of manager’s: : behavior with thrower’s behavior, individual behavior with organizational ; Behavior and there by furnish better analysis of economic rationality on the part of the Firm.

Economic Rationality

You may often hear that as a decision maker you are asked to act rationally. Economics L It self assumes rational behavior the part of its subjects like consumer, producer and seller. To act rationally ¡s to act objectively, keeping in view the ends and ‘the means, the objectives and constrains. In the decision-making context, a rational behavior implies the following.

First, all possible courses of action are known to you. Secondly, you are able lo separate all such courses of action into two categories — feasible and infeasible. Thirdly, based on available information, you are in a position to assess the consequences of following from the choice a particular feasible course of action out of a given set of alternatives. Fourthly, you can rank the alternatives in terms of priorities. Lastly, you choose that. alternative (course of action) which occupies the highest position in the order of priority.

Thus economic rationality is a precondition for attaining optionality in a given decision environment. We may take a couple of examples to illustrate it. For example, rationality on the part of a selling firm is to maximizes profit or sales revenue. The rationality on the part of an investors to maximize return. The rationality on the part of a manufacturing unit is to maximize production or to reduce costs. The rationality on the part of an investor is to maximizes return. The rationality on the part of a consumer is to maximize satisfaction. You may be tempted to think that rationality thus implies only statement of objectives in clear terms. That is not right. By way of rationality, you have to take care of constraint as well. In fact your judgement about feasibility of a particular course of action is based on your evaluation of objectives and constraints : together. To be exact, feasibility, consistency and optimality of a decision— almost L be considered to define the dimension of economic rationality.

Methodology of Managerial Economics

Managerial Economics is supposed of help up in analyzing the rational economic behavior of the decision-making unit. Economic analysis Its own methods. An economist often starts with a sec. of assumptions. Assumptions are hypothesized premises, some of those assumptions may be wo ¡deal to be real. However, the ideal set of assumptions helps logical construction of analysis. Analysis is followed by deduction of inferences. Such inference, positive or normative, may hold good in reality, provided they have been based on realistic assumptions. Otherwise, the initial assumptions are to be relaxed and end that light inferences have to be re-worked.

The methodology of economic analysis can be exampled. We may proceed to analyses The purchase behavior of a household unit, assuming that the household’s family size; income level and its tastes and preferences arc held constant; and we observe that the household purchases less of vegetables and fruits as and when the price of these hems rises. This inference needs to be changed if we relax some of initial assumptions of other things remaining qual. For example, suppose the household has a new source of income such that its purchasing capacity goes up. Now, this household nay continue to buy the same basket of vegetables and fruits even if their prices have gone up. It is through the relaxation of unrealistic assumptions that a realistic analysis has to be built up. In fact, the criterion of sound economic analysis is often stated on: Fewer the assumptions, better it is. The argument is most assumptions are theoretical constructions having very negligible empirical relevance.

The statement of assumptions, and the construction of a theoretical framework thereby is termed as model building. Economic analysis runs in terms of these models. a model can be viewed as an approximation of reality. Sometimes a situation already experienced or what we call case study may be used to highlight decision making context and concepts — complexly of context and variety of concepts. Such “case studies” may be regarded as some form of models” in economic sense; because every case may be unique by itself; it is historic individual; something which has been experienced in the past may not get repeated in exact form in the present or the future; yet the past experience is a valuable reference; offers lessons or guidelines of the decision maker. in Managerial Economics, we may use both theoretical models and empirical case studies; both may develop the analytical lent of mind of our decision maker. In a subsequent unit, we will have something more to add on these models or cases— their uses and abuses as techniques of analysis.