MANAGERIAL ECONOMICS MEANING OF MANAGERIAL ECONOMICS Managerial economics, used synonymously with business economics, is a branch of economics that deals with the application of microeconomic analysis to decision-making techniques of businesses and management units. It acts as the via media between economic theory and pragmatic economics. Managerial economics bridges the gap between 'theoria' and 'pracis'. The tenets of managerial economics have been derived from quantitative techniques such as regression analysis, correlation and Lagrangian calculus (linear). An omniscient and unifying theme found in managerial economics is the attempt to achieve optimal results from business decisions, while taking into account the firm's objectives, constraints imposed by scarcity and so on. A paradigm of such optmisation is the use of operations research and programming. Managerial economics is thereby a study of application of managerial skills in economics. It helps in anticipating, determining and resolving potential problems or obstacles. These problems may pertain to costs, prices, forecasting future market, human resource management, profits and so on. DEFINITIONS OF MANAGERIAL ECONOMICS Edwin Mansfield: "concerned with application of economic concepts and economic analysis to the problems of formulating rational managerial decision." McGutgan and Moyer: “Managerial economics is the application of economic theory and methodology to decision-making problems faced by both public and private institutions”. McNair and Meriam: “Managerial economics consists of the use of economic modes of thought to analyse business situations”. Spencer and Siegelman: Managerial economics is “the integration of economic theory with business practice for the purpose of facilitating decision-making and forward planning by management”. Haynes, Mote and Paul: “Managerial economics refers to those aspects of economics and its tools of analysis most relevant to the firm’s decision-making process”. By definition, therefore, its scope does not extend to macroeconomic theory and the economics of public policy, an understanding of which is also essential for the manager. Managerial economics studies the application of the principles, techniques and concepts of economics to managerial problems of business and industrial enterprises. The term is used interchangeably with business economics, microeconomics, economics of enterprise, applied economics, managerial analysis and so on. Managerial economics lies at the junction of economics and business management and traverses the hiatus between the two disciplines. Managerial decision areas include: • assessment of investible funds • selecting business area • choice of product • determining optimum output • determining price of product • determining input-combination and technology • sales promotion. Almost any business decision can be analyzed with managerial economics techniques, but it is most commonly applied to: • Risk analysis - various models are used to quantify risk and asymmetric information and to employ them in decision rules to manage risk. • Production analysis - microeconomic techniques are used to analyze production efficiency, optimum factor allocation, costs, economies of scale and to estimate the firm's cost function. • Pricing analysis - microeconomic techniques are used to analyze various pricing decisions including transfer pricing, joint product pricing, price discrimination, price elasticity estimations, and choosing the optimum pricing method. • Capital budgeting - Investment theory is used to examine a firm's capital purchasing decisions NATURE AND CHARACTERISTICS OF MANAGERIAL ECONOMICS: Following points constitute nature of managerial economics Managerial Economics is a Science Managerial Economics is an essential scholastic field. It can be compared to science in a sense that it fulfils the criteria of being a science in following sense: Science is a Systematic body of Knowledge. It is based on the methodical observation. Managerial economics is also a science of making decisions with regard to scarce resources with alternative applications. It is a body of knowledge that determines or observes the internal and external environment for decision making. In science any conclusion is arrived at after continuous experimentation. In Managerial economics also policies are made after persistent testing and trailing. Though economic environment consists of human variable, which is unpredictable, thus the policies made are not rigid. Managerial economist takes decisions by utilizing his valuable past experience and observations. Science principles are universally applicable. Similarly policies of Managerial economics are also universally applicable partially if not fully. The policies need to be changed from time to time depending on the situation and attitude of individuals to those particular situations. Policies are applicable universally but modifications are required periodically. Managerial Economics requires Art Managerial economist is required to have an art of utilising his capability, knowledge and understanding to achieve the organizational objective. Managerial economist should have an art to put in practice his theoretical knowledge regarding elements of economic environment. A scientific art: Science is a system of rules and principles engendered for attaining given ends. Scientific methods have been credited as the optimal path to achieving one's goals. Managerial economics has been is also called a scientific art because it helps the management in the best and efficient utilisation of scarce economic resources. It considers production costs, demand, price, profit, risk etc. It assists the management in singling out the most feasible alternative. Managerial economics facilitates good and result oriented decisions under conditions of uncertainty. Managerial Economics for administration of organization Managerial economics aims at supporting the management in taking corrective decisions and charting plans and policies for future. Managerial economics helps the management in decision making. These decisions are based on the economic rationale and are valid in the existing economic environment. Managerial economics is helpful in optimum resource allocation The resources are scarce with alternative uses. Managers need to use these limited resources optimally. Each resource has several uses. It is manager who decides with his knowledge of economics that which one is the preeminent use of the resource. Managerial Economics has components of micro economics It studies the problems and principles of an individual business firm or an individual industry. It aids the management in forecasting and evaluating the trends of the market. Managers study and manage the internal environment of the organization and work for the profitable and long-term functioning of the organization. This aspect refers to the micro economics study. The managerial economics deals with the problems faced by the individual organization such as main objective of the organization, demand for its product, price and output determination of the organization, available substitute and complimentary goods, supply of inputs and raw material, target or prospective consumers of its products etc. Managerial Economics has components of macro economics Managerial economics incorporates certain aspects of macroeconomic theory. These are essential to comprehending the circumstances and environments that envelop the working conditions of an individual firm or an industry. Knowledge of macroeconomic issues such as business cycles, taxation policies, industrial policy of the government, price and distribution policies, wage policies and antimonopoly policies and so on, is integral to the successful functioning of a business enterprise. None of the organization works in isolation. They are affected by the external environment of the economy in which it operates such as government policies, general price level, income and employment levels in the economy, stage of business cycle in which economy is operating, exchange rate, balance of payment, general expenditure, saving and investment patterns of the consumers, market conditions etc. These aspects are related to macro economics. Normative economics: It is concerned with varied corrective measures that a management undertakes under various circumstances. It deals with goal determination, goal development and achievement of these goals. Future planning, policy-making, decision-making and optimal utilisation of available resources, come under the banner of managerial economics. Managerial Economics is Pragmatic (practical in outlook) Managerial economics is pragmatic. In pure micro-economic theory, analysis is performed, based on certain exceptions, which are far from reality. However, in managerial economics, managerial issues are resolved daily and difficult issues of economic theory are kept at bay. Uses theory of firm: Managerial economics employs economic concepts and principles, which are known as the theory of Firm or 'Economics of the Firm'. Thus, its scope is narrower than that of pure economic theory. Managerial Economics is dynamic in nature Managerial Economics deals with human-beings (i.e. human resource, consumers, producers etc.). The nature and attitude differs from person to person. Thus to cope up with dynamism and vitality managerial economics also changes itself over a period of time. Prescriptive rather than descriptive:
Managerial economics is a normative and applied discipline. It suggests the application of economic principles with regard to policy formulation, decision-making and future planning. It not only describes the goals of an organisation but also prescribes the means of achieving these goals.
SCOPE OF MANAGERIAL ECONOMICS Well scope is something which tells us how far a particular subject will go. As faras Managerial Economic is concerned it is very wide in scope. It takes intoaccount almost all the problems and areas of manager and the firm.ME deals with Demand analysis, Forecasting, Production function, Cost analysis,Inventory Management, Advertising, Pricing System, Resource allocation etc.Following aspects are to be taken into account while knowing the scope of ME: Operational issues or internal issues 1. Resource Allocation 2. Demand Analysis and Forecasting 3. Cost and Production Analysis 4. Pricing Decisions, Policies and Practices 5. Profit Management 6. Capital Management 7. Strategic Planning
Environmental or external issues • Economic Environment: • Social environment • Political Environment • Technological Environment • International environment 1. Demand analysis and forecasting: Unless and until knowing the demand for a product how can we think of producing that product. Therefore demand analysis is something which is necessary for theproduction function to happen. Demand analysis helps in analyzing thevarious types of demand which enables the manager to arrive atreasonable estimates of demand for product of his company. Managersnot only assess the current demand but he has to take into account thefuture demand also. Theory of Demand: According to Spencer and Siegelman, “A business firm is an economic organisation which transforms productivity sources into goods that are to be sold in a market”. a. Demand analysis: Analysis of demand is undertaken to forecast demand, which is a fundamental component in managerial decision-making. Demand forecasting is of importance because an estimate of future sales is a primer for preparing production schedule and employing productive resources. Demand analysis helps the management in identifying factors that influence the demand for the products of a firm. Thus, demand analysis and forecasting is of prime importance to business planning. b. Demand theory: Demand theory relates to the study of consumer behaviour. It addresses questions such as what incites a consumer to buy a particular product, at what price does he/she purchase the product, why do consumers cease consuming a commodity and so on. It also seeks to determine the effect of the income, habit and taste of consumers on the demand of a commodity and analyses other factors that influence this demand. 2. Production function: Conversion of inputs into outputs is known asproduction function. With limited resources we have to make thealternative uses of this limited resource. Factor of production called asinputs is combined in a particular way to get the maximum output. Whenthe price of input rises the firm is forced to work out a combination of inputs to ensure the least cost combination. Theory of Production: Production and cost analysis is central for the unhampered functioning of the production process and for project planning. Production is an economic activity that makes goods available for consumption. Production is also defined as a sum of all economic activities besides consumption. It is the process of creating goods or services by utilising various available resources. Achieving a certain profit requires the production of a certain amount of goods. To obtain such production levels, some costs have to be incurred. At this point, the management is faced with the task of determining an optimal level of production where the average cost of production would be minimum. Production function shows the relationship between the quantity of a good/service produced (output) and the factors or resources (inputs) used. The inputs employed for producing these goods and services are called factors of production. a. Variable factor of production: The input level of a variable factor of production can be varied in the short run. Raw material inputs are deemed as variable factors. Unskilled labour is also considered in the category of variable factors. b. Fixed factor of production: The input level of a fixed factor cannot be varied in the short run. Capital falls under the category of a fixed factor. Capital alludes to resources such as buildings, machinery etc. Production theory facilitates in determining the size of firm and the level of production. It elucidates the relationship between average and marginal costs and production. It highlights how a change in production can bring about a parallel change in average and marginal costs. Production theory also deals with other issues such as conditions leading to increase or decrease in costs, changes in total production when one factor of production is varied and others are kept constant, substitution of one factor with another while keeping all increased simultaneously and methods of achieving optimum production. 3. Cost analysis: Cost analysis is helpful in understanding the cost of aparticular product. It takes into account all the costs incurred whileproducing a particular product. Under cost analysis we will take intoaccount determinants of costs, method of estimating costs, therelationship between cost and output, the forecast of the cost, profit,these terms are very vital to any firm or business. 4. Inventory Management: What do you mean by the term inventory? Wellthe actual meaning of the term inventory is stock. It refers to stock of rawmaterials which a firm keeps. Now here the question arises how much of the inventory is ideal stock. Both the high inventory and low inventory is not good for the firm.Managerial economics will use such methods as ABC Analysis, simplesimulation exercises, and some mathematical models, to minimize inventorycost. It also helps in inventory controlling. 5. Advertising: Advertising is a promotional activity. In advertising whilethe copy, illustrations, etc., are the responsibility of those who get it readyfor the press, the problem of cost, the methods of determining the totaladvertisement costs and budget, the measuring of the economic effects of advertising ---- are the problems of the manager. There’s a vast difference between producing a product and marketing it.It is through advertising only that the message about the product shouldreach the consumer before he thinks to buy it.Advertising forms the integral part of decision making and forwardplanning. 6. Pricing system: Here pricing refers to the pricing of a product. As you allknow that pricing system as a concept was developed by economics andit is widely used in managerial economics. Pricing is also one of thecentral functions of an enterprise. While pricing commodity the cost of production has to be taken into account, but a complete knowledge of theprice system is quite essential to determine the price. It is also importantto understand how product has to be priced under different kinds of competition, for different markets. Pricing = cost plus pricing and the policies of the enterprise Nowit is clear that the price system touches the several aspects of managerialeconomics and helps managers to take valid and profitable decisions. Theory of Exchange or Price Theory: Theory of Exchange is popularly known as Price Theory. Price determination under different types of market conditions comes under the wingspan of this theory. It helps in determining the level to which an advertisement can be used to boost market sales of a firm. Price theory is pivotal in determining the price policy of a firm. Pricing is an important area in managerial economics. The accuracy of pricing decisions is vital in shaping the success of an enterprise. Price policy impresses upon the demand of products. It involves the determination of prices under different market conditions, pricing methods, pricing policies, differential pricing, product line pricing and price forecasting. 7. Resource allocation: Resources are allocated according to the needsonly to achieve the level of optimization.As we all know that we have scarce resources, and unlimited needs. Wehave to make the alternate use of the available resources. For the allocationof the resources various advanced tools such as linear programming are used toarrive at the best course of action. 8.Theory of profit: Every business and industrial enterprise aims at maximising profit. Profit is the difference between total revenue and total economic cost. Profitability of an organisation is greatly influenced by the following factors: • Demand of the product • Prices of the factors of production • Nature and degree of competition in the market • Price behaviour under changing conditions Hence, profit planning and profit management are important requisites for improving profit earning efficiency of the firm. Profit management involves the use of most efficient technique for predicting the future. The probability of risks should be minimised as far as possible. 9.Theory of Capital and Investment: Theory of Capital and Investment evinces the following important issues: • Selection of a viable investment project • Efficient allocation of capital • Assessment of the efficiency of capital • Minimising the possibility of under capitalisation or overcapitalisation. Capital is the building block of a business. Like other factors of production, it is also scarce and expensive. It should be allocated in most efficient manner 10.Environmental issues: Managerial economics also encompasses some aspects of macroeconomics. These relate to social and political environment in which a business and industrial firm has to operate. This is governed by the following factors: • The type of economic system of the country • Business cycles • Industrial policy of the country • Trade and fiscal policy of the country • Taxation policy of the country • Price and labour policy • General trends in economy concerning the production, employment, income, prices, saving and investment etc. • General trends in the working of financial institutions in the country • General trends in foreign trade of the country • Social factors like value system of the society • General attitude and significance of social organisations like trade unions, producers’ unions and consumers’ cooperative societies etc. • Social structure and class character of various social groups • Political system of the country The management of a firm cannot exercise control over these factors. Therefore, it should fashion the plans, policies and programmes of the firm according to these factors in order to offset their adverse effects on the firm.
ECONOMIC CONCEPTS AND TECHNIQUES USED IN MANAGERIAL ECONOMICS Managerial economics uses a wide variety of economic concepts, tools, and techniques in the decision-making process. These concepts can be placed in three broad categories: (1) the theory of the firm, which describes how businesses make a variety of decisions; (2) the theory of consumer behavior, which describes decision making by consumers; and (3) the theory of market structure and pricing, which describes the structure and characteristics of different market forms under which business firms operate. 1.THE THEORY OF THE FIRM Discussing the theory of the firm is an useful way to begin the study of managerial economics, since the theory provides a broad framework within which issues relevant to managerial decisions are analyzed. A firm can be considered a combination of people, physical and financial resources, and a variety of information. Firms exist because they perform useful functions in society by producing and distributing goods and services. In the process of accomplishing this, they use society's scarce resources, provide employment, and pay taxes. If economic activities of society can be simply put into two categoriesroduction and consumptionirms are considered the most basic economic entities on the production side, while consumers form the basic economic entities on the consumption side. The behavior of firms is usually analyzed in the context of an economic model, an idealized version of a real-world firm. The basic economic model of a business enterprise is called the theory of the firm. 2.PROFIT MAXIMIZATION AND THE FIRM. Under the simplest version of the theory of the firm it is assumed that profit maximization is its primary goal. In this version of the theory, the firm's owner is the manager of the firm, and thus, the firm's owner-manager is assumed to maximize the firm's short-term profits (current profits and profits in the near future). Today, even when the profit maximizing assumption is maintained, the notion of profits has been broadened to take into account uncertainty faced by the firm (in realizing profits) and the time value of money (where the value of a dollar further and further in the future is increasingly smaller than a dollar today). It should be noted that expected profit in any one period can itself be considered as the difference between the total revenue and the total cost in that period. Thus, one can, alternatively, find the present value of expected future profits by subtracting the present value of expected future costs from the present value of expected future revenues. THE CONSTRAINED PROFIT MAXIMIZATION. Profit maximization is subject to various constraints faced by the firm. These constraints relate to resource scarcity, technology, contractual obligations, and laws and government regulations. In their attempt to maximize the present value of profits, business managers must consider not only the short-term and long-term implications of decisions made within the firm, but also various external constraints that may limit the firm's ability to achieve its organizational goals. The first external constraint of resource scarcity refers to the limited availability of essential inputs (including skilled labor), key raw materials, energy, specialized machinery and equipment, warehouse space, and other resources. Moreover, managers often face constraints on plant capacity that are exacerbated by limited investment funds available for expansion or modernization. Contractual obligations also constrain managerial decisions. Labor contracts, for example, may constrain managers' flexibility in worker scheduling and work assignment. Labor contracts may also determine the number of workers employed at any time, thereby establishing a floor for minimum labor costs. Finally, laws and regulations have to be observed. The legal restrictions can constrain decisions regarding both production and marketing activities. Examples of laws and regulations that limit managerial flexibility are: the minimum wage, health and safety standards, fuel efficiency requirements, antipollution regulations, and fair pricing and marketing practices. PROFIT MAXIMIZATION VERSUS OTHER MOTIVATIONS BEHIND MANAGERIAL DECISIONS. The present value maximization criterion as a basis for the study of the firm's behavior has come under severe criticism from some economists. The critics argue that business managers are interested, at least partly, in factors other than the firm's profits. In particular, they may be interested in power, prestige, leisure, employee welfare, community well-being, and the welfare of the larger society. The act of maximization itself has been criticized; there is a feeling that managers often aim merely to "satisfice" (seek solutions that are considered satisfactory), rather than really try to optimize or maximize (seek to find the best possible solution, given the constraints). Under the structure of a modern firm, it is hard to determine the true motives of managers. A modem firm is frequently organized as a corporation in which shareholders are the legal owners of the firm, and the manager acts on their behalf. Under such a structure, it is difficult to determine whether a manager merely tries to satisfy the stockholders of the firm while pursuing other goals, rather than truly attempting to maximize the value (the discounted present value) of the firm. BUSINESS VERSUS ECONOMIC PROFITS. As discussed above, profits are central to the goals of a firm and managerial decision making. Thus, to understand the theory of firm behavior properly, one must have a clear understanding of profits. While the term profit is very widely used, an economist's definition of profit differs from the one used by accountants (which is also usually used by the general public and the business community). Profit in accounting is defined as the excess of sales revenue over the explicit accounting costs of doing business. This surplus is available to the firm for various purposes. An economist also defines profit as the difference between sales revenue and costs of doing business, but includes more items in figuring costs, rather than considering only explicit accounting costs. For example, inputs supplied by owners (including labor, capital, and space) are accounted for in determining costs in the definition used by an economist. These costs are sometimes referred to as implicit cost their value is imputed based on a notion of opportunity costs widely used by economists. In other words, costs of inputs supplied by an owner are based on the values these inputs would have received in the next best alternative activity. For illustration, assume that the owner of the firm works for ten hours a day at his business. If the owner does not receive any salary, an accountant would not consider the owner's effort as a cost item. An economist would, however, value the owner's service to his firm at what his labor would have earned had he worked elsewhere. Thus, to compute the true profit, an economist will subtract the implicit costs from business profit; the resulting profit is often referred to as economic profit. It is this concept of profit that is used by economists to explain the behavior of a firm. The concept of economic profit essentially recognizes that owner-supplied inputs must also be paid for. Thus, the owner of a firm will not be in business in the long run until he recovers the implicit costs (also known as normal profit), in addition to recovering the explicit costs, of doing business. As pointed out earlier, a given firm attempts to maximize profits. Other firms do the same. Ultimately, profits decline for all firms. If all firms are operating under a competitive market structure, in equilibrium, economic profits (the excess of accounting profits over implicit costs) would be equal to zero; accounting profits (equal to explicit costs), however would be positive. When a firm makes profits above the normal profits level, it is said to be reaping above-normal profits.
HOW A FIRM ARRIVES AT A PROFIT-MAXIMIZING POINT. Let us assume throughout the discussion that a firm uses an economist's definition of profits. Assume that profit is the excess of sales revenue over cost (now assumed to be composed of both explicit and implicit costs). It can also be assumed, as discussed above, that the profit maximization is the firm's primary goal. Given this objective, important questions remain: How does the firm decide on the output level that maximizes its profits? Should the firm continue to produce at all if it is not profitable? A manufacturing firm, motivated by profit maximization, calculates the total cost of producing any given output level. The total cost is made up of total fixed cost (due to the expenditure on fixed inputs) and total variable cost (due to the expenditure on variable inputs). Of course, the total fixed cost does not vary over the short runnly the total variable cost does. It is important for the firm to also calculate the cost per unit of output, called the average cost. In addition to the average cost, the firm calculates the marginal cost. The marginal cost at any level of output is the increase in the total cost due to an increase in production by one unitssentially, the marginal cost is the additional cost of producing the last unit of output. The average cost is made up of two components: the average fixed cost (the total fixed cost divided by the number of units of the output produced) and the average variable cost (the total variable cost divided by the number of units of the output produced). As the fixed costs remain fixed over the short run, the average fixed cost declines as the level of production increases. The average variable cost, on the other hand, first decreases and then increases; economists refer to this as the U-shaped nature of the average variable cost. The U-shape of the average variable cost curve is explained as follows. Given the fixed inputs, output of the relevant product increases more than proportionately as the levels of variable inputs used increase. This is caused by increased efficiency due to specialization and other reasons. As more and more variable inputs are used in conjunction with the given fixed inputs, however, efficiency gains reach a maximumhe decline in the average variable cost eventually comes to a halt. After this point, the average variable cost starts increasing as the level of production continues to increase, given the fixed inputs. First decreasing and then increasing average variable cost lead to the U-shape for the average variable cost. The combination of the declining average fixed cost (true for the entire range of production) and the U-shaped average variable cost results into an U-shaped behavior of the average total cost, often simply called the average cost. The marginal cost also displays a U-shaped patternt first decreases and then increases. The logic for the shape of the marginal cost curve is similar to that for the average variable costoth relate to variable costs. But while the marginal cost refers to the increase in total variable cost due to an increase in the production by one unit, the average variable cost refers to the average variable cost per unit of output produced. It is important to notice, without going into finer details, that the marginal cost curve intersects the average and the average variable cost curves at their minimum cost points. In a graphic rendering of this concept there would be a horizontal line, in addition to the three cost curves. It is assumed that the firm can sell as many units as it wants at the given market price indicated by this horizontal line. Essentially, the horizontal line is the demand curve a perfectly competitive firm faces in the markett can sell as many units of output as it deems profitable at price "p" per unit (p, for example, can be $10 per unit of the product under consideration). In other words, p is the firm's average revenue per unit of output. Since the firm receives p dollars for every successive unit it sells, p is also the marginal revenue for the firm. A firm maximizes profits, in general, when its marginal revenue equals marginal cost. If the firm produces beyond this point of equality between the marginal revenue and marginal cost, the marginal cost will be higher than the marginal revenue. In other words, the addition to total production beyond the point where marginal revenue equals marginal cost, leads to lower, not higher, profits. While every firm's primary motive is to maximize profits, its output decision (consistent with the profit maximizing objective), depends on the structure of the market it is operating under. Before we discuss important market structures, we briefly examine another key economic concept, the theory of consumer behavior. 3.THE THEORY OF CONSUMER BEHAVIOR Consumers play an important role in the economy since they spend most of their incomes on goods and services produced by firms. In other words, they consume what firms produce. Thus, studying the theory of consumer behavior is quite important. What is the ultimate objective of a consumer? Economists have an optimization model for consumers, similar to that applied to firms or producers. While firms are assumed to be maximizing profits, consumers are assumed to be maximizing their utility or satisfaction. Of course, more goods and services will, in general, provide greater utility to a consumer. Nevertheless, consumers, like firms, are subject to constraintsheir consumption and choices are limited by a number of factors, including the amount of disposable income (the residual income after income taxes are paid for). The decision to consume by consumers is described by economists within a theoretical framework usually termed the theory of demand. The demand for a particular product by an individual consumer is based on four important factors. First, the price of the product determines how much of the product the consumer buys, given that all other factors remain unchanged. In general, the lower the product's price the more a consumer buys. Second, the consumer's income also determines how much of the product the consumer is able to buy, given that all other factors remain constant. In general, a consumer buys more of a commodity the greater is his or her income. Third, prices of related products are also important in determining the consumer's demand for the product. Finally, consumer tastes and preferences also affect consumer demand. The total of all consumer demands yields the market demand for a particular commodity; the market demand curve shows quantities of the commodity demanded at different prices, given all other factors. As price increases, quantity demanded falls. Individual consumer demands thus provide the basis for the market demand for a product. The market demand plays a crucial role in shaping decisions made by firms. Most important of all, it helps in determining the market price of the product under consideration which, in turn, forms the basis for profits for the firm producing that product. The amount supplied by an individual firm depends on profit and cost considerations. As mentioned earlier, in general, a producer produces the profit maximizing output. Again, the total of individual supplies yields the market supply for a particular commodity; the market supply curve shows quantities of the commodity supplied at different prices, given all other factors. As price increases, the quantity supplied increases. The interaction between market demand and supply determines the equilibrium or market price (where demand equals supply). Shifts in demand curve and/or supply curve lead to changes in the equilibrium price. The market price and the price mechanism play a crucial role in the capitalist systemhey send signals both to producers and consumers. 4.THEORIES ASSOCIATED WITH DIFFERENT MARKET STRUCTURES As mentioned earlier, firms' profit maximizing output decisions take into account the market structure under which they are operating. There are four kinds of market organizations: perfect competition, monopolistic competition, oligopoly, and monopoly. PERFECT COMPETITION. Perfect competition is the idealized version of the market structure that provides a foundation for understanding how markets work in a capitalist economy. Three conditions need to be satisfied before a market structure is considered perfectly competitive: homogeneity of the product sold in the industry, existence of many buyers and sellers, and perfect mobility of resources or factors of production. The first condition, the homogeneity of product, requires that the product sold by any one seller is identical with the product sold by any other supplierf products of different sellers are identical, buyers do not care from whom they buy so long as the price charged is also the same. The second condition, existence of many buyers and sellers, also leads to an important outcome: each individual buyer or seller is so small relative to the entire market that he or she does not have any power to influence the price of the product under consideration. Each individual simply decides how much to buy or sell at the given market price. The implication of the third condition is that resources move to the most profitable industry. There is no industry in the world that can be considered perfectly competitive in the strictest sense of the term. However, there are token examples of industries that come quite close to having perfectly competitive markets. Some markets for agricultural commodities, while not meeting all three conditions, come reasonably close to being characterized as perfectly competitive markets. The market for wheat, for example, can be considered a reasonable approximation. As pointed out earlier, in order to maximize profits, a supplier has to look at the cost and revenue sides; a perfectly competitive firm will stop production where marginal revenue equals marginal cost. In the case of a perfectly competitive firm, the market price for the product is also the marginal revenue, as the firm can sell additional units at the going market price. This is not so for a monopolist. A monopolist must reduce price to increase sales. As a result, a monopolist's price is always above the marginal revenue. Thus, even though a monopolist firm also produces the profit maximizing output, where marginal revenue equals marginal cost, it does not produce to the point where price equals marginal cost (as does a perfectly competitive firm). Regarding entry and exit decisions; one can now state that additional firms would enter an industryhenever existing firms are making above normal profits (that is, when the horizontal line is above the average cost at the profit maximizing output). A firm would exit the market if at the profit maximizing point the horizontal line is below the average cost curve; it will actually shut down the production right away if the price is less than the average variable cost. MONOPOLISTIC COMPETITION. Many industries that we often deal with have market structures that are characterized by monopolistic competition or oligopoly. Apparel retail stores (with many stores and differentiated products) provide an example of monopolistic competition. As in the case of perfect competition, monopolistic competition is characterized by the existence of many sellers. Usually if an industry has 50 or more firms (producing products that are close substitutes of each other), it is said to have a large number of firms. The sellers under monopolistic competition differentiate their product; unlike under perfect competition, the products are not considered identical. This characteristic is often called product differentiation. In addition, relative ease of entry into the industry is considered another important requirement of a monopolistically competitive market organization. As in the case of perfect competition, a firm under monopolistic competition determines the quantity of the product to produce based on the profit maximization principlet stops production where marginal revenue equals marginal cost of production. There is, however, one very important difference between perfect competition and monopolistic competition. A firm under monopolistic competition has a bit of control over the price it charges, since the firm differentiates its products from those of others. The price associated with the product (at the equilibrium or profit maximizing output) is higher than marginal cost (which equals marginal revenue). Thus, production under monopolistic competition does not take place to the point where price equals marginal cost of production. The net result of the profit maximizing decisions of monopolistically competitive firms is that price charged under monopolistic competition is higher than under perfect competition, and the quantity produced is simultaneously lower. OLIGOPOLY. Oligopoly is a fairly common market organization. In the United States, both the steel and automobile industries (with three or so large firms) provide good examples of oligopolistic market structures. Probably the most important characteristic of an oligopolistic market structure is the interdependence of firms in the industry. The interdependence, actual or perceived, arises from the small number of firms in the industry. Unlike under monopolistic competition, however, if an oligopolistic firm changes its price or output, it has perceptible effects on the sales and profits of its competitors in the industry. Thus, an oligopolist always considers the reactions of its rivals in formulating its pricing or output decisions. There are huge, though not insurmountable, barriers to entry to an oligopolistic market. These barriers can exist because of large financial requirements, availability of raw materials, access to the relevant technology, or simply existence of patent rights with the firms currently in the industry. Several industries in the United States provide good examples of oligopolistic market structures with obvious barriers to entry, such as the automobile industry, where significant financial barriers to entry exist. An oligopolistic industry is also typically characterized by economies of scale. Economies of scale in production implies that as the level of production rises, the cost per unit of product falls from the use of any plant (generally, up to a point). Thus, economies of scale lead to an obvious advantage for a large producer. There is no single theoretical framework that provides answers to output and pricing decisions under an oligopolistic market structure. Analyses exist only for special sets of circumstances. One of these circumstances refers to an oligopoly in which there are asymmetric reactions of its rivals when a particular oligopolist formulates policies. If an oligopolistic firm cuts its price, it is met with price reductions by competing firms; if it raises the price of its product, however, rivals do not match the price increase. For this reason, prices may remain stable in an oligopolistic industry for a prolonged period. MONOPOLY. Monopoly can be considered as the polar opposite of perfect competition. It is a market form in which there is only one seller. While, at first glance, a monopolistic form may appear to be rarely found market structure, several industries in the United States have monopolies. Local electricity companies provide an example of a monopolist. There are many factors that give rise to a monopoly. Patents can give rise to a monopoly situation, as can ownership of critical raw materials (to produce a good) by a single firm. A monopoly, however, can also be legally created by a government agency when it sells a market franchise to sell a particular product or to provide a particular service. Often a monopoly so established is also regulated by the appropriate government agency. Provision of local telephone services in the United States provides an example of such a monopoly. Finally, a monopoly may arise due to declining cost of production for a particular product. In such a case the average cost of production keeps falling and reaches a minimum at an output level that is sufficient to satisfy the entire market. In such an industry, rival firms will be eliminated until only the strongest firm (now the monopolist) is left in the market. Such an industry is popularly dubbed as the case of a natural monopoly. A good example of a natural monopoly is the electricity industry, which reaps the benefits of economies of scale and yields decreasing average cost. Natural monopolies are usually regulated by the government. Generally speaking, price and output decisions of a monopolist are similar to a monopolistically competitive firm, with the major distinction that there are a large number of firms under monopolistic competition and only one firm under monopoly. Nevertheless, at any output level, the price charged by a monopolist is higher than the marginal revenue. As a result, a monopolist also does not produce to the point where price equals marginal cost (a condition met under a perfectly competitive market structure). MARKET STRUCTURES AND MANAGERIAL DECISIONS. Managerial decisions both in the short run and in the long run are partly shaped by the market structure relevant to the firm. While the preceding discussion of market structures does not cover the full range of managerial decisions, it nevertheless suggests that managerial decisions are necessarily constrained by the market structure under which a firm operates. TOOLS OF DECISION SCIENCES AND MANAGERIAL ECONOMICS Managerial decision making uses both economic concepts and tools, and techniques of analysis provided by decision sciences. The major categories of these tools and techniques are: optimization, statistical estimation, forecasting, numerical analysis, and game theory. While most of these methodologies are fairly technical, the first three are briefly explained below to illustrate how tools of decision sciences are used in managerial decision making. 5.OPTIMIZATION. Optimization techniques are probably the most crucial to managerial decision making. Given that alternative courses of action are available, the manager attempts to produce the most optimal decision, consistent with stated managerial objectives. Thus, an optimization problem can be stated as maximizing an objective (called the objective function by mathematicians) subject to specified constraints. In determining the output level consistent with the maximum profit, the firm maximizes profits, constrained by cost and capacity considerations. While a manager does not solve the optimization problem, he or she may use the results of mathematical analysis. In the profit maximization example, the profit maximizing condition requires that the firm choose the production level at which marginal revenue equals marginal cost. This condition is obtained from an optimization exercise. Depending on the problem a manager is trying to solve, the conditions for the optimal decision may be different. 6.STATISTICAL ESTIMATION. A number of statistical techniques are used to estimate economic variables of interest to a manager. In some cases, statistical estimation techniques employed are simple. In other cases, they are much more advanced. Thus, a manager may want to know the average price received by his competitors in the industry, as well as the standard deviation (a measure of variation across units) of the product price under consideration. In this case, the simple statistical concepts of mean (average) and standard deviation are used. Estimating a relationship among variables requires a more advanced statistical technique. For example, a firm may want to estimate its cost function, the relationship between a cost concept and the level of output. A firm may also want to know the demand function of its product, that is, the relationship between the demand for its product and different factors that influence it. The estimates of costs and demand are usually based on data supplied by the firm. The statistical estimation technique employed is called regression analysis, and is used to develop a mathematical model showing how a set of variables are related. This mathematical relationship can also be used to generate forecasts. An automobile industry example can be used for the purpose of illustrating the forecasting method that employs simple regression analysis. Suppose a statistician has data on sales of American-made automobiles in the United States for the last 25 years. He or she has also determined that the sale of automobiles is related to the real disposable income of individuals. The statistician also has available the time series (for the last 25 years) on real disposable income. Assume that the relationship between the time series on sales of American-made automobiles and the real disposable income of consumers is actually linear and it can thus be represented by a straight line. A fairly rigorous mathematical technique is used to find the straight line that most accurately represents the relationship between the time series on auto sales and disposable income. 7.FORECASTING. Forecasting is a method or a technique used to predict many future aspects of a business or any other operation. While the term "forecasting" may appear to be rather technical, planning for the future is a critical aspect of managing any organizationusiness, nonprofit, or otherwise. In fact, the long-term success of any organization is closely tied to how well the management of the organization is able to foresee its future and develop appropriate strategies to deal with the likely future scenarios. There are many forecasting techniques available to the person assisting the business in planning its sales. For illustration, consider a forecasting method in which a statistician forecasting future values of a variable of business interestales, for example examines the cause-and-effect relationships of this variable with other relevant variables, such as the level of consumer confidence, changes in consumers' disposable incomes, the interest rate at which consumers can finance their excess spending through borrowing, and the state of the economy represented by the percentage of the labor force unemployed. Thus, this category of forecasting techniques uses past time series on many relevant variables to forecast the volume of sales in the future. Under this forecasting technique, a regression equation is estimated to generate future forecasts (based on the past relationship among variables). Risk analysis:
Various models are used to quantify risk and asymmetric information and to employ them in decision rules to manage risk.
Production analysis: Microeconomic techniques are used to analyse production efficiency, optimum factor allocation, costs and economies of scale. They are also utilised to estimate the firm's cost function. Pricing analysis: Microeconomic techniques are employed to examine various pricing decisions. This involves transfer pricing, joint product pricing, price discrimination, price elasticity estimations and choice of the optimal pricing method. Capital budgeting:
Investment theory is used to scrutinise a firm's capital purchasing decisions.
FIRMS OBJECTIVES Objectives of Business means the purpose for which the business is established. It is generally believed that the main objective of business is ta make profit and avoid loss. We do admit that profit is a driving force in undertaking any business activity but it is not the sole objective of any business. In the words of Urwick “earning of profit cannot be objective of a business any more than eating is the objective of living” . A business which is hunting after profits and ignores other objectives will not be doing service to the community. We here classify the objectives of business under three heads and then examine them briefly (1) Economic objectives (2) Social objectives(3)Humanobjectives.
I. Economic Objectives: Business, as we know. is primarily an economic activity. The major economic objectives to be achieved by business are:.
1.Profit Maximization The primary objective of business is to produce and sell goods for profit, of course, through the satisfaction of human wants. A business which does not earn profit cannot stay in the market for a longer period. The income of enterprise, therefore, must exceed expenditure over a period of time. Profit is necessary for the enterprise to. insure its own survival, growth and expansion. In the Words of Petter F Rucker NThe problem of any business is not the maximization of profitbut the achievement of sufficient profit to cover the fisk of economic activities and thus to avoid /osses”. It i clear from the above definition that a business enterprise should work for reasonable profit which should cover its own future risk. If the profit is made by over-charging customers, indulging in malpractices such as hoarding, blackmarketing, smuggling, etc, it will be against the ethics of business. It will be regarded robbery and not a business activity. Profit maximization is the process of obtaining the highest possible level of profit through the production and sale of goods and services. This is the guiding principle underlying the analysis of short-run production by a firm. In particular, economic analysis is assumed that firms undertake actions and make the decisions that increase profit. Profit is the difference between the total revenue a firm receives from selling output and the total cost of producing that output. Profit-maximization means that a firm seeks the production level that generates the greatest difference between total revenue and total cost. Alternative Aims of Firms Profit Satisficing. • In many firms there is separation of ownership and control. Those who own the company (shareholders) often do not get involved in the day to day running of the company.
• This is a problem because although the owners may want to maximise profits. The managers have much less incentive to max profits because they do not get the same rewards (share dividends)
• Therefore managers may create a minimum level of profit to keep the shareholders happy but then max other objectives such as enjoying work, getting on with other workers (not sacking them)Problem of separation between ownership and manager. This can be overcome, to some extent, by giving mangers share options and performance related pay although in some industries it is difficult to measure performance
2. Creating Markets Every business tries to create customers for its products and services. The more the customers are treated, the wider will be the market for the goods and larger the profit.
3. Technological Improvements The business, if it is to stay in, the market, must offset stagnation by using efficient methods of production. The creation of new products, new designs and application of new techniques of production contributes to growth, change and expansion in the economy. 4. Sales Maximisation. Firms often seek to increase their market share even if it means less profit this could occur for various reasons: a) Increased market share increases monopoly power and may enable to put up prices and make more profit in the long run.
b) Managers prefer to work for bigger companies as it leads to greater prestige and higher salaries
c) Increasing market share may force rivals out of business. E.g. supermarkets have lead to the demise of many local shops. Some firms may actually engage in predatory pricing which involves making a loss to force a rival out of business 5. Growth Maximisation. This is similar to sales maximisation and may involve mergers and takeovers. 6. Long Run Profit Maximisation
II.Pursuit of Personal Welfare The people who make decisions for a business are, in fact, people. They have likes and dislikes. They have personal goals and aspirations just like people who do not make decisions for firms. On occasion these people use the firm to pursue their own personal welfare. When they do, their actions could enhance the firm's profit maximization or, in many cases, prevent profit maximization. How about a few examples? Once again, consider William J. Wackowski, the president of The Wacky Willy Company. Perhaps Willy enjoys the finer things in life--a large house, fancy cars, and expensive vacations--which require a hefty income. As the primary stockholder of The Wacky Willy Company, when the business maximizes profit, then William J. Wackowski benefits with more income. In this case, the pursuit of personal welfare coincides with profit maximization. Alternatively, suppose that the Mr. Wackowski hates the color purple. He simply refuse to produce ANY purple Stuffed Amigos. However, market studies clearly indicate that buyers want purple Stuffed Amigos. Moreover, the purple fabric that would be used to produce purple Stuffed Amigos is significantly less expensive than other colors. Mr. Willy clearly is wacky in this case. His purple-phobia prevents profit maximization. William the Wackster might also decide to enhance his corporate lifestyle at the expense of corporate profit. He could, for example, give himself a bigger, more luxurious (but unneeded) office, a higher (but unneeded) salary, a company jet (also unneeded), season tickets to Shady Valley Primadonnas baseball team (clearly unneeded) and other (unneeded) amenities that are NOT needed to profitably produce Stuffed Amigos. These improve William's personal welfare, but at the expense of corporate profit.
III. Social Objectives: Pursuit of Social Welfare The people who make decisions for firms also have social consciences. Part of their likes and dislikes might be related to the overall state of society. As such, they might use the firm to pursue social welfare, which could enhance or prevent the firm's profit maximization. How might William J. Wackowski's pursuit of social welfare enhance or prevent profit maximization of The Wacky Willy Company? Suppose that William wants a cleaner environment. As such, he might implement more costly environmentally "friendly" production techniques and materials. He does his part to "clean the environment," but at the expense of company profit. Then again, Mr. Wackowski might feel that government environmental quality regulations restrict capital investment and economic growth. As such, William might have The Wacky Willy Company use part of its advertising budget to promote this view point. He might even use company revenue to set up the Wackowski Foundation for Policy Studies that is both a scientific think tank and a special interest lobbying organization with the goal of reducing environmental quality regulations. While the pursuit of social welfare is likely to reduce company profit, it could have the opposite effect as well. Such activities could give The Wacky Willy Company a likeable public image that motivates people to buy more Stuffed Amigos than they would otherwise. In fact, some firms use the pursuit of social welfare as one aspect of their overall advertising efforts. They enhance their public image at the same time they do something "good" for society. The social objectives of business are gaining more and more recognition with each passing year. The main social objectives of business are as follows:-
(i) Supplying desired goods at reasonable prices:
Business is expected to supply the goods and services required by the society. Goods and services should be of good quality and these should be supplied at reasonable prices. It is also the social obligation of business to avoid malpractices like boarding, Black marketing and misleading advertising.
(ii) Fair Remuneration to employees: Employees must be given fair compensation for their work. In addition to wages and salary a reasonable part of profits should be distrib¬uted among employees in recognition of their contributions. Such sharing of profits will help to increase the motivation and efficiency of employees.It is the obligation of business to provide healthy and safe work environment for employees. Good working conditions are beneficial to the organisation because these help to improve the produc¬tivity of employees and thereby the profits of business. Employees work day and night to ensure smooth functioning of business. It is, therefore, the duty of employers to pro¬vide hygienic working and living conditions for workers.
(iv) Fair return to investor:
Business is expected to pay fair return to shareholders and creditors in the form of dividend and interest. Investors also expect safety and apprecia¬tions of their investment. They should be kept informed about the financial health and future prospects of business.
(v) Social welfare: Business should provide support to social, cultural and religious organisations. Business enterprises can build schools, colleges, libraries, dharam shalas, hospitals, sports bodies and research institutions. They can help non-government organisations (NGOs) like CRY, Help Age, and others which render services to weaker sections of society.
(vi) Payment of Government Dues: Every business enterprise should pay tax dues (income tax, sales tax, excise duty, customs duty, etc.) to the government honestly and at the right time. These direct and indirect taxes provide revenue to the Government for spending on public welfare.Business should also abide faithfully by the laws of the country. Thus, businessmen should pursue those policies and take those actions which are desir¬able in terms of the objectives and values of our society.
(vii) Supply of standard quality of goods One of the social responsibilities of business is to produce goods of standard quality. If the enterprise is producinginferior, substandard and adulterated goods, it will be doing disservice to the society.
(viii) Avoidance of anti-social practices It is not fair on the part of a business to indulge in anti-social practices such as hoarding, black marketing, smuggling, overcharginq etc., to earn profit. A reasonable profit on a legitimate business is regarded a healthy sign and considered hi/al from Islamic point of view also.
(ix) Provision of more employment. Business provides employment to the people. It thus helps in increasing the standard of living of the members of the society.
(x) Cooperation with the government The business community should adopt a positive approach towards the policies of the government of the country. They should pay all taxes and dues in time to the gqvernment. All business activity should be carried within the legal frame work of the country.
(xi) Use of national resources The business should use the national resources in the best interest of the country. Wastage should be reduced to the maximum. The motto should be more and more goods for more and more people at lower and lower prices.
IV. Human Objectives: The business’activity is carried on by the people (entrepreneurs) through the people (employees) and for the people (customers). Human factor is thus an important element in business. A business which overlooks the human factor cannot prosper and ultimately suffers losses. The human objectives of business are that (1) the employees working in a business should be fairly rewarded (2) A healthy climate is created by providing opportunities to the employers for deve new skills and abilities (3) The employees should have say in the affairs which directiy affect them. (4) thinking of modern business must go well beyond material benefits of its employees. It must reduce unpleasantness of work and plan forjob satisfaction to the workths.
i.Labour welfare: Business must recognise the dignity of labour and human factor should be given due recognition. Proper opportunities should be provided for utilising indi¬vidual talents and satisfying aspirations of workers. Adequate provisions should be made for their health, safety and social security. Business should ensure job satisfaction and sense of belonging to workers.
ii. Developing human resources: Employees must be provided the opportunities for devel¬oping new skills and attitudes. Human resources are the most valuable asset of business and their development will help in the growth of business.Business can facilitate self- development of workers by encouraging creativity and innovation among them. Devel¬opment of skilled manpower is necessary for the economic development of the country.
iii. Participative management: Employees should be allowed to take part in decision mak¬ing process of business. This will help in the development of employees. Such participa¬tion will also provide valuable information to management for improving the quality of decisions. Workers' participation in management will usher in industrial democracy.
iv. Labour management cooperation: Business should strive for creating and maintaining cordial employer employee relations so as to ensure peace and progress in industry. Employees should be treated as honourable individuals and should be kept informed.
V. National Objectives Every business whether operating on small or large scale must have an obligation towards nation also. It should help in achieving national goals such as promoting social justice, increasing valued added goods for exports, finding out better and cheaper substitutes for imports and helping in increasing exports for building the foreign exchange reserves to meet the import bills
(i) Optimum utilisation of resources:
Business should use the nation's resources in the best possible manner. Judicious allocation and optimum utilisation of scarce resources is essential for rapid and balanced economic growth of the country.Business should pro¬duce goods in accordance with national priorities and interests. It should minimise the wastage of scarce natural resources.
(ii) National self-reliance: It is the duty of business to help the government in increasing experts and in reducing dependence on imports. This will help a country to achieve economic independence. This requires development of new technology and its applica-tion in industry.
(iii) Development of small scale Industries: Big business firms are expected to encourage growth of small scale industries which are necessary for generating employment. Small scale firms can be developed as ancillaries, which provide inputs to large scale industries.
(iv) Development of backward areas: Business is expected to give preference to the industrialisation of backward regions of the country. Balanced regional development is necessary for peace and progress in the country. It will also help to raise standard of living in backward areas. Government offers special incentives to the businessmen who set up factories in notified backward areas.
SOME OF THE MORE COMMON PRICING OBJECTIVES ARE: • maximize long-run profit • maximize short-run profit • increase sales volume (quantity) • increase monetary sales • increase market share • obtain a target rate of return on investment (ROI) • obtain a target rate of return on sales • stabilize market or stabilize market price: an objective to stabilize price means that the marketing manager attempts to keep prices stable in the marketplace and to compete on non-price considerations. Stabilization of margin is basically a cost-plus approach in which the manager attempts to maintain the same margin regardless of changes in cost. • company growth • maintain price leadership • desensitize customers to price • discourage new entrants into the industry • match competitors prices • encourage the exit of marginal firms from the industry • survival • avoid government investigation or intervention • obtain or maintain the loyalty and enthusiasm of distributors and other sales personnel • enhance the image of the firm, brand, or product • be perceived as “fair” by customers and potential customers • create interest and excitement about a product • discourage competitors from cutting prices • use price to make the product “visible" • help prepare for the sale of the business (harvesting) • social, ethical, or ideological objectives
ROLE OF MANAGERIAL ECONOMIST.
A managerial economist helps the management by using his analytical skills and highly developed techniques in solving complex issues of successful decision-making and future advanced planning. Mangerial economics holds that the goal of the firm is to maximize the owners' wealth. Managerial Economics is a part of the study of economics that applies decision science theory, quantifying the concepts learned in microeconomics, or the study of the firm. The study of economics holds that all companies are in the business to maximize the wealth of its owners. Applying this goal requires quantitative methods or measurable objectives, to maximize owner wealth. 1. Maximize Efficient Use of Labor o In managerial economics, the concept of comparative advantage is used to maximize the output of employees. For example, in a hairstyling salon, Marissa and Joan both work as assistants to the stylists. Their duties are to shampoo clients, clean stylists' work areas, and to answer the telephone. If Marissa takes three minutes to shampoo a client, but in that time she could have cleaned two work areas, or taken three phone calls, Joan should perform the shampooing to allow Marissa to be efficient on cleaning work areas and taking phone calls. Optimize Price and Output o In a purely competitive firm (assuming many sellers and buyers in the industry), managerial analysis holds that a company should set its price where marginal revenue equals marginal costs. Marginal revenue is the amount of money earned on the last product sold. Similarly, marginal cost is amount of money spent on the last product made. While marginal revenue often stays static, marginal cost tends to increase. This is due to wear and tear on machinery, reduced productivity of the employees and other inputs. This is the law of diminishing returns. For example, if a t-shirt manufacturer sells each t-shirt for $10, this amount is also the marginal revenue. As marginal costs increase, the t-shirt manufacturer should sell t-shirts as long as the marginal costs are less than or equal to $10. Minimize Uncertainty o In managerial economics, uncertainty is always an unknown input. In our salon example above, the hairstylist may not know how many haircuts she will do in the next month. She reduces her uncertainty by requesting that clients make an appointment for their next haircut to ensure they get the desired time slot. Other companies may reduce uncertainty by offering discounts if a client signs a long-term contract. Minimize Opportunity Costs o Opportunity costs refer to the sacrifice made when one option is chosen over another. In a firm, the goal is to ensure that the foregone revenue is always less than the chosen option. If a t-shirt manufacturer could use the same machinery to produce jogging shorts that would sell for $7 each, his opportunity cost is $7 per t-shirt. The two objectives of reducing uncertainty and minimizing opportunity cost may sometimes seem to be in conflict with each other, but when uncertainty cannot be quantified, it is often preferable to take the less profitable, more certain option. THE ROLE OF MANAGERIAL ECONOMIST CAN BE SUMMARIZED AS FOLLOWS: 1. He studies the economic patterns at macro-level and analysis it’s significance to the specific firm he is working in. 2. He has to consistently examine the probabilities of transforming an ever-changing economic environment into profitable business avenues. 3. He assists the business planning process of a firm. 4. He also carries cost-benefit analysis. 5. He assists the management in the decisions pertaining to internal functioning of a firm such as changes in price, investment plans, type of goods /services to be produced, inputs to be used, techniques of production to be employed, expansion/ contraction of firm, allocation of capital, location of new plants, quantity of output to be produced, replacement of plant equipment, sales forecasting, inventory forecasting, etc. 6. In addition, a managerial economist has to analyze changes in macro- economic indicators such as national income, population, business cycles, and their possible effect on the firm’s functioning. 7. He is also involved in advicing the management on public relations, foreign exchange, and trade. He guides the firm on the likely impact of changes in monetary and fiscal policy on the firm’s functioning. 8. He also makes an economic analysis of the firms in competition. He has to collect economic data and examine all crucial information about the environment in which the firm operates. 9. The most significant function of a managerial economist is to conduct a detailed research on industrial market. 10. In order to perform all these roles, a managerial economist has to conduct an elaborate statistical analysis. 11. He must be vigilant and must have ability to cope up with the pressures. 12. He also provides management with economic information such as tax rates, competitor’s price and product, etc. They give their valuable advice to government authorities as well. 13. At times, a managerial economist has to prepare speeches for top management. WHY MANAGERS NEED TO KNOW ECONOMICS The contribution of economics towards the performance of managerial duties and responsibilities is of prime importance. The contribution and importance of economics to the managerial profession is akin to the contribution of biology to the medical profession and physics to engineering. It has been observed that managers equipped with a working knowledge of economics surpass their otherwise equally qualified peers, who lack knowledge of economics. Managers are responsible for achieving the objective of the firm to the maximum possible extent with the limited resources placed at their disposal. It is important to note that maximisation of objective has to be achieved by utilising limited resources. In the event of resources being unlimited, like air or sunshine, the problem of economic utilisation of resources or resource management would not have arisen. Resources like finance, workforce and material are limited. However, in the absence of unlimited resources, it is the responsibility of the management to optimise the use of these resources. HOW ECONOMICS CONTRIBUTES TO MANAGERIAL FUNCTIONS Though economics is variously defined, it is essentially the study of logic, tools and techniques, to make optimum use of the available resources to achieve the given ends. Economics affords analytical tools and techniques that managers require to accomplish the goals of the organisation they manage. Therefore, a working knowledge of economics, not necessarily a formal degree, is indispensable for managers. Managers are fundamentally practicing economists. While executing his duties, a manager has to take several decisions, which conform to the objectives of the firm. Many business decisions fall prey to conditions of uncertainty and risk. Uncertainty and risk arise chiefly due to volatile market forces, changing business environment, emerging competitors with highly competitive products, government policy, external influences on the domestic market and social and political changes in the country. The intricacy of the modern business world weaves complexity in to the decision making process of a business. However, the degree of uncertainty and risk can be greatly condensed if market conditions are calculated with a high degree of reliability. Envisaging a business environment in the future does not suffice. Appropriate business decisions and formulation of a business strategy in conformity with the goals of the firm hold similar importance. Pertinent business decisions require an unambiguous understanding of the technical and environmental conditions under which business decisions are taken. Application of economic theories to explain and analyse technical conditions and business environment, contributes greatly to the rational decision-making process. Economic theories have many pronged applications in the analysis of practical problems of business. Keeping in view the escalating complexity of business environment, the efficacy of economic theory as a tool of analysis and its contribution to the process of decision-making has been widely recognised.
CONTRIBUTIONS OF ECONOMIC THEORY TO BUSINESS ECONOMICS
According to Baumol, there are three main contributions of economic theory to business economics. 1. The practice of building analytical models, which assist in recognising the structure of managerial problems and eliminating minor details, which might obstruct decision-making has been derived from economic theory. Analytical models help in eradicating peripheral problems and help the management in retaining focus on core issues. 2. Economic theory comprises a founding pillar of business analysis-‘a set of analytical methods’, which may not be applied directly to specific business problems, but they do enhance the analytical capabilities of the business analyst. 3. Economic theories offer an unequivocal perspective on the various concepts used in business analysis, which enables the manager to swerve from conceptual pitfalls. IMPORTANCE OF MANAGERIAL ECONOMICS Business and industrial enterprises aim at earning maximum proceeds. In order to achieve this objective, a managerial executive has to take recourse in decision-making, which is the process of selecting a specified course of action from a number of alternatives. A sound decision requires fair knowledge of the aspects of economic theory and the tools of economic analysis, which are directly involved in the process of decision-making. Since managerial economics is concerned with such aspects and tools of analysis, it is pertinent to the decision-making process. Spencer and Siegelman have described the importance of managerial economics in a business and industrial enterprise as follows: 1. Accommodating traditional theoretical concepts to the actual business behaviour and conditions: Managerial economics amalgamates tools, techniques, models and theories of traditional economics with actual business practices and with the environment in which a firm has to operate. According to Edwin Mansfield, “Managerial Economics attempts to bridge the gap between purely analytical problems that intrigue many economic theories and the problems of policies that management must face”. 2. Estimating economic relationships: Managerial economics estimates economic relationships between different business factors such as income, elasticity of demand, cost volume, profit analysis etc. 3. Predicting relevant economic quantities: Managerial economics assists the management in predicting various economic quantities such as cost, profit, demand, capital, production, price etc. As a business manager has to function in an environment of uncertainty, it is imperative to anticipate the future working environment in terms of the said quantities. 4. Understanding significant external forces: The management has to identify all the important factors that influence a firm. These factors can broadly be divided into two categories. Managerial economics plays an important role by assisting management in understanding these factors. • External factors: A firm cannot exercise any control over these factors. The plans, policies and programmes of the firm should be formulated in the light of these factors. Significant external factors impinging on the decision-making process of a firm are economic system of the country, business cycles, fluctuations in national income and national production, industrial policy of the government, trade and fiscal policy of the government, taxation policy, licensing policy, trends in foreign trade of the country, general industrial relation in the country and so on. • Internal factors: These factors fall under the control of a firm. These factors are associated with business operation. Knowledge of these factors aids the management in making sound business decisions. 5. Basis of business policies: Managerial economics is the founding principle of business policies. Business policies are prepared based on studies and findings of managerial economics, which cautions the management against potential upheavals in national as well as international economy. Thus, managerial economics is helpful to the management in its decision-making process.
APPLICATION OF MANAGERIAL ECONOMICS
Tools of managerial economics can be used to achieve virtually all the goals of a business organisation in an efficient manner. Typical managerial decision-making may involve one of the following issues: • Decisions pertaining to the price of a product and the quantity of the commodity to be produced • Decisions regarding manufacturing product/part/component or outsourcing to/purchasing from another manufacturer • Choosing the production technique to be employed in the production of a given product • Decisions relating to the level of inventory of a product or raw material a firm will maintain • Decisions regarding the medium of advertising and the intensity of the advertising campaign • Decisions pertinent to employment and training • Decisions regarding further business investment and the modes of financing the investment It should be noted that the application of managerial economics is not restricted to profit-seeking business organisations. Tools of managerial economics can be applied equally well to decision problems of nonprofit organisations. Mark Hirschey and James L. Pappas cite the example of a nonprofit hospital making use of the managerial economics techniques for optimisation of resource use. While a nonprofit hospital is not like a typical firm seeking to maximise its profits, a hospital does strive to provide its patients the best medical care possible given its limited staff (doctors, nurses and support staff), equipment, space and other resources. The hospital administrator can employ concepts and tools of managerial economics to determine the optimal allocation of the limited resources available to the hospital. In addition to nonprofit business organisations, government agencies and other nonprofit organisations (such as cooperatives, schools and museums) can exploit the techniques of managerial decision making to achieve goals in the most efficient manner. While managerial economics aids in making optimal decisions, one should be aware that it only describes the predictable economic consequences of a managerial decision. For example, tools of managerial economics can explain the effects of imposing automobile import quotas on the availability of domestic cars, prices charged for automobiles and the extent of competition in the auto industry. Analysis of managerial economics reveals that fewer cars will be available, prices of automobiles will increase and the extent of competition will be reduced. However, managerial economics does not address whether imposing automobile import quotas is a good government policy. TOOLS OF DECISION SCIENCE AND MANAGERIAL ECONOMICS Managerial decision-making draws on economic concepts as well as tools and techniques of analysis provided by decision sciences. The major categories of these tools and techniques are optimisation, statistical estimation, forecasting, numerical analysis and game theory. Most of these methodologies are technical. The first three are briefly explained below to illustrate how tools of decision sciences are used in managerial decision-making. Optimisation:
Optimisation techniques are probably the most crucial to managerial decision making. Given that alternative courses of action are available, the manager attempts to produce the most optimal decision, consistent with stated managerial objectives. Thus, an optimisation problem can be stated as maximising an objective (called the objective function by mathematicians) subject to specified constraints. In determining the output level consistent with the maximum profit, the firm maximises profits, constrained by cost and capacity considerations. While a manager does not resolve the optimisation problem, he or she may make use of the results of mathematical analysis. In the profit maximisation example, the profit maximising condition requires that the firm select the production level at which marginal revenue equals marginal cost. This condition is obtained from an optimisation model/technique. The techniques of optimisation employed depend on the problem a manager is trying to solve.
Statistical estimation: A number of statistical techniques are used to estimate economic variables of interest to a manager. In some cases, statistical estimation techniques employed are simple. In other cases, they are much more complex and advanced. Thus, a manager may want to know the average price received by his competitors in the industry, as well as the standard deviation (a measure of variation across units) of the product price under consideration. In this case, the simple statistical concepts of mean (average) and standard deviation are used. Estimating a relationship among variables requires a more advanced statistical technique. For example, a firm may desire to estimate its cost function i.e. the relationship between cost concept and the level of output. A firm may also wish to the demand function of its product that is the relationship between the demand for its product and factors that influence it. The estimates of costs and demand are usually based on data supplied by the firm. The statistical estimation technique employed is called regression analysis and is used to engender a mathematical model showing how a set of variables are related. This mathematical relationship can also be used to generate forecasts. An example from the automobile industry is befitting for illustrating the forecasting method that employs simple regression analysis. Let us assume that a statistician has data on sales of American-made automobiles in the United States for the last 25 years. He or she has also determined that the sale of automobiles is related to the real disposable income of individuals. The statistician also has available the time series data (for the last 25 years) on real disposable income. Assume that the relationship between the time series on sales of American-made automobiles and the real disposable income of consumers is actually linear and it can thus be represented by a straight line. A rigorous mathematical technique is used to locate the straight line that most accurately represents the relationship between the time series on auto sales and disposable income. Forecasting:
It is a method or a technique to predict many future aspects of a business or any other operation. For example, a retailing firm that has been in business for the last 25 years may be interested in forecasting the likely sales volume for the coming year. Numerous forecasting techniques can be used to accomplish this goal. A forecasting technique, for example, can provide such a projection based on the experience of the firm during the last 25 years; that is, this forecasting technique bases the future forecast on the past data.
While the term 'forecasting' may appear technical, planning for the future is a critical aspect of managing any organisation or a business. The long-term success of any organisation has close association with the propensity of the management of the organisation to foresee its future and develop appropriate strategies to deal with the likely future scenarios. Intuition, good judgment and knowledge of economic conditions enables the manager to 'feel' or perhaps anticipate the likelihood in the future. It is not easy, however, to metamorphose a feeling about the future outcome into concrete data for instance, as a projection for next year's sales volume. Forecasting methods can help predict many future aspects of a business operation, such as forthcoming years' sales volume projections. Suppose a forecast expert has been asked to provide quarterly estimates of the sales volume for a particular product for the next four quarters. How should he attempt at preparing the quarterly sales volume forecasts? Reviewing the actual sales data for the product in question for past periods will give a good start. Suppose that the forecaster has access to actual sales data for each quarter during the 25-year period the firm has been in business. Employing this historical data, the forecaster can identify the general trend of sales. He or she can also determine whether there is a pattern or trend, such as an increase or decrease in sales volume over time. An in depth review of the data may unearth some type of seasonal pattern, such as, peak sales occurring around the holiday season. Thus, by reviewing historical data, there is a high probability that the forecaster develops a good understanding of the pattern of sales in the past periods. Understanding such patterns can result in better forecasts of future sales of the product. In addition, if the forecaster is able to identify the factors that influence sales, historical data on these factors (variables) can also be used to generate forecasts of future sales. There are many forecasting techniques available to the person assisting the business in planning its sales. Take for example a forecasting method in which a statistician forecasting future values of a variable of business interest—sales, for example, examines the cause-and-effect relationships of this variable with other relevant variables. The other pertinent variable may be the level of consumer confidence, changes in consumers' disposable incomes, the interest rate at which consumers can finance their excess spending through borrowing and the state of the economy represented by the percentage of the labour force unemployed. This category of forecasting technique utilises time series data on many relevant variables to forecast the volume of sales in the future. Under this forecasting technique, a regression equation is estimated to generate future forecasts (based on the past relationship among variables).
An economy consists of a set of people or individuals and their environment. Each individual in an economy has an economic problem.
An economic problem arises because each individual has unique desires (defined as experiences he or she would like to have) and a limited set of assets (consisting of human capital, possessions, and time). This limitation prevents the individual from ever satisfying all his desires and dictates his behavior.
Human Capital includes physical attributes, mental capabilities, skill, personality, associates (people she knows or know her), creativity, influence, and a philosophy of life.
Possessions are the physical objects the individual posses or, more properly, has a claim on.
Time is limited to 24 hours each day for the remainder of an individual's life.
The economic problem we face forces us to economize, that is, to decide which desires to satisfy and which ones to leave unsatisfied. This behavior is both economically rational and the rationale behind economics.
It is important to note that the process of economizing occurs entirely in the context of uncertainty because the consequences of our actions happen in the future (of which we know nothing), and our decisions are made while being unaware of all things which exist in the present.
Economics then is the study of the consequences of economizing in the context of uncertainty. Economics is relevant as an internal model against which we can compare our present situation and make better decisions about our behavior. It does not give a set of tools to use, but rather an understanding of the world in which we live.