The Fundamentals of Managerial Economics

Economics:
The term economics comes from the Greek work ikos (house) and nomos (law).
Economics is a social science. Its basic function is to study how people-individuals,
households, firms and nations-maximize their gains form their limited resources and
opportunities. It means selecting the best out of available options with the
objective of maximizing gains from the given resources. When applied to
managerial decision making, economic analysis can be applied to problems
encountered by businesses, like management of resources, costs and profits. So be
prepared to be surprised to find out how useful the knowledge of Managerial
Economics is and how pervasive its applications are! The study of how societies
and individuals allocate scarce resources among competing ends. This is a study of
allocation decisions. It applies widely to an immense variety of topics. It is not, for
example, particularly focused on the decisions of businesses. It applies to profit as
well as to non profit institutions.
Types of Economic Analysis:
i.
ii.
iii.
iv.

Micro and Macro

Positive and Normative
Short run and Long run
Partial and General equilibrium

Micro Economics: Micro means small. Looks at the smaller picture of the economy
and is the study of the behavior of small economic units.
Macro Economics: Macro means large. It is that branch of economic analysis that
deals with the study of aggregates.
Positive Economics: Positive statements are factual by nature. It establishes a
relationship between cause and effect. It is what is in economic matters.
Normative Economics: It involves some degree of value judgment, and cannot be
verified by empirical study or logic. It is concerned with questions involving value
judgments. It is what ought to be in economic matters.
Short run: It is a time period not enough for consumers and producers to adjust
completely to any new situation.
Long run: It is a planning horizon in which consumers and producers can adjust to
any new situation.
Equilibrium: It is a state of balance that can occur in a model.

Partial equilibrium: Analysis studies the internal outcome of any policy action in a
single market only.
General equilibrium: Analysis explains economic phenomena in an economy as a
whole.
Kinds of Economic Decisions:

What to produce?
How to produce?
For whom to produce?
Are resources used economically?
Are resources fully employed?
Is the economy growing?

The Manager:
A person who directs resources to achieve a stated goal. In business or
organizational contexts, managers control resources other than their own time and
energy such as
a. The efforts of others
b. Input acquisition and use
c. Output/Pricing decisions
The business contain full of risk and uncertainty. To reduce the risk and make the
certainty in business activity the manager has to take right decision in right time i.e.
decision making and forward planning.
Decision making means process of selecting one action from two or more
alternative courses of action. Forward planning means establishing plans for the
future.
Factors influencing managerial decisions:
-

Human and behavioral considerations.

Technological forces, and
Environmental factors

Factors constraints managerial decisions:

-

Resource constraints
Output quantity and quality constraints
Legal constraints
Environmental constraints

INTRODUCTION
Managerial economics draws on economic analysis for such concepts as cost,
demand, profit and competition. Managers can take Decision for a business related
problems based on Economic concept.
MEANING OF MANAGERIAL ECONOMICS
Managerial Economics is a discipline that combines economic theory with
managerial practice.
DEFINITION OF MANAGERIAL ECONOMICS
According to Spencer and Seigelman Managerial Economics is defined as
the integration of economic theory with business practices for the purpose of
facilitating decision making and forward planning by management.
Managerial Economics:
The study of how to direct scarce resources in the way that most efficiently
achieves a managerial goal. The difference between this course and, say
microeconomics is that it is policy oriented. That is, we focus on giving you tools to
make decisions, rather than describing how a market or an economy as a whole
works.
Managerial economics refers to the application of economic theory and the
tools of analysis of decision science to examine how an organization can achieve its
aims or objectives most efficiently.
It is a means to an end to managers in any business, in terms of finding the
most efficient way to allocating scarce organizational resources and reaching stated
objectives.

Managerial economics is applied microeconomics to a significant

extent; though it draws extensively from microeconomic theory as
well.
Managerial economics has a normative bias stating what firms
should do, in order to reach certain objective.

Managerial economics deals with partial equilibrium analysis, with

focus on equilibrium of a firm or an industry, not the economy.

The Nature of Managerial Economics:

Economics theory deals with a number of concepts and principles relating to solve
the problems of business management. The way economic analysis can be used
towards solving business problems, constitutes subject-matter of managerial
economics.
Management decision
problems

Economic
theory
Microeconomic
s

Decision Sciences
Mathematical
economics,
Econometrics

MANAGERIAL ECONOMICS
Application of economic
theory and decision science
tools to solve managerial
decision problems

OPTIMAL SOLUTION
TO MANAGERIAL
DECISION
PROBLEMS

Microeconomics
Studies the economy at the level of individual consumers, workers,
firms, goods, and markets
Macroeconomics
Studies the economy at the aggregate level, at the level of the
economy as a whole.
Examines total consumer behavior, total employment, total production,
total sales, etc.
Managerial Decision Area:
Assessment of investible funds
Selecting Business Area
Choice of product

Determining optimum output

Determining price of the product
Determining input-combination and technology
Sales promotion

Components of Effective Decision Making or Factors influencing

managerial decision making:
1. Identify Goals and Constraints.
2. Recognize the Nature and Importance of Profits: Economic profits differ
from Accounting profits. . Good decision-making involves the maximization of
economic profits.
3. Understanding Incentives. .Compensation and the structure of
organizations affects importantly organizations.
a. Organizational Incentives
b. Incentives for Motivating Individuals
4. Understand Markets. Market forces represent a series of rivalries. In any
problem, you must appreciate your position relative to other agents.
5. Recognize the Time Value of Money
6. Appreciate Marginal Analysis. Marginal decisions are an easy way to
optimize totals. Calculus is just a formal expression of marginal analysis.

a. Discrete Decisions.
b. Continuous Decisions and the calculus
c. Incremental Analysis
1. Pay attention to incremental costs and incremental benefits.
2. Ignore sunk costs.
Limitations of Managerial Economics:
1.
2.
3.
4.
5.

It does not give the correct pictures of the working of the economy.
It does not provide solution to certain economic problems.
The area of study covered by it is limited.
The area of study covered by it is limited.
It cannot be abruptly applied to the study of macro economic problem.

6. The study of individual units becomes more useful than study of aggregates.
7. It is useful for develop countries for solving their problems but less useful or
underdeveloped country.
8. It studies the economy in general or in detail.
9. Most of the Micro Economic theories are abstract.
10.Most of the micro economic theories are static-based on centeris paribus i.e.
other things being equal.
11.Micro economics misleads when one tries to generalize from the individual
behavior.
12.Micro economics in dealing with macro economics system unrealistically
assumes full employment.

Scope of Managerial Economics:

1.
2.
3.
4.
5.
6.
7.
8.
9.

Choice of business and the nature of product, i.e. what to produce

Choice of size of the firm, i.e. how much to produce
Choice of technology, i.e. choosing the factor-combination
Choice of price, i.e. how to price the commodity
How to promote sales
How to face price competition
How to decide on new investments
How to manage profit and capital
How to manage an inventory (stock of both finished goods and raw
materials)

Objectives of Business Firms:

1.

2.
3.
4.
5.
6.
7.
8.
9.

Profit Maximization
Theories of Profit
Risk-Bearing Theories of Profit
- Frictional Theory of Profit
- Monopoly Theory of Profit
- Innovation Theory of Profit
- Managerial Efficiency Theory of Profit
Sales Maximization
Firms value maximization
Size maximization
Long run survival
Management utility maximization
Satisfying
Non-Profit objectives
Others

Risk-Bearing Theories of Profit: According to these theories, above normal

returns are required by firms to enter and remain in such fields as petroleum

exploration with above-average risks. Frictional Theory of Profit: This theory

stresses that profits arise as a result of friction or disturbances from long-run
equilibrium. At the time of the energy crisis in the early 1970s, firms
producing insulating materials enjoyed a sharp increase in demand, which led
to large profits. With the sharp decline in petroleum prices in the mid-1980s,
many of these firms began to incur losses.
Monopoly Theory of Profit: Some firms with monopoly power can restrict
output and charge higher prices than under perfect competition, thereby
earning a profit. Because of restricted entry into the industry, these firms can
continue to earn profits even in the long run.
Innovation Theory of Profit: It is the theory of profit postulates that profit is
the reward for the introduction of a successful innovation.
Managerial Efficiency Theory of Profit: This theory rests on the observation
that if the average firm tends to earn only a normal return on its investment
in the long run, firms that are more efficient than the average would earn
above-normal returns and profits.
Some Fundamental Economic Concepts applied to business analysis or
Used in Business Decisions:
Before embarking on individual problems of decision making and their
analysis, it would be useful to explain the basic principles of managerial economics,
such as the principles as follows;
1.
2.

3.

4.

5.

The Opportunity Cost and Decision rule (Production possibilities)

It is the benefit forgone from the alternative that is not selected.
Marginal Principle and Decision rule
The concept of marginality deals with a unit increase in cost or revenue
or utility
Incremental principle and decision rule
It refers to time value of money (i.e.) outflow and inflow of money and
resource that take place at different points of time.
The equi-marginal principle
It is the allocation of the available resources among the alternative
activities. An input should be so allocated that the value added by the
last unit is the same in all cases.
Time perspective in business decisions
A decision may be made on the basis of short-run consideration, but
may as time elapses have long-run repercussions which make it more
or less profitable than it at first appeared.

How does managerial economics help the manager in decision making and
forward planning:

Demand estimation and forecasting

Preparation of business forecasts; to provide forecasts of
changes in costs and business conditions based on market
research and policy analysis
Analysis of the market survey to determine the nature and
extent of competition
Analyzing the issues and problems of the concerned industry
Assisting the business planning process of the firm
Discovering new and possible fields of business endeavor
and its cost benefits analyze as well as feasibility studies
Advising on pricing, investment and capital budgeting
policies
Evaluation of capital budgets

IMPORTANCE OF MANAGERIAL ECONOMICS

Helps to achieve firms objectives
Helps to make a decision for business related problems
Helps to allocate the resources ( man, Money, materials ect.,)
SCOPE OF MANAGERIAL ECOMOMICS
Managerial Economics consist of two branches
1. Micro Economics
2. Macro Economics
1. Micro Economics
Micro economics studies the economic behavior of individual decision making units
such as consumers, producers/firms and resource owners. Scope of Managerial
Economics Are
a) 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 the production function to happen. Demand analysis helps in
analyzing the various types of demand which enables the manager to arrive
at reasonable estimates of demand for product of his company. Managers not
only assess the current demand but he has to take into account the future
demand also.
b) Production function
Conversion of inputs into outputs is known as production function. With
limited resources we have to make the alternative uses of this limited
resource. Factor of production called as inputs is combined in a particular way

to get the maximum output. When the price of input rises the firm is forced to
work out a combination of inputs to ensure the least cost combination.
c) Cost analysis
Cost analysis is helpful in understanding the cost of a particular
product. It takes into account all the costs incurred while producing a
particular product. Under cost analysis we will take into account determinants
of costs, method of estimating costs, the relationship between cost and
output, the forecast of the cost, profit, these terms are very vital to any firm
or business.

d) Inventory Management
What do you mean by the term inventory? Well the actual meaning of
the term inventory is stock. It refers to stock of raw materials which a firm
keeps. Now here the question arises how much of the inventory is idea stock.
Both the high inventory and low inventory is not good for the firm. Managerial
economics will use such methods as ABC Analysis, simple simulation
exercises, and some mathematical models, to minimize inventory cost. It also
helps in inventory controlling.
e) Pricing system
Here pricing refers to the pricing of a product. As you all know that
pricing system as a concept was developed by economics and it is widely
used in managerial economics. Pricing is also one of the central functions of
an enterprise. While pricing commodity the cost of production has to be taken
into account, but a complete knowledge of the price system is quite essential
to determine the price. It is also important to understand how product has to
be priced under different kinds of competition, for different markets.
MANAGERIAL ECONOMICS AND OTHER DISCIPLINE
1) Microeconomic Theory:
As stated in the introduction, the roots of managerial economics spring
from micro-economic theory. Price theory, demand concepts and theories of
market structure are few elements of micro economics used by managerial
economists. It has an applied bias as it applies economic theories in order to
solve real world problems of enterprises.

2) Macroeconomic Theory:
This field has little relevance for managerial economics but at least one
part of it is incorporated in managerial economics i.e. national income
forecasting. The latter could be an important aid to business condition
analysis, which in turn could be a valuable input for forecasting the demand
for specific product groups.

3) Operations Research:
This field is used in managerial economics to find out the best of all
possibilities. Linear programming is a great aid in decision making in business
and industry as it can help in solving problems like determination of facilities
on machine scheduling, distribution of commodities and optimum product
mix etc.
4) Theory of Decision Making
Decision theory has been developed to deal with problems of choice or
decision making under uncertainty, where the applicability of figures
required for the utility calculus are not available. Economic theory is based
on assumptions of a single goal whereas decision theory breaks new
grounds by recognizing multiplicity of goals and persuasiveness of
uncertainty in the real world of management.
5) Statistics
Statistics helps in empirical testing of theory. With its help, better
decisions relating to demand and cost functions, production, sales or
distribution are taken. Managerial economics is heavily dependent on
statistical methods.
6) Management Theory and Accounting
Maximization of profit has been regarded as a central concept in the
theory of the firm in microeconomics. In recent years, organization
theorists have talked about satisfying instead of maximizing as an
objective of the enterprise. Accounting data and statements constitute the
language of business. In fact the link is so close that managerial
accounting has developed as a separate and specialized field in itself.

Economy Works:

Working of a modern economy is extremely complex. Millions of persons participate

and contribute to its working in different ways and different capacities-as producers,
traders, workers, financiers, and consumers. Thousands of goods and services are
produced and consumed and millions of persons are engaged in production and
distributions of a single commodity. To present a complete picture of economic
system showing the role of each individual participation in respect of each
commodity is an extremely difficult task, rather impossible. However, we present
below working of an economy in a simplified model.
A simple model of the economy consists of two sectors: (Two Sector Model)
1. Households
2. Business Firms
The two are main decision makers in an economy. House holds supply all the
factors of production, viz., Land, labor and capital, to the firms which constitute the
production sector, and they consume all the goods and services produced by the
business firms.
Business firms include all firms, farms, factories and shops engaged in production
and distribution of goods and services. Business firms perform two functions: They
hire factors of production from the households and transform them into final goods
and services, and they supply all the goods and services to the households, the
consumers.

Interaction between the Households and Firms:

The functions and the mode of interaction between the two kinds of economic
entities and working of the economic system are exhibited.

Households and firms interact in two ways: As sellers and buyers of inputs, and as
buyers and sellers of output. The sale and purchase of inputs creates factor market
where factor prices are determined, and sale and purchase of final goods and
services creates product market where product prices are determined. Factors of
production flow from the households to the factor market. The interaction between
households and business firms determines the factor prices. Once factor prices are
determined, inputs move to business firms. In return, factor payments flow to the
households.
The business firms transform the factor inputs into finished products. Finished
products flow to the product market. The interaction between the business firms,
the suppliers, and the households, the buyers, determine the product prices. Once
product prices are determined, products flow to the households. In return, the
payments made by the households for their purchases flows to the firms. They use
their receipts to hire inputs again and the process continues. In this process, two
circular flows are generated: i) Real flows, i.e., flows of inputs and final products as
shown by the outer circle, and
ii) Money flows, show by the inner circle.
Extension of the Model: (Four Sector Model)
The simple economy model may be extended to make it more realistic by adding
two other sectors, Viz., the government and the foreign sectors. A complete four
sector model is presented. The government and the foreign sectors too play an
important role in the working of an economy. The government performs two kinds
of function: i) administrative, and ii) economic functions. To perform its functions,
the government needs monetary resources. It acquires its monetary resources
through taxes on the incomes of households and firms, and on their transactions. It
uses its tax revenues i) to buy the requisite resources from the households and the
firms to perform its functions, and ii) to make transfer payments to both households
in the forms of old-age pension, dearness allowance, subsidies and to firms in the
form of subsidies and financial grants. Government taxes are withdrawals from the
economy and government expenditure are injections into the economy. So long as
injections and withdrawals are equal or injections exceed withdrawals economic
activities continue to expand and vice versa.
The foreign sector is constituted of foreign trade and financial inflows and outflows
including remittances from abroad. Exports are outflows from the economy and
imports are inflows of goods and services. So long as exports exceed imports and
financial inflows exceed the outflows the economy generally continues to grow.