Meaning of Managerial Economics: It is another branch in the science of economics.

Sometimes it is interchangeably used with business economics. Managerial economics is

concerned with decision making at the level of firm. It has been described as an
economics applied to decision making. It is viewed as a special branch of economics
bridging the gap between pure economic theory and managerial practices. It is defined as
application of economic theory and methodology to decision making process by the
management of the business firms. In it, economic theories and concepts are used to solve
practical business problem. It lies on the borderline of economic and management. It
helps in decision making under uncertainty and improves effectiveness of the
organization. The basic purpose of managerial economic is to show how economic
analysis can be used in formulating business plans. Definitions of Managerial Economics: In the
words of Mc Nair and Merriam,” ME
consist of use of economic modes of thought to analyse business situation”. According to
Spencer and Seigel man it is defined as the integration of economic theory with business
practice for the purpose of facilitating decision making and forward planning by the
management”. Economic provides optimum utilization of scarce resource to achieve the 10
desired result. ME’s purpose is to show how economic analysis can be used formulating
business planning. Managerial Economics = Management + Economics
Management deals with principles which helps in decision making under uncertainty and
improves effectiveness of the organization. On the other hand, economics provides a set of
preposition for optimum allocation of scarce resources to achieve a desired result.
Managerial Economics deals with the integration of economic theory with business
practices for the purpose of facilitating decision making and forward planning by
management. In other words it is concerned with using of logic of economics,
mathematics, and statistics to provide effective ways of thinking about business decision
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1.2 CONCEPT OF ECONOMICS IN DECISION MAKING
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Students, earlier we had discussed various aspects of economics- scarcity and efficiency
and meaning and role of managerial economics. Now we will be discussing the various
aspects of decision making. What do you mean by Decision Making?
Well decision making is not something which is related to managers only or which is
related to corporate world, but it is something which is related to everybody’s life.
Whether a person is working or non-working, irrespective of his/her field, decision
making is important to everyone. You need to make decision irrespective of the work you
are doing. As a student also, you have to take so many decisions. Suppose at a particular
point of time you want to go for a movie, and at the same point of you want to go for
shopping then what you will do. You can’t do two things at the same point of time. You
have to decide what to do first and what to do next. Therefore, decision making can be
called as choosing the right option from the given one. To decide is to choose. Whether to
do this or to do that is what is decision making.
Decision making is the most important function of business managers. Decision making
is the central objective of Managerial Economics. Decision making may be defined as the
process of selecting the suitable action from among several alternative courses of action.
The problem of decision making arises whenever a number of alternatives are available.
Such as:
• What should be the price of the product?
• What should be the size of the plant to be installed?
• How many workers should be employed?
• What kind of training should be imparted to them?
• What is the optimal level of inventories of finished products, raw material, spare
parts, etc.?
Therefore we can say that the problem of decision making arises due to the scarcity of
resources. We have unlimited wants and the means to satisfy those wants are limited,
with the satisfaction of one want, another arises, and here arises the problem of decision
making. While performing his function manager has to take a lot of decisions in
conformity with the goal of the firm. Most of the decisions are taken under the condition
of uncertainty, and involves risks. The main reasons behind uncertainty and risks are
uncertain behaviour of the market forces which are as follows:
• The demand and supply
• Changing business environment
• Government policies
• External influence on the domestic market
• Social and political changes
• The maximum use of limited resources.
Now we will discuss various aspects relating to the management decision making o
Managerial Decision Making.
• What Is Management?
Management is the process of coordinating people and other resources to
achieve the goals of the organization
.Most organizations use various kinds of resources.
• Basic Management Functions
A number of management functions must be performed if any organization is to
succeed.
Establishing Goals and Objectives.
Establishing Plans to Accomplish Goals and Objectives.
Organizing the Enterprise. Leading and Motivating
Controlling Ongoing Activities.
• Kinds of Managers
They can be classified along two dimensions:
Level within the organization which include: Top managers; Middle
Managers; First Line Managers.
Area of management which include: Financial Managers; Operation
Managers; Marketing Managers; Human Resources Managers
Administrative Managers.
• What Makes Effective Managers?
Key Management Skills. The skills that typify effective managers tend to fall into
three categories.
Technical Skills
Conceptual Skills.
Interpersonal Skills.
Managerial Roles.
Decisional Roles
Interpersonal Roles
Informational Roles.
• Managerial Decision Making
Decision-making is the act of choosing one alternative from among a set of
alternatives. Managerial decision making involves four steps.
Identifying the Problem or Opportunity
Generating Alternatives.
Selecting an Alternative
Implementing and Evaluating the Solution
ow we will discuss the various factors affecting decision making.
• Conditions Affecting Decision Making: An Ideal Business situation would be
the one where
Full Information with managers to make decisions with certainty
An Actual business situation with managers:
Most business are characterized by incomplete or ambiguous information
• Conditions that affect decision making: (certainty, risk and uncertainty)
Certainty: Situation when decision makers are fully informed about A
problem; Alternative solutions; their respective outcomes; Individuals can
anticipate, and even exercise some control over events and their outcomes.
Risk: Condition when decision makers rely on incomplete, yet reliable
information. Manager does not know the certainty the future outcomes
associated with alternative courses of action, although he knows the
probability associated with each alternative
Uncertainty: It is the condition that exists when little or no factual
information is available about a problem, its alternative and their respective
outcomes. He does not have enough information to determine the probabilities
associated with each alternative possible that he may be unable even to define
the problem
open you all must be clear with the concepts certainty, risk and uncertainty. Now, we
ill discuss various models of decision making. Decision Making Models
• The Classical Model:
Also called rational model
A prescriptive approach that outlines how managers should make decisions.
Assumptions: Manager has complete information about decision situation and
operations under condition of certainty; Problem is clearly defined, and the
decision – maker has knowledge of all possible alternatives and their
outcomes; Through the use of quantitative techniques, rationality and logic,
13
the decision maker evaluates the alternatives and selects the optimum
alternative .
• The Administrative Model
Descriptive approach that outlines how managers actually do make
decisions
Also called organizational, neoclassical or behavioural model
Simon recognized that people do not always make decisions with logic
and rationality , he introduced two concepts- bounded rationality and
satisfying Bounded rationality: Means people have limits, or
boundaries , to their rationality boundaries exist because people are
bound by their own values and skills, incomplete information, own
inability due to time , resource and rational decisions lack of time to
process complete information about complex decisions , wind up
having to make decisions with only partial knowledge about
alternative solutions and their outcomes. This leads manager often forgo the various steps of decision
making in favour of a quicker yet satisfying, process satisfying
Assumptions: Manager has incomplete information and operate under
condition of risk or uncertainty; Problem not clearly defined, manager
has limited knowledge of possible alternatives and their outcomes;
Satisfies by choosing the first satisfactory alternative – one that will
resolve the problem situation by offering a good solution to the
problem
Managerial economics is concerned with decision making at the firm level. Decision
making problems faced by business firms:
• To identify the alternative courses of action of achieving given objectives.
• To select the course of action that achieves the objectives in the economically
most efficient way.
• To implement the selected course of action in a right way to achieve the business
objectives.
The prime function of management is Decision making and forward planning. Forward
planning goes hand in hand with decision making. Forward planning means establishing
plans for the future.
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1.3 SCOPE OF MANAGERIAL ECONOMICS
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Can you tell me what you mean by the scope of the managerial economics? Well scope is
something which tells us how far a particular subject will go. As far as Managerial
Economic is concerned it is very wide in scope. It takes into account almost all the
problems and areas of manager and the firm. Managerial economics 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 managerial economics:
• 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 analysing 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.
• Production Function: Conversion of inputs into outputs is known as production
function. With limited resources we have to make the alternative use 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.
• 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.
• 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
ideal 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.
• Advertising: Advertising is a promotional activity. In advertising while the copy,
illustrations, etc., are the responsibility of those who get it ready for the press, the
problem of cost, the methods of determining the total advertisement 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
should reach the consumer before he thinks to buy it. Advertising forms the
integral part of decision making and forward planning.
• 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. Pricing equals
cost plus pricing and the policies of the enterprise. Now it is clear that the price
system touches the several aspects of managerial economics and helps managers
to take valid and profitable decisions.
• Resource allocation: Resources are allocated according to the needs only to
achieve the level of optimization. As we all know that we have scarce resources,
and unlimited needs. We have to make the alternate use of the available resources.
For the allocation of the resources various advanced tools such as linear
programming is used to arrive at the best course of action. Nature of Managerial Economics:
Managerial economics aims at providing help in
decision making by firms. It is heavily dependent on microeconomic theory. The various
concepts of micro economics used frequently in managerial economics include
Elasticity of demand; Marginal cost; Marginal revenue and Market structures and their
significance in pricing policies. Macro economy is used to identify the level of demand at
some future point in time, based on the relationship between the level of national income
and the demand for a particular product. It is the level of national income only that the
level of various products depends. In managerial economics macroeconomics indicates
the relationship between (a) the magnitude of investment and the level of national
income, (b) the level of national income and the level of employment, (c) the level of
consumption and the level of national income. In managerial economics emphasis is laid
on those prepositions which are likely to be useful to management.
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1.4 RELATIONSHIP BETWEEN MANAGERIAL ECONOMICS AND
OTHER SUBJECTS
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After studying the above you will be able to distinguish managerial economics with its
related subjects. Managerial economic is not something which is related to economics
only, but there are other areas also to which managerial economic is related. Other related
subjects of managerial economics are:
• Economics
• Mathematics
• Statistics
• Accounting
• Operation Research
• Computers
• Management
Before knowing the relationship between managerial economics and other related fields it
is customary to divide economics into “positive” and “normative” economics.
Economists make a distinction between positive and normative that closely parallels
popper’s line of demarcation. Positive Economics: It deals with description and explanation of
economic behaviour,
Economics and Managerial economics. Managerial economics draws on positive
economics by utilizing the relevant theories as a basis for prescribing choices. A positive
statement is a statement about what is and which contains no indication of approval or
disapproval. It’s not like that positive statement is always right, positive statement can be
wrong. Positive statement is a statement about what exists. Normative Economics: It is concerned
with prescription or what ought to be done. In
normative economics, it is inevitable that value judgment is made as to what should and
what should not be done. Managerial economics is a part of normative economics as its
focus is more on prescribing choice and action and less on explaining what has happened.
It expresses a judgment about whether a situation is desirable or undesirable. The primary
task of Managerial economics is to fit relevant data to this framework of logical analysis
so as to reach valid conclusion as a basis for action. Another branch of economics which
is normative like managerial is public policies analysis which is concerned with the
problems of managing the government of a country. Economic and Managerial Economics:
Economics contributes a great deal towards the
performance of managerial duties and responsibilities. Just as the biology contributes to
the medical profession and physics to engineering, economics contributes to the
managerial profession. All other qualifications being same, managers with working
knowledge of economics can perform their function more efficiently than those without
it. What is the Basic Function of the Managers of the Business?
As you all know that the basic function of the manager of the firm is to achieve the
organizational objectives to the maximum possible extent with the limited resources
placed at their disposal. Economics contributes a lot to the managerial economics. Mathematics and
Managerial Economics: Mathematics in Managerial Economics has
an important role to play. Businessmen deal primarily with concepts that are essentially
quantitative in nature e.g. demand, price, cost, wages etc. The use of mathematical logic
in the analysis of economic variable provides not only clarity of concepts but also a
logical and systematically framework. Statistics and Managerial Economics: Statistical tools are a
great aid in business
decision making. Statistical techniques are used in collecting processing and analysing
business data, testing and validity of economics laws with the real economic phenomenon
before they are applied to business analysis. The statistical tools for e.g. theory of
probability, forecasting techniques, and regression analysis help the decision makers in
predicting the future course of economic events and probable outcome of their business
decision. Statistics is important to managerial economics in several ways. Managerial
Economics calls for marshalling of quantitative data and reaching useful measures of
appropriate relationship involves in decision making. Let me explain it through an
example: In order to base its price decision on demand and cost consideration, a firm
should have statistically derived or calculated demand and cost function. Operation Research and
Managerial Economics: It’s an inter-disciplinary solution
finding techniques. It combines economics, mathematics, and statistics to build models
for solving specific business problems. Linear programming and goal programming are
two widely used Operational Research in business decision making. It has influenced
Managerial Economics through its new concepts and model for dealing with risks.
Though economic theory has always recognized these factors to decision making in the
real world, the frame work for taking them into account in the context of actual problem
has been operationalized. The significant relationship between Managerial Economics
and Operational Research can be highlighted with reference to certain important
problems of Managerial Economics which are solved with the help of Operational
Research techniques, like allocation problem, competitive problem, waiting line problem,
and inventory problem. Management Theory and Managerial Economics: As the definition of
management
says that it’s an art of getting things done through others. Bet now a day we can define
management as doing right things, at the right time, with the help of right people so that
organizational goals can be achieved. Management theory helps a lot in making
decisions. ME has also been influenced by the developments in the management theory.
The central concept in the theory of firm in micro economic is the maximization of
profits. ME should take note of changes concepts of managerial principles, concepts, and
changing view of enterprises goals. Accounting and Managerial Economics: There exists a very close
link between
Managerial Economics and the concepts and practices of accounting. Accounting data
and statement constitute the language of business. Gone are the days when accounting
was treated as just bookkeeping. Now it’s far more behind bookkeeping. Cost and
revenue information and their classification are influenced considerably by the
accounting profession. As a student of MBA, you should be familiar with generation,
interpretation, and use of accounting data. The focus of accounting within the enterprise
is fast changing from the concept of bookkeeping to that of managerial decision making.
Mathematics is closely related to Managerial Economics, certain mathematical tools such
as logarithm and exponential, vectors, determinants and matrix algebra and calculus etc. Computers
and Managerial Economics: You all know that today’s age is known as
computer age. Every one of us is totally dependent on computers. These computers have
affected each one of us in every field. Managers also have to depend on computers for
decision making. Computer helps a lot in decision making. Through computers data
which are presented in such a nice manner that it’s really very easy to take decisions.
There are so many sites which help us in giving knowledge of various things, and in a
way helps us in updating our knowledge. Conclusions: Managerial Economics is closely related to
various subjects i.e.
Economics, mathematics, statistics, and accountings. Computers etc. a trained managerial
economist integrates concepts and methods from all these subjects bringing them to bear
on business problem of a firm. In particular all these subjects are getting closed to
Managerial Economics and there appears to be trends towards their integration.
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1.5 TOOLS AND TECHNIQUES IN DECISION MAKING
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After understanding the above you now will be able to know the various tools and
techniques of decision making. How these tools and technique are useful for managers in
making the right decision. But before knowing the tools and technique of decision
making can you answer some of my questions:
• Is decision making a process?
• Are there any particular steps required for decision making?
• Is decision making depends on the condition or situations?
• What are the various conditions affecting decision making? Factors Influencing Managerial
Decision: Now it’s clear that managerial decision
making is influenced not only by economics but also by several other significant
considerations. While economic analysis contributes a great deal to problem solving in an
enterprise it is important to remember that three other variables also influences the
choices and decision made by the managers. These are as follows:
• Human and behavioural considerations
• Technological forces
• Environmental factors. Steps in Decision Making: There are certain things which are to be taken
into account
while making decisions. No matter what’s the size of the problem but like everything
decision making should also be in certain steps. Following are the various steps in
decision making:
• Establish objectives
• Specify the decision problem
• Identify the alternatives
• Evaluate alternatives
• Select the best alternatives
• Implement the decision
• Monitor the performance
Business decision making is essentially a process of selecting the best out of alternative
opportunities open to the firm. The above steps put manager’s analytical ability to test
and determine the appropriateness and validity of decisions in the modern business
world. Modern business conditions are changing so fast and becoming so competitive and
complex that personal business sense, intuition and experience alone are not sufficient to
make appropriate business decisions. It is in this area of decision making that economic
theories and tools of economic analysis contribute a great deal. Basic Economic Tools in Managerial
economics for Decision Making: Economic
theory offers a variety of concepts and analytical tools which can be of considerable
assistance to the managers in his decision-making practice. These tools are helpful for
managers in solving their business-related problems. These tools are taken as guide in
making decision. Following are the basic economic tools for decision making:
• Opportunity cost principle;
• Incremental principle;
• Principle of the time perspective;
• Discounting principle;
• Equimarginal principle.
Opportunity Cost Principle: OC of a decision is the sacrifice of alternatives required by
that decision; OC represents the benefits or revenue forgone by pursuing one course of
action rather than another; OC are not recorded in the accounting records of the firm, but
have to be met if the firm aims at optimization. OC is always higher to Accounting Costs
Whenever a manager takes or makes a decision, he chooses one course of action,
sacrificing the other alternatives. We can evaluate the one chosen in terms of the other
(next best) which is sacrificed. All decisions which involve choice must involve
opportunity cost principle. OC may be either real or monetary, either implicit or explicit,
either non-quantifiable or quantifiable. Decisions involving opportunity cost includes;
Make or buy; Breakdown or preventive maintenance of machines; Replacement or new
investment decision; direct recruitment from outside or Departmental promotion.
Accountant never considers opportunity cost, he considers only explicit costs
.Accounting Profit = revenue-recorded costs. Economic profit=revenue – (explicit
+implicit costs) i.e. Economic profit= Accounting profit-opportunity costs. For optimal
allocation of scarce resources the manager should consider the opportunity costs of using
resources, human or non-human, in a given activity; Decision principle should be
minimization of opportunity costs, given objectives and constraints. By the opportunity
cost of a decision is meant the sacrifice of alternatives required by that decision. For e.g.
• The opportunity cost of the funds employed in one’s own business is the interest
that could be earned on those funds if they have been employed in other ventures.
• The opportunity cost of using a machine to produce one product is the earnings
forgone which would have been possible from other products.
• The opportunity cost of holding Rs. 1000as cash in hand for one year is the 10%
rate of interest, which would have been earned had the money been kept as fixed
deposit in bank.
It’s clear now that opportunity cost requires ascertainment of sacrifices. If a decision
involves no sacrifices, its opportunity cost is nil. For decision making opportunity costs
are the only relevant costs. Incremental Principle: It is related to the marginal cost and marginal
revenues, for
economic theory. Incremental concept involves estimating the impact of decision
alternatives on costs and revenue, emphasizing the changes in total cost and total revenue
resulting from changes in prices, products, procedures, investments or whatever may be
at stake in the decisions. The two basic components of incremental reasoning are
• Incremental cost
• Incremental Revenue
The incremental principle may be stated as under: “A decision is obviously a profitable
one if:
• It increases revenue more than costs
• It decreases some costs to a greater extent than it increases others
• It increases some revenues more than it decreases others and
• It reduces cost more than revenues”
Principle of Time Perspective: Managerial economists are also concerned with the short
run and the long run effects of decisions on revenues as well as costs. The very important
problem in decision making is to maintain the right balance between the long run and
short run considerations. Decision making is the task of co-coordinating along the time
scale- past, present and future. Whenever a manager confronts a decision environment, he
must analyse the present problem with reference to the past data of facts, figures and
observation in order to arrive at a decision, contemplating clearly its future implications
in terms of actions and reactions likely thereupon. Thus, time dimension is very
important. Economist consider time in terms of concepts like: Temporary run: the
supply of output; Fixed short run: supply can be changed slightly by altering the factor
proportion (all factors are not variable) Long run: All factors are variables, output level
can be adjusted freely. There exist constraints in temporary and short run, but none in
long run for a manager, Short run is the (present) period and long run is the future
(remote) period. Manager must calculate the opportunity cost if they have to choose
between the present and future. His decision principle must take care of both time
periods. He cannot afford to have a time period which is too short Example:
• He may set a high price for his product today but then he should be prepared to
face the declining sales
• Today the advertisement cost might inflate the prices but tomorrow it may
increase the revenue flow.
• Management may ignore labour welfare today to reduce costs but in future this
may deteriorate industrial relation climate with adverse effect on productivity and
profitability
It is important for a manager to take a short and a long view of his decision. For example,
suppose there is a firm with a temporary idle capacity. An order for 5000 units comes to
management’s attention. The customer is willing to pay Rs 4/- unit or Rs.20000/- for the
whole lot but not more. The short run incremental cost (ignoring the fixed cost) is only
Rs.3/-. Therefore, the contribution to overhead and profit is Rs.1/- per unit (Rs.5000/- for
the lot) Analysis: From the above example the following long run repercussion of the order is to
be taken into account: If the management commits itself with too much of business at
lower price or with a small contribution it will not have sufficient capacity to take up
business with higher contribution. If the other customers come to know about this low
price, they may demand a similar low price. Such customers may complain of being
treated unfairly and feel discriminated against. In the above example it is therefore
important to give due consideration to the time perspectives. “a decision should take into
account both the short run and long run effects on revenues and costs and maintain the
right balance between long run and short run perspective”. Discounting Principle: Discounting is both
a concept as well as technique borrowed
from accountancy. For explanation readopt the opportunity and time perspective.
Consider the case of the seller. The seller has to decide between the immediate cash
payment of Rs. 1000 by his customer and the future payment of say Rs. 1100 at the end
of one year from now.
• Human nature is such that there is time preference for present
• For the seller it is better to get Rs 1000 now and keep it in bank at 10 % rate
interest and realize Rs 1100 thereby.
• Should we say that the present value of future sum of Rs.1100 is just Rs. 1000?
• How have we arrived at this?
• A1= P+ rP , or P= A1 /(1+r)
• Second Year , P= A2 /(1+r)2
• If an investment of a sum yields a series of return Ai through in period; in=1n , the
in order to calculate its present value, we need to discount ∑ AI with the help
(1+r)I P =∑ Ai/ (1+r)I
• Longer the period, larger the discount factor, (1+r) I exceeds. Heavy discounting
for the distant period makes sense because future is uncertain; distant future
involves incalculable risk.
• Discounting enables risk hedging, particularly in context of investment decision
where the return on investment is spread over a number of years in future
• Present value of future return can be estimated by discounting it with the
opportunity costs of the safe rate of interest.
• Principle also has applications other than investments wages are equal to t
discounted value of the marginal productivity of labour”
Thus one of the fundamental ideas in Economics is that a rupee tomorrow is worth less
than a rupee today. Marginal Principle: Due to scarce resources at the disposable, the manager has to
be
careful of spending each and every additional unit of resources. In order to decide
whether to use an additional man hour or machine hour or not you need to know t
additional output expected from there. A decision about additional investment has to be
viewed in terms of additional returns from the investment. Economists use the wo
“Marginal” for additional magnitudes of production or return. Economist often use the
terms like
• Marginal output of labour
• Marginal output of machine
• Marginal return on investment
• Marginal revenue of output sold
• Marginal cost of production
• Marginal utility of consumption