Meaning of Managerial Economics
Managerial economics is the study of economic theories, logic and tools of economic analysis that are used in the process of business decision making. Economic theories and techniques of economic analysis are applied in analyze business problems, evaluate business options and opportunities with a view to arriving at an appropriate business decision. Managerial economics is thus constituted of that part of economic knowledge, logic theories and analytical tools that are used for rational business decision making.
Managerial economics is that subject which describes how economic analysis is used in taking business decisions. The purpose of Managerial Economics is to show how economic analysis can be used in formulating business policies.
Managerial economics is that discipline which uses economic concepts, principles and economic analysis in taking business decision and formulating future plans. It integrates economic theory with business practice for choosing business policies. Managerial economics lies on the borderline between economics and business management and bridges the gap between the two.
Definition of Managerial Economics:-
According to McNair and Meriam: “Managerial economics ……. Is the use of economics modes of thought to analyze business situation.”
According to Mansfield: “Managerial economics is concerned with the application of economic concepts and economics analysis to the problems of formulating rational decision making”.
Nature or Characteristics of Managerial Economics:
a) Managerial Economics is a Science: Managerial economics is a science because it establishes relationship between causes and effects. It studies the effects of a change in price of a commodity factors and forces on the demand of a particular product. It also studies the effects and implications of the plans, policies and programmes of a firm on its sales and profit.
b) Managerial Economics is an Art: Managerial economics may also be called an art. Because it also develops the best way of doing things. It helps management in the best and most efficient utilization of limited economic resources of the firm.
c) Managerial Economics is a Micro Economics: Entire study of economics may be divided into two segments – Macro economics and Micro economics. Managerial economics is mainly micro-economics. Micro economics is the study of the behaviour and problems of individual economic unit. In managerial economics unit of study is firm or business organization and an individual industry. It is the problem of business firms such as problem of forecasting demand, cost of production, pricing, profit planning, capital, management etc.
d) Managerial Economics is the Economics of firms: Managerial economics largely use that body of economic concepts and principles which is known as ‘Theory of the Firm’ or ‘Economics of the Firm’.
e) Managerial Economics uses Macro economic Analysis: Managerial economics also uses macro-economics to analysis and understand the general business environment in which the business firm must operate. Business management must have the adequate knowledge of external forces that affect the business of the firm. The important macro-factors that affect the firm are trends in national income and expenditure, business cycle, economic policies of the government, trends in foreign trade etc.
f) Managerial Economics is Pragmatic: It is concerned with practical problems and results. It has nothing to do with abstract economic theory which has no practical application to solve the problems faced by business firms.
g) Managerial Economics is Normative Science: There are two types of science – Normative Science and Positive Science. Positive science studies what is being done. Normative science studies what should be done. From this point of view, it can be concluded that managerial economics is normative science because its suggests what should be done under particular circumstances.
h) Aims at helping the management: Managerial economics aims at supporting the management in taking corrective decisions and charting plans and policies for future.
i) 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
Managerial economics is the application of economics theories in the process of decision making and formulation of future plans. The management will have to analyze the business problems that are faced by the firm. Thus, the principles relating to following topics constitute the scope of subject matter of managerial economics.
1) Demand Analysis: A business firm is in an economic organization which is engaged in transforming productive resources into goods that are to be sold in the market. A major part of managerial decision-making depends on accurate estimates of demand. A forecast of future sales serves as a guide to management for preparing production schedules and employing resources. It will help management to maintain or strengthen its market position and profit base. Demand analysis also identifies a number of other factors influencing the demand for a product. Demand analysis and forecasting occupies a strategic place in Managerial Economics.
2) Cost Analysis: Cost estimates are most useful for management decision. The different factors that cause variations in cost estimates should be given due consideration for planning purpose. There is the element of uncertainty of cost as other factor influencing cost are either uncontrollable or not always known.
3) Pricing Practices and Policies: As price gives income to the firm, it constitutes as the most important field of Managerial Economics. The success of a business firm depends very much on the correctness of the price decision taken by it. The various aspects that are deal under it cover the price determination in various market forms, pricing policies, pricing method, different pricing, productive pricing and price forecasting.
4) Profit Management:- The chief purpose of a business firm is to earn the maximum profit. There is always an element of uncertainty about profits because of variation in cost and revenue. It knowledge about the future were perfect, profit analysis would have been very easy task. But in this world of uncertainty expectations are not always realized. Hence profit planning and its measurement constitute the most difficult area of managerial economics. Under profit management we study nature and management of profit, profit policies and techniques of profit planning like Break Even Analysis.
5) Capital Management:- The problems relating to firm’s capital investments are perhaps the most complex and the troublesome. Capital management implies planning and control of capital expenditure. The main topics deal with under capital management is cost of capital, rate of return and selection of projects.
6) Analysis of Business Environment: The environmental factors influence the working and performance of a business undertaking. Therefore, the managers will have to consider the environmental factors in the process of decision-making. The factors which constitute economic environment of a country include the following factors:
Ø Economic System of the Country.
Ø Business Cycles.
Ø Fluctuations in National Income and National Production.
Ø Industrial Policy of the Government.
Ø Trade and Fiscal Policy of the Government.
Ø Taxation Policy.
Ø Licensing Policy etc.
Ø Political Environment.
Ø Social Factors.
Ø Trend in labour and capital markets.
7) Inventory Management: It refers to stock of raw materials which a firm keeps. If it is high, capital is unproductively tide up which might, if stock of inventory is reduced, be used for other productive purpose . On the other hand, if the level of inventory is low, production will be hampered. Hence, managerial economics with methods such as ABC analysis a simple simulation exercise and some mathematical models with a view to minimize inventory cost.
8) Advertising: Managerial economics helps in determining the total advertising cost and budget, the measuring of economic effects of advertising and form an integral part of decision making and forward planning.
9) Resource Allocation: Managerial economics with the help of advanced tools such as linear programming are used to arrive at the best course of action for the maximum use of the available resources and its substitutes.
10) Risk and Uncertainty Analysis: As business firm have to operate under conditions of risk and uncertainty both decision making and forward planning becomes difficult. Hence managerial economics helps the business firm in decision making and formulating plans on the basis of past data, current information and future prediction.
Significance of Managerial Economics in Managerial Decision Making
The most important function of management of a business firms is decision making and future planning. Business decision-making is essentially a process of selecting the best out of alternative opportunities open to the firm. The process of decision-making comprises following phases:-
a) Determining and defining the objective to be achieved.
b) Developing and analyzing possible course of action; and
c) Selecting a particular course of action.
Economic analysis helps the management in following ways:
1) Reconciling, Theoretical Concepts of economics to the Actual Business Behaviour and Conditions: Managerial economics attempts to reconcile the tools, techniques, models and theories of economics with actual business practices and with the environment in which a firm has to operate. Analytical techniques of economic theory builds models by which we arrive at certain assumptions and conclusions are reached thereon in relation to certain firms. There is need to reconcile the theoretical principles based on simplified assumptions with actual business practice and develop the economic theory, if necessary.
2) Estimating Economic Relationship:- Managerial economics plays an important role in business planning and decision making by estimating economic relationship between different business factors – income, elasticity of demand like price elasticity, income elasticity, cross elasticity and cost volume profit analysis etc. The estimates of this economic relationship can be used for purpose of business forecasts.
3) Predicting Relevant Economic Quantities:- Sound business plans and policies for future can be formulated on the basis of economic quantities. Managerial economics helps the management in predicting various economic quantities such as:
Ø Price etc.
Since a business manager has to work in an environment of uncertainty, future should be well predicted in the light of these quantities.
4) Understanding Significant External Forces:- The management has to identify all the important factors that influence firm. These factors broadly divided into two parts – Internal Factors and External Factors. External factors are the factors over which a firm cannot have any control. Therefore, the plans, policies and programmes of the firm should be adjusted in the light of these factors. Important external factors affecting decision-making process of a firm are:
Ø Economic System of the Country.
Ø Business Cycles.
Ø Fluctuations in National Income and National Production.
Ø Industrial Policy of the Government.
Ø Trade and Fiscal Policy of the Government.
Ø Taxation Policy.
Ø Licensing Policy etc.
Managerial economics plays an important role by assisting management in understanding these factors.
5) Basis of Business Policies:- Managerial economics is the foundation of all business policies. All the business policies are prepared on the basis of studies and findings of managerial economics. It warns the management against all the turning points in national as well as international economy.
6) Clear Understanding of Economic Concepts:- It gives clear understanding of various economic concepts (i.e. cost, price, demand etc.) used in business analysis. For example, the concept of cost includes ‘total’ ‘average’, ‘managerial’, ‘fixed’, ‘variable’, ‘actual cost’, and opportunity cost. Economics clarifies which cost concepts are relevant and in what context.
7) Increases the Analytical Capabilities:- Managerial Economics provides a number of tools and methods which increases the analytical capabilities of the business analysis.
Basic Problems of an economic system or Problems of business economics
The problem of scarcity of resources which arises before an individual consumer also arises collectively before an economy. On account of this problem and economy has to choose between the following:
(i) Which goods should be produced and in how much quantity?
(ii) What technique should be adopted for production?
(iii) For whom goods should be produced?
These three problems are known as the central problems or the basic problems of an economy. This is so because all other economic problems cluster around these problems. These problems arise in all economics whether it is a socialist economy like that of North Korea or a capitalist economy like that of America or a mixed economy like that of India. Similarly, they arise in developed and under-developed economics alike.
There are two aspects of this problem— firstlywhich goods should be produced, and secondlywhat should be the quantities of the goods that are to be produced. The first problem relates to the goods which are to be produced. In other words, what goods should be produced? An economy wants many things but all these cannot be produced with the available resources. Therefore, an economy has to choose what goods should be produced and what goods should not be. In other words, whether consumer goods should be produced or producer goods or whether general goods should be produced or capital goods or whether civil goods should be produced or defense goods. The second problem is what should be the quantities of the goods that are to be produced.
The second basic problem is which technique should be used for the production of given commodities. This problem arises because there are various techniques available for the production of a commodity such as, for the production of wheat, we may use either more of labour and less of capital or less of labour or more of capital. With the help of both these techniques, we can produce equal amount of wheat. Such possibilities exist relating to the production of other commodities also.
Therefore, every economy faces the problem as to how resources should be combined for the production of a given commodity. The goods would be produced employing those methods and techniques, whereby the output may be the maximum and cost of production be the minimum.
The main objective of producing a commodity in a country is its consumption by the people of the country. However, even after employing all the resources of a country, it is not possible to produce all the commodities which are required by the people. Therefore, an economy has to decide as to for whom goods should be produced. This problem is the problem of distribution of produced goods and services. Therefore, what goods should be consumed and by whom depends on how national product is distributed among various people.
All the three central problems arise because resources are scarce. Had resources been unlimited, these problems would not have arisen. For example, in the event of resources being unlimited, we could have produced each and every thing we had wanted, we could have used any technique and we could have produced for each and everybody
An economy has to face the problem of efficiently using its resources. Production can be increased even by improving the use of resources. Resources will be deemed to be better utilised when by reallocating them in various uses, production of a commodity can be increased without adversely affecting the production of other commodities.
In many economies, especially in developing economies, there is a tendency towards under-utilisation of resources. Resources lying idle or not being utilised fully is a recurring problem in many economies. This problem is particularly acute in labour-abundant economies like that of India where large scale unemployment exists. In many economies, a vital resource like land too remains under-utilised. Resources being relatively scarce, they should not be allowed to remain idle as it is a waste.
: The last problem is of growth. Every economy strives to increase its production for increasing standards of living of its people. Economic growth of a country depends upon the fact as to what extent; it can increase its resources. This problem is not confined to developing economies alone. It is also faced by developed economies which strive for increasing their resources in order to increase the material comforts of their technically advanced societies
Managerial Economics and Traditional Economics:
In the words of Haynes “The relation of managerial economics to economic theory is much like that of engineering to physics, or of medicine to biology or bacteriology. It is the relation of an applied field to the more fundamental but more abstract basic discipline from which it borrows concepts and analytical tools. The fundamental theoretical fields will no doubt on the long run make the greater contribution to the extension of human knowledge. But the applied fields involve the development of skills that are worthy of respect in themselves and that require specialized training. The practicing physician may not contribute much to the advance of biological theory but he plays an essential role in producing the fruits of progress in theory. The managerial economist stands in a similar relation to theory with perhaps the difference that the dichotomy between the pure and the “applied” is less clear in management than it is in medicine.”
Managerial economics has been defined as economics applied in decision-making. It is a special branch of economics bridging the gap between economic theory and managerial practice. The relationship between managerial economics and traditional economics is facilitated by considering the structure of traditional study. The traditional fields of economic study about theory, Micro economics focuses on individual consumers firms and industries. Macro economics focuses on aggregations of economics units, especially national economics. The emphasis on normative economics focuses on prescriptive statements that are established rules on the specified field. Positive economics focuses on description that describes that manner in which economics forces operate without attempting to state how they should operate. The focus of each field of study is sufficiently well defined to warrant the breakdown suggested.
Since each area of economics has some bearing on managerial decision making, managerial economics draws from them all. In practice, some are more relevant to the business firm that others and hence to managerial economics. Both micro-economics and macro-economics are important in managerial economics but the micro economic theory of the firm is especially significant. The theory of firm is the single most important element in managerial economics. However, because the individual firm is influenced by the general economy, that is domain of macro economics. Managerial economics is certainly on normative theory. We want to establish decision rules that will help managers attain the goals of their firm, agency or organization; this is the essence of the word normative. If managers are to establish valid decision rules, however, they must thoroughly know the environment in which they operate for this reason positive or descriptive economics is important.
Surveys conducted in various countries showed that business economists have found economic concepts such as price elasticity of demand, income elasticity of demand, opportunity casts, the multiplier, propensity to consume, marginal revenue products,. Speculative motive, production function, balanced growth, liquidity preference etc., quite useful and of frequent application. They have also found the following main areas of economics as useful in their works:
1. Demand theory
2. Theory of the firm-price and output
3. Business financing
4. Public Finance and Fiscal Policy
5. Money and banking
6. National income and Social accounting
7. Theory of international trade, and
8. Economics of developing countries.
Difference between Managerial Economics and Traditional Economics:
The difference between managerial economics and economics can be understood with the help of the following points:
1. Managerial economics involves application of economic principles to the problems of a business firm whereas; economics deals with the study of these principles only. Economics ignores the application of economic principles to the problems of a business firm.
2. Managerial economics is micro-economic in character; however, Economics is both macro-economic and micro-economic.
3. Managerial economics, though micro in character, deals only with a firm and has nothing to do with an individual’s economic problems. But microeconomics as a branch of economics deals with both economics of the individual as well as economics of a firm.
4. Economics is both positive and normative science but the Managerial Economics is essentially normative in nature.
5. Economics deals mainly with the theoretical aspect only whereas Managerial Economics deals with the practical aspect.
6. Managerial Economics studies the activities of an individual firm or unit. Its analysis of problems is micro in nature, whereas Economics analyzes problems both from micro and macro point of views.
7. Under Economics we study only the economic aspect of the problems but under Managerial Economics we have to study both the economic and non-economic aspects of the problems.
8. Economics studies principles underlying rent, wages, interest and profits but in Managerial Economics we study mainly the principles of profit only.
9. Sound decision-making in Managerial Economics is considered to be the most important task for the improvement of efficiency of the business firm; but in Economics it is not so.
10. The scope of Managerial Economics is limited and not as wide as that of Economics. Thus, it is obvious that Managerial Economics is very closely related to Economics but its scope is narrow as compared to Economics.
11. Under microeconomics, the distribution theories, viz., wages, interest and profit, are also dealt with. Managerial economics on the contrary is mainly concerned with profit theory and does not consider other distribution theories.
12. Economics involves the study of certain assumptions like in the law of proportion where it is assumed that “The variable input as applied, unit by unit is homogeneous or identical in amount and quality”. Managerial economics on the other hand, introduces certain feedbacks. These feedbacks are in the form of objectives of the firm, multi-product nature of manufacture, behavioral constraints, environmental aspects, legal constraints, constraints on resource availability, etc.
Thus managerial economics, attempts to solve the complexities in real life, which are assumed in economics. this is done with the help of mathematics, statistics, econometrics, accounting, operations research, etc.
Price mechanism refers to the system where the forces of demand and supply determine the prices of commodities and the changes therein. It is the buyers and sellers who actually determine the price of a commodity. Price mechanism is the outcome of the free play of market forces of demand and supply. However, sometimes the government controls the price mechanism to make commodities affordable for the poor people too. For example, the Government of India recently passed an order to decontrol the prices of diesel and remove it from the jurisdiction of the government. Now the prices will be determined by the demand from consumers and supply from the oil companies.
Role of price mechanism:
The price mechanism solves the problem of allocation of resources which is associated with what ,how and for whom to produce.
1. What to produce?
In a free market economy, producers are guided by profit motive. When price of a commodity increases with the increase in demand, the profits increase and this would encourage the production of this commodity. Producers would shift resources from the production of other commodities to this commodity. Therefore, the price mechanism would automatically solve the problem what to produce.
2. How to produce?
It is the question of choice of production technique. There are generally two techniques of production available:
a) Labour-intensive technique (in which more of labour is used than capital)
b) Capital-intensive technique (in which more of capital is used than labour)
If capital is available at a lower rate, firms adopt capital-intensive technique of production. If labour is available at lower rate, firms adopt labour intensive techniques. Therefore, it is the price of labour or the price of capital that will help the producer in deciding whether they should choose capital intensive or labour intensive technique.
3. For whom to produce?
In a market economy, the producers must produce for those who have the ability and willingness to pay the highest price. The income of the consumers determines the ability to pay ie; there is a direct relationship between income and consumption pattern. Hence, both the ability and willingness to pay determines who gets the available commodities.
4. Fuller Utilization of the factors
It is through price-mechanism that fuller utilization of the factors is attained in a capitalist economy .Volume of full employment depends upon the volume of production which in its turn, depends upon the level of investment. Amount of investment depends upon saving. Equality between saving and investment is brought about by change in price of capital ie; rate of interest. If at any given time, total savings are large and condition of unemployment prevails in the economy ,the rate of interest will fall. Due to fall in the rate of interest there will be increase in investment. Increase in investment will result into increase in production and the condition of less than fuller utilization of the factors will become possible. Classical economists were of the view that under condition of less than full employment of labour, price of labour, i.e; wage will fall. Fall in wage rate will stimulate demand and condition of full employment of labour will be achieved . In this way, price mechanism will help to achieve fuller utilization of the factors.
Shortcomings of Price mechanism
(1) Imperfection of completion: the working of the price mechanism assumes the existence of perfect completion in the economic system. But in practice, perfect completion does not exist; instead monopolistic forces prevail in many industries. These reduce supply and raise prices which are against the interests of the consumers.
(2) Loss of consumer’s sovereignty: it is stated that under market mechanism the consumers enjoyed complete freedom in choice of goods and services. Producers produced those goods and services that are demanded by the consumers. But in the real world consumer’s sovereignty is limited. For instance the demand of consumer is influenced by advertisement, personal selling social customs etc. Further there is in inequality of incomes among people and consequently the market demand but only the demand of well to do consumers.
(3) Elimination of completion: price mechanism is to encourage completion. But according to critics it is price mechanism itself that accounts for the elimination completion. In their desire of profit, competing firms attempt to eliminate is rightly said that “Monopoly is the mechanism of completion and at the same time its logical conclusion.” It is the negation of all the values for which market mechanism stands.
(4) Unequal Distribution of Income: the price mechanism through completion brings huge profits to big producers, the landlords, the entrepreneurs and the traders who accumulate vast amount of wealth and luxury the poor live in poverty and squalor.
(5) Non-utilization if resources: the price mechanism fails to employ the country’s resources fully. Free and cut throat competition, inequalities of income distribution over production and consequent depression lead to wastage also, as frivolous luxury goods are produced poor. Similarly natural resources are exploited for the short-run effect on the economy, for example soil erosion occurs when forests of timber are cut down by greedy contractors.
(6) Ignores social goods: price mechanism mainly takes into account individual wants but does not provide for social goods and social overheads like education, health, care, transport & communication services. These goods and services needed for the overall economic growth of the system may not be provided/produced by private individuals. This is because in such industries, huge investments are required; having there is a need for some intervention from some entity to overcome this limitation of the price mechanism.
(7) Ignores social cost: While determining his cost of production the producers include only the private cost of production (the price paid to factors of production and other inputs). He fails to include the social costs (e.g. air, water, and noise pollution) on his production process. Since social costs are not included in the market price, the producer produces an output which is larger than desirable.
The above shortcoming of price mechanism have led the free enterprise economics of West to modify the capital system by regulating and controlling the institutions of private property and freedom of enterprise to serve the best interests of the community at large.