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 Cost.
Ø Profit.
Ø Demand.
Ø Capital.
Ø Production.
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.
1. What to produce?
There are two aspects of this problem— firstly, which
goods should be produced, and secondly, what 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.
2. How to produce?
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.
3. For whom to produce?
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.
4. The problem of efficient use of resources: 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.
5. The problem of fuller
employment of resources: 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.
6. The Problem of Growth: 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:
Relationship
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
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.
