1 – Introduction to Managerial Economics

Introduction

In the dynamic landscape of business, the application of well-established principles is paramount to achieving profitability and sustained growth. One such indispensable tool is Managerial Economics. This field seamlessly combines economic theory with managerial practice, offering a bridge between analytical economic problems and the day-to-day decisions that shape the destiny of businesses.

1.1 Managerial Economics: Meaning and Definition

Managerial Economics is the strategic fusion of economic concepts and analysis tailored to the challenges of organisational decision-making. Mansfield quotes it as being “concerned with the application of economic concepts and economic analysis to the problems of formulating rational managerial decisions.” This interdisciplinary approach equips managers with analytical skills, logical problem structuring, and practical solutions to economic challenges.

It is “the integration of economic theory with business practice to facilitate decision-making and planning by management.” Spencer and Siegelman:

“We define managerial economics as the integration of economic theory and methodology with analytical tools for application to decision-making about allocating scarce resources in public and private institutions.” K. K. Seo & B.J. Winger

“It (managerial economics) is the study of why some businesses prosper and grow, why some simply survive, and why others fail at the market and go under.” T. J. Coyne

“Managerial economics is the study of allo­cation of the limited resources available to a firm or other unit of management among the various possible activities of that unit.” W. R. Henry & W. W. Haynes

1.2 The Nature and Importance of Managerial Economics

1.2.1 The Nature of Managerial Economics

Understanding the nature of Managerial Economics requires delving into the closely intertwined realms of management and economics. According to Koontz and O’Donell, management entails coordinating efforts in a setting where people work toward common objectives. On the other hand, economics grapples with the fundamental issue of scarcity, stemming from limitless human wants and limited resources.

Thus, management consists of:

1. Coordination

2. An ongoing activity or process

3. A methodical procedure

4. The art of getting other people to do things for you.

On the other hand, economics is what economists do in its broadest sense. Economists are primarily concerned with analysing and addressing manifestations of the most fundamental problem, scarcity. Two fundamental truths about life are the root causes of resource scarcity:

1. human wants are virtually limitless and insatiable and

2. economic resources to meet these human demands are limited.

As a result, we cannot have everything we desire; we must make broad choices between three areas:

1. What should be produced?

2. How do you produce?

3. For whom should the product be produced?

When viewed in this light, managerial economics can be defined as economics applied to “problems of choice” or alternatives and the allocation of scarce resources by firms. Thus, managerial economics studies how a firm’s or a unit of management’s resources are allocated among its activities.

1.2.2 Importance of Managerial Economics

1. Knowledge of business economics assists business organisations in making critical decisions because it deals with applying economics in real-life situations.
2. It assists the firm’s manager or owner in developing policies appropriate for their firm or business.
3. Business economics can help you plan your next steps.
4. It aids in cost control and profit monitoring by performing a cost-benefit analysis.
5. It aids in projecting the future to make critical judgements in the present.
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6. It assists in determining acceptable prices for diverse products by utilising accessible pricing algorithms.
7. It assists in analysing the consequences of various government policies on businesses and making appropriate decisions.
8. It improves firm efficiency by utilising numerous economic strategies.

1.3 The Scope of Managerial Economics

At its core, Managerial Economics is about solving problems and making decisions. Its scope encompasses resource allocation, inventory management, pricing strategies, and investment decisions. Let’s explore the four primary problem areas:

1. Resource Allocation: Maximizing efficiency with scarce resources, including production programming and transportation.

2. Inventory and Queuing Issues: Balancing optimal stock levels and addressing queuing problems in the face of demand and supply fluctuations.

3. Pricing Issues: Crafting pricing strategies that align with market conditions and business objectives.

4. Investment Issues: Strategic planning for allocating scarce resources over time, such as investments in new plants.

The study of managerial economics entails the examination of several major topics, including:

1. Demand analysis and forecasting methods

2. Cost-benefit analysis

3. Pricing policy and theory

4. Profit analysis, with emphasis on the break-even point

5. Capital budgeting to make investment decisions

6. The business and its goals

An examination of resource scarcity and decision-making raises three fundamental questions:

1. What should be produced, and how much should be produced?

2. How do you produce?

3. Whom should I produce for?

To answer these questions, a firm employs economic principles. The first question concerns the types of goods and services that should be produced and in what quantities. Demand theory is the manager’s guide when choosing the goods and services for production. It examines consumer behaviour in terms of:

1. the types of goods and services they are likely to purchase in the current period and the future;

2. the factors influencing the consumption of a particular good or service; and 3. the effect of a change in these factors on the demand for that particular good or service.

A thorough examination of these aspects of consumer behaviour assists the manager in making product decisions. At some point, a company may decide to launch new goods and services or discontinue the provision of an existing good or service. Knowledge of demand elasticities aids in establishing prices in the context of a firm’s revenue. Demand forecasting methods aid in determining the quantity of a good or service produced.

The second fundamental question is how to manufacture goods and services. It entails the selection of inputs as well as production techniques. Purchase decisions are made for items ranging from raw materials to capital equipment. Production and cost analysis are guidelines for a manager’s personnel practices, including hiring and staffing and input procurement. For example, the decision to use a PC network to automate clerical tasks results in a more capital-intensive mode of production. Capital budgeting decisions are also a component of the second fundamental question. Project appraisal methods can be used to allocate available capital in long-term investment projects.

The third fundamental question for businesses is about market segmentation. A company must decide for whom it will produce goods and services. For example, it must decide whether to target the domestic or international markets. Another example of market segmentation is the production of a premium good. Examining market structure explains how price and output decisions are made in various market forms.

In light of the complex business environment, appropriate business decision-making with the help of economic tools has gained recognition. Because the macroeconomic environment is dynamic and changes over time, managerial decisions must be reviewed regularly. Consumer behaviour, demand elasticities, demand forecasting, production and cost analysis, market structure analysis, and investment planning are all useful concepts in this context.

1.4 Economic Principles That Influence Managerial Decisions

The following subsections discuss key economic principles that are relevant to managerial decisions.

1.4.1 Division of Labour

I prioritised the division of labour because Adam Smith argued it is the primary cause of rising living standards. The concept of division of labour isn’t used much in modern economics, but two closely related concepts are:

1. Returns to Scale: Scale returns can increase, constant, or decrease. The case that leads to exceptional results is increasing returns to scale, and division of labour is one cause (arguably the leading cause) of increasing returns to scale.

2. Virtuous Circles in Economic Growth: Smith saw a “virtuous circle” of continuing growth as a significant result of the division of labour and increased productivity. There are more dimensions to modern “virtuous circle” theories, but division of labour and increasing returns to scale are two of them.

1.4.2 Opportunity Cost

The idea is that anything you must give up to make a decision is the cost. This concept has been used numerous times in modern economics.

1. Scarcity: According to modern economics, scarcity exists whenever there is an opportunity cost, that is, whenever a meaningful choice must be made.

2. Production Possibility Frontier: The production possibility frontier is a graphical representation of production scarcity.

3. Comparative Advantage: The principle of comparative advantage is very important and a key to understanding international trade. It also applies the opportunity cost principle to trade.

4. Discounting of Investment Returns: Another application of the opportunity cost principle, this one tells us how to handle opportunities that come at different times.

1.4.3 Principle of Equimarginality

This is the economic efficiency diagnostic principle. It is widely used in modern economics. Two of the most important are key economic principles in and of themselves:

1. The Fundamental Principle of Microeconomics: This principle defines the conditions that allow market outcomes to be efficient.

2. The Externality Principle describes some significant situations in which markets are inefficient.

3. Marginal Analysis: This is an essential principle in and of itself and widely used in modern economics. There isn’t a significant topic in microeconomics that doesn’t use marginal analysis and opportunity cost.

1.4.4 Market Stability

The market equilibrium model could be broken down into several principles—at least the definitions of supply, demand, quantity supplied and demanded, and equilibrium—but these complement one another so well that taking them separately is not profitable. There are, however, numerous applications and at least four essential subsidiary principles:

1. Elasticity and Revenue: These concepts are critical to understanding how market changes affect society.

2. The Entry Principle: According to this, increased competition will eliminate profits (over and above opportunity costs) when entry into a field of activity is free. This has a different meaning depending on whether the competition is “perfect” or monopolistic.

3. Cobweb Adjustment: This may explain why the market does not move smoothly to equilibrium but overshoots.

4. Competition vs. Monopoly: Why do economists value competition and despise monopoly?

1.4.5 Diminishing Returns

The Principle of Diminishing Returns, perhaps the most well-known of major economic principles, is much more reliable in short-run than in long-run applications, so the long-run/short-run dichotomy is a vital subsidiary principle. Because modern economists think of diminishing returns primarily in terms of margins, marginal analysis and the equimarginal principle are inextricably linked.

1.4.6 Game Equilibrium

Strategy can be incorporated into a game using game theory. As a result, we must account for various types of equilibrium.

1. Non-cooperative equilibrium

-Prisoner’s dilemma (dominant strategy) equilibrium

– Nash (best response) equilibrium (but not all Nash equilibriums are dominant strategy equilibrium)

2. Cooperative equilibrium

3. Oligopoly

1.4.7 Measurement Principles

Because economics is multidimensional, measuring production, income, and price levels can be challenging. Some of the issues can be resolved more or less entirely.

1. Value Added and Double Counting: We have a fairly complete solution to the problem of double counting: use value added.

2. “Real” Values and Index Numbers: We must account for inflation because we measure output and related quantities in dollars. Index numbers are a reasonable solution, but some drawbacks and criticisms exist.

3. Measurement of Inequality: Another issue is that “average income” may not mean much because no one is average, and income is unequally distributed. Even if we cannot correct this, we can obtain a rough estimate of the relative inequality and see where it is headed.

1.4.8 Medium of Exchange

Money is defined as anything that is widely accepted as a medium of exchange. A bank or other similar institution can create money if people trust it enough to accept its paper as a medium of exchange. This magical fact is known as the Fiduciary Principle.

1.4.9 Income-Expenditure Equilibrium

Like the market equilibrium principle, this model brings together several subsidiary principles that complement one another and form the “Keynesian” theory of aggregate demand. The implications of this theory are less contentious than the term “Keynesian”—the controversy stems from the details rather than the applications.

1. Coordination failure is one of the subsidiary principles.

2. The relationship between income and consumption

3. The Multiplier

4. Unanticipated inventory investment

5. Fiscal Policy

6. Investment Margin Efficiency

7. Money’s Influence on Interest

8. Real Money Balances

9. The Monetary Policy

1.4.10  Surprise Principle

People respond differently to the same stimuli when they are surprised than when they are not. This new economic principle plays the same fundamental role in aggregate supply as “Income-Expenditure Equilibrium” does in aggregate demand.

Reasonable Expectations: People do not want a lot of unpleasant surprises. They won’t be surprised in the same way as often if they use the information available to them effectively. This can result in (a) ineffective policy, (b) permanence, and (c) path dependence.

1.5 The Relationship Between Managerial Economics with Decision Sciences

Managerial ecology assists managers in making various strategic decisions. Demand analysis and forecasting assist a manager in the early stages of product selection and output-level planning. A study of demand elasticity can significantly help a firm set product prices. The cost theory is also an essential aspect of this subject. Estimation is required to make output variations with fixed plants or for new investments in the same or a different production line. Profits are the firm’s goal, and optimal or near-maximal profits depend on accurate price decisions. Price determination theories under various market conditions enable the firm to solve price fixation problems. Cost control, proper pricing policies, break-even point analysis, and alternative profit policies are some essential techniques in profit planning for a firm that must work under uncertain conditions. Thus, managerial economics determines which course of action is most likely beneficial to the firm under a given set of circumstances.

Economics and Other Disciplines

Economics is intertwined with a variety of other fields of study, including:

1. Operation Research: In economics, this field is used to determine the best possible outcome. Operation Research is a valuable tool in business and industry decision-making because it can assist in solving problems such as deciding facilities for machine scheduling, commodity distribution, optimum product mix, etc.

2. Decision-Making Theory: Decision theory was developed to deal with problems of choice or decision-making under uncertainty when the figures required for the utility calculus are unavailable. Economic theory is based on the assumption of a single goal. In contrast, decision theory breaks new ground by acknowledging the multiplicity of goals and the persuasiveness of uncertainty in the real management world.

3. Statistics: Statistics aid in empirically testing theories. They also help make better decisions about demand and cost functions, production, sales, and distribution. Statistical methods are heavily used in economics.

4. Accounting and Management Theory: Profit maximisation has long been regarded as a central concept in the microeconomic theory of firms. In recent years, organisational theorists have discussed “satisficing” (a decision-making strategy that attempts to meet criteria for adequacy rather than identifying an optimal solution) as an enterprise goal rather than “maximising.” Accounting data and statements are the business language. The connection is so strong that “managerial accounting” has emerged as a distinct and specialised field in its own right.

1.6 Central Problems of an Economy

Every economy faces some difficulties. These issues are linked to economic growth, business cycles, unemployment, and inflation. The macroeconomic theory is intended to explain how supply and demand interact in the aggregate to address these four issues. Economists refer to these critical national issues as macroeconomic problems, which cannot be understood or solved without a comprehensive understanding of the economic system as a whole. The four distinct macroeconomic issues are as follows:

1. Recession

2. Unemployment

3. Inflation

4. Economic Growth or Stability?

1.6.1 Recessions, Depressions, and Economic Volatility

The event that gave rise to modern macroeconomics was dubbed “the Great Depression.” Still, in contemporary economics, the general term for a decrease in national output is referred to as a recession.

A recession is defined as two or more consecutive quarters of declining output. Various variables are used to assess production. One important metric is the real Gross Domestic Product. We will concentrate our efforts primarily on it.

But why do economists consider a recession to be a problem?

It is not self-evident that a decrease in output is a bad thing. For example, people may want to spend more time leisurely and less time producing goods and services. If production fell for that reason, there would be no reason to consider it an economic problem.

However, there is evidence that this did not occur in some recessionary periods. During many recessions, businesses that announced hiring had long lines of people waiting to apply, far outnumbering the number of positions available. This implies that the people waiting in line for a job had more leisure than they desired and would have preferred employment and income to buy more goods and services. In the 1930s, some people sold apples or pencils on the street to supplement their income, typically much lower than they would have earned in their previous jobs. This again suggests that people had too much leisure time and would have preferred more work and income. If this is the case, it appears that something was wrong. In various ways, it appeared that the recession was the cause of unemployment.

Another possibility is that production will fall due to a war or natural disaster that destroys factories and other capital goods. However, it appears highly unlikely that the economy’s productive capacity could have dropped by 30% in 1933. There had been no conflict. Factories that could have been reopened and put back to work had been closed while many people were looking for work. These circumstances may demonstrate why the recession is a significant economic problem.

1.6.2 Unemployment

Unemployment is our second macroeconomic issue. Although it is highly correlated with the recession, it is distinct, and we must address it on its terms. Unemployment occurs when a person is available to work and actively looking for work but cannot find work. The unemployment rate, defined as the percentage of those in the labour force who are unemployed, is commonly used to assess the prevalence of unemployment.

Economists differentiate between different types of unemployment. Examples include cyclical, frictional, structural, classical, seasonal, hardcore, and hidden. Real-world unemployment can be of various kinds. Each of these is difficult to quantify, partly because they overlap.

Unemployment is a state in which people are unemployed and looking for work. It is one of the most pressing issues confronting any economy, particularly those in developing countries. This has macroeconomic consequences, some of which are discussed below:

1. Output Reduction: The unemployed workforce could be used to produce goods and services. Because they are not doing so, the economy is losing output.

2. Reduced Tax Revenue: Income tax is a significant source of revenue for the government. The government loses income tax revenue because the unemployed are unable to work.

3. Increase in Government Expenditure: The government is required to pay claimants unemployment insurance benefits. As a result, the government will suffer losses in terms of unemployment benefits and tax revenue.

1.6.3 Inflation

In economics, inflation is defined as a rise in the overall level of prices for goods and services in an economy over time.

Inflationary pressures have the following consequences:

1. It creates uncertainty because people don’t know what their money will buy tomorrow.

2. In turn, uncertainty discourages productive activity, saving, and investing.

3. Inflation reduces a country’s competitiveness in international trade. If the value of the national currency relative to other currencies doesn’t decline correspondingly, imports into the country will become more desirable, and exports less desirable, creating a trade imbalance.

4. Inflation is a tax on “nominal balances.” When the price level rises, people who hold bonds and bank accounts in dollars lose the value of those accounts, just as if their money had been taxed away.

5. The inflation tax is arbitrary; some people benefit from it while others do not for no apparent economic reason.

6. As the monetary unit’s purchasing power becomes less predictable, people resort to inefficient and resource-intensive business methods.

1.6.4 Economic Growth or Stagnation

Stagnation is many years of slow gross domestic product growth, on average slower than the economy’s potential growth.

 Causes of Stagnation

-Population growth could be rapid.

-Fewer people may opt to work.

-The rate of increase in labour productivity may slow.

Stagnation is economic growth that, while positive, is less than the economy’s potential growth. Some economists believe that stagnation is a serious problem and a cause of other issues, but because identifying stagnation is dependent on one’s concept of potential, it is debatable whether the slowing we are witnessing is stagnation or a reduction in potential.