Note for Managerial Economics - ME By Tulasi Miriyala
- Managerial Economics - ME
- Note
- Andhra University AU - AU
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UNIT-1 Managerial Economics – Definition: “Managerial economics is concerned with the application of economic concepts and economic analysis to the problems of formulating rational managerial decisions. Nature and Scope of Managerial Economics: The most important function in managerial economics is decision-making. It involves the complete course of selecting the most suitable action from two or more alternatives. The primary function is to make the most profitable use of resources which are limited such as labor, capital, land etc. A manager is very careful while taking decisions as the future is uncertain; he ensures that the best possible plans are made in the most effective manner to achieve the desired objective which is profit maximization. Economic theory and economic analysis are used to solve the problems of managerial economics. Economics basically comprises of two main divisions namely Micro economics and Macro economics. Managerial economics covers both macroeconomics as well as microeconomics, as both are equally important for decision making and business analysis. Macroeconomics deals with the study of entire economy. It considers all the factors such as government policies, business cycles, national income, etc. Microeconomics includes the analysis of small individual units of economy such as individual firms, individual industry, or a single individual consumer. All the economic theories, tools, and concepts are covered under the scope of managerial economics to analyze the business environment. The scope of managerial economics is a continual process, as it is a developing science. Demand analysis and forecasting, profit management, and capital management are also considered under the scope of managerial economics. 1
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MANAGERIAL ECONOMICS IS THE DISPLINE WHICH DEALS WITH THE APPLICATION OF ECONOMIC THEORYOF BUSINESS MANAGEMENT: Managerial economics is the discipline, which deals with the application of economic theory to business management. Managerial Economics thus lies on the margin between economics and business management and serves as the bridge between the two disciplines. Reconciling traditional theoretical concepts of economics in relation to the actual business behavior and conditions: In economic theory, the technique of analysis is that of model building. This involves making some assumptions and, drawing conclusions on the basis of the assumptions about the behavior of the firms. The assumptions, however, make the theory of the firm unrealistic since it fails to provide a satisfactory explanation of what the firms actually do. Hence, there is need to reconcile the theoretical principles based on simplified assumptions with actual business practice and develop appropriate extensions and reformulation of economic theory. Based on this, the theory of the firm suggests how much the firm will produce and at what price it would sell. In practice, however, firms do not always aim at maximum profits (as they may think of diversifying or introducing new product etc.) To that extent, the theory of the firm fails to provide a satisfactory explanation of the firm’s actual behavior. Moreover, in actual business language, certain terms like profits and costs have accounting concepts as distinguished from economic concepts. In managerial economics, an attempt is made to merge the accounting concepts with the economics, an attempt is made to merge the accounting concepts with the economic concepts. This helps in a more effective use of financial data related to profits and costs to suit the needs of decision-making and forward planning. Estimating economic relationships: This involves the measurement of various types of elasticities of demand such as price elasticity, income elasticity, cross-elasticity, promotional elasticity and cost-output relationships. The estimates of these economic relationships are to be used for the purpose of forecasting. Predicting relevant economic quantities: Economic quantities such as profit, demand, production, costs, pricing and capital are predicated in numerical terms together with their probabilities. As the business manager has to work in an environment of uncertainty, the future needs to be foreseen so that in the light of the predicted estimates, decision-making and forward planning may be possible. Using economic quantities in decision-making and forward planning: This involves formulating business policies for establishing future business plans. This nature of economic forecasting indicates the degree of probability of various possible outcomes, i.e., losses or gains that will occur as a result of following each one of the available strategies. Thus, a quantified picture gets set up, that indicates the number of courses open, their possible outcomes and the quantified probability of each outcome. Keeping this picture in view, the business manager is able to decide about which strategy should be chosen. Understanding significant external forces: Applying economic theory to business management also involves understanding the important external forces that constitute the business environment and with which a business must adjust. Business cycles, fluctuations in national income and government policies pertaining to taxation, foreign trade, labor relations, anti-monopoly measures, industrial licensing and price controls are typical examples. The business manager has to appraise the relevance and impact of these external forces in relation to the particular business unit and its business policies. 2
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Demand Analysis and Forecasting: Demand analysis and forecasting involves huge amount of decision-making! Demand estimation is an integral part of decision making, an assessment of future sales helps in strengthening the market position and maximizing profit. In managerial economics, demand analysis and forecasting holds a very important place. Profit Management: Success of a firm depends on its primary measure and that is profit. Firms are operated to earn long term profit which is generally the reward for risk taking. Appropriate planning and measuring profit is the most important and challenging area of managerial economics. Capital Management: Capital management involves planning and controlling of expenses. There are many problems related to capital investments which involve considerable amount of time and labor. Cost of capital and rate of return are important factors of capital management. Demand for Managerial Economics: The demand for this subject has increased post liberalization and globalization period primarily because of increasing use of economic logic, concepts, tools and theories in the decision making process of large multinationals. FIRM: A firm is a business organization, such as a corporation, limited liability company or partnership, that sells goods or services to make a profit. While most firms have just one location, a single firm can consist of one or more establishments, as long as they fall under the same ownership and utilize the same Employer Identification Number (EIN). The title "firm" is typically associated with business organizations that practice law, but the term can be used for a wide variety of business operation units, such as accounting. "Firm" is often used interchangeably with "business" or "enterprise." OBJECTIVES OF FIRM IN MODERN ECONOMY: 1. Profit Satisfying: In many firms there is separation of ownership and control. Those who own the company (shareholders) often do not get involved in the day to day running of the company. A. This is a problem because although the owners may want to maximise profits, the managers have much less incentive to maximise profits because they do not get the same rewards, (share dividends). B. Therefore managers may create a minimum level of profit to keep the shareholders happy, but then maximise other objectives, such as enjoying work, getting on with other workers. (e.g. not sacking them) This is the problem of separation between owners and managers. C.This ‘principal agent’ problem can be overcome, to some extent, by giving mangers share options and performance related pay although in some industries it is difficult to measure performance. 2. Sales maximization: Firms often seek to increase their market share – even if it means less profit. This could occur for various reasons: A. Increased market share increases monopoly power and may enable the firm to put up prices and make more profit in the long run. B. Managers prefer to work for bigger companies as it leads to greater prestige and higher salaries. 3
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C. Increasing market share may force rivals out of business. E.g. supermarkets have lead to the demise of many local shops. Some firms may actually engage in predatory pricing which involves making a loss to force a rival out of business. 3. Growth maximization: This is similar to sales maximisation and may involve mergers and takeovers. With this objective, the firm may be willing to make lower levels of profit in order to increase in size and gain more market share. 4. Long run profit maximization: In some cases, firms may sacrifice profits in the short term to increase profits in the long run. For example, by investing heavily in new capacity, firms may make a loss in the short run, but enable higher profits in the future. 5. Social / environmental concerns: A firm may incur extra expense to choose products which don’t harm the environment or products not tested on animals. Alternatively, firms may be concerned about local community / charitable concerns. 6. Co-operatives: Co-operatives may have completely different objectives to a typical PLC. A co-operative is run to maximize the welfare of all stakeholders – especially workers. Any profit the co-operative makes will be shared amongst all members. Diagram showing different objectives of firms Management Theories: Management theories are implemented to help increase organizational productivity and service quality. Not many managers use a singular theory or concept when implementing strategies in the workplace. Theory X and Theory Y 4
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