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CHAPTER
Decision
problem
Decision science
Traditional Managerial (tools and techniques
economics economics of analysis)
Optimal solution
to business
problem
problems in the economy. The basic business problems that arise in any decision
making or forward planning process involves operational and environmental
issues.
Resource Allocation- Managerial economics is first and foremost, like traditional
economic theory is concerned with the problem of optimum allocation of resources.
The problem of determining optimum level of output that maximizes profit is taken
care by the marginal analysis. On should ensure the most effective use of scare
resources to get the optimal results. Linear programming technique is the most
effective tool in decision making used to solve optimization problems.
Demand Estimation- It is very important for the firm to accurately estimate the
market demand and to cater to the respective demand at the right time with right
quantity. The basic understanding of demand is crucial for demand forecasting or
demand estimation. Demand analysis helps to identify the factors responsible for
influencing the market demand. There are many factors that contribute in influencing
the market demand, namely, income of an individual, price of the commodity and
price of the related goods and many more. It has increasing becoming easy to forecast
the demand with the help of many computer softwares like SPSS , SAS etc.
Managing Inventory and handling Queuing problem -Managing inventory
requires the correct estimation about the holding of the inventory stocks of raw
material and also of the finished goods over time. These decisions are based upon
the demand analysis by considering the demand and supply conditions. For instance,
suppose a firm expects a rise in the future demand for its product, it has to plan
accordingly whether it need to hire more labors or need to install more machinery, to
cope with the increased demand. Such problems are termed as queuing problems.
Cost Analysis – Cost analysis is a very crucial in decision making. Pricing policy
along with the cost analysis forms the base of profit planning. It also deals with the
concept of cost benefit analysis.
Pricing and Competitive strategy- Pricing plays a very crucial role when you are
not the only supplier of a good in the market. The pricing strategy depends on the
type of market structure, may be oligopolistic, monopolistic or monopoly market.
Price theory explains how the prices are determined in these different markets.
Competitive strategy anticipates price determination by taking into consideration
other players strategies regarding pricing, advertising and marketing.
Profit Analysis – Economist defines profit as the reward for uncertainty bearing and
risk taking abilities. The manger is successful if it can reduce uncertainty and earn
higher profits. Profit estimating and measuring is the most challenging aspect of
managerial economics. Profit earning is the main yardstick to measure the success
of a firm in the long run.
Nature and Scope of Managerial Economics 5
The present value of all the future profits also can be interpreted as the value of
the firm that is what a willing buyer would pay for the business.
The above equation will work only if the different departments would work
together to reduce cost and increase efficiency. For instance, the marketing,
production and other departments could provide timely services and information to
bring down the cost and increase the sales.
6 Managerial Economics
not to their humanity but to their self love; never talk to them of our own necessities,
but of their own advantage.
According to Smith there is an ‘invisible hand’ at work that guides the private
decisions in socially beneficial ways. This is the coordinating mechanism in the
economy, the price system.
Every individual endeavors to employ his capital so that its produce may be of
greatest value. He generally neither intends to promote the public interest, nor
knows how much he is promoting it. He intends only his own security, only his own
gain. And he is in this led by an invisible hand to promote an end which was no part
of his intention. By pursuing his own interest he frequently promotes that of society
more effectually than when he really intends to promote it.
Thus we see that even in 1776, Adam Smith could clearly see the advantages that
an economic system based on the self interest of the individual and the firm could
bring forth
Theories of Profit
Disequilibrium Profit Theories
Markets are sometimes in disequilibrium because of unanticipated changes in demand
or cost conditions. The unanticipated shocks produce positive or negative economic
8 Managerial Economics
profits for some firms. Profits are sometimes above or below normal because of
factors that prevent instantaneous adjustment to new market conditions.
Monopoly profit theory is an extension of the frictional profit theory explained
above. Monopoly profits exist when firms are sheltered from competition by high
barriers to entry. Economies of scale, high capital requirements, patents, or import
protection, among other factors, enable some firms to build monopoly positions that
allow above-normal profits for extended periods.
Function of Profit
Each of the preceding theory describes economic profit in one way or the other.
Economic profits play a valuable role in any market based economy. The firm
should increase its output is shown by the above normal profits earned by it.
Economic profits are very crucial because they help in allocating scarce economical
resources.
Demand
Demand is when under a certain economic condition the customer is ready to
purchase certain goods or services from a firm. The conditions could include the
price of the good in question, its availability, consumer’s income, consumer’s tastes,
and its preference and so on. Form the managerial point of view an aggregate of the
consumer demand is taken which is also called the market demand.
Sometimes goods and services are in demand because they are important
inputs in the manufacturing or distribution of some other products. Their demand
Nature and Scope of Managerial Economics 9
is derived from the demand for the products they are used to provide. This is also
called derived demand.
The market demand function the demand curve etc. would be explained and
dealt with in detail in the coming chapters.
Supply
The supply of a product or a service depends on the market. The amount of a good
or service supplied will rise when the marginal benefit to producers, is greater than
the marginal cost of production. The amount of any good or service supplied will
fall when the marginal benefits isles than the marginal cost of production.
The managerial decision making requires a firm understanding of both the
market as well as the individual supply conditions.
policies like monetary and fiscal that has an impact on any business activity. Thus
it is important to know all the current happening at both national and international
levels. They should also be able to keep pace with the ever changing technology
because all the business decisions are taken within the framework of technological
developments.
The managerial economists actively participate in the decision making and
forward planning process. Thus the economist should have the ability to express
himself clearly so that the non- economist stature person is able to interpret his
findings and is able to get the message across. Management is interested in the
practical solutions to the current problems, they are not interested to know the theory
and do the interpretation themselves, and thus the role of a managerial economist
comes into picture that helps them to translate economic concepts into day to day
business solutions.
It is well said that there is a very minute difference between the manager and the
managerial economist. Manager is a decision maker whereas managerial economist
is an advisor to the manager. A Managerial economist may certainly move ahead
to the decision making position in due course of time by attaining more expertise
required by the managerial decision making role.
person by Forbes magazine. He was barely 36 years of age and had a fortune of
$630 crores. America’s richest nerd has now surpassed some $4,000 crores and it’s
a phenomenal growth that his organization has shown. Now the question arises as
to how has he made it possible in a free enterprise system?
Bill Gates is college dropout and after he learnt what he could about personal
computers and its usage in Harvard he decided to built an operating system himself.
His operating system, MS-DOS or the Microsoft Disk Operating System was such
a creation that IBM agreed to use it in its line of personal computers. Later on it was
replaced by Windows and since then we have had Vista and many other updated
versions of the operating system from the Microsoft.
The firm had made its presence felt in the business community. In 1997, the firm
recorded a profit of more than $200 crores. It ranked third after IBM and Hewlett
- Packard. Microsoft also started producing some world class applications for the
PC and many such products. He has also ventured into many other works related
to the same field, for instance that of purchasing the electronic reproduction rights
to various art and photographic works across thousands of museums and libraries
around the world. This is a part of his interactive home entertainment systems
plan.
With extreme diligence, innovation and the ability to take timely and calculated
risks, Gates have demonstrated how much the market has the potential to reward.
Thus, he has shown the true essence of the free market economic system, where if
you deliver what the consumer needs and demands then you are suitably and richly
rewarded for your efficiency and innovativeness.
Review Questions
1. Should the firms be primarily viewed as economic entities?
2. Explain the role of profit in a free market economic system?
3. A firm’s profit has been at approximately Rs. 15 crores per year in each of
the last 5 years. The company has 25 lakhs shares of outstanding stock, and
the market price has been about Rs.500 per share. The top management has
been receiving only salary during this period. Develop a plan combining stock
option, bonus and other things to provide them with better incentives.
Absolute Advantage
The principle of absolute advantage refers to the ability of an individual, firm, or
country to produce more of a good or service than its competitors, by utilizing
the same amount of resources. The concept of absolute advantage is attributed to
Adam Smith for his 1776 publication “An Inquiry into the Nature and Causes of
12 Managerial Economics
India can produce 150 video games per day with 100 workers.
Thailand can produce 170 video games per day with 100 workers.
Bangladesh can produce 100 video games per day with 100 workers.
Keeping in mind that the labor and material costs are constant across the three
countries, Thailand has the absolute advantage over both Countries India and
Bangladesh because it can produce the 170 video games per day at the same cost
as other countries. India has an absolute advantage over Bangladesh because it
can produce 150 video games (more than 100) per day with the same number of
workers. Bangladesh does not have absolute advantage over any country because
it can’t produce more video games than either India or Thailand given the same
input.
Comparative Advantage
The law of comparative advantage refers to the ability of an individual, a firm or
a country to produce a particular good or service at a lower opportunity cost than
another party. It can be distinguished from absolute advantage which relates to the
ability of a party to produce a particular good at a lower absolute cost than another.
Comparative advantage concept explains the benefits from mutual trade between
two parties although both parties can produce all goods with fewer resources than
the other. The net benefits of mutual trade amongst the parties concerned are termed
gains from trade. It is the main concept of the pure theory of international trade.
Let us consider an example. Assume that each country has constant opportunity
costs of production between the two products and both economies have full
employment at all times. All the factors of production are mobile within the countries
between video games and Music system industry industries, but are immobile
between the countries.
Nature and Scope of Managerial Economics 13
Thailand has an absolute advantage over India in the production of food video
games and music systems Thus there seems to be no need for trade amongst the
two countries. Thialnd is more efficient in producing both the goods. But let’s have
a look from the opportunity cost aspect. The opportunity costs shows otherwise.
India’s opportunity cost of producing one video game is one music systems and
vice versa. Thailand’s opportunity cost of one music system is two video games
and vice versa. Thailand has a comparative advantage in video games production,
because of its lower opportunity cost of production compared to India. India has
a comparative advantage over Thailand in the production of music systems, the
opportunity cost of which is higher in Thailand with respect to video games than in
India.
Exchange Rate
International trade among different countries is difficult because of the existence of
different currencies used by different countries. International trade is only possible
if we can know how much to pay in the terms of other country’s currency. Foreign
Exchange rate refers to the amount of one currency that must be paid to attain
other country’s currency .It is the rate that specifies how much one currency is
worth in terms of other country’s currency or It is the value of a foreign nation’s
currency in terms of the home nation’s currency. Exchange rate are governed by the
host country’s exchange rate system. With the floating exchange rate, the value of
country’s currency is governed by the market demand and supply forces. Whereas
in the case of fixed exchange rates, the government of the host country tries to
change interest rates or buy and sell foreign currencies to maintain a fixed value
against the US dollar, the Euro or the basket of currencies. This is termed as pegging
the value of the currency to another.
For example an exchange rate of 50 Rs (Indian currency) to the United States
dollar (USD, $) means that Rs 50 is worth the same as USD 1. The foreign exchange
market is one of the biggest markets in the world.
The spot exchange rate refers to the current exchange rate whereas the forward
exchange rate refers to an exchange rate that is quoted and traded today but will be
delivered and executed on a specific future date.
The market regulated exchange rate fluctuates with the change in the values
of the two corresponding currencies. If the demand for certain currencies say
for instance, USD increases, supply remaining constant, the value of USD will
appreciate. On the contrary, if the supply of USD increases, demand remaining
14 Managerial Economics
constant, the value of USD will depreciate. The demand for certain currency could
be attributable to either for transaction purpose, known as transaction demand for
money or speculative purpose known as speculative demand for money.
Balance of payments
A balance of payments (BOP) is viewed as an accounting record of all monetary
transactions involving payments or receipts of foreign currency exchange between
a country and the rest of the world. These transactions in the BOP include payments
for the country’s exports and imports of goods, services, and financial capital and
financial transfers. It is a summary of international transactions for a specific
period, usually a year, and is prepared in a domestic currency of the country
concerned. Sources of funds for a country, such as exports or the receipts of loans
and investments, are recorded as positive or surplus items. Uses of funds, for the
purpose of imports or investments in foreign countries, are recorded as a negative
or deficit item
BOP comprises of current account and the capital account.
Current account records the net earnings of the country if the account is in
surplus or shows the net spending if the account is in deficit. It is the sum of the
balance of trade (net earnings on exports – payments for imports), factor income
(earnings on foreign investments – payments made to foreign investors) and cash
transfers.
The capital account records the net change in ownership of foreign assets. It
includes the reserve account (the international operations of a country’s central
bank), along with loans and investments between the country and the rest of
world.
Thus BOP is represented as:
BOP = Current Account – Capital account + Balancing Item.
The balancing item is an amount that accounts for any statistical errors and
ensures that the sum of current and capital accounts is zero. When all components
of the BOP sheet are included it must sum to zero as there cannot be any overall
surplus or deficit but certainly imbalances are possible on individual elements of the
BOP, such as the current account or capital account.
Opportunity Cost
The concept of an opportunity cost was first developed by John Stuart Mill.
It is one of the prime concepts in Economics. We all know that our appetite for
goods and services are insatiable thus it is important to determine how to allocate
limited resources. It expresses the basic relationship between scarcity and choice.
Opportunity cost concept ensures the optimum and efficient utilization of resources.
Nature and Scope of Managerial Economics 15
Summary
Economics not only helps us to better understand the human behavior and the activities
of the firm but it also provides valuable insights and tools to businessmen.
Managerial economics is the science of directing scarce resources to manage
cost effectively.
Managerial Economics provides strategic planning tool that helps in analyzing
the problem and formulating rational managerial decisions.
Management is about making choices. Economics is the study of decision
making thus it helps the manager in taking the correct decision.
A firm produces either what the consumer demands or what it thinks the
consumer requires. Thus, consumer satisfaction helps in the production of new and
innovative products.
Economist defines profit as the reward for uncertainty bearing and risk taking
abilities. The manger is successful if it can reduce uncertainty and earn higher
profits
Review Questions
1. Discuss the nature and scope of managerial Economics.
2. Explain the different roles of managerial economist.
3. Explain the concept of :
(i) Opportunity cost
(ii) Equi- marginal utility
(iii) Time Perspective principle
4. Comment on the International Framework of Managerial Economics
5. Should the firms be primarily viewed as economic entities?
6. Explain the role of profit in a free market economic system?
7. A firm’s profit has been at approximately Rs. 15 crores per year in each of the
last 5 years. The company has 25 lakhs shares of outstanding stock, and the
market price has been about Rs.500 per share. The top management has been
receiving only salary during this period. Develop a plan combining stock option,
bonus and other things to provide them with better incentives.
References
Managerial Economics by Atmananad, Excel Books.
Managerial economics by DM Mithani, Himalys Publishing House
Managerial economics by Ivan Png and Dale Lehman, Blackwell Publishing
The Nature of the Firm’, by R.H. Coase, Economica, November 1937.