Managerial Economics - Its Definition, Scope & Concept

MANAGERIAL ECONOMICS – DEFINITION

Managerial economics is a science that deals with the application of various economic theories, principles, concepts and techniques to business management in order to solve business and management problems. It deals with the practical application of economic theory and methodology to decision-making problems faced by private, public and non-profit making organizations.

The same idea has been expressed by Spencer and Seigelman in the following words. “Managerial Economics is the integration of economic theory with business practice for the purpose of facilitating decision making and forward planning by the management”. According to Mc Nair and Meriam, “Managerial economics is the use of economic modes of thought to analyze business situation”. Brighman and Pappas define managerial economics as,” the application of economic theory and methodology to business administration practice”. Joel dean is of the opinion that use of economic analysis in formulating business and management policies is known as managerial economics.

Scope of Managerial Economics:

The scope of managerial economics includes following subjects: 

1.  Theory of demand

2.  Theory of production

3.  Theory of exchange or price theory

4.  Theory of profit

5.  Theory of capital and investment

6.  Environmental issues, which are enumerated as follows:

1.  Theory of Demand:  According to Spencer and Siegelman, “A business firm is an economic organisation which transforms productivity sources into goods that are to be sold in a market”.

a. Demand analysis:  Analysis of demand is undertaken to forecast demand, which is a fundamental component in managerial decision-making. Demand forecasting is of importance because an estimate of future sales is a primer for preparing production schedule and employing productive resources. Demand analysis helps the management in identifying factors that influence the demand for the products of a firm. Thus, demand analysis and forecasting is of prime importance to business planning.

b. Demand theory:  Demand theory relates to the study of consumer behavior. It addresses questions such as what incites a consumer to buy a particular product, at what price does he/she purchase the product, why do consumers cease consuming a commodity and so on. It also seeks to determine the effect of the income, habit and taste of consumers on the demand of a commodity and analyses other factors that influence this demand.

 2. Theory of Production:  Production and cost analysis is central for the unhampered functioning of the production process and for project planning. Production is an economic activity that makes goods available for consumption. Production is also defined as a sum of all economic activities besides consumption. It is the process of creating goods or services by utilising various available resources. Achieving a certain profit requires the production of a certain amount of goods. To obtain such production levels, some costs have to be incurred. At this point, the management is faced with the task of determining an optimal level of production where the average cost of production would be minimum. Production function shows the relationship between the quantity of a good/service produced (output) and the factors or resources (inputs) used. The inputs employed for producing these goods and services are called factors of production. 

a. Variable factor of production: The input level of a variable factor of production can be varied in the short run. Raw material inputs are deemed as  variable factors. Unskilled labour is also considered in the category of  variable factors.

b. Fixed factor of production: The input level of a fixed factor cannot be varied in the short run. Capital falls under the category of a fixed factor. Capital alludes to resources such as buildings, machinery etc..Production theory facilitates in determining the size of firm and the level of production. It elucidates the relationship between  average and marginal costs and production. It highlights how a change in production can bring about a parallel change in average and marginal costs. Production theory also  deals with other issues such as  conditions leading to increase or decrease in costs, changes in total production when one factor of production is varied and others are kept constant, substitution of one factor with another while keeping all increased simultaneously  and methods of achieving optimum production.

3. Theory of Exchange or Price Theory: Theory of Exchange is popularly known as Price Theory. Price determination under different types of market conditions comes under the wingspan of this theory. It helps in determining the level to which an advertisement can be used to boost  market sales of a firm. Price theory is pivotal in determining the price policy of a firm. Pricing is an important area in managerial economics. The accuracy of pricing decisions is vital in shaping the success of an enterprise. Price policy impresses upon the demand of products. It involves the determination of prices under different market conditions, pricing methods, pricing policies, differential pricing, product line pricing and price forecasting.

4.  Theory of profit:  Every business and industrial enterprise aims at maximising profit. Profit is the difference between total revenue and total economic cost. Profitability of an organisation is greatly influenced  by the following factors:

• Demand of the product

• Prices of the factors of production

• Nature and degree of competition in the market

• Price behavior under changing conditions

 Hence, profit planning and profit management are important requisites for improving profit earning efficiency of the firm. Profit management involves the use of most efficient technique for predicting the future. The probability  of risks should be minimised as far as possible.

5.  Theory of Capital and Investment:  Theory of Capital and Investment evinces the following important issues:

• Selection of a viable investment project 

• Efficient allocation of capital 

• Assessment of the efficiency of capital 

• Minimising the possibility of under capitalisation or overcapitalisation. Capital is the building block of a business. Like other factors of production, it is also scarce and expensive. It should be allocated in most efficient manner.

6. Environmental issues: Managerial economics also encompasses some aspects of macroeconomics. These relate to social and political environment in which a business and industrial firm has to operate. This is governed by the following factors: 

• The type of economic system of the country

• Business cycles

• Industrial policy of the country

• Trade and fiscal policy of the country

• Taxation policy of the country

• Price and labour policy

• General trends in economy concerning the production, employment, income, prices, saving and investment etc.

• General trends in the working of financial institutions in the country

• General trends in foreign trade of the country

• Social factors like value system of the society

• General attitude and significance of social organisations like trade unions, producers’ unions and consumers’ cooperative societies etc.

• Social structure and class character of various social groups

• Political system of the country

 The management of a firm cannot exercise control over these factors. Therefore it should fashion the plans, policies and programmes of the firm according to these factors in order to offset their adverse effects on the firm.

Concept of Managerial Economics

The discipline of managerial economics deals with aspects of economics and  tools of analysis, which are employed by business enterprises for decision-making. Business and industrial enterprises have to undertake varied decisions that entail managerial issues and decisions. Decision-making can be delineated as a process where a particular course of action is chosen from a number of alternatives. This demands an unclouded perception of the technical and environmental conditions, which are integral to decision making. The decision maker must possess a thorough knowledge of aspects of economic theory and its tools of analysis. The basic concepts of decision-making theory have been culled from microeconomics theory and have been furnished with new tools of analysis. Statistical methods, for example, are pivotal in estimating current and future demand for products. The methods of operations research and programming  proffer scientific criteria for maximising profit, minimising cost and determining  a viable combination of products.Decision-making theory and game theory, which recognise the conditions of uncertainty and imperfect knowledge under which business managers operate, have contributed to systematic methods of assessing investment opportunities. Almost any business decision can be analysed with managerial economics techniques. However, the most frequent applications of these techniques are as follows: 

• Risk analysis:  Various models are used to quantify risk and asymmetric information and to employ them in decision rules to manage risk.

• Production analysis: Microeconomics techniques are used to analyse production efficiency, optimum factor allocation, costs and economies of scale. They are also utilised to estimate the firm's cost function.

• Pricing analysis: Microeconomics techniques are employed to examine various pricing decisions. This involves transfer pricing, joint product pricing, price discrimination, price elasticity estimations and choice of the optimal pricing method.

• Capital budgeting: Investment theory is used to scrutinise a firm's capital purchasing decisions.