Managerial Economics

Managerial Economics: Meaning & Scope

Introduction

  • Managerial economics focuses on business efficiency. - SAVAGE AND SMALL
  • This chapter aims to define managerial economics, its relation to economic analysis, its connection with other subjects, and the role of a managerial economist.

1.1. Meaning and Nature

  • Managerial Economics applies economics to decision-making, linking abstract theory and managerial practice.
  • It uses economic analysis for problem identification, information organization, and alternative evaluation.
  • Economics: the science concerned with scarce resource allocation.
  • Managerial economics applies economics to firms' choices and scarce resource allocation, aiming for maximum goal achievement.
1.1.1. Definitions of Managerial Economics
  • McNair and Meriam: Managerial economics uses economic thought to analyze business situations.
  • Spencer and Siegelman: It integrates economic theory with business practice for decision-making and planning.
  • Watson: Defines it as price theory serving business executives.
  • Brigham and Pappas: See it as applying economic theory and methodology to business administration.
  • Hague: Views it as understanding and analyzing business decision-making problems.
  • Common viewpoints:
    • Concerned with economic decision-making related to resource allocation.
    • Goal-oriented and prescriptive, guiding managerial decisions for organizational goals.
    • Pragmatic, focusing on useful analytical tools for improving decision-making.
    • Both conceptual and metrical, using quantitative techniques with considered judgment.
  • Managerial economics links traditional economics and decision sciences for optimal business problem solutions.
1.1.2. Nature of Managerial Economics
  • Focuses on the business firm and its economic problems.
  • Integrates economic theory and business practice for decision-making and forward planning (Spencer and Siegelman).
  • Operates within the broad economic environment (macro-economic conditions).
  • Key points regarding macro-economic conditions:
    • Operates in a free enterprise economy using prices and markets.
    • Deals with rapid technological and economic changes.
    • Faces increasing government intervention.
  • Progressive management stays informed of economic system changes.
  • Micro-economic analysis deals with individual firms, industries, consumers, etc.
    • Helps in studying internal firm dynamics, resource utilization, and efficiency.
    • Uses price theory concepts like elasticity of demand, marginal cost, economies of scale, opportunity cost, present value, and market structures.
    • Applies models for monopoly price, kinked demand, price discrimination, and behavioral/managerial aspects.
    • Avoids concepts like indifference curves due to quantification challenges.
  • Positive vs. Normative Approach
    • Positive approach deals with what is, was, or will be.
    • Normative approach concerns what ought to be.
    • Example: "A government deficit will reduce unemployment and cause an increase in prices" (positive), while "in setting policy, unemployment ought to matter more than inflation" (normative).
    • Positive economics includes description and theory.
    • Normative micro-economics deals with business objectives and policies.
    • Managerial economics is prescriptive or normative.
Integration of Economic Theory & Business Practice: A Critical Look
  • Economic theory helps understand business behavior but relies on simplified assumptions.
  • Managerial economists adjust theoretical constructs for actual business behavior.
  • Traditional theory assumes profit maximization and rationality but is often criticized.
    • Firms may aim at sales maximization or market share maintenance.
    • Firms often have imperfect knowledge and make decisions under uncertainty.
  • Managerial economics estimates and predicts economic quantities and relationships (e.g., elasticity of demand).
  • Economic forecasting suggests outcomes with probabilities for managerial choice.
  • Managers must understand and adjust to external factors like government intervention and business cycle fluctuations, modifying traditional models.
  • Managerial economics:
    • Micro-economic, focusing on the firm.
    • Normative, prescribing what should happen rather than describing what does.
    • Application-oriented, making theory more practical.
    • Pragmatic, addressing complexities economists ignore.
    • It uses macro-economics to understand external conditions.

1.2. Chief Characteristics of Managerial Economics

  1. Micro-economic.
  2. Uses macro-economics to understand the firm's environment.
  3. Normative, prescriptive, and involves value judgments.
  4. Conceptual and metrical, using both frameworks and quantitative techniques.
  5. Based on the 'theory of the firm,' using 'theory of distribution' for profit analysis.
  6. Helps in making wise choices to achieve objectives amid scarcity.

1.3. Significance of Managerial Economics

  • Aids decision-making by balancing simplification and handling various factors.
  • Provides tools and techniques for competent model building, capturing essential relationships.
  • Offers concepts, such as elasticity of demand, fixed and variable costs, opportunity costs, and net present value.
  • Helpful in decisions like product-mix, production technique, output level, pricing, investment, and advertising.
  • Requires logical analysis and clear problem-solving abilities.

1.4. Scope of Managerial Economics

  • Connects economic theory, operations research, statistics, mathematics, and decision-making theory.
  • Integrates ideas from functional management areas like production, marketing, finance, and project management.
  • Subject-matter includes:
    • Objectives of a Business Firm,
    • Demand Analysis and Demand Forecasting,
    • Production and Cost,
    • Competition,
    • Pricing and Output,
    • Profit,
    • Investment and Capital Budgeting, and
    • Product Policy, Sales Promotion and Market Strategy.
  • Demand analysis helps in product choice and output planning.
  • Managers aim to minimize costs for output levels.
  • Intelligent market management helps firms, including competition and advertisement.
  • Profit management and long-range decisions are crucial, involving investment and capital budgeting.
  • Managerial economics uses economic concepts to determine the best course of action.
1.4.1. Managerial Economics and Traditional Economics
  • Analogous to the relationship between engineering and physics or medicine and biology.
  • Economics provides concepts and analytical tools to apply to business.
  • Both address scarcity and resource allocation.
  • Managerial economics focuses on market/technological changes and market reactions.
  • Economics contributes:
    • Understanding market conditions and economic environment.
    • Providing a philosophy for resource allocation problems.
  • Business efficiency results from technical and economic efficiency.
  • Managerial economics seeks both technical and economic efficiency.
1.4.2. Managerial Economics and Operations Research
  • Both aim at effective decision-making given firm objectives.
  • Managerial economics analyzes business decision-taking, while operations research aids managers in problem-solving.
  • Operations research involves model-building drawing from various disciplines.
  • Models like queuing and linear programming are used in managerial economics.
  • Operations research is suited for complex problems with large potential savings or solutions applicable to many small problems over time.
  • Managerial economics provides tools for quick, cost-effective solutions.
1.4.3. Managerial Economics and Mathematics
  • Mathematics aids in economic analysis derivation and exposition.
  • Managerial economics is both conceptual and metrical, needing economic factor estimation.
  • Mathematics offers concepts and operations lacking in descriptive analysis.
  • Symbols are convenient for handling problems.
  • Branches used include geometry, algebra, and calculus.
  • Concepts include logarithms, exponentials, vectors, determinants, and input-output tables.
1.4.4. Managerial Economics and Statistics
  • Statistics helps in quantifying past economic activity and predicting the future.
  • It helps to understand uncertainty conditions in decision-making.
1.4.5. Managerial Economics and the Theory of Decision-making
  • Decision theory recognizes multiple goals and uncertainty.
  • It balances conflicting objectives, probing motivation and influence.
  • Economic theory is valuable in clear situations, while decision-making theory suits complex problems.
  • It helps business executives to combine sales management, production management ideas and method.

1.5. Role of a Managerial Economist in Business

  • Tasks: making decisions and processing information.
  • Purpose of learning economic theory: to help managers know what information should be obtained and how to process and use the information.
  • The managerial economist is crucial for problem-solving and planning.
  • Tasks take two forms:
    • Specific decisions.
    • General use of available information.
  • Specific functions include production scheduling.
    Some Management Questions:
  1. What are the economic conditions?
  2. Should our firm be in this business?
  3. What price and output levels should we set to maximize profit or minimize losses?
  4. How can we organize and invest in resources to maintain a competitive advantage?
  5. What are the risks involved?

5. Demand Analysis

LEARNING OBJECTIVES:

Understand the behaviour of commodity demand
Specify a demand function: identifying the relevant variables in a real-world business situation
Locate the sources of demand
Identify the nature of demand

5.1. MEANING OF DEMAND

Demand for a commodity refers to the quantity of the commodity which an individual consumer or a household is willing to purchase per unit of time at a particular price.
Demand for a commodity implies-
(a) desire of the consumer to buy the product,
(b) his willingness to buy the product, and
(c) sufficient purchasing power in his possession to buy the product.
The demand may arise from an individual, a household as well as a market.

5.2. DETERMINANTS OF DEMAND

Important demand determinants are as follows:

  • General factors
    • Price of the product itself
    • Tastes and preferences of the consumer
    • Consumer's expectations of future prices
    • Consumer's expectations of future income
    • Income of the consumer
    • Prices of related goods (which include prices of substitutes and complements)
  • Additional factors related to luxury goods and durables
  • Additional factors related to market demand
    • Population
    • Social, economic and demographic distribution of consumers
(i) Price of the Commodity
  • For a normal good, the price of a commodity and its demand vary inversely, determinants other than the price of the commodity remaining constant.
(ii) Income of the Consumer
  • With an increase in income, a household buys an increased amount of most of the commodities in his consumption bundle. However, there are some commodities in whose case, beyond a point, the amount demanded even starts decreasing with further increases in income. Such commodities in case of which amount demanded decreases with an increase in income and increases with a decrease in income after a particular level of income, are called inferior goods.
(iii) Prices of Related Goods
  • When a change in the price of one commodity influences the demand of the other commodity, we say that the two commodities are related. These related commodities are of two types: substitutes and complements.
(iv) Tastes and Preferences
  • We know it quite well that the change in tastes and preferences of a consumer in favour of a commodity results in greater demand for the commodity, while if this change is against the commodity it results in a smaller demand for the commodity.
(v) Advertisement
  • A lot of money is spent on advertisement to influence the tastes and preferences of the consumers in their favour. This increases their sales.
(vi) Expectations
  • The consumers make two kinds of expectations:
    • related to their future income; and
    • related to future prices of the good and its related goods.
5.3. DEMAND FUNCTION

Mathematical expression of the relationship between variables.

  • Individual Demand Function
    Q<em>ax=f(P</em>x,Y,P<em>p1…P</em>pt,T,A,E<em>y,E</em>p,u)Q<em>{ax} = f(P</em>x, Y, P<em>{p1}…P</em>{pt}, T, A, E<em>y, E</em>p, u)

  • Qax: Quantity demanded of product X

  • Px: Price of product X

  • Y: Household income

  • PP: Prices of related products

  • T: Tastes of consumers

  • A: Advertising

  • Ey: Consumer's expected future income
    Ep: Consumer's expectations about future prices
    u: other determinants

  • Market Demand Function
    Q<em>ax=f(P</em>x,Y,P<em>p1…P</em>pt,T,A,E<em>y,E</em>p,P,D,u)Q<em>{ax} = f(P</em>x, Y, P<em>{p1}…P</em>{pt}, T, A, E<em>y, E</em>p, P, D, u)

  • P: population (reflects market size)

  • D: distribution of consumers.

  • The price of complements have a negative relationship with the demand for X. This implies that if the price of good X or prices of its complements increase, the quantity demanded of good X decreases. On the other hand, if the price of a substitute increases, or the consumer expects to have higher income in the future or he expects price of good X to rise in future, he will demand a larger quantity of good X.

  • Economists need explicit demand function. To illustrate let us assume that we are analyzing demand for refrigerators, whose market demand function is specified as,

Q=a<em>0+a</em>1P+a<em>2Y+a</em>3Pop+a4AQ = a<em>0 + a</em>1P + a<em>2Y+a</em>3Pop+a_4A

5.4. THE LAW OF DEMAND

Law of demand states that the amount demanded of a commodity and its price are inversely related, other things remaining constant.

The law of demand operates due to the underlying effects of substitution and real income changes. Any change in the commodity price affects the amount demanded of the commodity in two ways:

(i) substitution effect of a price change; and (ii) income effect of a price change.

5.4.1. Individual and Market Demand Schedules
  • For an individual/household, the amount demanded of a commodity is different at different prices. If we put in a tabular form the amount demanded of a commodity a different price levels of the commodity, we get a demand schedule.
5.4.2. Individual(A) and Market Demand Curves
  • The demand schedule when represented diagrammatically is known as a demand curve. When this diagram is based on an individual demand schedule, we get an individual demand curve.
5.4.3. Why do Demand Curves Slope Downwards?

The law of diminishing marginal utility is at the root of the law of demand. The law of diminishing utility states that as one goes on consuming more and more units of a commodity its utility to him goes on diminishing.

5.4.4. Forms of Demand Function

\begin{aligned}
q = \frac{a - p}{b} \text{ or } p = a - bq \
q = \frac{a}{b^p} \text{ or } p = -\frac{1}{b} \log(\frac{q}{a}) \
q = ae^{-bp} \text{ or } p = \frac{\log(a/p)}{b} \end{aligned}

Demand Estimation and Forecasting

Demand Estimating and Demand Forecasting
  • The ultimate purpose of the analysis is largely the difference between demand forecasting and demand estimating.
PREREQUISITES OF A GOOD FORECAST
  • A forecast must be consistent with other parts of the business.
  • A forecast should be based on knowledge of the relevant past.
  • A forecast must consider the economic and political environment, as well as any potential changes.
  • A forecast must be timely.
FORECASTING TECHNIQUES
  1. Expert opinion
  2. Opinion polls and market research
  3. Surveys of spending plans
  4. Economic indicators
  5. Projections
  6. Econometric models
  • Qualitative forecasting is based on judgments of individuals or groups. Quantitative forecasting, in contrast, generally uses significant amounts of prior data as a basis for prediction.
  • Quantitative techniques can be naive or causal (explanatory).
  • Naive forecasting projects past data into the future without explaining future trends.
  • Causal or explanatory forecasting attempts to explain the functional relationships between the variable to be estimated (the dependent variable) and the variable or variables that account for the changes (the independent variables).
Expert Opinion
  • Jury of executive opinion: Forecasts are generated by a group of corporate executives assembled together.
  • The Delphi Method:This method, developed by the Rand Corporation in the 1950s, is used primarily in predicting technological trends and changes.
Opinion Polls and Market Research
Rather than soliciting experts, opinion polls survey a population whose activity may determine future trends. Opinion polls can be very useful because they may identify changes in trends
Surveys of Spending Plans
  • The use of surveys of spending plans is quite similar to opinion polling and market research, and the methods of data collection are also quite alike.
Economic Indicators
  • Designed to alert business to changes in economic conditions.
  • There are three major series: leading, coincident, and lagging indicators.
Table 5.4 Economic Indicators
Leading indicators
  1. Average weekly hours, manufacturing
  2. Average weekly claims for unemployment insurance
  3. Manufacturers' new orders, consumer goods and materials industries
  4. Index of supplier deliveries-vendor performance
  5. Manufacturers' new orders, nondefense capital goods industries
  6. New private housing units authorized by local building permits
  7. Stock prices, 500 common stocks-S&P500
  8. Real money supply (M2)
  9. Interest rate spread, 10-year treasury bonds less federal funds rate
  10. Consumer expectations, University of Michigan
Coincident indicators
  1. Employees on nonagricultural payrolls
  2. Personal income less transfer payments
  3. Industrial production index
  4. Manufacturing and trade sales
Lagging indicators
  1. Average duration of unemployment
  2. Ratio, manufacturing and trade inventories to sales
  3. Change in index of labor cost per unit of manufacturing output
  4. Average prime rate charged by banks
  5. Commercial and industrial loans outstanding
  6. Ratio, consumer installment credit outstanding to personal income
  7. Change in consumer price index for services

Pricing and Output Decisions: Perfect Competition

Perfect Competition (no market power)

  1. Large number of relatively small buyers and sellers
  2. Standardized product
  3. Very easy market entry and exit
  4. Nonprice competition not possible

Monopoly (absolute market power subject to government regulation)

  1. One firm, firm is the industry
  2. Unique product or no close substitutes
  3. Market entry and exit difficult or legally impossible
  4. Nonprice competition not necessary

Monopolistic Competition (market power based on product differentiation)

  1. Large number of relatively small firms acting independently
  2. Differentiated product
  3. Market entry and exit relatively easy
  4. Nonprice competition very important

Oligopoly (market power based on product differentiation and/or the firm's dominance of the market)

  1. Small number of relatively large firms that are mutually interdependent
  2. Differentiated or standardized product
  3. Market entry and exit difficult
  4. Nonprice competition very important among firms selling differentiated products
Competition & Market Types in Economic Analysis

In economic analysis, the most important indicator of the degree of competition is the ability of firms to control the price and use it as a competitive weapon.

Key Assumptions of the Perfectly Competitive Market
  1. The firm operates in a perfectly competitive market and therefore is a price taker.
  2. The firm makes a distinction between the short run and the long run.
  3. The firm's objective is to maximize its profit in the short run. If it cannot earn a profit, then it seeks to minimize its loss
  4. The firm includes its opportunity cost of operating in a particular market as part of its total cost of production.

7.6. THE METHODS OF DEMAND FORECASTING

  • Opinion Polling Methods
    • Consumers' Survey
    • Sales Force Opinion
    • Experts' Opinion
    • Complete Enumeration Survey
    • Sample Survey and Test Marketing Method
  • Statistical Methods
    • Mechanical or Trend Projection Method
      • Trend Fitting by Least Squares
      • Linear Time Series Analysis Method
      • Moving Average
      • Exponential Smoothing
      • ARIMA Method
    • Barometric Method
      • Leading, Lagging and Coincident Indices
    • Regression Method
    • Simultaneous Equation Method

7.7. CRITERIA FOR THE CHOICE OF A GOOD FORECASTING METHOD

  1. The results achievable by a forecasting method must be weighed against the cost of the method.
  2. The use to which the forecast can be made should be well understood.
  3. It is quite easy to judge the existing trend. But for a good forecast, it is necessary that it should also predict deviations and turning points so that the forecasts are more effective.
  4. There is a time gap between the occurrence of an event and its forecast-known as the 'lead' time.

Macroeconomics and Business Cycle Theory

  • Managerial economics uses tools of microeconomics to enable managers to make business decisions to tackle day-to-day situations they face. The overall economic environment within which a firm operates is the macroeconomic scenario.
MACROECONOMICS
  • Macroeconomics is concerned with the behavior of the economy as a whole-with booms and recessions, the growth of output, inflation rate and unemployment rate, balance of payments and exchange rates. It deals with long-run economic growth and short-run oscillations that constitute business cycles.
  • The study of macroeconomics is centered on three perspectives that describe the real world.
Macroeconomic Model
  • Macroeconomics needs a model so we can express the inter-relationships between different factors in a set of compact equations.
  • Assume that we have an open economy; in other words, the country has trade relations with the rest of the world.
    Equation 1: Z+Y=C+I+G+XZ+Y=C+I+G+X Y=C+I+G+(X-Z)
Real Business Cycle Theory
  • According to this theory, short-run oscillations should be explained while maintaining the assumptions of the classical model, namely that prices are fully flexible even in the short run.
HAS THE BUSINESS CYCLE CLIMATE CHANGED OVER TIME IN INDIA?
  • Three broad approaches are the classical business cycle, growth cycle and growth rate cycle
WHAT IS A RECESSION? CAN IT BE PREDICTED?

A recession happens when a decline occurs in some measure of aggregate economic activity and in a domino effect causes decline in other key measures of activity transition between vicious and virtuous cycle signals the start and end date of
the recession

  • A rule for determining the onset of recession is two consecutive quarters of decline in GDP.

26.1. NATIONAL INCOME: AN INDICATOR OF ECONOMIC ACTIVITY
The most comprehensive indicator of the level of economic activity of an economy is its aggregate output, i.e., the total annual output of finished goods and services, known as gross national product (GNP), which is defined as the total market value of all final goods and services produced in an economy during a given time period (usually a year). GNP is a monetary measure of total output.

GNP- GNI- GNE
Sum of the market value of all final goods
and services produced in an economy during a
given time period;
Sum of the money incomes derived from
activities involving current production in an
economy during a given time period; and
Sum of all that is spent of currently produced
goods and services by all types of buyers in an
economy during a given time period.
1.Net product (or, Value-added)' method. This is basically the production method. Sum of net value of goods and services produced at market prices is found.
2.Income Method. This method is also known as the factor-share or income-distributed method. it says that incomes received by all the 'basic' factors of production used in the production process are summed up.
3.Expenditure Method. This method is known as the final product method. says that the total national expenditure is the sum of the expenditure incurred by the society in a particular year.

26.2. THE PARAMETERS THAT INFLUENCE LEVEL OF ECONOMIC ACTIVITY
  1. Aggregate Demand and Aggregate Supply. The process of producing goods and services gives rise to an aggregate amount of income equal to the market value of output. The income thus, received by the firms and households is used.
  2. The Leakages and Injections. S, T and M flows are leakages , G. I and X are injections to over all economic stability is to balance leakages and injections economic stability. S+T+M= G+I+x
  3. Propensities to Consume and Save. Consumption refers to the part of income spent by households on the purchase of final consumer goods and services in the economy. Savings refer to that part of income which a consumer does not spend on the current purchase of final goods and services marginal propensity to consume (MPC) is AC/ AY, the marginal propensity to save (MPS) is AS/ AY.
  4. Investment. At macro level, investment is defined as the aggregate expenditure of the economy on currently produced capital goods like machinery, buildings, additions to stocks of goods, etc.
  5. Marginal Efficiency of Capital. private investment is determined by two factors: marginal efficiency of capital (MEC), and rate of interest (i).
    PV= A/ (1+r/100)
26.3. BUSINESS CYCLES

a. Business cycles are the wave-like fluctuations in economic activity as reflected in the basic economic variables like employment, income, output, and price level.
b. cyclical changes. The economic variables can form the part of business cycle.
c.The changes in business cycle will give the four phases of cycle i.e., recovery, prosperity, depression, and recession in a fair and similar pattern.
d.The rhythm or the periodicity between the cycles need not be similar.
e.Business cycles change aggregate economic activity and not in any single firm or industry.

26.3.1. Characteristics of Business Cycles.

a.Generally a 'minor' cycle has a duration of 3 to 4 years. And, 2 or 3 of these cycles go to make up a'major' cycle. 6 to 12 years for major cycle.
b.10% to 25% above the long-term trend usually during prosperity.
c.It will be twice the time as depression will take.
d.Same sequence in all cycles.
e.Boom is high means next depression will severe.

26.3.2. Phases of Business Cycle.

it will be divided typically to the cycle with these four phase a:(1) the recovery (2) expansion (3) the recession and (4) the depression. with regular manner.

  1. RECOVERY. Revival of demand for goods and services. industrial and business will get loans easily.
  2. PROSPERITY. Rapid cumulative movement of prices, employment, income and production will show a upward trend with a more increase.
  3. RECESSION. During the phase of prosperity, production increases with every increase in commodity prices. banks become reluctant to advance loans to customer lead of profit margin to decline.
  4. DEPRESSION.the process of falling prices, demand and employment gather more momentum