Managerial economics (sometimes referred to as business economics) is a branch of economics that applies microeconomic analysis to decision methods of businesses

or other management units. As such, it bridges economic theory and economics in practice. It draws heavily from quantitative techniques such as regression analysis and correlation, Lagrangian calculus (linear). If there is a unifying theme that runs through most of managerial economics it is the attempt to optimize business decisions given the firm's objectives and given constraints imposed by scarcity, for example through the use of operations research and programming. managerial decision areas

assessment of investible funds selecting business area choice of product determining optimum output determining price of product determining input-combination and technology sales promotion

Almost any business decision can be analyzed with managerial economics techniques, but it is most commonly applied to:

Risk analysis - various models are used to quantify risk and asymmetric information and to employ them in decision rules to manage risk. Production analysis - microeconomic techniques are used to analyze production efficiency, optimum factor allocation, costs, economies of scale and to estimate the firm's cost function. Pricing analysis - microeconomic techniques are used to analyze various pricing decisions including transfer pricing, joint product pricing, price discrimination, price elasticity estimations, and choosing the optimum pricing method. Capital budgeting - Investment theory is used to examine a firm's capital purchasing decisions.

At universities, the subject is taught primarily to advanced undergraduates and graduate business schools. It is approached as an integration subject. That is, it integrates many concepts from a wide variety of prerequisite courses. In many countries it is possible to read for a degree in Business Economics which often covers managerial economics, financial economics, game theory, business forecasting and industrial economics

Decisions made by managers are crucial to the success or failure of a business. Roles played by business managers are becoming increasingly more challenging as complexity in the business world grows. Business decisions are increasingly dependent on constraints imposed from outside the economy in which a particular business is based both in terms of production of goods as well as the markets for the goods produced. The

impact of rapid technological change on innovation in products and processes, as well as in marketing and sales techniques, figures prominently among the factors contributing to the increasing complexity of the business environment. Moreover, because of increased globalization of the marketplace, there is more volatility in both input and product prices. The continuous changes in the economic and business environment make it ever more difficult to accurately evaluate the outcome of a business decision. In such a changing environment, sound economic analysis becomes all the more important as a basis of decision making. Managerial economics is a discipline that is designed to provide a solid foundation of economic understanding in order for business managers to make well-informed and well-analyzed managerial decisions.

THE NATURE OF MANAGERIAL ECONOMICS

There are a number of issues relevant to businesses that are based on economic thinking or analysis. Examples of questions that managerial economics attempts to answer are: What determines whether an aspiring business firm should enter a particular industry or simply start producing a new product or service? Should a firm continue to be in business in an industry in which it is currently engaged or cut its losses and exit the industry? Why do some professions pay handsome salaries, whereas some others pay barely enough to survive? How can the business best motivate the employees of a firm? The issues relevant to managerial economics can be further focused by expanding on the first two of the preceding questions. Let us consider the first question in which a firm (or a would-be firm) is considering entering an industry. For example, what led Frederick W. Smith the founder of Federal Express, to start his overnight mail service? A service of this nature did not exist in any significant form in the United States, and people seemed to be doing just fine without overnight mail service provided by a private corporation. One can also consider why there are now so many overnight mail carriers such as United Parcel Service and Airborne Express. The second example pertains to the exit from an industry, specifically, the airline industry in the United States. Pan Am, a pioneer in public air transportation, is no longer in operation, while some airlines such as TWA (Trans World Airlines) are on the verge of exiting the airlines industry. Why, then, have

many airlines that operate on international routes fallen on hard times, while small regional airlines seem to be doing just fine? Managerial economics provides answers to these questions. In order to answer pertinent questions, managerial economics applies economic theories, tools, and techniques to administrative and business decision-making. The first step in the decision-making process is to collect relevant economic data carefully and to organize the economic information contained in data collected in such a way as to establish a clear basis for managerial decisions. The goals of the particular business organization must then be clearly spelled out. Based on these stated goals, suitable managerial objectives are formulated. The issue of central concern in the decisionmaking process is that the desired objectives be reached in the best possible manner. The term "best" in the decision-making context primarily refers to achieving the goals in the most efficient manner, with the minimum use of available resourcesimplying there be no waste of resources. Managerial economics helps the manager to make good decisions by providing information on waste associated with a proposed decision.

APPLICATIONS OF MANAGERIAL ECONOMICS

Some examples of managerial decisions have been provided above. The application of managerial economics is, by no means, limited to these examples. Tools of managerial economics can be used to achieve virtually all the goals of a business organization in an efficient manner. Typical managerial decision making may involve one of the following issues:

Deciding the price of a product and the quantity of the commodity to be produced Deciding whether to manufacture a product or to buy from another manufacturer Choosing the production technique to be employed in the production of a given product Deciding on the level of inventory a firm will maintain of a product or raw material Deciding on the advertising media and the intensity of the advertising campaign Making employment and training decisions

Making decisions regarding further business investment and the mode of financing the investment

It should be noted that the application of managerial economics is not limited to profitseeking business organizations. Tools of managerial economics can be applied equally well to decision problems of nonprofit organizations. Mark Hirschey and James L. Pappas cite the example of a nonprofit hospital. While a nonprofit hospital is not like a typical firm seeking to maximize its profits, a hospital does strive to provide its patients the best medical care possible given its limited staff (doctors, nurses, and support staff), equipment, space, and other resources. The hospital administrator can use the concepts and tools of managerial economics to determine the optimal allocation of the limited resources available to the hospital. In addition to nonprofit business organizations, government agencies and other nonprofit organizations (such as cooperatives, schools, and museums) can use the techniques of managerial decision making to achieve goals in the most efficient manner. While managerial economics is helpful in making optimal decisions, one should be aware that it only describes the predictable economic consequences of a managerial decision. For example, tools of managerial economics can explain the effects of imposing automobile import quotas on the availability of domestic cars, prices charged for automobiles, and the extent of competition in the auto industry. Analysis of managerial economics will reveal that fewer cars will be available, prices of automobiles will increase, and the extent of competition will be reduced. Managerial economics does not address, however, whether imposing automobile import quotas is good government policy. This latter question encompasses broader political considerations involving what economists call value judgments.

ECONOMIC CONCEPTS USED IN MANAGERIAL ECONOMICS

Managerial economics uses a wide variety of economic concepts, tools, and techniques in the decision-making process. These concepts can be placed in three broad categories: (1) the theory of the firm, which describes how businesses make a variety of decisions;

(2) the theory of consumer behavior, which describes decision making by consumers; and (3) the theory of market structure and pricing, which describes the structure and characteristics of different market forms under which business firms operate.

THE THEORY OF THE FIRM

Discussing the theory of the firm is an useful way to begin the study of managerial economics, since the theory provides a broad framework within which issues relevant to managerial decisions are analyzed. A firm can be considered a combination of people, physical and financial resources, and a variety of information. Firms exist because they perform useful functions in society by producing and distributing goods and services. In the process of accomplishing this, they use society's scarce resources, provide employment, and pay taxes. If economic activities of society can be simply put into two categoriesproduction and consumptionfirms are considered the most basic economic entities on the production side, while consumers form the basic economic entities on the consumption side. The behavior of firms is usually analyzed in the context of an economic model, an idealized version of a real-world firm. The basic economic model of a business enterprise is called the theory of the firm.

PROFIT MAXIMIZATION AND THE FIRM.

Under the simplest version of the theory of the firm it is assumed that profit maximization is its primary goal. In this version of the theory, the firm's owner is the manager of the firm, and thus, the firm's owner-manager is assumed to maximize the firm's short-term profits (current profits and profits in the near future). Today, even when the profit maximizing assumption is maintained, the notion of profits has been broadened to take into account uncertainty faced by the firm (in realizing profits) and the time value of money (where the value of a dollar further and further in the future is increasingly smaller than a dollar today). In this more complete model, the goal of maximizing short-term profits is replaced by goal of maximizing long-term profits, the present value of expected profits, of the business firm.

Defining present value of expected profits is based on first defining "value" and then defining "present value." Many concepts of value, such as book value, market value, going-concern value, break-up value, and liquidating value, are encountered in business and economics. The value of the firm is defined as the present value of expected future profits (net cash flows) of the firm. Thus, to obtain an estimate of the present value of expected profits, one must identify the stream of net cash flow in future years. Once this is accomplished, these expected future profit values are converted into present value by discounting these values by an appropriate interest rate. For illustration, assume that a firm expects a profit of $10,000 in one year and $20,000 in the second year it is assumed that the firm earns no profits after two years. Let us assume that the prevailing interest rate is 10 percent per annum. Thus, $10,000 in a year from now is only equal to about $9,091 at the present ([$10,000/(1 +0.1)] = $9,091)that is, the present value of a $10,000 profit expected in a year from now is about $9,091. Similarly, the present value of an expected profit of $20,000 in two years from now is equal to about $16,529 (since [$20,000/(1 + 0.1)2] = $16,529). Therefore, the present value of future expected profits is $25,620 (equal to the sum of $9,091 and $16,529). The present value of expected profits is a key concept in understanding the theory of the firm, and maximizing this profit is considered the primary goal of a firm in most models. It should be noted that expected profit in any one period can itself be considered as the difference between the total revenue and the total cost in that period. Thus, one can, alternatively, find the present value of expected future profits by subtracting the present value of expected future costs from the present value of expected future revenues.

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Managerial economics applies economic theory and methods to business and administrative decision making. Managerial economics prescribes rules for improving managerial decisions. Managerial economics also helps managers recognize how economic forces affect organizations and describes the economic consequences of managerial behavior. It links traditional economics with the decision sciences to develop vital tools for managerial decision making. This process is illustrated in Figure 1.1. Managerial economics identifies ways to efficiently achieve goals. For example, suppose a small business seeks rapid growth to reach a size that permits efficient use of national media advertising. Managerial economics can be used to identify pricing and production strategies to help meet this short-run objective quickly and effectively

THE ROLE OFMANAGERIAL ECONOMICS INMANAGERIAL DECISIONMAKING

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Similarly, managerial economics provides production and marketing rules that permit the company to maximize net profits once it has achieved growth objectives. Managerial economics has applications in both profit and not-for-profit sectors. For example, an administrator of a nonprofit hospital strives to provide the best medical care possible given limited medical staff, equipment, and related resources. Using the tools and concepts of managerial economics, the administrator can determine the optimal allocation of these limited resources. In short, managerial economics helps managers arrive at a set of operating rules that aid in the efficient use of scarce human and capital resources. By following these rules, businesses, nonprofit organizations, and government agencies are able to meet objectives efficiently. To establish appropriate decision rules, managers must understand the economic environment in which they operate. For example, a grocery retailer may offer consumers a highly price-sensitive product, such as milk, at an extremely low markup over costsay, 1%or 2%while offering less price-sensitive products, such as nonprescription drugs, at markups of as high as 40% over cost.

CHAPTER SUMMARY Managerial economics is the science of directing scarce resources to manage cost effectively. It consists of three branches: competitive markets, market power, and imperfect markets. A market consists of buyers and sellers that communicate with each other for voluntary exchange. Whether a market is local or global, the same managerial economics apply. A seller with market power will have freedom to choose suppliers, set prices, and use advertising to influence demand. A market is imperfect when one party directly conveys a benefit or cost to others, or when one party has better information than others. An organization must decide its vertical and horizontal boundaries. For effective management, it is important to distinguish marginal from average values and stocks from flows. Managerial economics applies models that are necessarily less than completely realistic. Typically, a model focuses on one issue, holding other things equal. KEY CONCEPTS ue horizontal boundaries economic model other things equal market power marginal value vertical boundaries imperfect market GENERAL CHAPTER OBJECTIVES 1. Define managerial economics and introduce students to the typical issues encountered in the field. 2. Discuss the scope and methodology of managerial economics. 3. Distinguish a marginal concept from its average and a stock concept from a flow. Chapter
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4. Describe the importance of the "other things equal" assumption in managerial economic analysis. 5. Describe what constitutes a market, distinguish competitive from non-competitive markets, and discuss imperfect markets. 6. Emphasize the globalization of markets. NOTES 1. Definition. Managerial economics is the science of directing scarce resources to manage cost effectively. 2. Application. Managerial economics applies to: (a) Businesses (such as decisions in relation to customers including pricing and advertising; suppliers; competitors or the internal workings of the organization), nonprofit organizations, and households. (b) The old economy and new economy in essentially the same way except for two distinctive aspects of the new economy: the importance of network effects and scale and scope economies. i. network effects in demand the benefit provided by a service depends on the total number of other users, e.g., when only one person had email, she had no one to communicate with, but with 100 mm users on line, the demand for Internet services mushroomed. ii. scale and scope economies scaleability is the degree to which scale and scope of a business can be increased without a corresponding increase in costs, e.g., the information in Yahoo is eminently scaleable (the same information can serve 100 as well as 100 mm users) and to serve a larger number of users, Yahoo needs only increase the capacity of its computers and links. iii. Note: the term open technology (of the Internet) refers to the relatively free admission of developers of content and applications. (c) Both global and local markets. 3. Scope. (a) Microeconomics the study of individual economic behavior where resources are costly, e.g., how consumers respond to changes in prices and income, how businesses decide on employment and sales, voters behavior and setting of tax policy. (b) Managerial economies the application of microeconomics to managerial issues (a scope more limited than microeconomics). (c) Macroeconomics the study of aggregate economic variables directly (as opposed to the aggregation of individual consumers and businesses), e.g., issues relating to interest and exchange rates, inflation, unemployment, import and export policies.
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4. Methodology. (a) Fundamental premise - economic behavior is systematic and therefore can be studied. Systematic economic behavior means individuals share common motivations and behave systematically in making economic choices, i.e, a person who faces the same choices at two different times will behave in the same way both times. (b) Economic model a concise description of behavior and outcomes: i. focuses on particular issues and key variables (e.g., price, salary), omits considerable information, hence unrealistic at times; ii. constructed by inductive reasoning; iii. to be tested with empirical data and revised as appropriate. 5. Basic concepts. (a) Margin vis a vis average variables in managerial economics analyses. i. marginal value of a variable the change in the variable associated with a unit increase in a driver, e.g., amount earned by working one more hour; ii. average value of a variable the total value of the variable divided by the total quantity of a driver, e.g., total pay divided by total no. of hours worked; iii. driver the independent variable, e.g., no. of hours worked; iv. the marginal value of a variable may be less that, equal to, or greater than the average value, depending on whether the marginal value is decreasing, constant or increasing with respect to the driver; v. if the marginal value of a variable is greater than its average value, the average value increases, and vice versa. (b) Stocks and flows. i. stock the quantity at a specific point in time, measured in units of the item, e.g., items on a balance sheet (assets and liabilities), the worlds oil reserves in the beginning of a year; ii. Flow the change in stock over some period of time, measured in units per time period e.g., items on an income statement (receipts and expenses), the worlds current production of oil per day. (c) Holding other things equal the assumption that all other relevant factors do not change, and is made so that changes due to the factor being studied may be examined independently of those other factors. Having analysed the effects of each factor, they can be put together for the complete picture. 6. Organizational boundaries. (a) Organizations include businesses, non-profits and households. (b) Vertical boundaries delineate activities closer to or further from the end user. (c) Horizontal boundaries - relate to economies of scale (rate of production or delivery of a good or service) and scope (range of different items produced or delivered).
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(d) Organizations which are members of the same industry may choose different vertical and horizontal boundaries. 7. Competitive markets. (a) Markets. i. a market consists of buyers and sellers that communicate with one another for voluntary exchange. It is not limited by physical structure. ii. in markets for consumer products, the buyers are households and sellers are businesses. iii. in markets for industrial products, both buyers and sellers are businesses. iv. in markets for human resources, buyers are businesses and sellers are households. v. Note: an industry is made up of businesses engaged in the production or delivery of the same or similar items. (b) Competitive markets. i. markets with many buyers and many sellers, where buyers provide the demand and sellers provide the supply, e.g., the silver market. ii. the demand-supply model - basic starting point of managerial economics, the model describes the systematic effect of changes in prices and other economic variables on buyers and sellers, and the interaction of these choices. (c) Non-competitive markets a market in which market power exists. 8. Market power. (a) Market power - the ability of a buyer or seller to influence market conditions. A seller with market power will have the freedom to choose suppliers, set prices and influence demand. (b) Businesses with market power, whether buyers or sellers, still need to understand and manage their costs. (c) In addition to managing costs, sellers with market power need to manage their demand through price, advertising, and policy toward competitors. 9. Imperfect Market. (a) Imperfect market - where one party directly conveys a benefit or cost to others, or where one party has better information than others. (b) The challenge is to resolve the imperfection and be cost-effective. (c) Imperfections can also arise within an organization, and hence, another issue in managerial economics is how to structure incentives and organizations. 10. Local vis a vis global markets. (a) Local markets owing to relatively high costs of communication and trade, some markets are local, e.g., housing, groceries. The price in one local market is independent of prices in other local markets.
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(b) Global markets - owing to relatively low costs of communication and trade, some markets are global, e.g., mining, shipping, financial services. The price of an item with a global market in one place will move together with the pries elsewhere. (c) Whether a market is local or global, the same managerial economic principles apply. (d) Note: Falling costs of communication and trade are causing more markets to be more integrated across geographical border enabling the opportunity to sell in new markets as well as global sourcing. Foreign sources may provide cheaper skilled labor, specialized resources, or superior quality, resulting in lower production costs and/or improved quality.