Nature and Scope of Managerial Economics

1. Introduction

Managerial economics is a special branch of economics evolved to bridge

the gap between abstract theory and managerial practice. It deals with
the use of economic concepts and principles for decision-making and
forward planning through an uncertain future. Economic theory provides a
number of concepts and analytical tools which are of considerable
significance to the executives in their decision-making process in an
uncertainty framework. But this does not mean that economic provides
answers for all the problems faced by the firm or a business unit. In
practice, many more skills are to be developed in solving the variety of
problems faced by the firm. Only conceptual knowledge is of no use. The
executives have to develop necessary skills to make use of their
knowledge in the context of the firm. Managerial economics, therefore,
refers to only those aspects of economics that are useful in the decision
making process of the firm. The scope of managerial economics mainly
confines to microeconomics and it generally does not extend to
macroeconomics. This does not mean that macroeconomics is completely
useless to a managerial economist. Even though the scope of managerial
economic does not cover the area of macroeconomics, its understanding is
absolutely essential for a potential business executive.

Managerial economics is thus a science which deals with the application of

economic theory to managerial practice. It lies on the borderline of
economics and business management. It may be defined precisely as the
study of the allocation of resources available to a firm among its activities.
Briefly, managerial economics may be called ‘economics applied in
decision making’. It is mainly concerned with classifying problems,
organizing and evaluating information and ultimately comparing the
alternative course of action.

McNair and Meriam in their book Problems in Business Economics maintain

that the managerial economics consists of the use of economic modes of
thought to analyze business situations. According to Milton H. Spencer
and Louis Siegelman, managerial economics is the integration of economic
theory with business practice for the purpose of facilitating decision
making and forward planning by management.

Managerial economics is highly pragmatic. It deals mainly with analytical

tools that are useful in decision-making process. It avoids some of the
abstract issues of economic theory, but has also certain complications that
are neglected in theory. Managerial economics, therefore, considers
particular environment of decision-making. William J. Baumol in his
article, ‘What Can Economic Theory Contribute to managerial Economics?’,
points out that it is not the final theorems of economics that are important
to management but rather the methods of reasoning. Managerial
economics borrows only the analytical tools of economic theory and gives
very little importance to the final theorems of economics.

Managerial economics is thus realistic in nature. It is applied to solve

some of the problems faced by the firm. These problems generally relate
to choices faced by the firm. These problems generally relate to choices
and allocation of recourses which are essentially economic in character
and are experienced by the managers. It should be remembered here that
even though managerial economics helps a great deal in solving some of
the ticklish problems of the firm by influencing decision-making process,
the decision-making process is not only dependent on the tools and
concepts of managerial economics; but there are several other factors
which also significantly influences the decision-making process of the firm.
In other words, managerial decision-making is influenced not only by
economic factors but also by many other considerations. The other factors
influencing the decisions made by the managers are:
i) Human and behavioral consideration
ii) Technological forces
iii) Environmental factors
2. Scope/Areas of Managerial Economics

The areas of business issues to which economic theories can be directly

applied may be divided into followings:
a) Demand Analysis and Forecasting
b) Cost and Production Analysis
c) Pricing Decision, Policies and Practices
d) Profit Management
e) Capital Management
f) Linear Programming and the Theory of Games

(a) Demand Analysis and Forecasting. Effective decision-making at

the fir level depends on accurate estimates of demand. Demand
analysis aims at discovering the forces that determine sales. It has two
main managerial purposes (i) forecasting sales, and (ii) manipulating
demand. It is useful for business planning and hence occupies a pivotal
place in managerial economics. The demand analysis mainly relates to
the study of demand determinants, demand distinctions and demand
forecasting.
The Case of Wool production:
a) During the late 1980s, wool prices increased considerably due to
increased demand by China and the former Soviet Union. From
1977 to 1988, the price of wool for worsted clothing rose from
$3.67 to $5.81 per pound. Expecting that wool prices would remain
high, wool producers raised a lot more sheep. Did this result in a
shift right in the supply curve for wool?
b) At the same time the Chinese and Russians cut back on their
purchases of wool because of lack of foreign currency (and in the
case of Chain because of organizational problem).
c) Australia is the world’s largest producer of wool and for a time
Australia Wool Corporation propped up the price of wool by buying
up any unsold Australian wool.
Why was it necessary to prevent the price from falling?
(b) Cost and Production Analysis. Cost estimates are also essential
for effective decision-making and production planning at the firm level.
Profit planning, cost control and sound pricing practices call for an
accurate cost and production analysis. Cost analysis is wider in scope
than the production analysis. While production analysis is in physical
terms, the cost analysis is in monetary terms. Cost analysis deals with
cost concepts and classifications, cost-output relations, economies and
diseconomies of scale, production functions and cost control.
Production theory helps in determine the size of firm, size of the total
output and the factor proportion, that is, the amount of capital and
labor to be employed.

(c) Pricing decisions, Policies and Practices. Pricing is an important

area of managerial economics. Success of a business firm largely
depends on the accuracy of price decisions. Price determination under
different markets, pricing methods and policies product line pricing and
price forecasting are some of the topics studied in this area.

(d) Profit management. Business firms are mainly profit-hunting

institutions. The success of the firm is always measured in terms of
profits. Nature and management of profits, profits policies and
techniques and profit planning are the important aspects covered
under his area.

(e) Capital Management. The most complex, troublesome and ticklish

problem faced by a business manager is the capital management.
Capital management implies planning and control of capital
expenditures. Cost of capital, rate of return selection projects are the
important topics to be studied under capital management.

(f) Linear Programming and the Theory of Games. Since managerial

economics and operations research are closely connected with each
other, managerial economics has started using such techniques of
 operations research as Linear Programming and the Theory of Games.
Recently, the Linear Programming and Theory of Games have been
brought as a part of the study of managerial economics.

3. Managerial Economics and other Disciplines

Managerial economics is closely related to other disciplines. It is intimately

related to microeconomic theory, macroeconomic theory, the theory of
decision-making, operations research, mathematics, statics and
accounting. The management executive makes use of the concepts and
methods form all these disciplines.

Managerial Economics and Microeconomic Theory

Managerial economics is mainly microeconomic in character.
Microeconomic theory provides all important concepts and analytical tools
to managerial economics. Managerial economic makes use of such micro
economic concepts as the elasticity of demand, marginal cost, market
structures, short and long-runs and so on. It also deals with monopoly
price, the kinked demand theory and the price discrimination. While
making use of some of these microeconomic concepts, managerial
economics also neglects some of the important issues that occupy a
pivotal place in economic theory. For instance, managerial economic is
totally indifferent to the indifference curves which have helped in clarifying
important aspects in economic theory such as separation of income and
substitution effects of price change. Managerial economics tries to use
only those concepts of microeconomic theory which command immediate
applicability.

Microeconomic theory mainly deals with the theory of firm and the theory
of pricing. The main concepts and analytical apparatus of managerial
economics are drawn from these two branches of macroeconomics theory.
The study of microeconomic theory, therefore, constitutes an essential
condition for the better understanding of the managerial economics.
Managerial Economics and Macroeconomic Theory
Macroeconomic theory has comparatively less concern with the
managerial economics. It is useful to managerial economics mainly in the
area of forecasting. Macroeconomic theory being aggregative in character
is immense importance in forecasting general business conditions. The
general theory of income and employment, which is at the core of
macroeconomics, has a direct impact upon the forecasting of general
business conditions. Managerial economics makes use of such
macroeconomic concepts as the National Income and Social Accounting,
Propensity to Consume, Marginal Efficiency of Capital, the Multiplier, the
Accelerator, Liquidity Preference, Business Cycles, Public Finance and
Fiscal Policy; and so on. Since the decisions at a firm level are taken in
the board framework of an economic system, it becomes essential
conditions. It is in this context, macroeconomic theory is useful to
managerial economics.

In recent years, a new branch of study known as the Business

Environment and Policy has come into vogue which has relevance to
macro economic theory.

Managerial economics is thus closely related to both micro and

macroeconomic theory. The relation of managerial economics and
economic theory is like the relation of engineering to physics.

Managerial Economics and the Theory of Decision Making

Managerial economics is also closely related to the theory of decision-
making. The theory of decision-making is comparatively a new subject. It
deals with the processes by which a particular course of action is selected
from out of a number of alternatives available. It details the processes by
which expectations under conditions of uncertainty framework are
constituted. It takes into account of uncertainty the sociological and
psychological factors influencing human behavior. In practice, the theory
of decision-making and economic theory come in contrast with each other
as they are based on a different set of assumptions. The case method
employed in managerial economics is a part and parcel of the theory of
decision-making.

Managerial Economics and Operations Research

Operations research is one of the most important developments in the
fields of management science. Even though the roots of operation all
areas of administrations requiring planning and control in all areas of
administration requiring planning and control. Operations research has
been broadly defined as the application of mathematical techniques in
solving the business problems. It deals with model building – the
construction of theoretical models that helps the decision-making process.

The origin of Operation Research can be traced back to the inter-

disciplinary research that took place in the United States and other
Western countries to solve the complicated operational problems of
planning and resource allocation in defense and key disciplines such as
engineers, statisticians, mathematicians and other came together and
developed models and other apparatus. Since then, these have grown into
specialized fields known as Operations Research.

Operations research has enhanced the utility of managerial economics in

actual practice. Managerial economics has a very close connection with
the operations research. The techniques of operations research are highly
mathematical in character. One of the popular techniques evolved and
very often used is the Linear or Mathematical Programming. It is applied
to a variety of problems of choice. Managerial economics makes use of
linear programming and other concepts of operations research for dealing
with problems involving risk and uncertainty.

Managerial Economics and Mathematics

Mathematics is another subject with which managerial economics has a
very close relation. Recent advancements have compelled the business
executives to make use of mathematical concepts and techniques.
Mathematics has almost become a part and parcel of the managerial
economics. Managerial economics today has become metrical in character.
Professor Joel Dean in the early stages of the development of the
managerial economics maintained that it is conceptual rather than
metrical. But Professors Savage and Small contend that ‘managerial
economics should be both conceptual and metrical ; for while
measurement without theory can only lead to false precision, theory
without measurement can rarely be operationally useful’. Mathematics is
useful in managerial economics in estimating various economic
relationships, measuring relevant economic quantities and employing
them in decision-making and forward planning. Modern business executive
therefore should have the knowledge of geometry, trigonometry, and
algebra and also of integral and differential calculus.

Managerial Economics and Statistics

Statistics is also useful in many ways to managerial economics.
Managerial economics obtains the basis for the empirical testing of theory
from statistics. The importance of statistics to managerial economics also
lies in the fact that it provides the individual firm with measures of the
appropriate functional relationship involved in decision-making. Since
management executives take their decisions in an uncertainly framework,
the theory of probability evolved in statistics provides the logic for dealing
with such uncertainty. Management executives are constantly confronted
with the choice between models neglecting uncertainty and those that
involve probability theory. Therefore, there exists a very close relation
between statistics and managerial economics.

Managerial Economics, Management Theory and Accounting

Management theory and Accounting also exercise a profound influence on
managerial economics. Since decision-making is mainly the function of
management, the developments in management theory do influence
managerial economics which helps the process of decision-making at the
firm level. Modern management theorists now contend that satisfying is
the objective of modern firms’ rather than maximizing as thought earlier.
Managerial economics cannot afford to ignore these development and
changing views of management theorists as they have important bearing
on the decision-making process of the firm.
There also exists a very close relationship between managerial economics
and accounting. Accounting refers to the recording of pecuniary
transactions of the firm in certain prescribed books. The decision-making
process of the firm depends heavily on accounting information. Language
of business consists of accounting data and statements. Therefore,
managerial economists have to get him acquainted with the concepts and
practices of accounting. He should also know the interpretation and use of
accounting data. Growing specialization in the form of Cost and
Management Accounting has become much common in recent years.
Managerial economist has to keep pace with the changing times.
Accounting has in fact strengthened the applied bias of managerial
economics.

Case Study:

Decision Making in Business and Military Strategy

According to William E. Peacock, a former president of two St. Louis
companies and Assistant Secretary of the Army, decision making in
business has much in common with military strategy. Although business
managers’ actions are restricted by laws and regulations to prevent unfair
practices and the objective of managers, of course, is not to literally
destroy the competition, there is much that they can learn from military
strategists. Peacock points out that, down through history; military
conflicts have produced a set of Darwinian basic principles that are an
excellent guideline to business managers in meeting the competitions in
the market place. Neglecting these principles can make the difference
between business success and failure.

In business as in war, it is crucial to have clear objective as to what the

organization wants to accomplish and to explain this objective to all
employees. The benefits of a simple marketing strategy that all employees
can understand are clearly evidenced by the success of McDonald’s. Both
business and warfare also require the development of a strategy for
attacking. Being aggressive is important because few competitions are
ever won by being passive. Furthermore, both business and warfare
require unity of command to pinpoint responsibility. Even in decentralized
companies with informal lines of command, there are always key
individuals who must make important decisions. Finally, in business as in
war, the element of surprise and security (keeping your strategy secret) is
crucial. For example, Lee Iacocca stunned the competition in 1964 by
introducing the immensely successful Mustang. Furthermore, industrial
espionage to discover a rival’s plans or steal a rival’s new technological
breakthrough is becoming increasingly common.

More than ever before, today’s business leaders must learn how to tap
employees’ ideas and energy, manage large-scale rapid change, anticipate
business conditions five or ten years down the road, and muster the
courage to steer the firm in radical new directions when necessary. Above
all, firms must think and act strategically in a world of increasing global
competitions.

4. Characteristics/Features of Managerial Economics

1 Managerial economics basically uses the principles of micro
economics that is micro economic in character; It studies the
business units and only the problems of business firms are
studied.
2 It uses price theory than the theory of distribution. It uses only
profit theories, which is a part of the theory of distribution.
3 Managerial economics is more normative in character. Traditional
economics is descriptive in character. It does not care at all
whether a thing is good or bad. For example, it explains that
according to the law of demand price increases when demand
increases, but does not say whether the increase in price is good
or bad. On the other hand, since managerial economics is
concerned with decision-making , it includes value judgment.
4 Managerial economics integrates the economic theory and
business practice.
Nature of Profit

Every business firm is organized with the objective of making profits.

Profits are the primary measure of its success. The survival of any firm
depends upon its ability to earn profits.

The word profit has different meaning to businessman, workers and

economists. The meaning of profit;
- to a layman, profit means all income that flow to the investors,
- to a business community, profit refers to the revenue of the firm
minus the explicit and accounting cost,
To an economist, profit is of pure profit also called economic profit.

Profit is described as a reward for entrepreneurship for successfully

managing the businessman faces certain risks which can be divided
broadly into two categories.
i) Insurable risks
ii) Non-insurable risks

Insurable risk are those which can be calculated and insured against with
the insurance companies. The entrepreneur does not bother much about
these risks as they are covered by insurance companies. For example risk
like due to fire, earthquake, floods, other natural calamities, loss due to
theft, burglary, and robbery.

Non-insurable risks are those which cannot be measured and insured

against. These are to be necessarily borne by the entrepreneur himself.
These are known as non-insurable risks and include the risk of
competition, technical risks, business cycle risks, risk or development of
new products and risks arising from government action through changes
in economic policy.

The non-insurable risks are described by the professor F.H. Knight.

According to him- “Profit is a reward for assuming and successfully
managing risks and for bearing uncertainties.”
Profit, according to some writers, is essentially a residual sum. It is the
income received by an organizer. A firm makes profits when it receives a
surplus after it has paid interest on capital, wages to laborers and rent for
land. In other words, profit is the residual income which is equal to the
difference between the total revenue and the total cost of production.

Profits nay arise also on account of market imperfections and monopoly.

They arise due to the monopolistic control which the organizer is able to
acquire in the market due to certain peculiar conditions prevalent.
Monopolistic control gives the entrepreneur complete control over the
supply of a commodity and the price fixation in the absence of any
competition. This situation contributes to the emergence of profits.

Sometimes profits are due to mere luck. Few entrepreneurs flourish only
due to their good luck. Few entrepreneurs flourish only due to their good
luck. Apart from luck, sometimes profits many arise just by chance that
appears in the business. For instance, during the World War some
countries could get the chance of selling their commodities at a better and
higher price in the market. Such profits are called the fortuitous gains.

Professor Schumpeter, a noted German economist, is of the opinion that

profits arise on account of economic innovation. Economic innovation
implies the introduction of a new product, introduction of a new process,
opening of a new market, invention of new methods of production,
development of a new source of raw material and new methods of
business organization. Innovation, according to Schumpeter, is the source
of profits.

Economic and Accounting Profit

The two important concepts of profits that figure in business are:

economic profit and accounting profit. In accounting sense profit is surplus
of revenue over and above all paid-out costs. Accounting profit may be
calculated as:
 Accounting Profit = TR ─ (W + R + I + M)
where,
TR = Total Revenue,
W = Wages and salaries
R = Rent
I = Interest, and
M = Cost of materials

While calculating accounting profits, only explicit costs or book costs are
considered.

Economic profit takes into account also the implicit costs or opportunity
costs. Opportunity cost is income forgone which a businessman could
expect from the second best alternative use of his resources. For example,
if an entrepreneur uses his capital in his own business, he forgoes interest
which he might earn by purchasing debenture of other companies or by
depositing his money with joint stock companies for a period.
Furthermore, if an entrepreneur uses his labour in his own business, he
forgoes his salary which he might earn by working as a manager in
another firm. Similarly, by using productive assets (land and building) in
his own business, he sacrifices his market rent. These foregone incomes
are called opportunity costs.

Economic profit or pure profit may be defined as a residual left after all
contractual costs have been met, including insurable risk, depreciation,
payment to shareholders. Thus,

Economic Profit = Total Revenue ─ (Explicit cost + Implicit cost)

Limitations:
1) Economic profit may exist only in short period; it does not exist in
the long-run especially under perfect competition.

2) It may not be possible to calculate the economic profit every year by

a single firm.
Problem related to profit of a business

A business person who has a MBA degree invests Rs.200,000 in a retail

shop. The projected income statement for the year as prepared by an
accountant is shown as:

Rs. Rs.

Sales 90,000

Less: Cost of goods 40,000

sold

Gross Profit 50,000

Less: Advertising 10,000

Depreciation 10,000

Utilities 3,000

Property Tax 2,000

Miscellaneous 5,000
Expenses

Total of Expenses 30,000

Net Annual Profit 20,000

In the above income and expenditure statement net accounting profit or

business profit is Rs.20,000. The economists recognize other costs,
defined as implicit costs. Implicit costs are not included in the accounting
statements, but must be included in any rational decision making
framework.

There are two major implicit costs in the preceding example:

i) The owner has Rs.200,000 invested in the business. Suppose the

best alternative use for this money is a bank account paying a 5
percent interest rate. Therefore, this investment would return
Rs.10,000 annually. This Rs.10,000 should be considered as the
implicit or opportunity cost of having Rs.200,000 invested in the
retain store.

ii) The second implicit cost includes the managers' time and talent.
The annual wage return on an MBA degree from a reasonably
 good business school may be Rs.60,000 per year. Thus, the
income statement should be amended in the following way in
order to determine economic profit.

Rs. Rs.

Sales 90,000

Less: Cost of goods 40,000

sold

Gross Profit 50,000

Less: explicit costs

Advertising 10,000

Depreciation 10,000

Utilities 3,000

Property Tax 2,000

Miscellaneous Expenses 5,000

Total of Expenses 30,000

Accounting Profit before 20,000

implicit cost

Less: implicit costs

Return on Rs.200,000 10,000

Foregone wages 60,000

Total of implicit costs 70,000

Net Economic profit/loss (50,000)

Most decision makers are unaware of this concept. The concept of

economic profit accounts for all costs and therefore is more useful
management tools than the more normally defined concept of accounting
profit.