Scope of Managerial Economics November 23, 2010Posted by Chetan Chitre in Introduction, Managerial Economics.
Managerial Economics –
Managerial Economics is a branch of economics that studies application of principles of economics to various business situations.
A Business organization is essentially a group of people who have come together for attaining certain common objectives. These objectives are largely material in nature – eg. profits, salaries, production for the purpose of consumption, etc. The behavior of this group of people is therefore a subject matter of study for economics.
A Business Manager is responsible for leading this group of people in the direction of attainment of the objectives. In this capacity she has to take several decisions during the course of her day-to-day operations. An understanding and application of principles of economics would help the Business Manager to take appropriate decisions under various situations.
Scope of Managerial Economics –
Principle of Economics can help a Manager in taking decisions in various business situations. These can be summarized with the help of the following diagram –
Business Decisions are primarily centered around Production and Sales. In addition to this, the environment in which a business organization operates has an impact on the Business Decisions. Various topics in Economic Theory help Business Managers in their functions.
(i) Sales, Marketing and Advertising – Sales, marketing and advertising related decision need an in-depth understanding of the Consumer Behavior. We need to understand the reasons for consumption, factors affecting consumption, constraints faced by the consumers, the decision-making process of the consumer as regards price to be paid, quantity to be purchased, allocation of resources between different needs, etc.
Theory of Demand helps in developing an understanding between Price and quantity demanded.
Price Elasticity helps us understand the ability and willingness to pay of different categories of consumers. This also helps us in Market segmentation.
Cross Price Elasticity helps in identifying competitors which may not be essentially within the same product category – eg. Should soft-drinks manufacturers be seen as competitors for Tea?
Theory of Consumer’s Equilibrium helps in understanding how a consumer allocates his income between different needs.
Having understood the various factors that affect demand for a product and the decision-making process of a consumer helps business managers in devising more effective sales, marketing and advertising strategies.
(ii) Production – Production is perhaps the most important activity in a business organization. A Business Manager has to take several decisions regarding production – eg. What to produce, what should be the plant capacity, what should be the capacity utilization, which technology to use, etc.
While organizing of production activity, Business Managers have to take several factors into consideration, such as –
(a) Objective of the Firm – To begin with the firm has to decide its objective. A Firm could have various objectives such as profit maximization, sales maximization, maximization of market share, etc. Economics helps us to understand what impact these different objectives will have on key variables such as Sales, Production, Prices, Costs, Profits, etc. Organization Economics, a branch of economics helps us in understanding relationship between firm objectives and internal dynamics of an organization.
(b) Profit Maximization – In traditional theory we examine a firm that has profit maximization as its central objective. In order to maximize profits a firm has to minimize costs and maximize its revenues. Thus, a deeper understanding of the Costs and Revenues is required for achieving this objective.
(c) Revenues – Revenues of a firm depend on the demand scenario and the competitive scenario in the market. The understanding of the above two would be essential for a business manager to predict the revenues that the business will be able to generate.
(d) Demand scenario – To decide on the plant capacity and capacity utilization, an understanding of quantity demanded in the market in different time periods is important
(e) Market Structures – In addition to the quantity demanded, one has to understand the competitive scenario. How many players are competing for the given market demand? What is the market structure and how will it impact the firm’s own sales?
(f) Costs – In order to maximize profits, a firm needs to minimize costs. Costs are impacted by several factors. Primary among them are quantity of production and factor prices.
(g) Technology – Technology has multi-dimensional impact on costs. On one hand technology determines what combination of various factors is to be used – eg. capital-intensive technology or labor intensive technology.
Technology also determines the levels of production possible – both in terms of optimum capacity as also in terms of range of capacities at which a plant can operate. This in turn has an impact on the costs. – eg. The most efficient level of operation of a certain plant may be at 1000 units per day (where cost of production is lowest). However, it would be possible to operate the same plant within a range of 500 units per day to 1200 units per day (though may not be at same levels of efficiencies – i.e. it may result in higher costs).
Thus while taking a decision to select technology for production; its impact on costs will have to be kept in mind. Quite often the most advanced technology may not be the best choice in terms of its impact on costs.
(h) Factor Pricing – Technology dictates a certain combination of factors that need to be used. One has to check whether it would be affordable for business to employ those factors in the given quantities. Often prohibitively high price of factors would dictate choice of technology.
Thus, while taking important decisions regarding the production activity, understanding of Economics would be essential at every step.
(iii) Business Environment – Finally, businesses operate in a given social, political and economic environment. There is a symbiotic relationship between the business and its environment. A business organization, through its operations, causes an impact on the surrounding socio-economic conditions. So also, the socio-economic environment prevailing in the outer world has an impact on the business. From time to time, Business Managers are required to foresee the changes in the outer world, analyze their likely impact on their business and take necessary corrective actions. Events from the economic environment such as changes in government policies, tax structures, trade regulations, changes in key variables such as interest rates, inflation, etc., business cycles and growth projections are some of the important events that directly or indirectly impact every business activity. Knowledge of macroeconomics is quite often required to be able to predict these events in the economy and understand the likely impact of these changes on business.
Other Analytical Tools
Apart from these, economics equips the Business Manager with important analytical tools that help him in performing his functions in the following aspects :
(iv) Fundamental Principles of Behavior – As pointed out earlier, a Business Manager deals with a group of human beings plating different roles – eg. consumers, suppliers, share-holders, workers, etc. Economics studies the fundamental motivating factors behind behavior of these different economics agents. This knowledge would thus help the Business Manager in influencing behavior of these economic agents in a manner that enables the business to achieve its objectives.
(v) Decision Criterion – An important part of study of economics is to understand the decision criterion of different economic agents such as consumers, firms, workers, etc. Economics aims at arriving at a logical method of arriving at a decision given the objectives that the economic agent has to achieve and the constraints within which she operates. This technique is helpful to a Business Manager in taking the numerous decisions that she is required to take during the course of her work.
(vi) Resource Allocation – The above techniques of decision-making studied in economics can be used for taking a wide range of decisions including those regarding allocation of resources, capital management, distribution and logistics, etc. – eg. If a decision has to be taken for distributing a capital of Rs. 1 million between various used A, B and C, the technique of Marginal Analysis tells us that the Capital should be distributed in such a manner that the marginal returns from each use is equal.
(vii) Designing of Management Information Systems (MIS) – The decision criteria tells what information would be required so as to enable us to take the right decision. One can use this input in designing a proper MIS that is relevant and useful – eg. In the above case the MIS should be designed to give the manager information about marginal returns. Instead, if the MIS gives information about average and total returns, it would not help in the decision-making process.
(viii) Economic v/s Accounting Decisions – Economics introduces us to certain differences between good accounting decisions and good business decisions. It tells us how a result which may seemingly be good and proper in accounts may, in-fact be a wrong business decision – eg. it may not be taking into account opportunity costs or replacement costs.
(ix) Cost-Benefit Analysis – Economics helps Business Managers in enlarging their scope of Cost-Benefit Analysis. Economics informs us that the C-B Analysis should not be looked at from the narrow perspective of immediate increase in profitability to business. Along with this a more comprehensive Social Cost-Benefit Analysis is also essential to understand the long-term implications of business on the economy and the society. Such an understanding can also be leveraged to enhance the overall profitability of business – eg. Ability of business to generate employment in the economy can be used as leverage in extracting tax concessions from the government.