Nature and Scope of Managerial Economics

Relationship between Managerial Economics and related Disciplines

• Relationship with economics

Microeconomics is the study of the economic behavior of individuals, firms and other such micro-
organizations. Managerial economics is rooted in Micro Economic theory. Managerial Economics makes
use to several Micro Economic concepts such as marginal cost, marginal revenue, elasticity of demand as
well as price theory and theories of market structure to name only a few.

Macro theory on the other hand is the study of the economy as a whole. It deals with the analysis of
national income, the level of employment, general price level, consumption and investment in the
economy and even matters related to international trade, Money, public finance, etc.

Managerial economics has an applied bias and its wider scope lies in applying economic theory to solve
real life problems of enterprises. Both managerial economics and economics deal with problems of
scarcity and resource allocation.

To solve Managerial Economics problems, we use Economic Theory and Decision Science. Under
Managerial Economics Application of economic theory and decision science tools to solve managerial
decision problems and it leads to Optimal Solutions to Managerial Decision Problems.

Managerial Economics is the application of economic theory and decision science

tools to examine how an organization can achieve its goals most efficiently.

Goals – Maximize Profit or Revenue

Efficiently – By minimizing the cost and getting a higher output.
Managerial Economics deals with:
How management decisions should be made by managers in any organization (firms, not-for-profit
organizations, government agencies, etc.) to achieve a goal under some constraints (to find the optimal
solution to a managerial decision problem).

Under some constraints – E.g.: Fuel Constraints, Raw material constraints, legal barriers, power cuts.

Economics Vs. Managerial Economics

Economics Managerial Economics

Study of economic theory Application of economic theory
(Examines the human behavior in using scarce (Studies the way of applying economic theory for
resources on unlimited needs and wants) decision making in firms)
Mostly related to positive economics Mostly related to normative economics
Use theories, models, frameworks. Use Mathematics and Statistics
E.g.: Theory of Production E.g.: When applying theory of production in
practical we need statistics and mathematics.

Relationship to Economic Theory

Economic theory seeks to predict and explain economic behavior.

E.g.:
• Under theory of Consumer Behavior
- What is the optimal behavior of the customer?
- At what time prices should be change and response of the customer
- When do we consider prices of the product and quantity consumed from the products?

• Theory of Demand – We can identify quantity of demand based on the behavior of the
independent variable that the effect to the quantity demand of a particular product.
E.g.: Price, Substitute Price, complement price, Income: If they are changing what
happened to the quantity of demand.

Relationship to Decision Sciences

These use the tools of mathematical economics and econometrics to construct and estimate decision
models aimed at determining how the firm can achieve its goals most efficiently.

• Mathematical economics
Mathematical concepts and techniques are widely used in economic logic to solve these problems. Also
mathematical methods help to estimate and predict the economic factors for decision making and
forward planning.
Mathematical symbols are more convenient to handle and understand various concepts like incremental
cost, elasticity of demand etc.

Statistical methods provide and sure base for decision-making. Thus, statistical tools are used in
collecting data and analyzing them to help in the decision-making process. Statistical tools like the theory
of probability and forecasting techniques help the firm to predict the future course of events.

• Econometrics
We can construct models to find optimal solutions for firms to achieve goals.
E.g.: To estimate Demand, we make Demand model by using Regression, forecast output level based on
real information which affects output.

Relationship to Functional Areas of Business Administration

• Business Administration includes accounting, finance, marketing, human resource management

and production.
• They study the business environment. Business environment consists with micro and macro, and
environment is unpredictable and full of uncertainties.
• They provide the background for managerial decision making.
- Thes functional areas are dependent on each other.
E.g.: If there is a problem with workers it affects production, finance, sales etc.
- Can’t regret any functional area when we are making a decision.
- Need to consider the effects of decisions on all functions.
- So, functions provide a background for managerial decisions.

• Managerial Economics is regarded as an overview course that integrates economic theory,

decision sciences, and functional areas of business administration.

Why is Managerial Economics Important?

• A powerful “analytical engine”

- We use real world data using statistical models and try to identify the relationships.
- We link theories and models in the economics with statistic tools.

• To make decisions related to internal issues

- Effectively utilize resources (What/how much/how/to whom, to produce)
- Maximizing sales, revenues, profits
- Face price and non-price competitions Pricing

• To estimate economic relationships

• To use theoretical concepts in economics to actual behavior of firms
E.g.: Use Theory of Demand for marketing purposes.

• To identify the impact of external factors on the firm

Basic Process of Decision Making

1. Define the Problem/ Clearly identify the problem.

2. Determine the Objectives
3. Identify Possible Solutions (Alternatives)
4. Select the Best Possible Solution
5. Implement the Decision

As managers we need to identify the problems clearly. Then objectives are to overcome these problems.
Need to identify alternative solutions. Out of them select the best possible solution. Finally Interpret it.

How demand theory can be used to reach optimal solutions?

- Optimal Solutions means profit maximization (MR = MC), Revenue Maximization, Wealth
maximization.

- Our goal is to Increase QD

- How can we change price and other variables to achieve it?
- Need information on the Price Elasticity of the product.
E.g.: Ed > 1 ---- Reduce price and then QD increase by higher amount.

- It increases Qd and TR and Ultimately the Profit.

The Theory of the Firm

- Things are becoming highly globalized.

- Can’t predict the Business environment.
- Decision making is very risky.
- So Managerial Economics has become more important. In here we use real data to get
decisions with help of mathematical models.

A firm is an organization which combines and organizes resources for the purpose of producing goods
and/or services for sale.

The Reason for the Existence of Firms

• We don’t have the ability to provide everything we want. We don’t have ability, it will be a huge
cost, we don’t have time. So, that’s why basically we need firms.
• Firms exist because it would be very inefficient and costly for an entrepreneur to enter and
enforce contracts with owners of resources for each separate step of the production and
distribution process.
Therefore, firms exist to save transaction costs by internalizing many transactions.
 We have taken all the transactions to a particular point, and we have given different
responsibilities to the different people in particular organizations. They try to minimize
transaction costs by doing so.

Functions of Firms

- Receive factors from Recourse Owners and Pay for them.

- Transforms Resources into Goods and Services for Sale. (Main Task) – Firms need to be
efficient and effective. (Decrease cost and Increase Quality)
- Sale goods and services to customers.
- Pays Taxes to Government
- Receive concessionary from Government.
- Receive facilities from Government (Common goods and Welfare)

The Objective and Value of the Firm (Ultimate Objective)

The Theory of the Firm assumes that the primary objective of a firm is to maximize the wealth or value
of the firm.

Wealth – Wealth of Share Holders and Entrepreneurs

The value of the firm – can be measured in two aspects.
• Goodwill of the firm – Every function should work to develop the goodwill of the firm.
E.g.: Production Department – Providing a quality good
• Investment of the firm

The wealth or value of the firm = The present value of all expected future profits
of the firm
To maximize the wealth of the firm, all functional departments should contribute together.

TR TC

• TR depends on the demand for the output and pricing decisions – The Marketing Department
holds the responsibility.
• TC depends on the technology of production and resource prices – The Production and Human
Resources Departments hold the responsible
• The discount rate (r) depends on the perceived risk and cost of borrowing – The Finance
Department holds the responsibility.

Constraints the Firms are facing

1. Resource Constraints - Limitations on the availability of resources

• Raw materials
• Skilled Educated labors
• Technology limitations

2. Legal Constraints
E.g.: Minimum Wage Laws, Health & Safety Standards, Laws on Pollution Emission

Constrained Optimization:
Maximization of the Wealth subject to the Constraints the Firm is facing.
E.g.: Sri Lankan Transport Authority had fuel constraints last year. But as a firm they tried their best to
give better service to the passengers and cover all areas of the country. While doing it they try to
maximize the profit too.

Limitations of the Theory of the Firm

The theory of the firm, which assumes that the objective of a firm should be maximization of the wealth
has been criticized as being too narrow and unrealistic.
Reasons:
• Have to consider social responsibility (e.g., looking after the environment) and co-operatives
which seek to improve the welfare of all society.
• Real world it is much more complex.
Three alternative theories have been proposed to replace the theory of the firm.
1. Maximization of Sales: Sales maximization means making the most sales revenue possible
without the business taking a loss. After all, businesses generally want to make as much revenue
as possible with as little cost as possible, which can lead to greater profits.

2. Maximization of Management Utility: Firms should provide sufficient facilities to managers to

do their job well.
E.g.: Transportation, Telephone

3. Satisficing Behavior: Not Maximizing but behave in satisfying way and survive within the
industry.

Although the alternative theories of the firm stress some relevant aspects of modern firms, they do not
provide a satisfactory alternative to the theory of the firm.
So, it’s very difficult to go out from theory of firm. Still, we are within the framework.

Due to the rigorous competition in markets as well as in managerial and entrepreneurial talent,
managers are forced to pay close attention to profits.
Profit Maximizing is important for survival in the industry.

Also, firms have to consider CSR, Environment and Global Environments.