CHAPTER ONE

THE NATURE AND SCOPE OF MANAGERIAL ECONOMICS

1.0. Objectives

After going through this unit, you will be able to:

• Understand the meaning and nature of managerial economics

• Understand the business decision making process and economic analyses

• Explain the importance of managerial Economics

• Understand the scope of managerial economics

1.1. The meaning of Managerial Economics.

Definition of Managerial Economics

Dear learner, it should be noted that the recent complexities associated with business
decisions has increased the need for application of economic concepts, theories and tools of
economic analysis in business decisions. The reason has been that making appropriate
business decision requires clear understanding of existing market conditions, market
fundamentals and the business environment in general. Business decision-making processes,
therefore, requires intensive and extensive analysis of the market conditions in the product,
input and financial markets. Economic theories, logic and tools of analysis have been
developed for the analysis and prediction of market behaviors. The application of economic
concepts, theories, logic, and analytical tools in the assessment and prediction of market
conditions and business environment has proved to be a significant help to business decision
makers all over the globe.

The discovery of managerial economics as a separate course in management studies has,

therefore, been attributed to three major factors:

1. The growing complexity of business decision-making processes, because of changing

market conditions and the globalization of business transactions.

2. The increasing use of economic logic, concepts, theories, and tools of economic
analysis in business decision-making processes.

3. Rapid increase in demand for professionally trained managerial manpower.

So, what is Managerial Economics?

Managerial economics has been generally defined as the study of economic theories, logic
and tools of economic analysis, used in the process of business decision making. It involves
the understanding and use of economic theories and techniques of economic analysis in
analysing and solving business problems. It refers to the application of economic theory and
the tools of analysis of decision science to examine how an organization can achieve its aims
or objectives most efficiently. The meaning of this definition can best be examined with the
aid of Figure 1.1
 Many different definitions have been given but most of them involve the application of
economic theory and methods to business decision-making. Some of the definitions of
Managerial economics by scholars are the following.

“Managerial economics is concerned with the application of economic concepts and

economics to the problems of formulating rational decision making.” --- (Mansfield)

“Managerial economics is the integration of economic theory with business practice for the
purpose of facilitating decision making and forward planning by management.” --- (Spencer
and Seigelman)

“Managerial economics applies the principles and methods of economics to analyze problems
faced by management of business, or other types of organizations and to help find solutions
that advance the best interest of such organizations.” --- (Davis and Chang)

To conclude, managerial economics refers to the application of economic theory and decision
science tools to find the optimal solution to managerial decision problems.

Therefore, Managerial Economics can be seen as a means to an end by managers in terms of

finding the most efficient way of allocating their scarce resources and reaching their
objectives.

Economic principles contribute significantly towards the performance of managerial duties as

well as responsibilities. Managers with some working knowledge of economics can perform
their functions more effectively and efficiently than those without such knowledge.

Taking appropriate business decisions requires a good understanding of the technical and
environmental conditions under which business decisions are taken. Application of economic
theories and logic to explain and analyze these technical conditions and business environment
can contribute significantly to the rational decision-making process.

1.2. Economic Analysis and Business Decisions Making

Business decision-making basically involves the selection of best out of alternative

opportunities open to the business organization. Decision making processes involve the
following four main phases:

Phase One: Determining and defining the objective to be achieved.

Phase Two: Collection and analysis of information on economic, social, political, and
technological environment.

Phase Three: Inventing, developing and analyzing possible course of action

Phase Four: Selecting a particular course of action from available alternatives.

Note that phases two and three are the most crucial in business decision-making. They put the
manager’s analytical ability to test and help in determining the appropriateness and validity of
decisions in the modern business environment. Personal intelligence, experience, intuition
and business acumen of the manager need to be supplemented with quantitative analysis of
business data on market conditions and business environment. It is in fact, in this area of
decision-making that economic theories and tools of economic analysis make the great
contribution in business.

Decision making lies at the heart of most important business and government problems. The
range of business decisions is vast: Should a high-tech company undertake a promising but
expensive research and development program? Should a petrochemical manufacturer cut the
price of its best-selling industrial chemical in response to a new competitor’s entry into the
market? What bid should company management submit to win a government
telecommunications contract? Should management of a food products company launch a new
product after mixed test-marketing results? Likewise, government decisions range far and
wide: Should the Department of Transportation impose stricter rollover standards for sports
utility vehicles? Should a city allocate funds for construction of a harbor tunnel to provide
easy airport and commuter access? These are all interesting, important, and timely questions
—with no easy answers. They are also all economic decisions. In each case, a sensible
analysis of what decision to make requires a careful comparison of the advantages and
disadvantages (often, but not always, measured in dollars) of alternative courses of action.

As the term suggests, managerial economics is the analysis of major management decisions
using the tools of economics. Managerial economics applies many familiar concepts from
economics—demand and cost, monopoly and competition, the allocation of resources, and
economic trade-offs—to aid managers in making better decisions.

If for instance, a business firm plans to launch a new product for which close substitutes are
available in the market; one method of deciding whether or not this product should be
launched is to obtain the services of a business consultant. In doing this, the manager would
need to investigate and analyze the following thoroughly:

(a) Production related issues; and,

(b) Sales prospects and problems.

With regards to production, the manager will be required to collect and analyze information
or data on:

(c) Available production techniques;

(d) Cost of production associated with each production technique;

(e) Supply position of inputs required for the production process;

(f) input prices;

(g) Production costs of the competitive products; and,

(h) Availability of foreign exchange, if inputs are to be imported.

Regarding the sales prospects and problems, the manager will be required to collect and
analyze data on:

(a) General market trends;

(b) The industrial business trends;

(c) Major existing and potential competitors, as well as their respective market shares;

(d) Prices of the competing products;

(e) Pricing strategies of the prospective competitors;

(f) Market structure and the degree of competition; and,

(g) The supply position of complementary goods.

The application of economic theories in solving business problems helps in facilitating

decision-making in the following ways:

First, it can give clear understanding of the various necessary economic concepts, including
demand, supply, cost, price, and the like that are used in business analysis.
Second, it can help in ascertaining the relevant variables and specifying the relevant data.

For example, it can help us in deciding what variables need to be considered in estimating the
demand for two different sources of energy, petrol and electricity.

Third, it provides consistency to business analysis and helps in arriving at right conclusions.

 Importance of Managerial Economics

In a nutshell, three major contributions of economic theory to business economics have been
enumerated:

1. Building of analytical models that help to recognize the structure of managerial

problems, eliminate the minor details that can obstruct decision making, and help to
concentrate on the main problem area.

2. Making available a set of analytical methods for business analyses thereby, enhancing
the analytical capabilities of the business analyst.

3. Clarifications of the various concepts used in business analysis - enabling the

managers avoid conceptual pitfalls.

The purpose of managerial economics is to provide economic terminology and reasoning for
the improvement of managerial decisions.

1.3. Scope of Managerial Economics

Managerial economics comprises both micro- and macro-economic theories. Generally, the
scope of managerial economics extends to those economic concepts, theories, and tools of
analysis used in analyzing the business environment, and to find solutions to practical
business problems. In broad terms, managerial economics is applied economics.

The area of business issues to which economic theories can be directly applied is divided into
two broad categories:

i. Operational or internal issues, and

ii. Environment or external issues

 Operational problems -are of internal nature. These problems include all those
problems which arise within the business organization and fall within the control of
management. Some of the basic internal issues include:
(a) Choice of business and the nature of product (what to produce);

(b) Choice of size of the firm (how much to produce);

(c) Choice of technology (choosing the factor combination);

(d) Choice of price (product pricing);

(e) How to promote sales;

(f) How to face price competition;

(g) How to decide on new investments;

(h) How to manage profit and capital; and,

(i) How to manage inventory.

The microeconomic theories dealing with most of these internal issues include, among others:

a. The theory of demand, which explains the consumer behavior in terms of decisions on
whether or not to buy a commodity and the quantity to be purchased.

b. Theory of Production and production decisions. The theory of production or theory of

the firm explains the relationship between inputs and output.

c. Analysis of Market structure and Pricing theory. Price theory explains how prices are
determined under different market conditions.

d. Profit analysis and profit management. Profit making is the most common business
objective. However, making a satisfactory profit is not always guaranteed due to business
uncertainties. Profit theory guides firms in the measurement and management of profits, in
making allowances for the risk premium, in calculating the pure return on capital and pure
profit, and for future profit planning.

e. Theory of capital and investment decisions - Capital is the foundation of any business.
It efficient allocation and management is one of the most important tasks of the managers, as
well as the determinant of the firm’s success level. Some of the important issues related to
capital include: choice of investment project; assessing the efficiency of capital; and, the most
efficient allocation of capital.

 Environmental issues are issues related to the general business environment. These
are issues related to the overall economic, social, and political atmosphere of the country in
which the business is situated. The factors constituting economic environment of a country
include:

a. The existing economic system

b. General trends in production, income, employment, prices, savings and investment,

and so on.

c. Structure of the financial institutions.

d. Magnitude of and trends in foreign trade.

e. Trends in labor and capital markets.

f. Government’s economic policies.

g. social organizations, such as trade unions, consumers’ cooperatives, and producer

unions.

h. The political environment.

i. The degree of openness of the economy

Managerial economics is particularly concerned with those economic factors that form the
business climate. In macroeconomic terms, managerial economics focus on business cycles,
economic growth, and content and logic of some relevant government activities and policies
which form the business environment.