Managerial Economics

Module 1
Ms. Archana Vijay

Topics to be covered :

Introduction: Managerial Economics: Meaning, Nature, Scope & Significance, Uses of Managerial
Economics, Role and Responsibilities of Managerial Economist. Theory of the Firm: Firm and Industry,
Objectives of the firm, alternate objectives of firm. Managerial theories: Baumol’s Model, Marris’s model of
growth maximization, Williamson’s model of managerial discretion.

Economics : Meaning
⚫ Economics is a social science, which studies human behaviour in relation to optimizing allocation
of available resources to achieve the given ends.
⚫ Economics studies how people - individuals, households, firms and nations allocate their limited
resources (income) between the various goods and services they consume so that they are able
to maximize their total satisfaction.
⚫ It analyzes how households with limited income decide 'what to consume' and 'how much to
consume' with the aim of maximizing total utility.

Three Choice Problems of an Economy

Unlimited Choice Limited Resources

SCARCITY
What to
For whom to
produce?
produce?

How to produce?

Managerial Economics : Meaning

⚫ Managerial Economics can be broadly defined as the study of economic theories, logic and tools
of economic analysis that are used in the process of business decision-making. Economic
theories and techniques of economic analysis are applied to analyze business problems,
evaluate business options and opportunities with a view to arriving at an appropriate business
decision.
⚫ Managerial Economics is concerned with the application of economic principles and
methodologies to the decision-making process within the firm or organization. It seeks to
establish rules and principles to facilitate the attainment of the desired economic goals of
management.

Application of Economics to Managerial Decision Making

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 Use of Quantitative Tools
Econometrics
Statistical Tools
Application of Economic Mathematical Tools
Theories and Concepts in
Decision Making
Managerial Economics
Application of Economic Concepts, Theories
and Analytical Tools to find Optimum
Solution to Business Problems.

Nature of Managerial Economics

Normative
Economics
Dynamic in Use inputs from
nature Microeconomics
Nature of
Managerial Managerial Managerial Economics
Economics is an art Economics is Science

Theory of the Use inputs from

firm Macroeconomics
Pervasive in
Nature

⚫ Managerial Economics uses inputs from microeconomics - It focuses on the basic theories of
supply and demand in individual markets and deals with how individual businesses decide how
much of something to produce and at what price to sell it, and how individual consumers decide
on how much of something to buy.
⚫ Managerial Economics uses inputs from macroeconomics - It also derives market intelligence
from the knowledge of national income, inflation and stages of recession and expansion, which
are subject matter of macroeconomics.
⚫ Managerial Economics is pragmatic in nature - It is practical in outlook. It seeks to provide
powerful tools of analysis and reasoning approaches for business policy making.

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 ⚫ Theory of the Firm - Theory of the firm states that firms exist and make decisions in order to
maximize profits. Businesses interact with the market to determine pricing and demand
andthen allocate resources according to models that look to maximize net profits.
⚫ Applied Economics - ME deals with the application of economic principles and methodologies
to the decision making process, within the firm under the given situation.
⚫ Dynamic in nature - ME deals with human beings (i.e. human resource, consumers, producers
etc.). The nature and attitude differs from person to person. Thus to cope with dynamism and
vitality managerial economics also changes itself over a period of time.
⚫ Normative Economics - It is concerned with varied corrective measures that a management
undertakes under various circumstances. It deals with goal determination, goal development
and achievement of these goals. Future planning, policy making, decision making and optimum
utilization of available resources, come under the banner of managerial economics.
⚫ Managerial Economics is a science - Managerial Economics is a science of making decisions
with regard to scarce resources with alternative applications. It is a body of knowledge that
determines or observes the internal and external environment for decision making. Policies of
managerial economics are also universally applicable partially or fully.
⚫ Managerial Economics requires art - Managerial Economist is required to have an art of utilizing
his capability, knowledge and understanding to achieve the organizational objective. Managerial
Economist should have an art to put in practice his theoretical knowledge regarding elements of
economic environment.
⚫ Pervasive in nature - The theories, tools and principles of managerial economics are more or
less applicable throughout the world and has wide variety of applications.

Significance of Managerial Economics

Price and Output
Investment Decision Decisions

Long run
Production Decision Significance of
Managerial Economics Demand
Estimation
Advertising
Decision Choice of a technique
of production

⚫ Price and output decisions - Firms estimates of demand and production cost will determine how
much quantity of output it should produce to maximize its profits. Demand for a product tells
the firms the quantities of a product that can be sold at various prices, and cost-output
relationship determines the cost per unit that has to be incurred by producing different levels of
output. Thus, demand together with cost determines the profit possibilities of producing a
product.
⚫ Demand Estimation - Helps in the study of demand of the goods in the market, forecasting the
demand for product launching or predicting the production and supply etc. It also studies the
elasticity of demand and plans the business strategies accordingly.

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 ⚫ Choice of a technique of production - It is concerned with the usage of scarce resources and its
alternative uses so as to achieve maximum profit.A technique of production involves the use of
particular combination of factors, especially labour and capital to produce a commodity. Some
production techniques involves the use of relatively more labour as compared to capital and are
therefore called labour intensive techniques. Some others use more capital relative to labour
and are therefore called capital-intensive techniques. The choice between different techniques
would depend on the available supplies of different factors of production and their relative
prices.
⚫ Advertising decision - Managerial Economics studies the demand of goods in the market, the
cost of production and supply etc. It is also aware of the price and demand elasticity of products.
Using this knowledge, advertisement budgets and strategies can be designed. How much
expenditure has to be incurred on advertisement and through what media is an important
decision to be made by a business firm.
⚫ Long run production decision - Where to locate the plant for manufacturing, what size of plant,
that is, magnitude of productive capacity to be built, what product-mix should be produced to
maximize profits and developing and introducing a new product fall in the category of long-run
production decisions. The choice among alternative courses in these matters obviously depends on
the costs.
⚫ Investment Decision - Investment expenditure is required to expand the productive capacity,
developing and introducing new products. The theory of capital budgeting is useful for deciding
whether or not to undertake any specific investment or capital expenditure, or whether it is
desirable to take over other firms to expand capacity as it involves evaluating costs of an
investment project and returns or profits flowing from it in future years.

Scope of Managerial Economics

Business Decisions

Sales Production Business Environment

Theory of Firm Macroeconomics

Theory of Consumer
Behavior
Policies, Business Cycles,
Profit Maximization
Trend, Growth
Demand

Costs
Revenue

Technology
Market
Structure Factor Pricing

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 Following microeconomic theories give the scope of microeconomics:
⚫ Theory of Demand - Demand theory deals with consumer's behavior. It answers such questions
as : How do the consumers decide whether or not to buy a commodity? How do they decide on
the quantity of a commodity to be purchased? The knowledge of demand theory can, therefore,
be helpful in making the choice of commodities, finding the optimum level of production and in
determining the price of the product.
⚫ Theory of Production and Production decisions -Production theory explains the relationship
between inputs and output. It also explains under what conditions costs increase or decrease,
how total output behaves when units of one factor are increased keeping other factors
constant. Production theory, thus, helps in determining the size of the firm, size of the total
output and the amount of capital and labour to be employed, given the objective of the firm.
⚫ Analysis of Market-Structure and Pricing Theory - Price theory explains how price is determined
under different kinds of market conditions; when price discrimination is desirable, feasible and
profitable; and to what extent advertising can be helpful in expanding sales in a competitive
market. Thus, price theory can be helpful in determining the price policy of the firm. Price and
production theories together, in fact, help in determining the optimum size of the firm.
⚫ Profit Analysis and Profit Management - Making a satisfactory profit is not always guaranteed
because a firm has to carry out its activities under conditions of uncertainty with regard to i)
demand for the product, ii) input prices in the factor market, iii) nature and degree of
competition in the product market, and iv) price behavior under changing conditions in the
product market etc. Profit theory guides firms in the measurement and management of profit, in
making allowances for the risk premium, in calculating the pure return on capital and pure profit
and also for future profit planning.
⚫ Theory of Capital and Investment Decisions - The major issues related to capital are i) choice
of investment project, ii) assessing the efficiency of capital, and most efficient allocation of
capital.
Knowledge of capital theory can contribute a great deal in investment-decision making, choice
of projects, maintaining the capital, capital budgeting, etc.

Macroeconomics applied to business environment

The factors which constitute economic environment of a country include the following:
⚫ the type of economic system in the country.
⚫ general trends in national income, employment, prices, savings and investment.
⚫ structure of and trends in the working of financial institutions, e.g. banks, financial corporations,
insurance companies.
⚫ magnitude of and trends in foreign trade,
⚫ trend in labour supply and strength of the capital market,
⚫ government's economic policies, e.g. industrial policy, monetary, fiscal, price and foreign trade,
⚫ social factors like value system of the society, property rights, customs and habits,
⚫ the degree of globalization of the economy and the influence of MNC's on the domestic
markets.

Uses of Managerial Economics

Business economics essentially implies the application of economic principles and
methodologies to the decision-making process within the firm under the condition of
uncertainty.

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 Economic theories are very useful in business analysis and practice for decision-making and
forward planning by management. Managerial Economics may be useful in the following
respects:
⚫ It makes problem-solving easy in business.
⚫ It improves the quality and preciseness of decisions.
⚫ It helps in arriving at quick and appropriate decisions.

 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 analyse production efficiency,
optimum factor allocation, costs and economies of scale. They are also utilised to estimate the
firm's cost function.
 Pricing analysis: Microeconomic techniques are employed to examine various pricing decisions.
This involves price discrimination, price elasticity estimations and choice of the optimal pricing
method.
 Capital budgeting: Investment theory is used to scrutinize a firm's capital purchasing decisions.

Roles and Responsibilities of a Managerial Economist

A managerial economist helps the management by using his analytical skills and highly developed
techniques in solving complex issues of successful decision-making and future advanced planning.

The role of managerial economist can be summarized as follows:

1. He studies the economic patterns at macro-level and analyses it’s significance to the specific
firm he is working in.
2. He has to consistently examine the probabilities of transforming an ever-changing economic
environment into profitable business avenues.
3. He assists the business planning process of a firm.
4. He also carries cost-benefit analysis.
5. He assists the management in the decisions pertaining to internal functioning of a firm such as
changes in price, investment plans, type of goods /services to be produced, inputs to be used,
techniques of production to be employed, expansion/ contraction of firm, allocation of capital,
location of new plants, quantity of output to be produced, replacement of plant equipment,
sales forecasting, inventory forecasting, etc.
6. In addition, a managerial economist has to analyze changes in macro- economic indicators such
as national income, population, business cycles, and their possible effect on the firm’s
functioning.
7. He is also involved in advicing the management on public relations, foreign exchange, and trade.
He guides the firm on the likely impact of changes in monetary and fiscal policy on the firm’s
functioning.
8. He also makes an economic analysis of the firms in competition. He has to collect economic data
and examine all crucial information about the environment in which the firm operates.
9. The most significant function of a managerial economist is to conduct a detailed research on
industrial market.
10. In order to perform all these roles, a managerial economist has to conduct an elaborate
statistical analysis.
11. He must be vigilant and must have ability to cope up with the pressures.

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 12. He also provides management with economic information such as tax rates, competitor’s priceand
product, etc. They give their valuable advice to government authorities as well.
13. At times, a managerial economist has to prepare speeches for top management.

Responsibilities of a Managerial Economist

1. To make reasonable profits on capital employed:

He must have strong conviction that profits are essential and his main obligation is to assist themanagement in
earning reasonable profits on capital invested by the firm.

2. Successful forecasts:
It is necessary for the managerial economist to make successful forecasts by making in-depth study of internal
and external factors that may have influence over the profitability or the working of the firm.

3. Knowledge of sources of economic information’s:

A managerial economist should establish and maintain close contacts with specialists and data sourcesin order to
collect quickly the relevant and valuable information in the field.

For this purpose he should develop personal relation with those having specialized knowledge of thefield.

4. His Status in the Firm:

A managerial economist must earn full status in the business team because only then he can be really helpful to
the management in formulating successful business policies.

Theory Of the Firm

A firm is an entity that draws various types of factors of production in different amounts from
the economy and converts them into desirable output, through a process with the help of
suitable technology. Economists have identified five factors of production, namely land,
labour, capital, enterprise and organization, of which enterprise and organization are
relatively new entrants. The process of identifying the potential sources of the factors
such as land, labour andcapital, collecting them in required quantities and assigning them
specific tasks as per their skills is the subject matter of an organization. Using these
factors of production for economic activities without any certainty of returns is the
function of an enterprise, or the entrepreneur.

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 Firm and Industry
A firm is an individual productive unit which takes the inputs from the external
environment, process it and produce the finished goods. whereas industry is a set of all
such firms, big or small, engaged in the identical productive activity. For eg., Infosys is a
firm, which belongs to Software Industry, Maruti is a firm which belongs to automobile
industry.

Objectives of the firm

Every business has some objective, which provides the framework for all the functions,
strategies and managerial decisions of that business. It determines the short term and long
term perspective of the firm.

Profit maximization is regarded as the most common and theoretically most plausible objective
of business firms.

Profit Maximization Theory

According to profit maximization theory, objective of business is generation of the largest
amount of profit. This thought is based on the belief that an individual would risk one’s capital
and time for uncertain returns, only with the expectation of generating profits.
Profit may be stated as :
Profit = Total Revenue – Total Cost
Owners of the company generally aim for profit maximization as the business objective.
Profit maximization is important for the following reasons :
 Profit is indispensable for firm’s survival.
 Achieving other objectives depends on firm’s ability to make profit.
 More reliable measure of a firm’s efficiency.
 Market value of a firm is largely dependent upon profits earned.

Alternate Objectives of Firm

Some important objectives, other than profit maximization are: a) maximization of sales revenue,
b) maximization of firm’s growth rate, c) maximization of manager’s utility function, d)making a
satisfactory rate of profit, and e) long-run survival of the firm.

Baumol’s Theory of Sales Revenue Maximization

Sales maximization theory asserts that managers attempt to maximize the firm’s total revenue,
instead of profits. According to Baumol, sales volume, and not profit volumes, determine
market leadership in competition. He further stressed that in large organizations, management
is separate from owners. Hence, there would always be a dichotomy of manager’s goals and
owner’s goals. Manager’s salary and other benefits are largely linked with sales volumes, rather
than profits.

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 Since operations of the firm are in the hands of managers, and manager’s performance is
measured in terms of achieving sales targets, therefore it follows that management is more
interested in maximizing sales, with a constraint of minimum profit.
According to Baumol, the factors which explain the pursuance of sales maximization by the
managers are following :
 First, salary and other earnings of managers are more closely related to sales revenue
than to profits.
 Secondly, banks and financial corporations look at and lay a great emphasis on sales
revenue while financing a corporation.
 Thirdly, trend in sales revenue is a readily available indicator of the performance of the
firm.
 Fourthly, increasing sales revenue enhances the prestige, reputation and perks of
managers, while profits go to the owners.
 Fifthly, managers find profit maximization a difficult objective to fulfill consistently over
time and at the same level.
 Finally, growing sales strengthen competitive spirit of the firm in the market whereas
decreasing sales put the survival of the firm at risk.

Agency Theory
Conflict of interests between the owners and the managers of a firm is a principal agent
problem. For eg. While going for a pleasure trip to Europe, a travel agent is hired to plan the
trip. In an organizational set up the owners are the principal, while managers are the agents.
In an organizational set up the owners (principals) hire managers (agents) who work on a well
defined task, as the latter have better knowledge of the market and are expected to steer the
business.

Marris’s Hypothesis
Working on the principle of segregation of managers from owners, Marris proposed that owners
(shareholders) aim at profits and market share, whereas managers aim at better salary, job security and
growth. These two sets of goals can be achieved by maximising balanced growth of the firm (G), which is
dependent on ihe growth rate of demand for the firm's products (GD) and growth rate of capital supplyto
the firm (GC). Hence growth rate of the firm is balanced when the demand for its product and the Capital
supply to the firm grow at the same rate.
Marris further said that firms face two constraints in the objective of maximisation of balanced growth,

i) Managerial Constraint
Among managerial constraints, Marris stressed on the importance of the role of human resource in
achieving organisational objectives. According to him, skills, expertise, efficiency and sincerity of team
managers are vital to the growth of the firm. Non availability of managerial skill sets in required size
creates constraints for growth.

ii) Financial Constraint

This relates to the prudence needed in managing financial resources. Marris suggested that a prudent
financial policy will be based on at least three financial ratios, which in turn set the limit for the growth
of the firm. In order to prove their discretion managers will normally create a tradeoff and prefer a
moderate debt equity ratio (rj), moderate liquidity ratio (r2) and moderate retained profit ratio (r3)

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 (a) Debt equity ratio (r1) This is the ratio between borrowed capital and owners* capital. High value of
debt equity ratio may cause insolvency; hence a low value of this ratio is usually preferred by managers
to avoid insolvency. However, a low value of r, may create a constraint to the growth of the firm in
terms of dependence on high cost capital, i.e., equity.

(b) Liquidity ratio (r2) This is the ratio between current assets and current liabilities and is an indicator
of coverage provided by current assets to current liabilities. According to Marris, a manager would try to
operate in a region where there is sufficient liquidity and safety and hence would prefer a high liquidity
ratio. But a high r2 would imply low yielding assets, since liquid assets either do not earn at all (like cash
and inventory), or earn low returns (like short term securities).

(c) Retention ratio (r3) This is the ratio between retained profits and total profits. i.e., the retained
profits are that portion of net profit which is not distributed among shareholders. A high retention ratio
is good for growth, as retained profits provide internal source of funds. However, a higher r3
would
imply greater volume of retained profits, which may annoy the shareholders. Hence managers cannot
afford to keep a very high value of retention ratio.

Williamson’s Model
Oliver E. Williamson hypothesised (1964) that profit maximization would not be the objective of the
managers of a joint stock organisation. This theory, like other managerial theories of the firm, assumes that
utility maximisation is a manager’s sole objective.

(d) Managerial utility function

The managerial utility function includes variables such as salary, job security, power, status, dominance,
prestige and professional excellence of managers. Of these, salary is the only quantitative variable and
thus measurable. The other variables are non-pecuniary, which are non-quantifiable. The variables
expenditure on staff salary, management slack, discretionary investments can be assigned nominal
values.

Utility function or "expense preference"of a manager can be given by:

U = S + M + ID
where U denotes the Utility function, S denotes the “monetary expenditure on the staff”, M stands for
"Management Slack" and ID stands for amount of "Discretionary Investment".

"Monetary expenditure on staff" include not only the manager's salary and other forms of monetary
compensation received by him from the business firm but also the number of staff under the control of
the manager as there is a close positive relationship between the number of staff and the manager's
salary.

"Management slack" consists of those non-essential management perquisites such as entertainment

expenses, lavishly furnished offices, luxurious cars, large expense accounts, etc. which are above
minimum to retain the managers in the firm. These perks, even if not provided would not make the
manager quit his job, but these are incentives which enhance their prestige and status in the
organisation in turn contributing to efficiency of the firm's operations.

"Discretionary investment" refers to the amount of resources left at a manager's disposal, to be able to
spend at his own discretion. For example, spending on latest equipment, furniture, decoration material,
etc. It satisfies their ego and gives them a sense of pride. These give a boost to the manager's esteem
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 and status in the organisation.

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 Concepts of profit in the model
Williamson has put forth four main concepts of profits in his model:
Actual profit = R + C + S
where R is the total revenue, C is the cost of production and S is the staff expenditure.

Reported profit

Reported Profit = Actual Profit + M

where M is the management slack.

Minimum profit
It is the amount of profit after tax which should be paid to the shareholders of the firm, in the form of
dividends, to keep them satisfied. If the minimum level of profit cannot be given out to the
shareholders, they might resort of bulk sale of their shares which will transfer the ownership to other
hands leaving the company in the risk of a complete take over.

Discretionary profit

It is basically the entire amount of profit left after minimum profits and tax which is used to increase the
manager’s utility, that is, to pay out managerial emoluments as well as allow them to make discretionary
investments.

THANK YOU

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