Managerial economics
Managerial economics is a branch of economics involving the application of economic methods in the organizational decision-making process.[1] Economics is the study of the production, distribution, and consumption of goods and services. Managerial economics involves the use of economic theories and principles to make decisions regarding the allocation of scarce resources.[2] It guides managers in making decisions relating to the company's customers, competitors, suppliers, and internal operations.[3]
Managers use economic frameworks in order to optimize profits, resource allocation and the overall output of the firm, whilst improving efficiency and minimising unproductive activities.[4] These frameworks assist organisations to make rational, progressive decisions, by analysing practical problems at both micro and macroeconomic levels.[5] Managerial decisions involve forecasting (making decisions about the future), which involve levels of risk and uncertainty. However, the assistance of managerial economic techniques aid in informing managers in these decisions.[6]
Managerial economists define managerial economics in several ways:
[3]
The two main purposes of managerial economics are:
The core principles that managerial economist use to achieve the above purposes are:
In order to optimize economic decisions, the use of operations research, mathematical programming, strategic decision making, game theory[8][9] and other computational methods[10] are often involved. The methods listed above are typically used for making quantitate decisions by data analysis techniques.
The theory of Managerial Economics includes a focus on; incentives, business organization, biases, advertising, innovation, uncertainty, pricing, analytics, and competition.[11] In other words, managerial economics is a combination of economics and managerial theory. It helps the manager in decision-making and acts as a link between practice and theory.[12]
Furthermore, managerial economics provides the tools and techniques that allow managers to make the optimal decisions for any scenario.
Some examples of the types of problems that the tools provided by managerial economics can answer are:
Managerial economics is sometimes referred to as business economics and is a branch of economics that applies microeconomic analysis to decision methods of businesses or other management units to assist managers to make a wide array of multifaceted decisions. The calculation and quantitative analysis draws heavily from techniques such as regression analysis, correlation and calculus.[15]
Microeconomics is the dominant focus behind managerial economics, some of the key aspects include:
The law of supply and demand describes the relationship between producers and consumers of a product.[16] The law suggests that price set by the producer and quantity demanded by a consumer are inversely proportional, meaning an increase in the price set is met by a reduction in demand by the consumer.[16]
The law further describes that sellers will produce a larger quantity of the good if it sells at a higher price.[16]
Excess demand exists when the quantity of a good demanded is greater than the quantity supplied. Where there is excess demand, sellers can benefit by increasing the price. The inverse applies to excess supply.
Production theory describes the quantity of a good a business chooses to produce.[17] This decision is informed by a variety of factors, including raw material inputs, labor, and capital costs like machinery.[17] The production theory states that a business will strive to employ the cheapest combination of inputs to produce the quantity demanded.
The production function can be described in its simplest form by the function where Q denotes the firm's production, L is the variable inputs and K is the fixed inputs.[18]
The opportunity cost of a choice is the foregone benefit of the second best choice.[19] Determining the opportunity cost requires detailing the costs and benefits of each action the business is considering to pursue, and the cost of choosing one activity over another.[20] The decision-maker is then in the position to choose the action with the highest payoff.
The principle uses the conjecture of supply and demand to set an accurate price for a good.[21] The aim of price theory is to allocate a price for a good such that the supply of a good is met with equal demand for the product.[21] If a manager sets the price of a good too high, the consumer may think it is not worth the cost and decide not to purchase the good, hence creating excess supply. The opposite occurs when the price is set too low, causing demand for a good to be greater than supply.[21]
Capital investment decisions are a critical factor in an enterprise. They involve determining the rational allocation of funds that will enable an organization to invest in profitable projects or enterprises to improve the efficiency of organizations.[22]
The rational allocation of funds may include acquiring business, investing in equipment, or determining whether an investment will improve the business at all.[22]
The elasticity of demand is a prominent concept in managerial economics. Established by Alfred Marshall, elasticity of demand describes how sensitive a change in the quantity demanded is given a unit change in price. In his own words, Marshall describes the concept as ‘The elasticity of demand in a market is great or small according to as the amount demanded increases much or little for a given fall in price and diminish much or little for a given rise in price.[23]
The microeconomic principles are useful principles to inform manager's decision making. Managerial economics draws upon all of these analytical tools to make informed business decisions.
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The price elasticity of demand is a highly useful tool in managerial economics as it provides managers with the predicted change in demand associated with an increase in the price charged for its goods and services.[24] The price elasticity principle also outlines the changes in demand for goods with changes in the income of a populous.[24]
Where is the change in quantity demand for the respective change in price , with Q and P representing the quantity and price of the good before a change was made.[25]
The price elasticity is important for managerial economics as it aids in the optimization of marginal revenue of firms.[25]
In economics, marginal refers to the change in revenue and cost by producing one extra unit of output. Both the marginal cost and marginal revenue are extremely important in economics as a firm's profit is maximized when the marginal cost is equal to the marginal revenue.[26] Managers can make business decisions on the output level based on this analysis in order to maximize the profit of the firm.
Marginal Analysis is considered the one of most chief tools in managerial economics which involves comparison between marginal benefits and marginal costs to come up with optimal variable decisions. Managerial economics uses explanatory variables such as output, price, product quality, advertising, and research and development to maximise net benefits.
The use of econometric analysis has grown with the development of economics and management, as has the use of differential calculus to determine profit maximisation.[27]
By taking the derivative of a function, the maximum and minimum values of the function are easily determined by setting the derivative equal to zero. This can be applied to a production function to find the quantity of production that maximizes the profit of the firm.[28] This concept is important for managers to understand in order to minimize costs or maximize profits.[29]
The main applications of mathematical models are:
Demand forecasting assists management in predicting future sales and revenue projection, which inform operations and marketing decisions as well future financial planning.[87] The process of demand forecasting often uses business analytics, particularly predictive analytics, with respect to historical data and other analytical information, to make an accurate estimation. For example, using an estimate of a firm's capital expenditure and cash flow, managers can create forecasts that assist in financial planning and improve the financial health of the firm.[88]
Effective demand management considers factors which are both within and beyond the firm's control, such as disposable income, competition, price, advertising and customer service.[87]
Consumer choice is highly influential on demand analysis, as each consumer aims to maximise their satisfaction with a combination of goods and services, subject to their personal budget constraint.[87] Costs of production
Production costs directly affect a firm's profitability. In order to maximise profits, firms identify the cost minimising output level for a firm where marginal cost equals marginal revenue. The most common types of costs that are factored into this decision include:[89]
The impact of short-run and long run costs are important in determining production in a certain firm
. It is assumed some costs are fixed in the short-run and are thus considered "fixed costs". Thus production costs are determined by variable costs. However, in the long run, all costs are variable, which allows more flexibility in changing inputs to determine the optimal level of inputs for a profit maximising output.[30]
Profitability Management[edit]
Profitability management is understanding what makes a firm profitable, and what can be done to improve its profitability.[90] It integrates finance and sales, and aims to optimize sales revenue and marginal cost of the firm. Profit management is technology enabled, as firms must be quick to respond to rapid changing market and to know the true economic cost of its products and services. Management needs to drive cooperation between different functions of the firm such as sales, marketing, and finance, to ensure the teams recognize the importance of coordinated effort. Proper planning and profitability management is key to good business management.[91]
Capital management is the planning, monitoring, and controlling of the assets and liabilities of a firm, particularly, in an effort to maintain cash flow to meet the firm's short-term and long-term financial obligations. Proper capital management is important to the financial health of a firm, with efficient resource allocation through capital management, firms can improve its cash flow and profitability. Capital management involves tracking various ratios within the firm, most important ones include:[92]
Rate of return and cost of capital (i.e. interest rate) are important factors of capital management.[93]
From a management perspective, managerial economics techniques are useful in many areas regarding business decision-making, most commonly including: