ROLE OF MANAGERIAL ECONOMICS

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.

Managerial economics, or business economics, is a division of microeconomics that focuses on

applying economic theory directly to businesses. The application of economic theory through
statistical methods helps businesses make decisions and determine strategy on pricing,
operations, risk, investments and production. The overall role of managerial economics is to
increase the efficiency of decision making in businesses to increase profit.

The role of economics in management can be summarized as follows:

1. Study of economic pattern at macro-level and analysis its significance to the

organization and its functioning
2. Examine how the changing environment is profitable to ones organization in the best
possible way
3. Helps is making sound decision by choosing the best available alternative in  case of
choices.
4. Many managerial economic tools and analysis models are used to help make investing
decisions both for corporations and savvy individual investors. These tools are used to make
stock market investing decisions and decisions on capital investments for a business.
5. Assists businesses in determining pricing strategies and appropriate pricing levels for
their products and services. Some common analysis methods are price discrimination, value-
based pricing and cost-plus pricing
6. 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, etc…
7. Analyse changes in macroeconomic indicators such as national income, population,
business cycles, and their possible effect on the firm’s functioning.
8. The most significant function of a managerial economist is to conduct a detailed
research on industrial market.
9. He also provides management with economic information such as tax rates,
competitor’s price and product, etc. They give their valuable advice to government
authorities as well.
10. 10. Uncertainty exits in every business and managerial economics can help reduce risk
through uncertainty model analysis and decision-theory analysis. Heavy use of statistical
probability theory helps provide potential scenarios for businesses to use when making
decisions.

MAJOR OBJECTIVE OF MANAGERIAL ECONOMICS

 BRANCHES OF MANAGERIAL ECONOMICS

BASIC CONCEPTS OF MANAGERIAL ECONOMICS

The discipline of managerial economics deals with aspects of economics and tools of
analysis, which are employed by business enterprises for decision-making. Business and industrial
enterprises have to undertake varied decisions that entail managerial issues and decisions. Decision-
making can be delineated as a process where a particular course of action is chosen from a number
of alternatives. This demands an unclouded perception of the technical and environmental
conditions, which are integral to decision making. The decision maker must possess a thorough
knowledge of aspects of economic theory and its tools of analysis. The basic concepts of decision-
making theory have been culled from microeconomic theory and have been furnished with new
tools of analysis. Statistical methods, for example, are pivotal in estimating current and future
demand for products. The methods of operations research and programming proffer scientific
criteria for maximising profit, minimising cost and determining a viable combination of products.

Decision-making theory and game theory, which recognise the conditions of uncertainty and
imperfect knowledge under which business managers operate, have contributed to systematic
methods of assessing investment opportunities.

Almost any business decision can be analysed with managerial economics techniques. However,
the most frequent applications of these techniques are as follows:
• 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 transfer pricing, joint product pricing, price discrimination, price elasticity
estimations and choice of the optimal pricing method.

• Capital budgeting: Investment theory is used to scrutinise a firm's capital purchasing decisions.

(a) Margin vis a vis average variables in managerial economics analyses.

i. marginal value of a variable – the change in the variable associated with a unit
increase in a driver, e.g., amount earned by working one more hour;
ii. average value of a variable – the total value of the variable divided by the total
quantity of a driver, e.g., total pay divided by total no. of hours worked;
iii. driver – the independent variable, e.g., no. of hours worked;
 iv. the marginal value of a variable may be less that, equal to, or greater than the
average value, depending on whether the marginal value is decreasing, constant or
increasing with respect to the driver;
v. if the marginal value of a variable is greater than its average value, the average
value increases, and vice versa.
(b) Stocks and flows.
i. stock – the quantity at a specific point in time, measured in units of the item, e.g.,
items on a balance sheet (assets and liabilities), the world’s oil reserves in the
beginning of a year;
ii. Flow – the change in stock over some period of time, measured in units per time
period e.g., items on an income statement (receipts and expenses), the world’s
current production of oil per day.
(c) Holding other things equal – the assumption that all other relevant factors do not change,
and is made so that changes due to the factor being studied may be examined independently
of those other factors. Having analysed the effects of each factor, they can be put together
for the complete picture.

PRINCIPLES OF MANAGERIAL ECONOMICS

Marginal and Incremental Principle

This principle states that a decision is said to be rational and sound if given the firm’s
objective of profit maximization, it leads to increase in profit, which is in either of two
scenarios-

If total revenue increases more than total cost.

If total revenue declines less than total cost.

Marginal analysis implies judging the impact of a unit change in one variable on the other.
Marginal generally refers to small changes. Marginal revenue is change in total revenue per
unit change in output sold. Marginal cost refers to change in total costs per unit change in
output produced (While incremental cost refers to change in total costs due to change in
total output). The decision of a firm to change the price would depend upon the resulting
impact/change in marginal revenue and marginal cost. If the marginal revenue is greater
than the marginal cost, then the firm should bring about the change in price.

Incremental analysis differs from marginal analysis only in that it analysis the change in the
firm’s performance for a given managerial decision, whereas marginal analysis often is
generated by a change in outputs or inputs. Incremental analysis is generalization of
marginal concept. It refers to changes in cost and revenue due to a policy change. For
example – adding a new business, buying new inputs, processing products, etc. Change in
output due to change in process, product or investment is considered as incremental
change. Incremental principle states that a decision is profitable if revenue increases more
than costs; if costs reduce more than revenues; if increase in some revenues is more than
decrease in others; and if decrease in some costs is greater than increase in others.

Equi-marginal Principle

Marginal Utility is the utility derived from the additional unit of a commodity consumed. The
laws of equi-marginal utility states that a consumer will reach the stage of equilibrium when
the marginal utilities of various commodities he consumes are equal. According to the
modern economists, this law has been formulated in form of law of proportional marginal
utility. It states that the consumer will spend his money-income on different goods in such a
way that the marginal utility of each good is proportional to its price, i.e.,

Mux / Px = MUy / Py = MUz / Pz

Where, MU represents marginal utility and P is the price of good.

Similarly, a producer who wants to maximize profit (or reach equilibrium) will use the
technique of production which satisfies the following condition:

MRP1 / MC1 = MRP2 / MC2 = MRP3 / MC3

Where, MRP is marginal revenue product of inputs and MC represents marginal cost.

Thus, a manger can make rational decision by allocating/hiring resources in a manner

which equalizes the ratio of marginal returns and marginal costs of various use of resources
in a specific use.

Opportunity Cost Principle

By opportunity cost of a decision is meant the sacrifice of alternatives required by that

decision. If there are no sacrifices, there is no cost. According to Opportunity cost principle,
a firm can hire a factor of production if and only if that factor earns a reward in that
occupation/job equal or greater than it’s opportunity cost. Opportunity cost is the minimum
price that would be necessary to retain a factor-service in it’s given use. It is also defined as
the cost of sacrificed alternatives. For instance, a person chooses to forgo his present
lucrative job which offers him Rs.50000 per month, and organizes his own business. The
opportunity lost (earning Rs. 50,000) will be the opportunity cost of running his own
business.

Time Perspective Principle

According to this principle, a manger/decision maker should give due emphasis, both to
short-term and long-term impact of his decisions, giving apt significance to the different time
periods before reaching any decision. Short-run refers to a time period in which some
factors are fixed while others are variable. The production can be increased by increasing
the quantity of variable factors. While long-run is a time period in which all factors of
production can become variable. Entry and exit of seller firms can take place easily. From
consumers point of view, short-run refers to a period in which they respond to the changes
in price, given the taste and preferences of the consumers, while long-run is a time period in
which the consumers have enough time to respond to price changes by varying their tastes
and preferences.

Discounting Principle

According to this principle, if a decision affects costs and revenues in long-run, all those
costs and revenues must be discounted to present values before valid comparison of
alternatives is possible. This is essential because a rupee worth of money at a future date is
not worth a rupee today. Money actually has time value. Discounting can be defined as a
process used to transform future dollars into an equivalent number of present dollars. For
instance, $1 invested today at 10% interest is equivalent to $1.10 next year.

FV = PV*(1+r)t

Where, FV is the future value (time at some future time), PV is the present value (value at
t0, r is the discount (interest) rate, and t is the time between the future value and present
value.

CHARACTERISTICS OF MANAGERIAL ECONOMICS

1. Microeconomics: It studies the problems and principles of an individual business firm or an
individual industry. It aids the management in forecasting and evaluating the trends of the
market.

2. 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 optimal
utilisation of available resources, come under the banner of managerial economics.

3. Pragmatic: Managerial economics is pragmatic. In pure micro-economic theory, analysis is

performed, based on certain exceptions, which are far from reality. However, in managerial
economics, managerial issues are resolved daily and difficult issues of economic theory are kept
at bay.

4. Uses theory of firm: Managerial economics employs economic concepts and principles, which
are known as the theory of Firm or 'Economics of the Firm'. Thus, its scope is narrower than that
of pure economic theory.

5. Takes the help of macroeconomics: Managerial economics incorporates certain aspects of

macroeconomic theory. These are essential to comprehending the circumstances and
environments that envelop the working conditions of an individual firm or an industry.
Knowledge of macroeconomic issues such as business cycles, taxation policies, industrial policy
of the government, price and distribution policies, wage policies and antimonopoly policies and
so on, is integral to the successful functioning of a business enterprise.

6. Aims at helping the management: Managerial economics aims at supporting the management in
taking corrective decisions and charting plans and policies for future.

7. A scientific art: Science is a system of rules and principles engendered for attaining given ends.
Scientific methods have been credited as the optimal path to achieving one's goals. Managerial
economics has been is also called a scientific art because it helps the management in the best
and efficient utilisation of scarce economic resources. It considers production costs, demand,
price, profit, risk etc. It assists the management in singling out the most feasible alternative.
Managerial economics facilitates good and result oriented decisions under conditions of
uncertainty.

8. Prescriptive rather than descriptive: Managerial economics is a normative and applied discipline.
It suggests the application of economic principles with regard to policy formulation, decision-
 making and future planning. It not only describes the goals of an organisation but also
prescribes the means of achieving these goals.

SCOPE, IMPORTANCE AND USES OF MANAGERIAL ECONOMICS

The scope of managerial economics includes following subjects:

1. Theory of demand

2. Theory of production

3. Theory of exchange or price theory

4. Theory of profit

5. Theory of capital and investment

6. Environmental issues, which are enumerated as follows:

1. Theory of Demand: According to Spencer and Siegelman, “A business firm is an economic

organisation which transforms productivity sources into goods that are to be sold in a market”.

a. Demand analysis: Analysis of demand is undertaken to forecast demand, which is a

fundamental component in managerial decision-making. Demand forecasting is of importance
because an estimate of future sales is a primer for preparing production schedule and
employing productive resources. Demand analysis helps the management in identifying factors
that influence the demand for the products of a firm. Thus, demand analysis and forecasting is
of prime importance to business planning.

b. Demand theory: Demand theory relates to the study of consumer behaviour. It addresses
questions such as what incites a consumer to buy a particular product, at what price does
he/she purchase the product, why do consumers cease consuming a commodity and so on. It
also seeks to determine the effect of the income, habit and taste of consumers on the demand
of a commodity and analyses other factors that influence this demand.

2. Theory of Production: Production and cost analysis is central for the unhampered functioning of
the production process and for project planning. Production is an economic activity that makes
goods available for consumption. Production is also defined as a sum of all economic activities
besides consumption. It is the process of creating goods or services by utilising various available
resources. Achieving a certain profit requires the production of a certain amount of goods. To
obtain such production levels, some costs have to be incurred. At this point, the management is
 faced with the task of determining an optimal level of production where the average cost of
production would be minimum. Production function shows the relationship between the
quantity of a good/service produced (output) and the factors or resources (inputs) used. The
inputs employed for producing these goods and services are called factors of production.

a. Variable factor of production: The input level of a variable factor of production can be varied
in the short run. Raw material inputs are deemed as variable factors. Unskilled labour is also
considered in the category of variable factors.

b. Fixed factor of production: The input level of a fixed factor cannot be varied in the short run.
Capital falls under the category of a fixed factor. Capital alludes to resources such as
buildings, machinery etc.

Production theory facilitates in determining the size of firm and the level of production. It
elucidates the relationship between average and marginal costs and production. It highlights how a
change in production can bring about a parallel change in average and marginal costs. Production
theory also deals with other issues such as conditions leading to increase or decrease in costs, changes
in total production when one factor of production is varied and others are kept constant, substitution of
one factor with another while keeping all increased simultaneously and methods of achieving optimum
production.

3. Theory of Exchange or Price Theory: Theory of Exchange is popularly known as Price Theory.
Price determination under different types of market conditions comes under the wingspan of
this theory. It helps in determining the level to which an advertisement can be used to boost
market sales of a firm. Price theory is pivotal in determining the price policy of a firm. Pricing is
an important area in managerial economics. The accuracy of pricing decisions is vital in shaping
the success of an enterprise. Price policy impresses upon the demand of products. It involves the
determination of prices under different market conditions, pricing methods, pricing policies,
differential pricing, product line pricing and price forecasting.

4. Theory of profit: Every business and industrial enterprise aims at maximising profit. Profit is the
difference between total revenue and total economic cost. Profitability of an organisation is
greatly influenced by the following factors:
• Demand of the product
• Prices of the factors of production
• Nature and degree of competition in the market
• Price behaviour under changing conditions
Hence, profit planning and profit management are important requisites for improving profit earning
efficiency of the firm. Profit management involves the use of most efficient technique for predicting
the future. The probability of risks should be minimised as far as possible.
5. Theory of Capital and Investment: Theory of Capital and Investment evinces the following
important issues:
• Selection of a viable investment project
• Efficient allocation of capital
• Assessment of the efficiency of capital
• Minimising the possibility of under capitalisation or overcapitalisation. Capital is the building
block of a business. Like other factors of production, it is also scarce and expensive. It should be
allocated in most efficient manner.
6. Environmental issues: Managerial economics also encompasses some aspects of
macroeconomics. These relate to social and political environment in which a business and
industrial firm has to operate. This is governed by the following factors:
• The type of economic system of the country
• Business cycles
• Industrial policy of the country
• Trade and fiscal policy of the country
• Taxation policy of the country
• Price and labour policy
• General trends in economy concerning the production, employment, income, prices, saving and
investment etc.
• General trends in the working of financial institutions in the country
• General trends in foreign trade of the country
• Social factors like value system of the society
• General attitude and significance of social organisations like trade unions, producers’ unions
and consumers’ cooperative societies etc.
• Social structure and class character of various social groups
• Political system of the country
The management of a firm cannot exercise control over these factors. Therefore, it should fashion
the plans, policies and programmes of the firm according to these factors in order to offset their
adverse effects on the firm.

IMPORTANCE
 Helps in evaluating managerial policies – There are certain operational policies of
company which yield no return or are not at all important in altering certain
market conditions. It calls for timely evaluation of these policies so that there can
be solutions for budding obstacles in the way of business decision-making.
Managerial economics plays an active role in the evaluation and assessment of
certain managerial policies.

 Advantageous in business organization – Managerial economics is quite beneficial

when it comes to organizing and managing the tasks, events related to the
smooth functioning of business. It helps in taking the accurate decision related to
the business organization.

 Recognizes the economic strength and weakness – This significance of

managerial economics is of utmost value as it defines the perks and pitfalls of the
business economy. By exercising managerial economics the business managers
can be sure of certain activities that could affect the growth of business.

 Computing the economic relationship – There are certain business aspects like
income, profit, acquisitions, loss, demand elasticity etc. The relationship and
accord among these factors are estimated with the help of managerial economics.

 Makes business planning much easier – The managerial economics is immense

significant and essential in planning an appropriate prospect in order to achieve
rewarding results and operations. This business planning plays an important role
in connecting the tools of production and systems of operation. Through these
benefits we can easily apprehend the importance of managerial economics.

 Helps in managing the cost – Managerial economics offer a helping hand when it
comes to deciding the correct and appropriate way for operating a business. All
these decisions and arbitrations are possible when there is an active role and
exercise of managerial economics which automatically affects the decisions
related to cost control.

 Systemization of business activities – There are several business activities that

needs to be coordinated and managed in a systematic manner. Managerial
economics helps in coordination of activities related to business.

 Resolves problem related to business taxation – Managerial economics proves to

be the giant problem solving tool in various types of issues related to taxation in
the business.

 Helps in computing firm’s efficiency – Managerial economics helps the business

managers to measure the ability and efficiency of the firm.
USES

1. Integrating economic theory with business practice

2. Using economics tools to analyze business situations 
3. Applying economic principles to solve business problems
4. Using economic ideas for crisis management
5. Facilitating demand analysis and demand forecasting
6. Allocating scarce resources for optimizing returns
7. Enabling risk taking and uncertainly bearing
8. Helping in profit maximization
9. Pursuing the larger objectives of the firm other than profit maximization
10. Formulating short-term and long-term business strategies