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Introduction

Managerial Economics and Business economics are the two terms, which, at times have been

used interchangeably. Of late, however, the term Managerial Economics has become more

popular and seems to displace progressively the term Business Economics.

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

attributed to three major factors:

i) The growing complexity of business decision-making processes, because of

changing market conditions and the globalization of business transactions.

ii) The increasing use of economic logic, concepts, theories, and tools of economic

analysis in business decision-making processes.

iii) Rapid increase in demand for professionally trained managerial manpower.

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 of making appropriate business decision requires clear

understanding of existing market conditions, market fundamentals and the business environment

in general. Business decision-making processes require 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 world.

Definition of 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 analyzing

and solving business problems, evaluate business options and opportunities with a view of

arriving to appropriate business decision.

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Spencer and Siegelman have defined Managerial Economics as "The integration of economic

theory with business practice for the purpose of facilitating decision making and forward

planning by management"1.

Douglas also defined “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”2.

Davis and Chang defined as “Managerial economics applies the principles and methods of

economics to analyse problems faced by management of a business, or other types of

organizations and to help find solutions that advance the best interests of such organizations”3.

Mansfield defines “Managerial Economics is concerned with the application of economic

concepts and economics to the problems of formulating rational decision making”4

We may, therefore define Managerial Economics as the discipline which deals with the

application of economic theory to business management. Managerial Economics thus lies on the

borderline between economics and business management and serves as a bridge between

economics and business management.

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. M H Spencer and L Seigelman, Managerial Economics, (Irwin Illinois, 1969), 1.

2. Evan J Douglas, Managerial Economics: Analysis and Strategy, (Prentice-Hall, N.J., 1987), Ch.1. 3. R Davis and S Chang, Principles of managerial Economics (Prentice-Hall, N.J., 1986), ch.3.

4. E Mansfield (ed.), Managerial Economics and Operations Research, (New York: W.W. Norton and Co., Inc.,

1966), 11.

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Applications of Economics to Managerial Economics

The application of economics to managerial economics or the integration of economic theory

with business practice, as Spencer and Siegelman have put it, has the following aspects:-

i) Estimating economic relationships, viz., measurement of various types of elasticities of

demand such as price elasticity, income elasticity, cross-elasticity, promotional elasticity,

cost-output relationships, etc. The estimates of these economic relationships are to be

used for purposes of forecasting.

ii) Predicting relevant economic quantities, e.g. profit, demand, production, costs, pricing,

capital, etc., in numerical terms together with their probabilities. As the business manager

has to work in an environment of uncertainty, future is to be predicted so that in the light

of the predicted estimates, decision making and forward planning may be possible.

iii) Using economic quantities in decision making and forward planning, that is, formulating

business policies and, on that basis, establishing business plans for the future pertaining

to profit, prices, costs, capital, etc. The nature of economic forecasting is such that it

indicates the degree of probability of various possible outcomes, i.e. losses or gains as a

result of following each one of the strategies available. Hence, before a business manager

there exists a quantified picture indicating the number o courses open, their possible

outcomes and the quantified probability of each outcome. Keeping this picture in view,

he decides about the strategy to be chosen.

iv) Understanding significant external forces constituting the environment in which the

business is operating and to which it must adjust, e.g., business cycles, fluctuations in

national income and government policies pertaining to public finance, fiscal policy and

taxation, international economics and foreign trade, monetary economics, labour

relations, anti-monopoly measures, industrial licensing, price controls, etc. The business

manager has to appraise the relevance and impact of these external forces in relation to

the particular business unit and its business policies.

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The application of economics concepts and theories in combination with quantitative methods is

illustrated in figure below..

Figure for Applications of Economics to Managerial Economics

Managerial Decision Areas

• Assessment of Invisible Funds

• Selecting Business Area

• Choice of Product

• Determining Optimum Output

• Determining Price of the Product

• Determining Input-Combination and Product and technology

• Sales Promotion

Application of Economic

Concepts and Theories in

Decision-Making

Use of Quantitative

Methods

• Mathematical Tools

• Statistical Tools

• Econometrics

Managerial Economics

Application of Economics Concepts, Theories and Analytical Tools to find

Optimum Solution to Business Problems

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Characteristics of Managerial Economics

It would be useful to point out certain chief characteristics of Managerial Economics as much as

they throw further light on the nature of the subject matter and help in a clearer understanding

thereof.

i) Managerial Economics is micro-economic in character.

ii) Managerial Economics largely uses that body of economic concepts and principles,

which is known as 'Theory of the firm' or 'Economics of the firm'. In addition, it also

seeks to apply Profit Theory, which forms part of Distribution Theories in Economics.

iii) Managerial Economics is pragmatic. It avoids difficult abstract issues of economic theory

but involves complications ignored in economic theory to face the overall situation in

which decisions are made. Economic theory appropriately ignores the variety of

backgrounds and training found in individual firms but Managerial Economics considers

the particular environment of decision making.

iv) Managerial Economics belongs to normative economics rather than positive economics

(also sometimes known as Descriptive Economics). In other words, it is prescriptive

rather than descriptive. The main body of economic theory confines itself to descriptive

hypothesis, attempting to generalize about the relations among different variables without

judgment about what is desirable or undesirable. For instance, the law of demand states

that as price increases. Demand goes down or vice-versa but this statement does not tell

whether the outcome is good or bad. Managerial Economics, however, is concerned with

what decisions ought to be made and hence involves value judgments.

Importance of Managerial Economics

There are three major contributions of economic theory to business economics which have

been enumerated by Baumol5 as follows:

i) 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.

5. W J Baumol, ‘What Can Economic Theory contribute to Managerial Economics.’ In AER. Vol. 51, No. 2,

May 1966.

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ii) Making available a set of analytical methods for business analyses thereby,

enhancing the analytical capabilities of the business analyst.

iii) Clarification of the various concepts used in business analysis, enabling the

managers avoids conceptual pitfalls.

Economic Analysis and Business Decisions

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

open to the business organization. Decision making processes6 involve four main phases,

including:

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

Second Phase: Collection and analysis of information on economic, sociopolitical and

technological environment.

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

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

Note that second phase and third phase 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 greatest

contribution in business. 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. The other method would be

for the decision-maker or manager to decide. In doing this, the manager would need to

investigate and analyse the following thoroughly:

(a) Production related issues; and,

(b) Sales prospects and problems.

6. Also in Herbert A Simon, ‘ The Decision-Making Process’ in Mansfield (ed.), Managerial Economics and

Operations research, (New York: W.W. Norton and Co., Inc., 1966).

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With regards to production, the manager will be required to collect and analyse Information or

data on:

(a) Available production techniques;

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

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

(d) Input prices;

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

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

Regarding the sales prospects and problems, the manager will be required to collect and analyse

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, 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.

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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 areas of business

issues to which economic theories can be directly applied are 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:

i) 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.

ii) Theory of Production and production decisions. The theory of production or theory of

the firm explains the relationship between inputs and output.

iii) Analysis of Market structure and Pricing theory. Price theory explains how prices are

determined under different market conditions.

iv) 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

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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.

v) 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.

Macroeconomics applied to Business Environment.

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:

i) The existing economic system in the country,

ii) General trends in production, income, employment, prices, savings and investment, and

so on.

iii) Structure of the financial institutions.

iv) Magnitude of and trends in foreign trade.

v) Trends in labour and capital markets.

vi) Government’s economic policies.

vii) Social organizations, such as trade unions, consumers’ cooperatives, and producer

unions.

ix) The degree of openness of the economy.

x) The political environment.

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.

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Gap between Theory and Practice and the Role of Managerial Economics.

It is a general knowledge that there exists a gap between theory and practice in the world of

economic thinking and behaviour. By implication, a theory which appears logically sound might

not be directly applicable in practice. Take for instance, when there are economies of scale, it

seems theoretically sound that when inputs are doubled, output will be more or less doubled, and

when inputs are tripled, output would be more or less tripled. This theoretical conclusion may

not hold in practice. Economic theories are highly simplistic because they are propounded on the

basis of economic models based on simplifying assumptions. Through economic models,

economists create a simplified world with its restrictive boundaries from which they derive their

conclusions. Although economic models are said to be an extraction from the real world, the

closeness of this extraction depends on how realistic the assumptions of the model are. It is a

general belief that assumptions of economic models are unrealistic in most cases. The most

common assumption of the economic models, as you may recall, is the ceteris paribus

assumptions (that is all other things being constant or equal). This assumption has been alleged

to be the most unrealistic assumption. Though economic theories are, no doubt, hypothetical in

nature, in their abstract form however, they do look divorced from reality. Abstract economic

theories cannot be simply applied to real life situations. This however, does not mean that

economic models and theories do not serve useful purposes. ‘Microeconomic theory facilitates

the understanding of what would be a complicated confusion of billions of facts by constructing

simplified models of behaviour that are sufficiently similar to the actual phenomenon to be of

help in understanding them’7. It cannot, nevertheless, be denied the fact that there is a gap

between economic theory and practice. “The big gap between the problems of logic that intrigue

economic theorists and the problems of policy that plague practical management needs to be

bridged in order to give executive access to the practical contributions that economic thinking

can make to top management polices”.8 The gap arises from the fact that there exists a gap

between the abstract world of economic models and the real world. It suffices to say that

although economic theories do not directly offer custom-made solutions to business problems,

they provide a framework for logical economic thinking and analysis. In the words of Keynes,

“The objective [economic) analysis is to provide a machine, or method of blind manipulation,

7. A P Lerner, ‘ Microeconomic Theory’ in Perspective in Economics-Economists Looks at Their Field of Study by

AA Brown, E Neuberger, and M Pakmastier (eds.), (NY: McGraw-Hill), 36.

8. Joel Dean, Managerial Economics, (New Delhi: Prentice Hall of India, 1977), vii...

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which will furnish an infallible answer, but to provide ourselves with an organized and orderly

method of thinking out particular problem……”.9 In the opinion of Boulding, the objective of

economic analysis is to present the ‘map’ of reality rather than a perfect picture of it.10

The need

for such a framework arises because the real economic world is too complex to permit

consideration of every bit of economic facts that influence economic decisions. Economic

analysis presents the business decision makers with a road map; it guides them to their

destinations, and does not take them to their destinations. Managerial economics can bridge the

gap between economic theory and real world business decisions.

The managerial economic logic and tools of analysis guide business decision makers in:

i) Identifying their problems in the achieving their goals,

ii) Collecting the relevant data and related facts,

iii) Processing and analyzing the facts,

iv) Drawing the relevant conclusions,

v) Determining and evaluating the alternative means of achieving the goal and,

vi) Taking appropriate decision.

Without the application of economic logic and tools of analysis, business decisions may likely be

irrational and arbitrary. Irrationality is highly counter-productive.

Conclusion

This unit has been able to expose what managerial economics is all about and why it is necessary

to have it for effective business decisions. Managerial Economics comprises both micro-and

macro-economic theories. Its scope extends to those economic concepts, theories, and tools of

analysis used in the analysis of business environment, and to find solutions to practical business

problems.

9. J M Keynes, The General Theory of Employment Interest and Money, (Harcourt Brace, New York, 1936), 297.

10. K E Boulding, Economic Analysis, (New York: Harper and Bros., 1948), 14.

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Summary

To put some light to the understanding and appreciation of managerial economics as a tool of

business analysis, the unit focused on the following issues:

i) Economic analysis and business decisions, where it was pointed out that business

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

open to the business enterprise.

ii) Scope of Managerial Economics, where we learned that the scope of managerial

economics extends to some economic concepts and tools used in analyzing the business

environment in order to seek for solutions to practical business problems.

iii) Managerial Economics and the gap between theory and practice, where it was pointed out

that there exists a gap between theory and practice in the world of economic thinking and

behaviour. Managerial economics can bridge this gap through logic and tools of analysis

that guide business decision makers.

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References

• Dwivedi, D. N. (2002) Managerial Economics, sixth edition (New Delhi: Vikas

Publishing House Ltd).

• Evan J Douglas, Managerial Economics: Analysis and Strategy, (Prentice-Hall, N.J.,

1987).

• R Davis and S Chang, Principles of managerial Economics (Prentice-Hall, N.J., 1986).

• M H Spencer and L Seigelman, Managerial Economics, (Irwin Illinois, 1969).

• E Mansfield (ed.), Managerial Economics and Operations Research, (New York: W.W.

Norton and Co., Inc., 1966).

• Joel Dean, Managerial Economics, (New Delhi: Prentice Hall of India, 1977).

• J M Keynes, The General Theory of Employment Interest and Money, (Harcourt Brace, New

York, 1936).

• K E Boulding, Economic Analysis, (New York: Harper and Bros., 1948).