Nature, Scope and Methods of Managerial Economics

Meaning and Definition:

The science of Managerial Economics has emerged only recently. With the growing
variability and unpredictability of the business environment, business managers have become
increasingly concerned with finding rational and foresightful ways of adjusting to an exploiting
world environmental change.
The problems of business world attracted the attentions of the academicians from 1950
onwards. Managerial Economics as a subject gained popularity in the U.S.A. after the
publication of the book “Managerial Economics” by Joel Dean,1951.
Emergence of Managerial Economics can be attributed to at least three factors.
(1) Growing complexity of business decision–making process due to changing
market conditions and business environment.
(2) Consequent upon, the increasing use of economic logic, concepts, theories and
tools of economic analysis in the process of business decision making.
(3) Rapid increase in demand for professionally trained managerial manpower.
Economic theories and analytical tools, which are widely used in business decision-
making, have crystallized in to a separate branch of management studies, called Managerial
Economics or Business Economics.
In simple terms Managerial Economics means the application of economic theory to the
problem of management. Managerial Economics enables business executive to assume and
analyze things. Every firm tries to get satisfactory profit even though economic emphasizes
maximizing the profit. Hence it becomes necessary to redesign economic ideas to the practical
world.
Managerial Economists have defined Managerial Economics in a variety of ways:
(i) E.F.Brigham and John R.Small: hey defined as Managerial Economics as “ the
application of economic theory and method to business administrative practice.”
(ii) Christopher Savage and John R Small: “Managerial Economics is concerned with
business efficiency.”
Prof. P.Naresh Kumar, Lecturer in economics, SIBER, Kolhapur. E-mail id:
srivastavb4u@gmail.com

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(iii) Milton H.Spencer and Lonis Siegleman: “ The integration of economic theory
with business practice for the purpose of facilitating decision making and forward planning by
management.”
(iv) Mc Nair and Merian : “Managerial Economics consists of the use of economic
modes of thought to analyze business situations.
(v) D.C.Hague: “ A fundamental academic subject which seeks to understand and
analyse the problems of decision making.”
(vi) W.W.Haynes: “Managerial Economics is the study of the allocation of resources
available to a firm of other unit of management among the activities of that unit.”

Economic Theory and Managerial Theory

What is Economics?
Economics is a social science, which studies human behavior in relation to optimizing
allocation of available resources to achieve the given ends.

Economic Theory is a system of interrelationship. Among all social sciences,

economics is the most advanced in terms of theoretical orientations. There are well-
defined theoretical structures in economics. One of the most widely discussed structures
is the postulational or axiomatic method of theory formulation. It insists that there is a
logical core of theory consisting of postulates and their predictions, which forms the basis
of economic reasoning and analysis. Economics has a logically consistent system of
reasoning. The theory of competitive equilibrium is entirely based on axiomatic method.
Both in deductive inferences and inductive generalizations, the underlying principle is the
interrelationships.
Managerial theory refers to those aspects of economic theory and application
which are directly relevant to the practice of management and the decision making
process. It is concerned with those analytical tools, which are useful in improving
decision-making. Managerial theory provides necessary conceptional tools, which can be
of considerable help to the manager in taking scientific decisions. The managerial
theoretical concepts and techniques are basic to the entire gamut of managerial theory.

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 Economic Theory
(1) It deals with the body of principlesIt de
(2) It has the characteristics of both micro
and macro economics
(3) It deals with a study of individual firm
and individual consumer.
(4)It based on certain assumptions.
(5) It studies only economic aspect of the
problem
Managerial Theory
(1) it deals with the application of certain
Principles to solve the problem of a firm.
(2) It has only micro characteristics
(3) It deals with a study of only profit theories.
(4) In managerial theory assumptions disappear
due to practical situations
(5) It studies both economic and non-economic
aspects.

Nature of Managerial Economics

Managerial Economics is a science applied to decision-making. It bridges the gap between
abstract theory and managerial practice. In short Managerial Economics is “Economics applied n
decision making.”
Decision Making: Managerial Economics is supposed to enrich the conceptional and technical
skill of manager. It is concentrated on the decision process, decision model and decision
variables at the firm level.
The primary function of a manager in business organization and forward planning under
certain business conditions. Some of the important business decisions are:
(i) Production decision,
(ii) Inventory decision,
(iii) Cost decision,
(iv) Marketing decision,
(v) Financial decision,
(vi) Personnel decision,
(vii) Mislleneous decision

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One of the hallmarks of a good executive is the ability to take quick decision. He must have
clarity of goods, use of all the information he can get, weigh pros and cons and make fact
decisions.
The decisions are taken to achieve certain objectives. Several acts are performed to attain the
objectives. Quantitative techniques are also used in decision-making. But it may noted that acts
and quantitative techniques alone will not produce desirable results. It is important to remember
that other variables such as human and behavioural considerations, technological forces and
environmental factors influence the choices and decisions made by managers.

Scope of Managerial Economics

The scope of managerial economics refers to its area of study. Managerial economics has
its roots in economic theory. The empirical nature of managerial economics makes its scope
wider.
Managerial economics provides management with strategic planning tools that can be
used to get a clear perspective of the way of business world works and what can be done to
maintain profitability in ever changing environment. Its scope does not extend to macro
economic theory and economics of public policy, which will also be of interest to the managers.
While considering managerial economics we have to understand whether it is positive economics
or normative economics.

Positive versus Normative Economics

Most of the managerial economists are of the opinion that managerial economics is
fundamentally normative and perspective in nature. It is concerned with what decisions ought to
be made. The application of managerial economics is inseparable from consideration of values
and norms, for it is always concerned with the achievement of objectives or the optimization
goals. In managerial economics, we are interested in what should happen rather what does
happen.
Positive Economics: positive science is concerned with ‘what is’. Robbins regards
economics as a pure science of what is, which is not concerned with moral or ethical questions.
Economics is neutral between ends. The economist has no right to pass judgments on the wisdom

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or folly of the ends itself. He is simply concerned with the problem of resources in relation to the
ends desired.
Ex: The manufacture and sale of cigarettes and wine may be injurious to health and therefore
morally unjustifiable but the economists have no right to pass judgment on these since both
satisfy human wants and involve economic activity.
Normative Economics: normative economics is concerned with describing what should be
things. It is, therefore, also called prescriptive economics
Ex: what price for a product should be fixed, what wage should be paid, how income should be
distributed etc.
It should be noted that normative economics involves value judgments. Almost all the
leading economists are of the opinion that managerial economics is fundamentally normative and
perspective in nature. It refers mostly what ought to be and cannot be neutral about the ends.
Subject matter of managerial economics

Managerial economics deals with the following topics.

(i) Demand analysis and forecasting
(ii) Cost and production analysis
(iii) Inventory management
(iv) Advertising
(v) Pricing decision, policies and practices
(vi) Profit management
(vii) Capital
Demand analysis and forecasting: a firm is an organization with transforms input into
output that is to be sold in a market. Accurate estimation of demand, by analyzing the forces
acting on demand of the product produced by the firm, forms the vital issue in taking
effective decision at the firm level. When demand is estimated, the manager does not stop at
the stage of assessing the current demand, but estimates future demand as well. This is what s
meant by demand forecasting. Demand analysis helps in identifying the various factors
influencing the demand for a firm’s product and thus provides guidelines to manipulate
demand.
Major topics: demand determination, demand distinctions, demand forecasting
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Cost and Production analysis: cost analysis is yet another function of managerial
economics. In decision-making, cost estimates are very essential. The factors causing cost
must be recognized and allowed for if management is to arrive at cost estimates, which are
significant for planning purposes. The determinants of estimating costs, the relationship
between cost and output, the forecast of cost and profit are very vital to a firm. An element of
cost uncertainty exists because all the factors determining costs are always as an effective
knowledge and the application of which is corner stone for the success of a firm.
Production analysis frequently proceeds in physical terms. Inputs play a vital role in the
economies of production. The factors of production may be combined in a particular way to
yield maximum output.
Major topics: production function, least cost combination of inputs, factor productivity,
returns to scale, cost concepts-classifications, cost output relationship, linear programming

Inventory management: An inventory refers to a stock of raw materials, which a firm

keeps. Now the problem is how much of the inventory is the ideal stock. If it is high, capital
is unproductively tied up. If the level of inventory is low, production will be affected.
Therefore, managerial economics will use such methods as Economic Order Quantity
(E.O.Q) approach, ABC analysis with a view to minimizing the inventory cost.
Advertising: to produce a commodity is one thing and to market it is another. Yet the
message about the product should reach the consumer before the thinks of buying it.
Therefore, advertising forms an integral part of decision making and forward planning.
Expenditure on advertisement and related types of proportional activities is called selling
costs by economists.
Major topics: Percentage of ales approach, All you can Afford Approach, Competitive
Parity Approach, Objective and Test Approach and Return to Investment Approach.
Pricing Decision, Policies and Practices:
Pricing is very important area of managerial economics. The control functions of an
enterprise are not only productions but pricing as well. When pricing a commodity, that cost
of production has to be taken into account. Business decisions are greatly influenced by
pervading market structure and the structure of markets that is actually guided by

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 consideration of cost plan pricing and the policies of public enterprises. The knowledge of
pricing of a product under conditions of oligopoly is also essential.

Profit Management: a business firm is an organization designed to make profits. Profits are
acid test of the individual firm’s performance. The concept of profit maximization is very
useful in selecting the alternatives in making decision at the firm level. Profit forecasting is
an essential function of any management. It relates to projection of future earnings and
involves the analysis actual and expected behavior of firms, the sales volume, prices and
competitors strengths.
Capital Management: planning and control of capital expenditures is the basic executive
function. The managerial problem of planning and control of capital is examined from an
economic standpoint. The capital budgeting process takes different forms in different
industries. It involves the equi-marginal principle. The objective is to assure most profitable
use of funds.
The Firm: Objectives and Constraints
Meaning of firm:
(1) The basic unit for organizing production which performs the crucial role of linking
product, factor and money markets.
(2) An administrative organization utilizing a pool of resources.
(3) A business organization under a single management which one or more establishments.
Firm, Inputs, Outputs:
A firm is understood as an organization, which converts inputs into output and sells it in the
market. The inputs are called as factors of production (FOP). The inputs can be classified as class
as follows:

F O P

H u m a n R e s o u r c e s C a p i t a l R e s o u

l a b o u r E n t e r p r e n N u ea rt u r a l M a n - m a d
( l a n d ) ( s t r u c t u r e s , e
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 Under human resources, labour input includes both physical and mental labour i.e. both unskilled
(blue collar) and skilled (white collar) labour. Labour is the part of human effort in an organization,
which is paid wages and salaries as its remuneration.
The other kind of human resource is entrepreneurial resource. An entrepreneur takes the
initiative, coordinates, innovates and takes risk, and receives a compensation profits or loss. Under
land resource, in consists of the barren land, minerals,, forests, sea, mountains etc.
An development work which mankind has carried over all these is part of the man-made capital.
It includes all construction on land, like roads, bridges and buildings, all the equipments, such as
plant, machines and tools, and inventories which consist of unsold finished and semi finished goods
and raw materials.
In economic terms, the factors of production are referred to as land, labour, capital (man-made)
and entrepreneur (organization) and the remuneration they receive as rent, wage, interest and profit
respectively.
The output of firms consists of goods and services they produce. It includes production in various
sectors such as agriculture, industry, transport, banking and communication, consumer gods as well
as producer gods.
The firms are also classified into categories like private sector firms, public sector firms, joint
sector firms and non-profit firms. They are also classified according to the number of owners of a
firm, on the basis of firms are known as proprietorship, partnership and corporations.

Firms Objectives
There are a number of theories about the objectives of a firm. The important ones are of
the following.
(a) Profit maximization
(b) Firms value maximization
(c) Sales(Revenue) maximization subject to some pre-determined profit.
(d) Size maximization
(e) Long-run survival
(f) Management Utility maximization
(g) Satisfying
(h) Other (non-profit) objectives

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(i) Profit maximization: the traditional theory of a firm’s behavior assumes that the
objective of firm owners is to maximize the amount of short-run profits. Profit is
defined in business and economics.
The public and business community define profit as an accounting concept, where it
is the difference between total receipts and the explicit(accounting) costs of carrying out
the business.

Business profit = total receipts – Explicit cost

Explicit cost is the payments made to the hired factors of production. The profit concept
is the gross of the implicit cost, which stands for the imputed cost of the self-owned
factors of production employed in the business
Economic profit is the residual after both explicit cost and implicit costs are deducted
from the total receipts.

Economic Profit = total receipts – Explicit cost - implicit cost

Innovation theory: firms make innovations in new products, new production techniques,
new marketing strategies, etc. these innovations are costly and must be rewarding for
them to flow continuously. For this reason, innovating firms are some times awarded
patent rights for a specific period of time, during which time no other firm is permitted to
copy the product and/or technology, profits are thus considered a reward for innovation.
Risk-Bearing Theory: firms invest large sums in the production system, expecting to
produce goods and make profits on it. However, the production may run into difficulties,
be delayed and there may not be adequate market when production is ready. The firms
take these risks and must be adequately rewarded.
Monopoly Theory: some firms are able to enjoy certain monopoly powers in view of
being in possession of huge capital, patent protection etc.
Friction theory: According to this theory, there is a long-run equilibrium of economic
profit, which is zero. However, markets are seldom in equilibrium and that gives risk to
economic profits and losses.
Marginal efficiency theory: this theory argues that economic profits can arise because
of exceptional managerial skills of well managed firms. For example, if firm that operate

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 at an average level of efficiency can avoid losses, then those operate at above that level
must reap economic profits. Thus, existence of profit is essential to ensure good
performance.
(b) Firm’s Value maximization: since most of the firms expected to operate for long
period, they are postulated to aim for maximum long-run profits instead of maximum
short-run profit.
Thus if ∏ 1 ---- expected profit in period 1
∏ 2 ---- expected profit in period 2
……………………………………
…………………………………….
∏ n ---- expected profit in period n.
firms aims at maximum value of the sum, adjusted properly for the time value of money.
2
Value of the firm = ∏ 1 /(1+i)1 + ∏ 2 /(1+i) +………+ ∏ n / (1+i)n
n
= Σ ∏ i /(1+i)t
t=1

Where i = appropriate rate if interest

The goal of value or wealth maximization is recognized as the primary objective of a business
firm.
(c ) Sales maximization subject to pre-determined profit: William J.Baumol has advanced a
theory “sales revenue maximization.” He argues that if a firm seeks a certain level of profit and
within that constraint aims at maximum sales.
(d) Size maximization: some experts have suggested growth or size maximization as an
alternative goal for firms. By growth, they mean, an increase in sales, assets and for the number
of employees.
Edith Pensore argues that managers have a vital interest in growth because “ individually
gain prestige, personnel satisfaction in successful growth of the firm with which they are
connected, more responsible and better paid positions, and wide scope for their ambitions and
abilities.”

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(e) Long-run survival: K.W.Rothschild (1947) has suggested yet another alternative goal for the
firm into pursue, that is, of assuring long-run survival for the firm. Under this objective, the firm
seeks to maximize the probability of its survival into the future. Such an objective would
commensurate with the interests of the shareholders and the management.
Unlike other objectives of the firm, the objective of long-run survival is hard to measure
and difficult to practice or achieve.
(f) Management Utility Maximization: O.E.Willianson’s model of firm behavioural (1963) “
focuses on the self-interest seeking bahaviour of corporate managers.” The theory basically
ignores the owner’s interest whenever there is a dichotomy between owners and managers. To
this extent managers at least ensure some minimum profit for the owners.
There are many variables in an organization which affect the management utility. Among
these, the prominent ones are the salary including bonus, if any, number of subordinates and
management’s role in investment decisions.
(g) Satisfying: Herbert Simon, a Nobel Prize winner, had proposed an alternative theory of firm
bahaviour. According to his theory, firms do not aim at maximizing anything due to
imperfections in data and incompatibility of interests of various constituent of an organization.
Instead, they set up for themselves some minimum standards of achievement which they hope
will asure the firms viability over a long-period of time. This would require satisfying all the
constituents of the firm, including the stockholders, management, employees, customers,
suppliers and government.
(h) Other (non-profit) objectives: the non-profit objectives include goals such as, maximization
of quantity and quality of output subject to break-even budget constraint,administrators utility
maximization, maximization of productivity etc.

Firm’s Constraints

Decision-making by firms is often subject to certain restrictions or constraints., which may be

internal or external. The internal constraints refer to the ones imposed by the organization itself.
Ex: while deciding on what to produce, a firm might not like to explore each and every
alternative good or service it could produce.
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Among the external constraints, the important are:
(a) Resource constraints
(b) Output quantity and quality constraints
(c) Legal constraints
(d) Environmental constraints

(a) Resource constraints: certain resources might be available in a fixed or limited

quantity and the firm has to take the most appropriate decision. Fro example, for a
small entrepreneur, capital would be a constraint similarly, a raw material might have
to be imported and there may be an import restrictions or it might be locally available
locally, but only in a limited quantity.
Also some times skilled labour, plant and machine or electricity or even the house,
space could be a binding constraint for the expansion of the firm.
(b) Output quantity and quality constraints:
Production of many goods require a license from a competent authority, since the
licenses are issued for installing a certain unit of maximum capacity, they become a
constraint to the firm and, such constraints are sometimes dictated by the availability
of the market.
Similarly the licensing authority might prescribe certain quality norms, which the
organization must adhere to.
Ex: nutritional requirement for feed mixtures, audience exposure requirements for media
promotions.
(c ) Legal Constraints: The legal constraints o firms behaviour take the form of laws
that define minimum wages and bonus, health and safety standards, pollution emission,
fuel efficiency requirements etc. all these constraints impose restrictions on marginal
flexibility. Taking a decision require thorough understanding of all these restrictions and
facilities.
(d)Environmental Constraints: No firm can afford to ignore the economic, social and
political environment within which it has to function. It needs to understand these spheres
not only within economy but also in the world outside since most are open economies in
the present day context. The manager must have good knowledge about all the aspects of

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 public policy, such as those dealing with plan objectives, taxation, subsidies, industrial
policy, import-export policies, technology, and foreign exchange regulation.
Due to the coexistence of objectives and constraints, decisions have to be arrived at by
solving what is called, the constrained optimization problems.
Decision Process
Managerial economics is concerned with decision making at the firm level. Decisions are
often not easy to make. It is recommended that the systematic efforts be made to arrive at
the right decisions. The following steps should be followed for the purpose:

Establish objectives

Specify the decision problem

Identify alternatives

Evaluate alternatives

Select the best alternative

Implement the decision

Monitor the performance

Since the decisions depend on the objectives of a firm, it is important to be clear about them
from the outset. If there are no alternatives, there is no decision problem. However, there are
many alternatives available to a firm and as many constraints.

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 Evaluation of alternatives requires more effort. It would involve collection of all relevant
data and their analysis through appropriate techniques. Once the four steps are completed,
choosing an alternative on the basis of objectives is simple.
Time period under consideration will often be an important factor in decision analysis.
Ours is a dynamic economy and decisions would have to be made within a time constraint.
There are many problems of decision-making. In order to study those problems, it would
be useful to explain the basic principles of managerial economics.
Those are
(i) Opportunity Cost Principle (O.C.P)
(ii) Discounting and Compounding Principle (DCP)
(iii) Marginal or Incremental Principle (MIP)
(iv) Equi-marginal Principle
(v) Time Perspective Principle (TPP)

(i) Opportunity Cost Principle (O.C.P): the opportunity cost principle argues that a
decision to accept an employment for any factor of production is good(profitable) if the
total reward for the factor in that occupation is greater than or at least not less than the
factors opportunity cost: the opportunity cost being the loss of the reward in the next best
use of that resource. It should be noted that the reward includes both monetary and non-
monetary.
Ex: the opportunity cost of a professor’s time when he launches a full-fledged
consulting firm would be the loss of his salary, prerequisites in the form of residential
accommodation, if any, provident fund etc., and the academic environment for carrying
on research projects and publications. According to the O.C.P., his profit- gross of his
salary, should not be less than the sum of all benefits he was deriving when he was a
professor.
This principle is emphasized by economists because most economic resources
have more than one use and therefore have opportunity costs. Traditional business and
accounting executives ignored the opportunity cost of a resource while computing their
business costs or profits. No decision would be the right if the opportunity costs are
ignored.

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(ii) Discounting and Compounding Principle (DCP): DCP states that when a decision
involves money receipts or payments over a period of time, all the money transactions
must be valued at a common period to be meaningful for decision analysis. This is
because money has time value for three reasons: (1) earning power (2) changing prices
(3) uncertainty.
(iii) Marginal or Incremental Principle (MIP): the MIP states that given the objective
of profit maximization, a decision is sound if and only if it leads to increase in profit
which would arise in either of the following cases:

(a) if it causes total revenue to increase more than total cost.

(b) If it causes total revenue to decline less than the total cost.
The MIP is significant, for some businessman take an erroneous view that to make
maximum profit, they must make a profit on every job. The result is that refuse orders
that do not cover full cost plus some profit. Consider a firm whose output-cost
relationship is as follows:
Output Total cost Marginal cost Average cost
0 20 - -
1 28 8 28
2 37 9 18.50
3 47 10 15.70
4 58 11 14.50
5 68 10 13.60

Suppose the firm is producing three units and selling them at a price of Rs.25 per
unit, laming a total profit Rs.28. if the customer for its fourth unit of output, is offering
Rs.14 only, should the firm accept this offer? According to MIP, the offer must be
rejected since the average cost of four units equals to Rs.14.50, which excess the offered
price.
(iv) Equi-marginal Principle: the equi-marginal principle states that a rational decision
maker would allocate or hire resources in such a way that the ratio of marginal returns

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and marginal costs of various uses of a given resource or of various resources in a given
use is the same.
A producer seeking maximum profit would use that technique of production
(Input-mix), which would ensure
( MRP1 /MC1 ) = (MRP2 /MC2) =…………………= (MRPn/MCn)

MRPi= marginal revenue product of I th input.

Mci = marginal cost of ith input.
(iv) Time Perspective Principle (TPP): the time perspective argues that the decision
maker must give due consideration both to the short-run and long-run consequences,
giving appropriate weights to the various time periods, before arriving at a decision.
Ex: the order for the fourth unit are Rs. 14 in spite of an average cost of Rs 14.50
was worth accepting by the producer on the short-run considerations for sure. But if that
were to disturb the customers (market) in the long run, it may have to be rejected.
Nirma soap powder and RIN soap cakes perhaps fall in this category. If the
managers did not have time perspective in their mind, they would never have restored to
such practices.

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