Managerial Economics is a part of the study of economics that applies decision science theory, quantifying the concepts learned in microeconomics, or the study of the firm. The study of economics is based on the tenet that all companies are in the business to maximize the wealth of its owners. Applying this goal requires quantitative methods or measurable objectives, to maximize owner wealth.
Maximize Efficient Use of Labor
In managerial economics, the concept of comparative advantage is used to maximize the output of employees. For example, in a hairstyling salon, Marissa and Joan both work as assistants to the stylists. Their duties are to shampoo clients, clean stylists’ work areas, and to answer the telephone. If Marissa takes three minutes to shampoo a client, but in that time she could have cleaned two work areas, or taken three phone calls, Joan should perform the shampooing to allow Marissa to be efficient on cleaning work areas and taking phone calls.
Optimize Price and Output
In a purely competitive firm (assuming many sellers and buyers in the industry), managerial analysis holds that a company should set its price where marginal revenue equals marginal costs. Marginal revenue is the amount of money earned on the last product sold. Similarly, marginal cost is amount of money spent on the last product made.
While marginal revenue often stays static, marginal cost tends to increase. This is due to wear and tear on machinery, reduced productivity of the employees and other inputs. This is the law of diminishing returns. For example, if a t-shirt manufacturer sells each t-shirt for $10, this amount is also the marginal revenue. As marginal costs increase, the t-shirt manufacturer should sell t-shirts as long as the marginal costs are less than or equal to $10.
Minimize Business Uncertainty
In managerial economics, uncertainty is always an unknown input. In our salon example above, the hairstylist may not know how many haircuts she will do in the next month. She reduces her uncertainty by requesting that clients make an appointment for their next haircut to ensure they get the desired time slot. Other companies may reduce uncertainty by offering discounts if a client signs a long-term contract.
Minimize Opportunity Costs
Opportunity costs refer to the sacrifice made when one option is chosen over another. In a firm, the goal is to ensure that the foregone revenue is always less than the chosen option. If a t-shirt manufacturer could use the same machinery to produce jogging shorts that would sell for $7 each, his opportunity cost is $7 per t-shirt. The two objectives of reducing uncertainty and minimizing opportunity cost may sometimes seem to be in conflict with each other, but when uncertainty cannot be quantified, it is often preferable to take the less profitable, more certain option.
Sara Huter is a professor of economics. Her background also includes risk management in the banking and energy industries with expertise in credit scores. Huter received an M.B.A. in finance from Texas A&M University and a B.S. in information systems from Kansas State University. She has been writing for over five years with work at Popsyndicate.com, WickedWordSmith.com and Simplejoy.com.