Being able to compete and stay in business requires an understanding of the dynamics of your market, competitors and customers. Decisions are made given the supply and demand characteristics that affect consumer buying habits and the reactions of competitors to your actions. This is where an understanding of managerial economics comes in handy.
Managerial economics is an aid to decision-making and allocation of resources. It bridges the gap between economic theories and the practice of day-to-day management.
Economic Objectives of Management
Theory of the firm: The theory of the firm states that business entities are driven to maximize profits. This theory spreads to encompass marketing campaigns, introductions of new products, hiring practices, pricing strategies and production planning. Managerial economics get applied to each of these areas to maximize performance for optimal results.
Business managers have several economic objectives for their companies:
Make a profit: Making a profit is the core objective when running a company. A business must make a profit that produces a reasonable return on shareholders' equity investment and provides funds for growth.
Grow and develop the business: Businesses cannot remain stagnant; they must grow to provide funds for expansion and offer more benefits for employees.
Maintain a regular supply of goods and services: Managers coordinate sales forecasts with orders for materials, setting manpower levels and scheduling production.
Plan for long-term survival: Plan for the future. Firms rise above the rest because they can sell more products, manage production more efficiently and control expenses better than their competitors.
Optimize the use of resources: Managerial economics looks for the best use of resources. This includes labor, capital, cash and fixed assets.
Improve labor utilization: Workers are most productive when they feel they are being adequately compensated, improving their skills in jobs and have a secure future for employment. The goal is to create an atmosphere where workers want to contribute their best performance to the benefit of the organization.
Minimize risks: Evaluate market factors using economic analysis for better forecasting and more accurate assessments of risks.
Managerial Economics Theory
Managerial economics applies economic concepts and methods to business decision-making that achieves the economic objectives of management. Economic theories help managers understand how economic forces affect their businesses and provide methods to evaluate the consequences of their decisions.
Macroeconomics and microeconomics are both covered by managerial economics. Macroeconomics studies the overall economy and considers such factors as business cycles, inflation rates, national income and interest rates. Microeconomics analyzes the individual units of the economy like consumers and individual companies.
Managerial economics offers a range of statistical and numerical models to analyze and formulate answers to business issues. It gives managers the tools and techniques to use for day-to-day decision-making and to utilize resources more efficiently.
Tools of Managerial Economics
Marginal analysis: Marginal analysis focuses on the costs and benefits of specific business activities. The objective is to find out if the benefits of a change in activity will exceed the costs of making the change. Marginal analysis looks at specific activities rather than the business as a whole.
Supply/demand curves: Microeconomics uses supply/demand curves to analyze consumers' reactions to changes in prices, effects of income on demand and availability of substitute for products.
Statistical analysis: Statistics provide a framework to evaluate the variations in a decision and apply probabilities to the uncertainties. Statisticians extract relevant data from complex information bases to make projections about future performance and results.
Game theory techniques: Game theory is a technique used in making decisions when the payoffs depend on the actions taken by competitors. However, the likelihood of competitors' actions are not known, so probabilities are attached to the various reactions to come up with a decision rule.
Optimization techniques: According to the theory of the firm, management attempts to make the most effective decisions out of the available alternatives. Optimization makes use of equations, tables and graphs to express the various economic relationships between variables. Differential techniques are applied to equations to determine optimal solutions.
Application of Managerial Economics
Setting business goals: Forecasting from marketing models are used to set revenue and profit goals. These objectives can often become metrics for performance evaluations of employees and managers.
Creating a pricing strategy: Managerial economics uses supply/demand curves to predict how consumers will react to price changes.
Deciding how much product to produce: Depending on the projections from sales forecasts, managers have to decide how much of each product to produce and at what price points.
Creating an internet strategy: Developing an effective internet strategy is about understanding SEO, driving traffic and monetizing a website. Economics gets applied to define the demographics of the visitors to the site and creating a content marketing strategy to develop those consumers.
Hiring policies needed to attract labor: Workers want to receive reasonable pay and benefits and have some assurance of long-term stability in their jobs. Managers must balance the marginal cost of labor with the incremental revenues received from product expansions or introductions of new products.
Evaluating investments and capital budgets: Long-term investments in plant and equipment are typically assessed and prioritized using a type of discounted cash flow technique.
Marketing and promotional strategies: Marketing strategies rely on the level of consumer demand for goods and services. Marketing managers try to estimate the size of the market for existing or new products. However, the market size depends on non-economic and economic factors which are represented by the price/demand curves for a product. Managerial economics applies income and price elasticity to make projections of demand.
Introducing new products: Managers use statistical forecasting and supply/demand curves to gauge the potential success of launching a new product. Discounted cash flow projections analyze future cash expenditures for the cost of a new plant and equipment and cash inflows from revenues.
Planning production schedules: Sales forecasts from marketing must be translated into production schedules, inventory quantities and number of workers needed on a production line. Managerial economics analyzes labor performance and provides insights into labor productivity and effects of the law of diminishing returns.
Financial applications: Decisions for purchases of capital equipment and budgeting decisions use economics to quantify and understand the variables of time and uncertainty. Financial managers use economic techniques to make estimates of future cash flows from investments in new plants and equipment. Managers will often have to make choices of how to allocate cash resources. Do they spend more money on advertising or invest in new plants for expansions of product lines?
Forecasting procedures: Managers need forecasts to set goals for sales staff, allocate funds for expansion, create production schedules and hire sufficient manpower. Economics techniques for forecasting include market surveys, regressions analyses of indicators, analyses of moving averages of past performances and diffusion indices.
Managers develop strategies to reach their long-term economic objectives. They apply the theories and methods of managerial economics to the implementation and execution of their strategies and estimate the probability of success. Managerial economics is used to analyze the risks of business decisions and as a method to identify and quantify the uncertainties in a situation.
Managers use some form of economic principles in making day-to-day decisions. They may not state the principles in a formal sense or even be aware of the applications, but they will, nevertheless, intuitively use the techniques.
- Institute of Cost Accountants of India: Fundamentals of Economics and Management
- Concordia University: What Is Managerial Economics?
- Colorado College: Cross-Elasticity of Demand & Supply and Income Elasticity of Demand
- Penn State University: Beyond the Cost Model: Understanding Price Elasticity and Its Applications
James Woodruff has been a management consultant to more than 1,000 small businesses. As a senior management consultant and owner, he used his technical expertise to conduct an analysis of a company's operational, financial and business management issues. James has been writing business and finance related topics for National Funding, PocketSense, Bizfluent.com, FastCapital360, Kapitus, Smallbusiness.chron.com and e-commerce websites since 2007. He graduated from Georgia Tech with a Bachelor of Mechanical Engineering and received an MBA from Columbia University.