Managerial Economics

This article will focus on managerial economics. It will provide an analysis of the different types of economic tools, methods, and approaches used by business managers to solve business decisions. Examples of managerial economic tools and techniques include the theory of the firm, demand theory, production and cost analysis, pricing analysis, capital budgeting, and game theory. A case study about managerial economic approaches to the problem of cyberslacking in the workplace will be included. The issues associated with current developments in managerial economics will be addressed.

Keywords Business Managers; Capital Budgeting; Demand Theory; Managerial Economics; Pricing Analysis; Theory of the Firm

Business & Public Policy > Managerial Economics

Overview

Business managers and economists, though both interested in markets and money, have different knowledge bases and goals. Business mangers use branches of economic theory selectively based on their degree of applicability and relevance. Business managers, unlike economists, must make decisions and act before transactional data becomes available. Most business decisions are based on non-transactional data or data collected in advance of market transactions. Examples of non-transactional data include market research and consumer research. Economists generally do not value non-transactional data while business mangers rely on it to make business decisions (Calfee and Rubin, 1993). Business managers rely on applied economics to inform their decision making process. In particular, business mangers use managerial economics to optimize firm profits and secure an ever-larger market share.

Corporate leaders and managers, including the chief executive officers of large firms and the business managers of small family businesses, need to have an understanding of how market forces affect business practices in order to be competitive in their industry. Corporate decision makers use and rely on the tools, methods, and approaches of managerial economics to make informed business decisions that maximize profit and secure market share. Managerial economics is ultimately a short-hand for applying microeconomic theory to business problems. Managerial economics is one of the most applied fields of economic theory.

Managerial economics, a type of applied economics, refers to microeconomic analysis of business decisions. Managerial analysis uses techniques such as regression and correlation analyses to optimize business decisions based on the business' stated goals and objectives and available resources. Managerial economics is one of the strongest tools of financial management and managerial decision-making. Managerial economics serves as a general method for solving optimization problems. It includes numerous tools and techniques for managers to achieve optimization under constraints and satisfy the objectives of the firm.

In the twenty-first century, managerial economics is usually applied by business managers in business environments with the following characteristics (Egan, 1995):

• The modern corporation is usually organized into business units (BU);
• Each business unit within the modern corporation is responsible for its' own profits or losses;
• Business planning is generally decentralized;
• Business unit product line managers focus on profits for single products over the shorter term;
• Rapid development and innovation in information technology will continue to change production methods and the way products and services are sold and delivered to customers.

While managerial economics can be used to analyze a wide range of business decisions, the main aspects of managerial economics and the most common applications of managerial economics include the theory of the firm, demand theory, production and cost analysis, capital budgeting, and game theory. The following sections will describe and analyze the main techniques of managerial economics. This section will serve as the foundation for a discussion of the issues associated with the adaptation of managerial economics to new twenty-first century business organizations and will provide a case study about managerial economics and cyberslacking.

Applications

Managerial economics is an economic tool kit for business leaders and managers. The following theories, techniques, and approaches, including the theory of the firm, demand theory, production and cost analysis, capital budgeting, and game theory, are used by business managers to optimize firm profits and market share.

The Theory of the Firm

Managerial economics builds on the theory of the firm. The theory of the firm (a microeconomic approach to business analysis of inputs, production methods, output, and prices) argues that profit maximization is the main goal of all firms. The theory of the firm, developed in the nineteenth century by French and English economists, focuses on profit maximization, demand and price, production and factor utilization, and cost minimization. Limitations of the theory of the firm rest in its traditional approach to business practices. The theory of the firm emphasizes the optimization of quantity, price, costs and profits in a single time period for a single kind of product produced in a single facility. While the theory of the firm approach, with its focus on optimization, remains relevant for small farms, small natural resource producers, or small factories serving local markets, the approach is not useful for mid to large size businesses with multiple products, production facilities, and markets. The optimization goals and objectives of mid to large-scale companies vary from small, single-product and single-market businesses (Egan, 1995).

Demand Theory

Business managers are responsible for forecasting and estimating the demand for a product within the marketplace and producing the product in appropriate volume. Demand theory refers to the amount of product that a buyer is willing and able to buy at a specified price. Customers who once demanded a single, easily-produced product are increasingly demanding a combination of physical units and bundles of associated support services and quality attributes. Managerial economics offers tools to create a demand forecast that represents the quantity of both units and support services demanded as a function of price (Egan, 1995).

Production & Cost Analysis

Production and cost analysis refers to the microeconomic techniques used to analyze production efficiency, optimum factor allocation, economies of scale, and cost function. Production and cost analysis incorporates the expenses associated with raw materials, components, subassemblies, communications, transportation, and customer support services. Business managers work to add more value to the products that their companies produce. Business managers often face transfer pricing problems as they determine product price points (Egan, 1995).

Capital Budgeting

Capital budgeting refers to the branch of managerial economics that is concerned with investment decisions and capital purchasing decisions. Capital budgeting is the analytical process of determining the optimal investment of scarce capital so as to realize the greatest profit from that investment. Capital budgeting ranks proposed investments in order of their potential profitability. There are two main criteria for selecting potential business investments:

1. Business managers, engaged in capital budgeting, generally have a minimum desired rate of return specified as the cut-off point to determine whether or not a project should be accepted or rejected.
2. Business managers, engaged in capital budgeting, generally experience constraint from top management regarding the total amount of potential investment.

Business managers, engaged in capital budgeting, take hold of stockholders' funds and work to maximize their earning potential through four main strategies:

1. The postponability method: The postponability method, also referred to as the urgency method, occurs when business managers purchase new equipment and replacements based on their level of urgency. Investments are not made if they can be postponed until a later point. This method allows businesses to keep equipment past when the equipment is at its top performance. The postponability method provides no assistance to business managers in forecasting and choosing potential projects.
2. The payback method: The payback method is used to measure the worth of an investment project. The payback period refers to the length of time that it takes for cash proceeds produced by the investment to equal the original cash outlay required by the investment. The payback method focuses primarily on profitable near-future earnings rather than long-term profits with uncertain profits.
3. Financial statement method: The financial statement method, also referred to as the accounting method, the book value method, the rate of return on assets method, and the approximate rate of return method, is based on accounting information. Business managers generate figures on which to base investment decisions. Business managers hope that the figures they generate will eventually match the accounts after the project is completed. The main limitation of the financial statement method is its' lack of differentiation between income generated in the near future and investment generated in the distant future.
4. Discounted cash flow technique: The discounted cash flow technique analyzes the cash flow of projects at different times in the life of the project. The discounted cash flow technique recognizes that the use of money has a cost. In addition, the technique recognizes, and bases decisions on the fact, that money spent or received today has a different value than money spent or received in the future.

Business managers engaged in capital budgeting develop an economic forecast for each proposed project. The business manager generally chooses the project that has the highest future earnings and the lowest associated costs. This approach is complicated by the different risks associated with each potential project. Competing investment projects have different levels of associated risk. Exogenous variables, which refer to influence from outside a system, inevitably complicate the economic outcome of investment projects. There is no scientific approach to measuring or predicting the probability of influence by exogenous variables (Parkinson, 1971).

Game Theory

Game theory is a decision-making tool for business managers. Game theory refers to a mathematical method for analyzing a conflict. The opposing interests in the game are called players. The alternative is not between two decisions to be made but between two or more strategies to be used against the opposing interest. The value of the game is called the average gain. Each player supports a strategy that maximizes his or her average gain. Game theory is often used during capital budgeting analysis. Game theory allows capital budgeters to consider all possible forecasts for proposed investment projects.

Game theory is potentially limited by the inputs used in analysis, and is limited by the facts utilized in the game. Incorrect or misleading information will result in inaccurate analysis of the potential gains of a project. For example, when game theory is used in capital budgeting forecasts to select an investment project, business mangers will usually perform a backward analysis when the project is complete. The results of the project are compared with the forecast. If there is dissonance between the forecast and the outcome, the results suggest incorrect inputs (Parkinson, 1971).

In addition to the tools, techniques, and methods described above, managerial economics aids business managers in their efforts at risk analysis, market and pricing analysis, cost minimization, reengineering decisions, and outsourcing decisions. Ultimately, managerial economics can be applied to any business decision. The business manager is responsible for choosing the appropriate tool, technique or method of economic analysis that best suits the business problem or scenario.

Case Studies: Cyberslacking & Managerial Economics

Managerial economics, as described in this article, can be applied by business managers to any business problem. Business managers are responsible for matching the tools, technique, or method of managerial economics to the business problem or scenario. Business managers in contemporary firms are increasingly challenged to handle new and unanticipated business problems and issues. The following case study of the relationship between managerial economics and cyberslacking is presented to illustrate how the relevant principles of managerial economics can be applied to real-life situations involving managerial decision-making.

The use of the Internet and related technology in business environments has created numerous problems for business managers. In particular, firms are reporting problems with cyberslacking. Cyberslacking refers to when employees use company resources to visit sites unrelated to business endeavors while at work. Sites can include pornographic, news, shopping, stock trading, vacation planning, gaming, and chatting websites. Business managers must decide how to solve the problem of cyberslacking as well as what effect cyberslacking is having on the firm’s productivity, profits, and morale. Is cyber slacking on the job immoral? Is it a kind of theft? Does cyberslacking hinder or improve productivity? Business managers may or may not believe that inputs are relevant to success in business as outputs are all that really count.

Managerial economics, a profit maximizing strategy, does not answer the question of what approach to take in dealing with cyberslacking in the firm. There is no general managerial advice that will suffice for all businesses. Individual businesses much learn through trial and error which styles and practices work best to meet their needs. Business managers, using the profit maximizing tools of managerial economics, must each decide for themselves what strategies and tools work for their business (Block, 2001).

Issues

Modern Developments in Managerial Economics

Managerial economics is, in many ways, geared to the business managers and decision-making needs of traditional firms. In the twenty-first century, corporations are increasingly transnational operations. Globalization and the Internet, and related communication technologies, have changed business practices and business environments. Corporations are increasingly part of global networks of product research and design, production, and distribution. Firms are moving from linear, centralized, hierarchical structures to decentralized, cooperative, and team-based structures. Businesses are increasingly providing extensive and complex product and customer support such as customer inquiry services, order entry services, order status services, delivery services, billing services, and returns and repairs services. Customer support services are increasingly critical to winning market segments or shares and serves to differentiate one competitor from another. These customer support services factor into the expense and profit forecasts made by business managers. The range of support services offered by different companies influences product price points and creates complex choices for consumers and producers.

In response to the changes in the global business environment, managerial economics is evolving to remain a relevant and useful forecasting and decision-making tool. Managerial economics is going through a transformation process as the production process, decision-making process, and firm structure changes to meet the demands of the new global economy. While traditional managerial economics is based on the idea that profit maximization is the goal of the firm, contemporary business practices and environments suggest that firms are increasingly motivated by market share and strong profits.

Small-scale businesses still rely on applied economic models based on single-product, single production function and a comparative static analysis framework but larger businesses are finding that they need reformed managerial economic tools and techniques. Managerial Economics needs to update its tools to remain useful and responsive to the needs twenty-first century business managers. Examples of changes to traditional managerial economics include (Egan, 1995):

• Managerial economic models need to be reconceptualized to account for multi-period, two-to-five-year decision cycles faced by business unit planners.
• Managerial economic models of demand, price, and cost must reflect the costs associated with customer service and quality elements.
• Contemporary models of profit maximization, cost minimization, and factor utilization tools must incorporate the business decision of multi-product facilities.

Ultimately, changes in the economic landscape and the transaction and coordinating costs of economic activity have transformed both firms and the economic tools used for decision-making in firms. The centralized, single-product, production-unit notion of firms is being replaced by a decentralized, multi-product firm. In response, managerial economics is moving away from its exclusive focus on the firm as a production unit to focusing on the firm as a transacting and coordinating unit. Changes to the structure of firms require that managers adapt and learn new decision-making tools. Business managers of the twenty-first century will need to incorporate the following developments in exchange practices into economic forecasting (Acs, 1999):

• Costs of acquiring information to measure the multiple dimensions of what is being exchanged are rising;
• Costs associated with enforcing contracts and making credible commitments across time and space are rising;
• Technological and organizational advances will require constant learning and adjustment by the business manager and business unit.

Conclusion

Managerial Economics, which applies economic theory and methods to business and administrative decision-making and managerial problems, is a vital tool for effective economic forecasting and profit optimization. Business managers make business decisions in an effort to maximize profits. Business managers use the economic tools of managerial economics, namely constrained optimization and econometric estimation, to maximize profits and secure market share. Additional examples of tools of managerial economics include cost analysis, production functions, and market structures, scale, relative factor intensity, and cost minimization. In the final analysis, the need for managerial economics has not changed, but the economic tools and approaches needed by managers in twenty-first century business organizations have changed significantly. The modern business environment has been transformed as a result of technological advances, global competition, and advances in organizational practice. The field of managerial economics has a lot to contribute to modern business practices in this changed environment (Erfle, 2001).

Recommendations for business managers who wish to use and apply twenty-first century managerial economics to their business decisions include the following five skill sets (Acs, 1999):

1. Develop a set of principles with which to understand what differentiates one company from another in the new global economy.
2. Understand how contracting, transaction costs, and agency theory are influenced by new technologies and the new global business environment.
3. Understand how to quantitatively calculate supply and demand functions for individual firms and evaluate revenue and costs for monopolies, oligopolies, and competitive firms.
4. Learn basic statistics, spreadsheets, five forces analysis, and regression analysis. These tools will aid the managers in calculating cost and price and making effective pricing decisions for product lines.
5. Develop pricing and bidding strategies that compliment the business goals and objectives of the business organization.

Ultimately, managerial economics functions as a tool kit that allows informed and savvy business managers to make a wide range of economically-informed business decisions.

Terms & Concepts

Business Managers: Business personnel responsible for the smooth running of business operations, profit optimization, and market share.

Business Units: Self sufficient groups within a form that manage the design, purchase, production, delivery, and support service for a number of products or services.

Capital Budgeting: The analytical process of determining the optimal investment of scarce capital so as to realize the greatest profit from that investment.

Cyberslacking: When employees use company resources to visit sites unrelated to business endeavors while at work. Sites can include pornographic, news, shopping, stock trading, vacation planning, gaming, and chatting websites.

Demand Theory: The amount of product that a buyer is willing and able to buy at a specified price.

Game Theory: A mathematical method for analyzing a conflict.

Managerial Economics: A type of applied economics that promotes microeconomic analysis of business decisions.

Production & Cost Analysis: The microeconomic techniques utilized in the analysis of production efficiency, optimal factor allocation, economies of scale, and cost function.

Risk Analysis: Probability models and risk quantification techniques used to determine the risks associated with a business decision.

Pricing Analysis: Microeconomic techniques used to examine pricing decisions such as transfer pricing and price discrimination in order to determine the optimal pricing method.

Theory of the Firm: A microeconomic approach to business analysis of inputs, production methods, outputs, and prices that argues that profit maximization is the main goal of all firms.

Bibliography

Acs, Z., & Gerlowski, D. (1999). Teaching managerial economics. Financial Practice & Education, 9, 125-131. Retrieved June 4, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=4398648&site=ehost-live

Arce M., D. (2004). Conspicuous by its absence: Ethics and managerial economics. Journal of Business Ethics, 54, 261-277. Retrieved June 4, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=18661612&site=ehost-live

Block, W. (2001). Cyberslacking, business ethics and managerial economics. Journal of Business Ethics, 33, 225-231. Retrieved June 5, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=5440168&site=ehost-live

Calfee, J., & Rubin, P. (1993). Nontransactional data in managerial economics and marketing. Managerial & Decision Economics, 14, 163-173. Retrieved June 5, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=5997220&site=ehost-live

Chng, D., Rodgers, M.S., Shih, E., & Song, X. (2012). When does incentive compensation motivate managerial behaviors? An experimental investigation of the fit between incentive compensation, executive core self-evaluation, and firm performance. Strategic Management Journal, 33, 1343-1362. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=82616050&site=ehost-live

Egan, T. (1995). Updating managerial economics. Business Economics, 30, 51. Retrieved June 4, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=9508070977&site=ehost-live

Erfle. S. (2001). Excel as a teaching platform for managerial economics. Social Science Computer Review, 19, 480-487.

Karagiannopoulos, D., Georgopoulos, N, Nikolopoulos, K. (2005). Fathoming porter's five forces model in the internet era. Info, 7, 66-76. Retrieved June 4, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=19141527&site=ehost-live

Kraft, K. (2013). The incentives for innovative activity in the managerial firm. Managerial & Decision Economics, 34, 397-408. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=88904729&site=ehost-live

Parkinson, P. (1971). Investment decision-making: Conventional methods vs. game theory. Management Accounting, 53, 13-17.

Suggested Reading

Anderson, R., Muraoka, D., & Bartlett, R. (1990). Survey of managerial economics textbooks. Journal of Economic Education, 21, 79-91. Retrieved June 6, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=5421752&site=ehost-live

Barney, J. (1990). The debate between traditional management theory and organizational economics: Substantive differences or intergroup conflict?. Academy of Management Review, 15, 382. Retrieved June 6, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=4308815&site=ehost-live

Reekie, W., McNicoll, I., & Forman, L. (1980). Editorial. Managerial & Decision Economics, 1, 1. Retrieved June 4, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=5996087&site=ehost-live