Managerial Economics Week 2 (Aug. 12-18, 2024) PDF

Managerial Economics Introduction to Managerial Economics Week 2 (Aug. 12 to 18, 2024) Introduction to Managerial Economics I. Introduction to managerial economics and its importance. II. Economic models and their role in decision-making. III. Marginal analysis and optimization principles. ...

Managerial Economics Introduction to Managerial Economics Week 2 (Aug. 12 to 18, 2024) Introduction to Managerial Economics I. Introduction to managerial economics and its importance. II. Economic models and their role in decision-making. III. Marginal analysis and optimization principles.  A close interrelationship between management and economics had led to the development of managerial economics. Economic analysis is required for various concepts such as demand, profit, cost, and competition. In this way, managerial economics is considered as economics applied to “problems of choice’’ or alternatives and allocation of scarce resources by the firms.  Managerial economics is a discipline that combines economic theory with managerial practice. It helps in covering the gap between the problems of logic and the problems of policy. The subject offers powerful tools and techniques for managerial policy making.  To quote Mansfield, “Managerial economics is concerned with the application of economic concepts and economic analysis to the problems of formulating rational managerial decisions.” Spencer and Siegelman have defined the subject as “the integration of economic theory with business practice for the purpose of facilitating decision making and forward planning by management.” Micro, Macro, and Managerial Economics Relationship Microeconomics studies the actions of individual consumers and firms; managerial economics is an applied specialty of this branch. Macroeconomics deals with the performance, structure, and behavior of an economy as a whole. Managerial economics applies microeconomic theories and techniques to management decisions. It is more limited in scope as compared to microeconomics. Macroeconomists study aggregate indicators such as GDP, unemployment rates to understand the functions of the whole economy.  Microeconomics and managerial economics both encourage the use of quantitative methods to analyze economic data. Businesses have finite human and financial resources; managerial economic principles can aid management decisions in allocating these resources efficiently. Macroeconomics models and their estimates are used by the government to assist in the development of economic policy. Nature and Scope of Managerial Economics The most important function in managerial economics is decision- making. It involves the complete course of selecting the most suitable action from two or more alternatives. The primary function is to make the most profitable use of resources which are limited such as labor, capital, land etc. A manager is very careful while taking decisions as the future is uncertain; he ensures that the best possible plans are made in the most effective manner to achieve the desired objective which is profit maximization.  Economic theory and economic analysis are used to solve the problems of managerial economics. Economics basically comprises of two main divisions namely Micro economics and Macro economics.  Managerial economics covers both macroeconomics as well as microeconomics, as both are equally important for decision making and business analysis. Macroeconomics deals with the study of entire economy. It considers all the factors such as government policies, business cycles, national income, etc. Microeconomics includes the analysis of small individual units of economy such as individual firms, individual industry, or a single individual consumer.  All the economic theories, tools, and concepts are covered under the scope of managerial economics to analyze the business environment. The scope of managerial economics is a continual process, as it is a developing science. Demand analysis and forecasting, profit management, and capital management are also considered under the scope of managerial economics. Demand Analysis and Forecasting Demand analysis and forecasting involves huge amount of decision- making! Demand estimation is an integral part of decision making, an assessment of future sales helps in strengthening the market position and maximizing profit. In managerial economics, demand analysis and forecasting holds a very important place. Profit Management Success of a firm depends on its primary measure and that is profit. Firms are operated to earn long term profit which is generally the reward for risk taking. Appropriate planning and measuring profit is the most important and challenging area of managerial economics. Capital Management Capital management involves planning and controlling of expenses. There are many problems related to capital investments which involve considerable amount of time and labor. Cost of capital and rate of return are important factors of capital management. Demand for Managerial Economics The demand for this subject has increased post liberalization and globalization period primarily because of increasing use of economic logic, concepts, tools and theories in the decision making process of large multinationals. Also, this can be attributed to increasing demand for professionally trained management personnel, who can leverage limited resources available to them and maximize returns with efficiency and effectiveness. II. Economic models and their role in decision-making An economic model is a simplified representation of a real-world economic situation or phenomenon that is used to analyse and understand the underlying economic principles at work. Economic models are built on assumptions about how people, firms, and markets behave, and they use mathematical and statistical techniques to make predictions and test hypotheses about economic phenomena. The importance of assumptions An economic assumption is a simplified statement about how people, firms, or markets are expected to behave in a given situation. For example, an economic model might assume that people always act in their own self-interest or that firms always maximise profits. It is important to note that economic assumptions are simplifications of reality and that they may not always hold true in all situations. The ceteris paribus assumption The ceteris paribus assumption is a Latin phrase that means "other things being equal." It is used in economics to refer to the assumption that all other factors are held constant in order to isolate the effect of a single variable on an economic outcome. The ceteris paribus assumption is often used when building and analyzing economic models. For example, an economist might build a model to analyze the effect of a change in taxes on consumer spending. In order to isolate the effect of the tax change, the economist would hold all other factors constant, such as income, prices, and consumer confidence. This would allow the economist to focus on the specific effect of the tax change on consumer spending, without the influence of other variables. The use of economic models Economic models are used to understand and explain micro and macro economic phenomena, to make predictions about future economic events, and to evaluate the effects of different economic policies. Examples of different economic models There are many different types of economic models that are used to analyze and understand economic phenomena. Some examples of different economic models include: 1. Supply and demand model: This model is used to understand the relationship between the quantity of a good or service that is available and the price at which it is offered. The model assumes that as the price of a good increases, the quantity demanded by consumers will decrease, while the quantity supplied by producers will increase. 2. Production function model: This model is used to understand the relationship between the inputs used in the production process (such as labor and capital) and the output of a good or service. The model assumes that as the inputs are increased, the output will also increase, but at a diminishing rate. 3. Utility maximization model: This model is used to understand how consumers make decisions about what goods and services to purchase. The model assumes that consumers aim to maximize their utility (or satisfaction) from their purchases and will choose the combination of goods and services that provides the greatest utility for their given budget. 4. Game theory model: This model is used to analyze strategic interactions between two or more individuals or firms. The model assumes that each participant will make decisions based on their own self-interest and on the expectations of the other participants. III. Marginal analysis and optimization principles. Marginal analysis compares the additional benefits derived from an activity and the extra cost incurred by the same activity. It serves as a decision-making tool in projecting the maximum potential profits for the company by comparing the costs and benefits of the activity. The term “marginal” is used by economists to refer to the changes resulting from one unit change in activity. It is concerned with the incremental cost and benefit stemming from a change in production.  Marginal analysis a decision-making tool used to examine the additional benefit of an activity contrasted with the extra cost incurred by the same activity. It is mostly used by companies to maximize efficiency and improve their decision-making processes. The marginal analysis of costs and benefits is necessary, especially for a company planning to expand its business operations.  In microeconomics, most decisions usually evaluate whether the benefit of a particular activity or action is greater than the cost. Marginal analysis comes in handy when making a decision with a causal relationship involving two variables. It explains the potential effect of some conditional changes on a company as a whole. By examining the associated costs and potential benefits, marginal analysis provides useful information that is likely to prompt price or production change decisions.  Marginal analysis also looks at the conditions under which the company may continue with the same cost of producing an individual unit or output in the face of expected or actual changes. Here, the dominating principle is the adjustment to change. The idea is that it is worthwhile for a company to continue investing until the marginal revenue from each extra unit is equal to the marginal cost of producing it.  Marginal analysis may also be applied in a situation where an investor is faced with two potential investments but with the resources to only invest in one. The investor can use marginal analysis to compare the costs and the benefits of both investments to determine the option with the highest income potential. Uses of Marginal Analysis The following are the two prevalent uses of marginal analysis: 1. Observed changes Marginal analysis can be used by managers to create controlled experiments based on the observed changes of particular variables. For example, the tool can be used to evaluate the impact of increasing production at a given percentage on cost and revenues.  A benefit is accrued when the marginal cost is reduced or the increased revenues cover and spill over total production costs. If the experiment yields a positive result, incremental steps are taken until the result yields a negative outcome. This may be the scenario when the market cannot take the additional production units, leading to excessive overheads. At that stage, a company with the capacity to expand will opt to increase its market reach. 2. The opportunity cost of an action Managers regularly find themselves in situations where they are required to make a choice among available options. For example, suppose a company has a single job opening, and they have the choice of hiring a junior administrator or a marketing manager. Marginal analysis may indicate that the company has resources to grow and that the market is saturated. As a result, hiring a marketing manager will yield higher returns than an administrator. Rules of Marginal Analysis in Decision- Making There are two rules for profit maximization that make marginal analysis a key component in the microeconomic analysis of decisions. They are: 1. Equilibrium Rule The first rule posits that the activity must be carried out until its marginal cost is equal to its marginal revenue. The marginal profit at such a point is zero. Typically, profit can be increased by expanding the activity if the marginal revenue exceeds marginal cost.  Marginal benefit is a measure of how the value of cost changes from the consumer side of the equation, while the marginal cost is a measure of how the value of cost changes from the producer side of the equation. The equilibrium rule implies that units will be purchased up to the point of equilibrium, where the marginal revenue of a unit is equal to the marginal cost of that unit. 2. Efficient Allocation Rule The second rule of profit maximization using marginal analysis states that an activity should be performed until it yields the same marginal return for every unit of effort. The rule is premised on the idea that a company producing multiple products should allocate a factor between two production activities such that each provides an equal marginal profit per unit. If it is not achieved, profit could be realized by allocating more input to the activity with the highest marginal profit and less to the other activity. Limitations of Marginal Analysis One of the criticisms against marginal analysis is that marginal data, by its nature, is usually hypothetical and cannot provide the true picture of marginal cost and output when making a decision and substituting goods. It therefore sometimes falls short of making the best decision, given that most decisions are made based on average data.  Another limitation of marginal analysis is that economic actors make decisions based on projected results rather than actual results. If the projected income is not realized as predicted, the marginal analysis will prove to be worthless.  For example, a company may decide to start a new production line based on a marginal analysis projection that the revenue will exceed costs to establish the production line. If the new production line does not meet the expected marginal costs and operates at a loss, it means that the marginal analysis used the wrong assumptions. Performance Task #2