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Basic economic tools in managerial economics for decision making

Business decision making is essentially a process of selecting the best out of alternative opportunities open to the firm. The steps below put managers analytical ability to test and determine the appropriateness and validity of decisions in the modern business world. Following are the various steps in decision making process:

1. Establish objectives2. Specify the decision problem3. Identify the alternatives4. Evaluate alternatives5. Select the best alternatives6. Implement the decision7. Monitor the performance

Modern business conditions are changing so fast and becoming so competitive and complex that personal business sense, intuition and experience alone are not sufficient to make appropriate business decisions. It is in this area of decision making that economic theories and tools of economic analysis contribute a great deal.

Basic economic tools in managerial economics for decision making:

Economic theory offers a variety of concepts and analytical tools which can be of considerable assistance to the managers in his decision making practice. These tools are helpful for managers in solving their business related problems. These tools are taken as guide in making decision.

Following are the basic economic tools for decision making:

1. Opportunity cost2. Incremental principle3. Principle of the time perspective4. Discounting principle5. Equi-marginal principle

1) Opportunity cost principle:

By the opportunity cost of a decision is meant the sacrifice of alternatives required by that decision.

For e.g.

a) The opportunity cost of the funds employed in one’s own business is the interest that could be earned on those funds if they have been employed in other ventures.

b) The opportunity cost of using a machine to produce one product is the earnings forgone which would have been possible from other products.

c) The opportunity cost of holding Rs. 1000as cash in hand for one year is the 10% rate of interest, which would have been earned had the money been kept as fixed deposit in bank.

Its clear now that opportunity cost requires ascertainment of sacrifices. If a decision involves no sacrifices, its opportunity cost is nil. For decision making opportunity costs are the only relevant costs.

2) Incremental principle:

It is related to the marginal cost and marginal revenues, for economic theory. Incremental concept involves estimating the impact of decision alternatives on costs and revenue, emphasizing the changes in total cost and total revenue resulting from changes in prices, products, procedures, investments or whatever may be at stake in the decisions.

The two basic components of incremental reasoning are

1. Incremental cost2. Incremental Revenue

The incremental principle may be stated as under:

“A decision is obviously a profitable one if –

it increases revenue more than costs it decreases some costs to a greater extent than it increases others it increases some revenues more than it decreases others and it reduces cost more than revenues”

3) Principle of Time Perspective

Managerial economists are also concerned with the short run and the long run effects of decisions on revenues as well as costs. The very important problem in decision making is to maintain the right balance between the long run and short run considerations.

For example;

Suppose there is a firm with a temporary idle capacity. An order for 5000 units comes to management’s attention. The customer is willing to pay Rs 4/- unit or Rs.20000/- for the whole lot but not more. The short run incremental cost(ignoring the fixed cost) is only Rs.3/-. There fore the contribution to overhead and profit is Rs.1/- per unit (Rs.5000/- for the lot)

Analysis:

From the above example the following long run repercussion of the order is to be taken into account:

1) If the management commits itself with too much of business at lower price or with a small contribution it will not have sufficient capacity to take up business with higher contribution.

2) If the other customers come to know about this low price, they may demand a similar low price. Such customers may complain of being treated unfairly and feel discriminated against.

In the above example it is therefore important to give due consideration to the time perspectives. “a decision should take into account both the short run and long run effects on revenues and costs and maintain the right balance between long run and short run perspective”.

4) Discounting Principle:

One of the fundamental ideas in Economics is that a rupee tomorrow is worth less than a rupee today. Suppose a person is offered a choice to make between a gift of Rs.100/- today or Rs.100/- next year. Naturally he will chose Rs.100/- today. This is true for two reasons-

i) The future is uncertain and there may be uncertainty in getting Rs. 100/- if the present opportunity is not availed of

ii) Even if he is sure to receive the gift in future, today’s Rs.100/- can be invested so as to earn interest say as 8% so that one year after Rs.100/- will become 108

5) Equi – marginal Principle:

This principle deals with the allocation of an available resource among the alternative activities. According to this principle, an input should be so allocated that the value added by the last unit is the same in all cases. This generalization is called the equi-marginal principle.

Suppose, a firm has 100 units of labor at its disposal. The firm is engaged in four activities which need labors services, viz, A,B,C and D. it can enhance any one of these activities by adding more labor but only at the cost of other activities.

Managerial Economics - How it is important for Business Managers

A business manager is essentially involved in the processes of decision making as well as forward planning. Decision making is an integral part of management. Management and decision making are to be considered as inseparable. It is the intellectual process and a purposeful activity which at varied times takes in hands all the managerial activities, such as, planning, organizing, staffing, directing and controlling. It is the process wherein an executive, by taking in to consideration several alternatives reaches at the conclusion about how it should be dealt successfully in a given situation. Thus, being a continuous activity, decision making is regarded to be the heart of management.

Decision making is nothing but choice-making and the importance of choice-making emerges due to the fact that a business faces the changes in the conditions in which it operates and there arise unforeseen contingencies. The survival and the growth of a business in such situations is directly determined through decision making process. It can be defined clearly as selecting one of the best alternatives available - that entails being two or more alternatives. According to George Terry, “Decision making is the selection of a particular course of action, based on some criteria, from two or more possible alternatives.” Decision making is thus choosing the best course of action out of the available options while aiming at the achievement of particular organizational objectives.

Since a business organization has the available resources, such as, capital, land and labor, a business manager needs to select the best alternative among others and employ in the most efficient manner so as to attain the desired results. After a particular decision is made relating to resources, plans about production, pricing and materials are to be implemented. In this way, decision making and forward planning go conjointly.

The fact that a business entity is influenced by the conditions is uncertainty about the future and due to the changes in the business environment resulting complexities in business decisions. Since no information or the knowledge about the future sales, profits or the costs is available for a business executive, the decisions are to be made on the basis of past data as well as the approximations being forecasted. In order that the decision making process is carried out in such conditions in an efficient way, economic theory is of great value and relevance as it deals with production, demand, cost, pricing etc. This gives rise to understand the concepts of managerial economics for business manager so that he may apply the economic principles to the business and appraise the relevance and impact of external factors in relation to the business.

Having been regarded as micro economic as well as the economics of the firm, managerial economics is related to the economic theory which is to be applied to the business with the objective of solving business problems and to analyze business situations and the factors constituting the environment in which a business is operated. Managerial economics has been defined by Spencer and Siegelman as, “The integration of economic theory with business practice for the purpose of facilitating decision making and forward planning by management.”

Managerial economics is very much capable of serving various purposes and useful for managers in making decisions in relation to the internal environment. It aims at the development of economic theory of the firm while facilitating the decision making process with regard to sales and profits etc. Moreover, it enables to take decisions about appropriate production and inventory policies for the future. It is a branch of economics that is applied to analyze almost all business decisions. It is meant to undertake risk analysis, production analysis that is useful for production efficiency. Likewise, it is of great use for capital budgeting processes as well. In the most positive form, it seeks to make successful forecasts with the objective of minimizing the risks involved. It deals with the aspects as how much cash should be available and how much of it should be invested in relation to a choice of processes and projects while making possible the economic feasibility of various production lines.

A business produces goods which are in course of time to be sold in the market on the basis of demand of consumers. Demand can be defined in brief as the quantity of goods that the consumers are willing to buy at certain prices. In this pursuit, the decisions related to demand are of much significance for managers as the process entails making appropriate estimates with successful forecasts on sales before the activity of production is to be carried out. It is therefore demand analysis is essential part of managerial economics since it enables to analyze the demand determinants and forecasting with a deep involvement of value judgments. Above and beyond, by considering whether the competitions are likely to increase or decrease, a business manager with the help of managerial economics applications is able to asses demand prospects as well as the social behavior that can result in the expansion or the reduction of the sales of business products.

As regards the pricing of products being produced by a business entity, it is one of the most critical decisions for a manager to fix the price of particular products as it is by means of pricing decisions taken by a manager, the inflow of revenue is determined. The areas that are to be covered through managerial economics application in this respect are, price methods, product line pricing and price forecasting. Further, Managerial economics deals with the cost estimates that are helpful for management decisions. More to the point, it is important for a manager to undertake production analysis and to determine economic cost with the objective of profit planning and cost control processes. Since the objective of a business entity in general is to generate profits, profit is the chief measure of success in this way. In respect of this, managerial economics cover the aspects, such as, Profit policies and the techniques of profit planning – Break Even Analysis – also called as cost volume profit analysis - that assists significantly in profit planning and cost control methods with a view to maximize profits of the business

Managerial economics plays a significant role in the business organizations. It is very much effective to the management in decision making and forward planning in relation to the internal

operations of a business as it gives clear understanding of market conditions as well as analytical tools through which the competitions prevailing in the markets can be studied, at the same time the market behavior can be predicted. It enables to analyze the information about the business environment in which a business is managed. It is meant to undertake systematic course of business plans by making possible forecasts. Managerial economics contributes to the profitable growth of business and effective solutions of the business problems by changing the economic scenario in to the feasible business opportunities for business organizations while enabling managers to optimize business decisions as well as involving them in the activity of forward planning efficiently.

By: K.A.Fareed (Fareed Siddiqui)(PhD-Management)BBA; MBA-Finance; M.Phil-Financial ManagementMA-English; M.Phil-EnglishPursuing CMA- USAMIMC-Individual Member of Institute of Management Consultants of India

Managerial Economics HelpAccording to Edwin Mansfield, Managerial economics is "concerned with application of economic concepts and economic analysis to the problems of formulating rational managerial decision."

Features of Managerial Economics

Managerial Economics makes use of microeconomic analysis to determine methods of decision for businesses and other units of management.

It correlates the inconsistency separating economics in theory and in practice. It primarily derives from quantitative methods like regression analysis, correlation and calculus. Given the preconditions of a firm's objectives and limitations compelled by scarcity, managerial

economics tries to optimize business decisions by making use of operations research, mathematical programming, computational methods and game theory for imperative decisions.

It uses microeconomic analysis and Quantitative techniques such as regression analysis, correlation, and Lagrangian calculus for the decision methods for management organizations and other businesses.

Managerial Economics helps organizations to find the following: o Efficiency in productiono Costs and decisions regarding pricing decisionso Decisions regarding purchase of Capitalo Managerial Economics involves decisions regarding demand and production.

Decisions of Managerial Economics

To estimate and evaluate Investible funds To select area of Business To select product

To regulate optimum output, price of product and input-combination and technology Promotion of sales

Applications of Managerial Economics

Analysis of Risk Models used for quantification of risk and information which are asymmetric are employed in rules for decision making regarding risk management.

Analysis of Production Microeconomic techniques are utilized for analysis of efficiency in production, perfect allocation of factors, costs, and economies of scale and estimating the cost function of a firm.

Analysis of Price Microeconomic techniques are utilized for analysis of decisions regarding price which includes transfer of price, pricing of joint product, discrimination in price, estimating elasticity in price and selecting the perfect method of pricing.

Capital budgeting This makes use of Investment theory to inspect decisions regarding purchase of capital.

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Reference for Business

Encyclopedia of Business, 2nd ed.

Reference for Business » Encyclopedia of Business, 2nd ed. » Man-Mix » Managerial Economics

MANAGERIAL ECONOMICS

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Decisions made by managers are crucial to the success or failure of a business. Roles played by business managers are becoming increasingly more challenging as complexity in the business

world grows. Business decisions are increasingly dependent on constraints imposed from outside the economy in which a particular business is based—both in terms of production of goods as well as the markets for the goods produced. The impact of rapid technological change on innovation in products and processes, as well as in marketing and sales techniques, figures prominently among the factors contributing to the increasing complexity of the business environment. Moreover, because of increased globalization of the marketplace, there is more volatility in both input and product prices. The continuous changes in the economic and business environment make it ever more difficult to accurately evaluate the outcome of a business decision. In such a changing environment, sound economic analysis becomes all the more important as a basis of decision making. Managerial economics is a discipline that is designed to provide a solid foundation of economic understanding in order for business managers to make well-informed and well-analyzed managerial decisions.

THE NATURE OF MANAGERIAL ECONOMICS

There are a number of issues relevant to businesses that are based on economic thinking or analysis. Examples of questions that managerial economics attempts to answer are: What determines whether an aspiring business firm should enter a particular industry or simply start producing a new product or service? Should a firm continue to be in business in an industry in which it is currently engaged or cut its losses and exit the industry? Why do some professions pay handsome salaries, whereas some others pay barely enough to survive? How can the business best motivate the employees of a firm? The issues relevant to managerial economics can be further focused by expanding on the first two of the preceding questions. Let us consider the first question in which a firm (or a would-be firm) is considering entering an industry. For example, what led Frederick W. Smith the founder of Federal Express, to start his overnight mail service? A service of this nature did not exist in any significant form in the United States, and people seemed to be doing just fine without overnight mail service provided by a private corporation. One can also consider why there are now so many overnight mail carriers such as United Parcel Service and Airborne Express. The second example pertains to the exit from an industry, specifically, the airline industry in the United States. Pan Am, a pioneer in public air transportation, is no longer in operation, while some airlines such as TWA (Trans World Airlines) are on the verge of exiting the airlines industry. Why, then, have many airlines that operate on international routes fallen on hard times, while small regional airlines seem to be doing just fine? Managerial economics provides answers to these questions.

In order to answer pertinent questions, managerial economics applies economic theories, tools, and techniques to administrative and business decision-making. The first step in the decision-making process is to collect relevant economic data carefully and to organize the economic information contained in data collected in such a way as to establish a clear basis for managerial decisions. The goals of the particular business organization must then be clearly spelled out. Based on these stated goals, suitable managerial objectives are formulated. The issue of central concern in the decision-making process is that the desired objectives be reached in the best possible manner. The term "best" in the decision-making context primarily refers to achieving the goals in the most efficient manner, with the minimum use of available resources—implying

there be no waste of resources. Managerial economics helps the manager to make good decisions by providing information on waste associated with a proposed decision.

APPLICATIONS OF MANAGERIAL ECONOMICS

Some examples of managerial decisions have been provided above. The application of managerial economics is, by no means, limited to these examples. Tools of managerial economics can be used to achieve virtually all the goals of a business organization in an efficient manner. Typical managerial decision making may involve one of the following issues:

Deciding the price of a product and the quantity of the commodity to be produced Deciding whether to manufacture a product or to buy from another manufacturer Choosing the production technique to be employed in the production of a given product Deciding on the level of inventory a firm will maintain of a product or raw material Deciding on the advertising media and the intensity of the advertising campaign Making employment and training decisions Making decisions regarding further business investment and the mode of financing the

investment

It should be noted that the application of managerial economics is not limited to profit-seeking business organizations. Tools of managerial economics can be applied equally well to decision problems of nonprofit organizations. Mark Hirschey and James L. Pappas cite the example of a nonprofit hospital. While a nonprofit hospital is not like a typical firm seeking to maximize its profits, a hospital does strive to provide its patients the best medical care possible given its limited staff (doctors, nurses, and support staff), equipment, space, and other resources. The hospital administrator can use the concepts and tools of managerial economics to determine the optimal allocation of the limited resources available to the hospital. In addition to nonprofit business organizations, government agencies and other nonprofit organizations (such as cooperatives, schools, and museums) can use the techniques of managerial decision making to achieve goals in the most efficient manner.

While managerial economics is helpful in making optimal decisions, one should be aware that it only describes the predictable economic consequences of a managerial decision. For example, tools of managerial economics can explain the effects of imposing automobile import quotas on the availability of domestic cars, prices charged for automobiles, and the extent of competition in the auto industry. Analysis of managerial economics will reveal that fewer cars will be available, prices of automobiles will increase, and the extent of competition will be reduced. Managerial economics does not address, however, whether imposing automobile import quotas is good government policy. This latter question encompasses broader political considerations involving what economists call value judgments.

ECONOMIC CONCEPTS USED IN MANAGERIAL ECONOMICS

Managerial economics uses a wide variety of economic concepts, tools, and techniques in the decision-making process. These concepts can be placed in three broad categories: (1) the theory of the firm, which describes how businesses make a variety of decisions; (2) the theory of consumer behavior, which describes decision making by consumers; and (3) the theory of market structure and pricing, which describes the structure and characteristics of different market forms under which business firms operate.

THE THEORY OF THE FIRM

Discussing the theory of the firm is an useful way to begin the study of managerial economics, since the theory provides a broad framework within which issues relevant to managerial decisions are analyzed. A firm can be considered a combination of people, physical and financial resources, and a variety of information. Firms exist because they perform useful functions in society by producing and distributing goods and services. In the process of accomplishing this, they use society's scarce resources, provide employment, and pay taxes. If economic activities of society can be simply put into two categories—production and consumption—firms are considered the most basic economic entities on the production side, while consumers form the basic economic entities on the consumption side.

The behavior of firms is usually analyzed in the context of an economic model, an idealized version of a real-world firm. The basic economic model of a business enterprise is called the theory of the firm.

PROFIT MAXIMIZATION AND THE FIRM.

Under the simplest version of the theory of the firm it is assumed that profit maximization is its primary goal. In this version of the theory, the firm's owner is the manager of the firm, and thus, the firm's owner-manager is assumed to maximize the firm's short-term profits (current profits and profits in the near future). Today, even when the profit maximizing assumption is maintained, the notion of profits has been broadened to take into account uncertainty faced by the firm (in realizing profits) and the time value of money (where the value of a dollar further and further in the future is increasingly smaller than a dollar today). In this more complete model, the goal of maximizing short-term profits is replaced by goal of maximizing long-term profits, the present value of expected profits, of the business firm.

Defining present value of expected profits is based on first defining "value" and then defining "present value." Many concepts of value, such as book value, market value, going-concern value, break-up value, and liquidating value, are encountered in business and economics. The value of the firm is defined as the present value of expected future profits (net cash flows) of the firm. Thus, to obtain an estimate of the present value of expected profits, one must identify the stream of net cash flow in future years. Once this is accomplished, these expected future profit values are converted into present value by discounting these values by an appropriate interest rate. For illustration, assume that a firm expects a profit of $10,000 in one year and $20,000 in the second year it is assumed that the firm earns no profits after two years. Let us assume that the prevailing interest rate is 10 percent per annum. Thus, $10,000 in a year from now is only equal to about $9,091 at the present ([$10,000/(1 +0.1)] = $9,091)—that is, the present value of a $10,000 profit

expected in a year from now is about $9,091. Similarly, the present value of an expected profit of $20,000 in two years from now is equal to about $16,529 (since [$20,000/(1 + 0.1)2] = $16,529). Therefore, the present value of future expected profits is $25,620 (equal to the sum of $9,091 and $16,529). The present value of expected profits is a key concept in understanding the theory of the firm, and maximizing this profit is considered the primary goal of a firm in most models.

It should be noted that expected profit in any one period can itself be considered as the difference between the total revenue and the total cost in that period. Thus, one can, alternatively, find the present value of expected future profits by subtracting the present value of expected future costs from the present value of expected future revenues.

THE CONSTRAINED PROFIT MAXIMIZATION.

Profit maximization is subject to various constraints faced by the firm. These constraints relate to resource scarcity, technology, contractual obligations, and laws and government regulations. In their attempt to maximize the present value of profits, business managers must consider not only the short-term and long-term implications of decisions made within the firm, but also various external constraints that may limit the firm's ability to achieve its organizational goals.

The first external constraint of resource scarcity refers to the limited availability of essential inputs (including skilled labor), key raw materials, energy, specialized machinery and equipment, warehouse space, and other resources. Moreover, managers often face constraints on plant capacity that are exacerbated by limited investment funds available for expansion or modernization. Contractual obligations also constrain managerial decisions. Labor contracts, for example, may constrain managers' flexibility in worker scheduling and work assignment. Labor contracts may also determine the number of workers employed at any time, thereby establishing a floor for minimum labor costs. Finally, laws and regulations have to be observed. The legal restrictions can constrain decisions regarding both production and marketing activities. Examples of laws and regulations that limit managerial flexibility are: the minimum wage, health and safety standards, fuel efficiency requirements, antipollution regulations, and fair pricing and marketing practices.

PROFIT MAXIMIZATION VERSUS OTHER MOTIVATIONS BEHIND MANAGERIAL DECISIONS.

The present value maximization criterion as a basis for the study of the firm's behavior has come under severe criticism from some economists. The critics argue that business managers are interested, at least partly, in factors other than the firm's profits. In particular, they may be interested in power, prestige, leisure, employee welfare, community well-being, and the welfare of the larger society. The act of maximization itself has been criticized; there is a feeling that managers often aim merely to "satisfice" (seek solutions that are considered satisfactory), rather than really try to optimize or maximize (seek to find the best possible solution, given the constraints). This question is often rhetorically posed as: does a manager really try to find the sharpest needle in a haystack or does he or she merely stop upon finding a needle sharp enough for sewing needs?

Under the structure of a modern firm, it is hard to determine the true motives of managers. A modem firm is frequently organized as a corporation in which shareholders are the legal owners of the firm, and the manager acts on their behalf. Under such a structure, it is difficult to determine whether a manager merely tries to satisfy the stockholders of the firm while pursuing other goals, rather than truly attempting to maximize the value (the discounted present value) of the firm. It is, for example, difficult to interpret company support for a charitable organization as an integral part of the firm's long-term value maximization. Similarly, if the firm's size is increasing, but profits are not, can one attribute the manager's decision to expand as being motivated by the increased prestige associated with larger firms, or as an attempt to make the firm more noticeable in the marketplace? As it is virtually impossible to provide definitive answers to these and similar questions, the attempt to analyze these issues has led to the development of alternative theories of firm behavior. Some of the preeminent alternate models assume one of the following: (1) a firm attempts primarily to maximize its size or growth, rather than its present value; (2) the managers of firms aim at maximizing their own personal utility or welfare; and (3) the firm is a collection of individuals with widely divergent goals, rather than a single common, identifiable goal.

While each of the alternative theories of the firm has increased our understanding of how a modern firm behaves, none has been able to completely take the place of the basic profit maximization assumption for several reasons. Numerous academic studies have shown that intense competition in the markets for goods and services of the firm usually forces the manager to make value maximization decisions; if a firm does not decide on the most efficient alternative (implying the need to seek the minimum costs for each output level, given the market price of the commodity the firm is producing), others can outcompete the firm and drive it out of existence. Competition also has its effects through the capital markets. As one would expect, stockholders are primarily interested in their returns on stocks and stock prices, which in turn, are determined by the firm's value (the discounted present value of expected profits). Thus, managers are forced to maximize profits in order to maximize firm value, an important basis for returns on common stocks in the long run. Managers who insist on goals other than maximizing shareholder wealth risk being replaced. An inefficiently managed firm may also be bought out; in almost all such hostile takeovers, managers pursuing their own interests will most likely be replaced. Moreover, a number of academic studies indicate that managerial compensation is closely correlated to the profits generated for the firm. Thus, managers themselves have strong financial incentives to seek profit maximization for their firms.

Before arriving at the decision whether to maximize profits or to satisfice, managers (like other economic entities) have to analyze the costs and benefits of their decisions. Sometimes, when all costs are taken into account, decisions that appear merely aimed at a satisfactory level of performance turn out to be consistent with value-maximizing behavior. Similarly, short-term firm-growth maximization strategies have often been found to be consistent with long-term value maximization behavior, since large firms have advantages in production, distribution, and sales promotion. Thus, many other goals that do not seem to be oriented to maximizing profits may be intimately linked to value or profit maximization—so much so that the value maximization model even provides an insight into a firm's voluntary participation in charity or other socially responsible behavior.

BUSINESS VERSUS ECONOMIC PROFITS.

As discussed above, profits are central to the goals of a firm and managerial decision making. Thus, to understand the theory of firm behavior properly, one must have a clear understanding of profits. While the term profit is very widely used, an economist's definition of profit differs from the one used by accountants (which is also usually used by the general public and the business community). Profit in accounting is defined as the excess of sales revenue over the explicit accounting costs of doing business. This surplus is available to the firm for various purposes.

An economist also defines profit as the difference between sales revenue and costs of doing business, but includes more items in figuring costs, rather than considering only explicit accounting costs. For example, inputs supplied by owners (including labor, capital, and space) are accounted for in determining costs in the definition used by an economist. These costs are sometimes referred to as implicit costs—their value is imputed based on a notion of opportunity costs widely used by economists. In other words, costs of inputs supplied by an owner are based on the values these inputs would have received in the next best alternative activity. For illustration, assume that the owner of the firm works for ten hours a day at his business. If the owner does not receive any salary, an accountant would not consider the owner's effort as a cost item. An economist would, however, value the owner's service to his firm at what his labor would have earned had he worked elsewhere. Thus, to compute the true profit, an economist will subtract the implicit costs from business profit; the resulting profit is often referred to as economic profit. It is this concept of profit that is used by economists to explain the behavior of a firm. The concept of economic profit essentially recognizes that owner-supplied inputs must also be paid for. Thus, the owner of a firm will not be in business in the long run until he recovers the implicit costs (also known as normal profit), in addition to recovering the explicit costs, of doing business.

As pointed out earlier, a given firm attempts to maximize profits. Other firms do the same. Ultimately, profits decline for all firms. If all firms are operating under a competitive market structure, in equilibrium, economic profits (the excess of accounting profits over implicit costs) would be equal to zero; accounting profits (equal to explicit costs), however would be positive. When a firm makes profits above the normal profits level, it is said to be reaping above-normal profits.

HOW A FIRM ARRIVES AT A PROFIT-MAXIMIZING POINT.

Let us assume throughout the discussion that a firm uses an economist's definition of profits. Assume that profit is the excess of sales revenue over cost (now assumed to be composed of both explicit and implicit costs). It can also be assumed, as discussed above, that the profit maximization is the firm's primary goal. Given this objective, important questions remain: How does the firm decide on the output level that maximizes its profits? Should the firm continue to produce at all if it is not profitable?

A manufacturing firm, motivated by profit maximization, calculates the total cost of producing any given output level. The total cost is made up of total fixed cost (due to the expenditure on fixed inputs) and total variable cost (due to the expenditure on variable inputs). Of course, the

total fixed cost does not vary over the short run—only the total variable cost does. It is important for the firm to also calculate the cost per unit of output, called the average cost. In addition to the average cost, the firm calculates the marginal cost. The marginal cost at any level of output is the increase in the total cost due to an increase in production by one unit—essentially, the marginal cost is the additional cost of producing the last unit of output.

The average cost is made up of two components: the average fixed cost (the total fixed cost divided by the number of units of the output produced) and the average variable cost (the total variable cost divided by the number of units of the output produced). As the fixed costs remain fixed over the short run, the average fixed cost declines as the level of production increases. The average variable cost, on the other hand, first decreases and then increases; economists refer to this as the U-shaped nature of the average variable cost. The U-shape of the average variable cost curve is explained as follows. Given the fixed inputs, output of the relevant product increases more than proportionately as the levels of variable inputs used increase. This is caused by increased efficiency due to specialization and other reasons. As more and more variable inputs are used in conjunction with the given fixed inputs, however, efficiency gains reach a maximum—the decline in the average variable cost eventually comes to a halt. After this point, the average variable cost starts increasing as the level of production continues to increase, given the fixed inputs. First decreasing and then increasing average variable cost lead to the U-shape for the average variable cost. The combination of the declining average fixed cost (true for the entire range of production) and the U-shaped average variable cost results into an U-shaped behavior of the average total cost, often simply called the average cost.

The marginal cost also displays a U-shaped pattern—it first decreases and then increases. The logic for the shape of the marginal cost curve is similar to that for the average variable cost—both relate to variable costs. But while the marginal cost refers to the increase in total variable cost due to an increase in the production by one unit, the average variable cost refers to the average variable cost per unit of output produced. It is important to notice, without going into finer details, that the marginal cost curve intersects the average and the average variable cost curves at their minimum cost points.

In a graphic rendering of this concept there would be a horizontal line, in addition to the three cost curves. It is assumed that the firm can sell as many units as it wants at the given market price indicated by this horizontal line. Essentially, the horizontal line is the demand curve a perfectly competitive firm faces in the market—it can sell as many units of output as it deems profitable at price "p" per unit (p, for example, can be $10 per unit of the product under consideration). In other words, p is the firm's average revenue per unit of output. Since the firm receives p dollars for every successive unit it sells, p is also the marginal revenue for the firm.

A firm maximizes profits, in general, when its marginal revenue equals marginal cost. If the firm produces beyond this point of equality between the marginal revenue and marginal cost, the marginal cost will be higher than the marginal revenue. In other words, the addition to total production beyond the point where marginal revenue equals marginal cost, leads to lower, not higher, profits. While every firm's primary motive is to maximize profits, its output decision (consistent with the profit maximizing objective), depends on the structure of the market it is

operating under. Before we discuss important market structures, we briefly examine another key economic concept, the theory of consumer behavior.

THE THEORY OF CONSUMER BEHAVIOR

Consumers play an important role in the economy since they spend most of their incomes on goods and services produced by firms. In other words, they consume what firms produce. Thus, studying the theory of consumer behavior is quite important. What is the ultimate objective of a consumer? Economists have an optimization model for consumers, similar to that applied to firms or producers. While firms are assumed to be maximizing profits, consumers are assumed to be maximizing their utility or satisfaction. Of course, more goods and services will, in general, provide greater utility to a consumer. Nevertheless, consumers, like firms, are subject to constraints—their consumption and choices are limited by a number of factors, including the amount of disposable income (the residual income after income taxes are paid for). The decision to consume by consumers is described by economists within a theoretical framework usually termed the theory of demand.

The demand for a particular product by an individual consumer is based on four important factors. First, the price of the product determines how much of the product the consumer buys, given that all other factors remain unchanged. In general, the lower the product's price the more a consumer buys. Second, the consumer's income also determines how much of the product the consumer is able to buy, given that all other factors remain constant. In general, a consumer buys more of a commodity the greater is his or her income. Third, prices of related products are also important in determining the consumer's demand for the product. Finally, consumer tastes and preferences also affect consumer demand. The total of all consumer demands yields the market demand for a particular commodity; the market demand curve shows quantities of the commodity demanded at different prices, given all other factors. As price increases, quantity demanded falls.

Individual consumer demands thus provide the basis for the market demand for a product. The market demand plays a crucial role in shaping decisions made by firms. Most important of all, it helps in determining the market price of the product under consideration which, in turn, forms the basis for profits for the firm producing that product.

The amount supplied by an individual firm depends on profit and cost considerations. As mentioned earlier, in general, a producer produces the profit maximizing output. Again, the total of individual supplies yields the market supply for a particular commodity; the market supply curve shows quantities of the commodity supplied at different prices, given all other factors. As price increases, the quantity supplied increases.

The interaction between market demand and supply determines the equilibrium or market price (where demand equals supply). Shifts in demand curve and/or supply curve lead to changes in the equilibrium price. The market price and the price mechanism play a crucial role in the capitalist system—they send signals both to producers and consumers.

THEORIES ASSOCIATED WITH DIFFERENT MARKET STRUCTURES

As mentioned earlier, firms' profit maximizing output decisions take into account the market structure under which they are operating. There are four kinds of market organizations: perfect competition, monopolistic competition, oligopoly, and monopoly.

PERFECT COMPETITION.

Perfect competition is the idealized version of the market structure that provides a foundation for understanding how markets work in a capitalist economy. Three conditions need to be satisfied before a market structure is considered perfectly competitive: homogeneity of the product sold in the industry, existence of many buyers and sellers, and perfect mobility of resources or factors of production. The first condition, the homogeneity of product, requires that the product sold by any one seller is identical with the product sold by any other supplier—if products of different sellers are identical, buyers do not care from whom they buy so long as the price charged is also the same. The second condition, existence of many buyers and sellers, also leads to an important outcome: each individual buyer or seller is so small relative to the entire market that he or she does not have any power to influence the price of the product under consideration. Each individual simply decides how much to buy or sell at the given market price. The implication of the third condition is that resources move to the most profitable industry.

There is no industry in the world that can be considered perfectly competitive in the strictest sense of the term. However, there are token examples of industries that come quite close to having perfectly competitive markets. Some markets for agricultural commodities, while not meeting all three conditions, come reasonably close to being characterized as perfectly competitive markets. The market for wheat, for example, can be considered a reasonable approximation.

As pointed out earlier, in order to maximize profits, a supplier has to look at the cost and revenue sides; a perfectly competitive firm will stop production where marginal revenue equals marginal cost. In the case of a perfectly competitive firm, the market price for the product is also the marginal revenue, as the firm can sell additional units at the going market price. This is not so for a monopolist. A monopolist must reduce price to increase sales. As a result, a monopolist's price is always above the marginal revenue. Thus, even though a monopolist firm also produces the profit maximizing output, where marginal revenue equals marginal cost, it does not produce to the point where price equals marginal cost (as does a perfectly competitive firm).

Regarding entry and exit decisions; one can now state that additional firms would enter an industry—whenever existing firms are making above normal profits (that is, when the horizontal line is above the average cost at the profit maximizing output). A firm would exit the market if at the profit maximizing point the horizontal line is below the average cost curve; it will actually shut down the production right away if the price is less than the average variable cost.

MONOPOLISTIC COMPETITION.

Many industries that we often deal with have market structures that are characterized by monopolistic competition or oligopoly. Apparel retail stores (with many stores and differentiated products) provide an example of monopolistic competition. As in the case of perfect competition, monopolistic competition is characterized by the existence of many sellers. Usually if an industry has 50 or more firms (producing products that are close substitutes of each other), it is said to have a large number of firms. The sellers under monopolistic competition differentiate their product; unlike under perfect competition, the products are not considered identical. This characteristic is often called product differentiation. In addition, relative ease of entry into the industry is considered another important requirement of a monopolistically competitive market organization.

As in the case of perfect competition, a firm under monopolistic competition determines the quantity of the product to produce based on the profit maximization principle—it stops production where marginal revenue equals marginal cost of production. There is, however, one very important difference between perfect competition and monopolistic competition. A firm under monopolistic competition has a bit of control over the price it charges, since the firm differentiates its products from those of others. The price associated with the product (at the equilibrium or profit maximizing output) is higher than marginal cost (which equals marginal revenue). Thus, production under monopolistic competition does not take place to the point where price equals marginal cost of production. The net result of the profit maximizing decisions of monopolistically competitive firms is that price charged under monopolistic competition is higher than under perfect competition, and the quantity produced is simultaneously lower.

OLIGOPOLY.

Oligopoly is a fairly common market organization. In the United States, both the steel and automobile industries (with three or so large firms) provide good examples of oligopolistic market structures. Probably the most important characteristic of an oligopolistic market structure is the interdependence of firms in the industry. The interdependence, actual or perceived, arises from the small number of firms in the industry. Unlike under monopolistic competition, however, if an oligopolistic firm changes its price or output, it has perceptible effects on the sales and profits of its competitors in the industry. Thus, an oligopolist always considers the reactions of its rivals in formulating its pricing or output decisions.

There are huge, though not insurmountable, barriers to entry to an oligopolistic market. These barriers can exist because of large financial requirements, availability of raw materials, access to the relevant technology, or simply existence of patent rights with the firms currently in the industry. Several industries in the United States provide good examples of oligopolistic market structures with obvious barriers to entry, such as the automobile industry, where significant financial barriers to entry exist.

An oligopolistic industry is also typically characterized by economies of scale. Economies of scale in production implies that as the level of production rises, the cost per unit of product falls

from the use of any plant (generally, up to a point). Thus, economies of scale lead to an obvious advantage for a large producer.

There is no single theoretical framework that provides answers to output and pricing decisions under an oligopolistic market structure. Analyses exist only for special sets of circumstances. One of these circumstances refers to an oligopoly in which there are asymmetric reactions of its rivals when a particular oligopolist formulates policies. If an oligopolistic firm cuts its price, it is met with price reductions by competing firms; if it raises the price of its product, however, rivals do not match the price increase. For this reason, prices may remain stable in an oligopolistic industry for a prolonged period.

MONOPOLY.

Monopoly can be considered as the polar opposite of perfect competition. It is a market form in which there is only one seller. While, at first glance, a monopolistic form may appear to be rarely found market structure, several industries in the United States have monopolies. Local electricity companies provide an example of a monopolist.

There are many factors that give rise to a monopoly. Patents can give rise to a monopoly situation, as can ownership of critical raw materials (to produce a good) by a single firm. A monopoly, however, can also be legally created by a government agency when it sells a market franchise to sell a particular product or to provide a particular service. Often a monopoly so established is also regulated by the appropriate government agency. Provision of local telephone services in the United States provides an example of such a monopoly. Finally, a monopoly may arise due to declining cost of production for a particular product. In such a case the average cost of production keeps falling and reaches a minimum at an output level that is sufficient to satisfy the entire market. In such an industry, rival firms will be eliminated until only the strongest firm (now the monopolist) is left in the market. Such an industry is popularly dubbed as the case of a natural monopoly. A good example of a natural monopoly is the electricity industry, which reaps the benefits of economies of scale and yields decreasing average cost. Natural monopolies are usually regulated by the government.

Generally speaking, price and output decisions of a monopolist are similar to a monopolistically competitive firm, with the major distinction that there are a large number of firms under monopolistic competition and only one firm under monopoly. Nevertheless, at any output level, the price charged by a monopolist is higher than the marginal revenue. As a result, a monopolist also does not produce to the point where price equals marginal cost (a condition met under a perfectly competitive market structure).

MARKET STRUCTURES AND MANAGERIAL DECISIONS.

Managerial decisions both in the short run and in the long run are partly shaped by the market structure relevant to the firm. While the preceding discussion of market structures does not cover the full range of managerial decisions, it nevertheless suggests that managerial decisions are necessarily constrained by the market structure under which a firm operates.

TOOLS OF DECISION SCIENCES AND MANAGERIAL ECONOMICS

Managerial decision making uses both economic concepts and tools, and techniques of analysis provided by decision sciences. The major categories of these tools and techniques are: optimization, statistical estimation, forecasting, numerical analysis, and game theory. While most of these methodologies are fairly technical, the first three are briefly explained below to illustrate how tools of decision sciences are used in managerial decision making.

OPTIMIZATION.

Optimization techniques are probably the most crucial to managerial decision making. Given that alternative courses of action are available, the manager attempts to produce the most optimal decision, consistent with stated managerial objectives. Thus, an optimization problem can be stated as maximizing an objective (called the objective function by mathematicians) subject to specified constraints. In determining the output level consistent with the maximum profit, the firm maximizes profits, constrained by cost and capacity considerations. While a manager does not solve the optimization problem, he or she may use the results of mathematical analysis. In the profit maximization example, the profit maximizing condition requires that the firm choose the production level at which marginal revenue equals marginal cost. This condition is obtained from an optimization exercise. Depending on the problem a manager is trying to solve, the conditions for the optimal decision may be different.

STATISTICAL ESTIMATION.

A number of statistical techniques are used to estimate economic variables of interest to a manager. In some cases, statistical estimation techniques employed are simple. In other cases, they are much more advanced. Thus, a manager may want to know the average price received by his competitors in the industry, as well as the standard deviation (a measure of variation across units) of the product price under consideration. In this case, the simple statistical concepts of mean (average) and standard deviation are used.

Estimating a relationship among variables requires a more advanced statistical technique. For example, a firm may want to estimate its cost function, the relationship between a cost concept and the level of output. A firm may also want to know the demand function of its product, that is, the relationship between the demand for its product and different factors that influence it. The estimates of costs and demand are usually based on data supplied by the firm. The statistical estimation technique employed is called regression analysis, and is used to develop a mathematical model showing how a set of variables are related. This mathematical relationship can also be used to generate forecasts.

An automobile industry example can be used for the purpose of illustrating the forecasting method that employs simple regression analysis. Suppose a statistician has data on sales of American-made automobiles in the United States for the last 25 years. He or she has also determined that the sale of automobiles is related to the real disposable income of individuals.

The statistician also has available the time series (for the last 25 years) on real disposable income. Assume that the relationship between the time series on sales of American-made automobiles and the real disposable income of consumers is actually linear and it can thus be represented by a straight line. A fairly rigorous mathematical technique is used to find the straight line that most accurately represents the relationship between the time series on auto sales and disposable income.

FORECASTING.

Forecasting is a method or a technique used to predict many future aspects of a business or any other operation. For example, a retailing firm that has been in business for the last 25 years may be interested in forecasting the likely sales volume for the coming year. There are numerous forecasting techniques that can be used to accomplish this goal. A forecasting technique, for example, can provide such a projection based on the experience of the firm during the last 25 years; that is, this forecasting technique bases the future forecast on the past data.

While the term "forecasting" may appear to be rather technical, planning for the future is a critical aspect of managing any organization—business, nonprofit, or otherwise. In fact, the long-term success of any organization is closely tied to how well the management of the organization is able to foresee its future and develop appropriate strategies to deal with the likely future scenarios. Intuition, good judgment, and an awareness of how well the economy is doing may give the manager of a business firm a rough idea (or "feeling") of what is likely to happen in the future. It is not easy, however, to convert a feeling about the future outcome into a precise number that can be used, for instance, as a projection for next year's sales volume. Forecasting methods can help predict many future aspects of a business operation, such as forthcoming years' sales volume projections.

Suppose that a forecast expert has been asked to provide quarterly estimates of the sales volume for a particular product for the next four quarters. How should one go about preparing the quarterly sales volume forecasts? One will certainly want to review the actual sales data for the product in question for past periods. Suppose that the forecaster has access to actual sales data for each quarter during the 25-year period the firm has been in business. Using these historical data, the forecaster can identify the general level of sales. He or she can also determine whether there is a pattern or trend, such as an increase or decrease in sales volume over time. A further review of the data may reveal some type of seasonal pattern, such as, peak sales occurring around the holiday season. Thus by reviewing historical data, the forecaster can often develop a good understanding of the pattern of sales in the past periods. Understanding such a pattern can often lead to better forecasts of future sales of the product. In addition, if the forecaster is able to identify the factors that influence sales, historical data on these factors (variables) can also be used to generate forecasts of future sales.

There are many forecasting techniques available to the person assisting the business in planning its sales. For illustration, consider a forecasting method in which a statistician forecasting future values of a variable of business interest—sales, for example—examines the cause-and-effect relationships of this variable with other relevant variables, such as the level of consumer confidence, changes in consumers' disposable incomes, the interest rate at which consumers can

finance their excess spending through borrowing, and the state of the economy represented by the percentage of the labor force unemployed. Thus, this category of forecasting techniques uses past time series on many relevant variables to forecast the volume of sales in the future. Under this forecasting technique, a regression equation is estimated to generate future forecasts (based on the past relationship among variables).

SEE ALSO : Economic Theories

[ Anandi P Sahu , Ph.D. ]

FURTHER READING:

Anderson, David P., Sweeney, Dennis J., and Thomas A. Williams, An Introduction to Management Science: Quantitative Approaches to Decision Making. 8th ed. West Publishing Co., 1997.

Hirschey, Mark, and James L. Pappas, Managerial Economics. 8th ed. Harcourt Brace Jovanovich College Publishers, 1996.

Mansfield, Edwin, ed. Managerial Economics and Operations Research: Techniques, Applications, Cases. 5th ed. New York: W. W. Norton & Co., 1987.

Mansfield, Edwin. Principles of Microeconomics. 9th ed. New York: W. W. Norton & Co., 1997.

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User Contributions:

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DIWAKAR

Sep 6, 2008 @ 12:12 pm

this is very intersting and in very easy languge but you should also give some example, so that it is very easy to understand and give some practical example so that it will help the people to understand. oterwise its good.

thank you

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What is the importance of correlation and regression analysis in business decision making?

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Correlation and regression analysis can help business to investigate the determinants of key variables such as their sales. Variations in a companies sales are likely to be related to variation in product prices,consumers,incomes,tastes and preference's multiple regression analysis can be used to investigate the nature of this relationship and correlation analysis can be used to test the goodness of fit. Regression can also be used to estimate the trend in a time series to make forecast

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