Managerial Economics & Financial Analysis

Introduction To Managerial Economics

Introduction to Economics
Economics is a study of human activity both at individual and national level. The economists
of early age treated economics merely as the science of wealth. The reason for this is clear. Every
one of us in involved in efforts aimed at earning money and spending this money to satisfy our
wants such as food, Clothing, shelter, and others. Such activities of earning and spending money
are called “Economic activities”. It was only during the eighteenth century that Adam Smith, the
Father of Economics, defined economics as the study of nature and uses of national wealth’.

Dr. Alfred Marshall, one of the greatest economists of the nineteenth century, writes
“Economics is a study of man’s actions in the ordinary business of life: it enquires how he gets his
income and how he uses it”.

Thus, it is one side, a study of wealth; and on the other, and more important side; it is the
study of man. As Marshall observed, the chief aim of economics is to promote ‘human welfare’,
but not wealth. The definition given by AC Pigou endorses the opinion of Marshall. Pigou defines
Economics as “the study of economic welfare that can be brought directly and indirectly, into
relationship with the measuring rod of money”.
Lord Keynes defined economics as ‘the study of the administration of scarce means and the
determinants of employments and income”.
Microeconomics
The study of an individual consumer or a firm is called microeconomics (also called the
Theory of Firm). Micro means ‘one millionth’. Microeconomics deals with behaviour and problems
of single individual and of micro organization. Managerial economics has its roots in
microeconomics and it deals with the micro or individual enterprises. It is concerned with the
application of the concepts such as price theory, Law of Demand and theories of market structure
and so on.

Macroeconomics
The study of ‘aggregate’ or total level of economics activity in a country is called
macroeconomics. It studies the flow of economics resources or factors of production (such as land,
labour, capital, organisation and technology) from the resource owner to the business firms and
then from the business firms to the households. It deals with total aggregates, for instance, total
national income total employment, output and total investment. It studies the interrelations among
various aggregates and examines their nature and behaviour, their determination and causes of
fluctuations in the. It deals with the price level in general, instead of studying the prices of
individual commodities. It is concerned with the level of employment in the economy. It discusses
aggregate consumption, aggregate investment, price level, and payment, theories of employment,
and so on. Though macroeconomics provides the necessary framework in term of government
policies etc., for the firm to act upon dealing with analysis of business conditions, it has less direct
relevance in the study of theory of firm.

1|
 Managerial Economics & Financial Analysis

2|
 Management
Management is the science and art of getting things done through people in formally
organized groups. It is necessary that every organisation be well managed to enable it to achieve
its desired goals. Management includes a number of functions: Planning, organizing, staffing,
directing, and controlling. The manager while directing the efforts of his staff communicates to
them the goals, objectives, policies, and procedures; coordinates their efforts; motivates them to
sustain their enthusiasm; and leads them to achieve the corporate goals.

Managerial
Economics
Introduction
Managerial Economics refers to the firm’s decision making process. It could be also
interpreted as “Economics of Management” or “Economics of Management”.

Managerial Economics is also called as “Industrial Economics” or “Business Economics”. As

Joel Dean observes managerial economics shows how economic analysis can be used in
formulating polices.

Meaning & Definition:

In the words of E. F. Brigham and J. L. Pappas Managerial Economics is “the applications of economics
theory and methodology to business administration practice”.

Managerial Economics bridges the gap between traditional economics theory and real business practices in
two days. First it provides a number of tools and techniques to enable the manager to become more competent
to take decisions in real and practical situations. Secondly it serves as an integrating course to show the
interaction between various areas in which the firm operates.
Nature of Managerial Economics
Managerial economics is, perhaps, the youngest of all the social sciences. Since it
originates from Economics, it has the basis features of economics, such as assuming that other
things remaining the same (or the Latin equivalent ceteris paribus). This assumption is made to
simplify the complexity of the managerial phenomenon under study in a dynamic business
environment so many things are changing simultaneously.

This set a limitation that we cannot really hold other things remaining the same. In such a
case, the observations made out of such a study will have a limited purpose or value. Managerial
economics also has inherited this problem from economics. Further, it is assumed that the firm or
the buyer acts in a rational manner (which normally does not happen). The buyer is carried away
by the advertisements, brand loyalties, incentives and so on, and, therefore, the innate behaviour
of the consumer will be rational is not a realistic assumption. Unfortunately, there are no other
alternatives to understand the subject other than by making such assumptions. This is because
the behaviour of a firm or a consumer is a complex phenomenon.

The other features of managerial economics are explained as below:

(a) Close to microeconomics: Managerial economics is concerned with finding the solutions
for different managerial problems of a particular firm. Thus, it is more close to microeconomics.
 (b) Operates against the backdrop of macroeconomics: The macroeconomics conditions of
the economy are also seen as limiting factors for the firm to operate. In other words, the
managerial economist has to be aware of the limits set by the macroeconomics conditions such as
government industrial policy, inflation and so on.

(c) Normative statements: A normative statement usually includes or implies the words ‘ought’
or ‘should’. They reflect people’s moral attitudes and are expressions of what a team of people
ought to do. For instance, it deals with statements such as ‘Government of India should open up
the economy. Such statement are based on value judgments and express views of what is ‘good’
or ‘bad’, ‘right’ or ‘ wrong’. One problem with normative statements is that they cannot to verify by
looking at the facts, because they mostly deal with the future. Disagreements about such
statements are usually settled by voting on them.

(d) Prescriptive actions: Prescriptive action is goal oriented. Given a problem and the
objectives of the firm, it suggests the course of action from the available alternatives for optimal
solution. If does not merely mention the concept, it also explains whether the concept can be
applied in a given context on not. For instance, the fact that variable costs are marginal costs can
be used to judge the feasibility of an export order.

(e) Applied in nature: ‘Models’ are built to reflect the real life complex business situations
and these models are of immense help to managers for decision-making. The different areas
where models are extensively used include inventory control, optimization, project management
etc. In managerial economics, we also employ case study methods to conceptualize the problem,
identify that alternative and determine the best course of action.
(f) Offers scope to evaluate each alternative: Managerial economics provides an opportunity
to evaluate each alternative in terms of its costs and revenue. The managerial economist can
decide which is the better alternative to maximize the profits for the firm.
(g) Interdisciplinary: The contents, tools and techniques of managerial economics are drawn
from different subjects such as economics, management, mathematics, statistics, accountancy,
psychology, organizational behaviour, sociology and etc.

(h) Assumptions and limitations: Every concept and theory of managerial economics is based
on certain assumption and as such their validity is not universal. Where there is change in
assumptions, the theory may not hold good at all.

Scope of Managerial Economics:

The scope of managerial economics refers to its area of study. Managerial economics refers to its
area of study. Managerial economics, Provides management with a strategic planning tool that can
be used to get a clear perspective of the way the business world works and what can be done to
maintain profitability in an ever-changing environment. Managerial economics is primarily
concerned with the application of economic principles and theories to five types of resource
decisions made by all types of business organizations.

a. The selection of product or service to be produced.

b. The choice of production methods and resource combinations.
c. The determination of the best price and quantity combination
d. Promotional strategy and activities.
 e. The selection of the location from which to produce and sell goods or service to
consumer. The production department, marketing and sales department and the finance
department usually handle these five types of decisions.
The scope of managerial economics covers two areas of decision making
a.Operational or Internal issues
b.Environmental or External issues
a. Operational issues:
Operational issues refer to those, which wise within the business organization and they are
under the control of the management. Those are:
1. Theory of demand and Demand Forecasting
2. Pricing and Competitive strategy
3. Production cost analysis
4. Resource allocation
5. Profit analysis
6. Capital or Investment analysis
7. Strategic planning

1. Demand Analyses and Forecasting:

A firm can survive only if it is able to the demand for its product at the right time, within the
right quantity. Understanding the basic concepts of demand is essential for demand forecasting.
Demand analysis should be a basic activity of the firm because many of the other activities of the
firms depend upon the outcome of the demand for cost. Demand analysis provides: 1. The basis for
analyzing market influences on the firms; products and thus helps in the adaptation to those
influences. 2. Demand analysis also highlights for factors, which influence the demand for a product.
This helps to manipulate demand. Thus demand analysis studies not only the price elasticity but also
income elasticity, cross elasticity as well as the influence of advertising expenditure with the advent
of computers, demand forecasting has become an increasingly important function of managerial
economics.

2. Pricing and competitive strategy:

Pricing decisions have been always within the preview of managerial economics. Pricing policies
are merely a subset of broader class of managerial economic problems. Price theory helps to
explain how prices are determined under different types of market conditions. Competitions
analysis includes the anticipation of the response of competitions the firm’s pricing, advertising
and marketing strategies. Product line pricing and price forecasting occupy an important place
here.

3. Production and cost analysis:

Production analysis is in physical terms. While the cost analysis is in monetary terms cost
concepts and classifications, cost-out-put relationships, economies and diseconomies of scale and
production functions are some of the points constituting cost and production analysis.

4. Resource Allocation:

Managerial Economics is the traditional economic theory that is concerned with the problem of
optimum allocation of scarce resources. Marginal analysis is applied to the problem of determining
the level of output, which maximizes profit. In this respect linear programming techniques has
been used to solve
optimization problems. In fact lines programming is one of the most practical and powerful
managerial decision making tools currently available.
5. Profit analysis:

Profit making is the major goal of firms. There are several constraints here an account of
competition from other products, changing input prices and changing business environment hence
in spite of careful planning, there is always certain risk involved. Managerial economics deals with
techniques of averting of minimizing risks. Profit theory guides in the measurement and
management of profit, in calculating the pure return on capital, besides future profit planning.

6. Capital or investment analyses:

Capital is the foundation of business. Lack of capital may result in small size of operations.
Availability of capital from various sources like equity capital, institutional finance etc. may help to
undertake large- scale operations. Hence efficient allocation and management of capital is one of
the most important tasks of the managers. The major issues related to capital analysis are: 1. The
choice of investment project
2. Evaluation of the efficiency of capital 3. Most efficient allocation of capital Knowledge of capital
theory can help very much in taking investment decisions. This involves, capital budgeting, feasibility
studies, analysis of cost of capital etc.

7. Strategic planning:

Strategic planning provides management with a framework on which long-term decisions can be
made which has an impact on the behavior of the firm. The firm sets certain long-term goals and
objectives and selects the strategies to achieve the same. Strategic planning is now a new
addition to the scope of managerial economics with the emergence of multinational corporations.
The perspective of strategic planning is global. It is in contrast to project planning which focuses
on a specific project or activity. In fact the integration of managerial economics and strategic
planning has given rise to be new area of study called corporate economics.

B. Environmental or External Issues:

An environmental issue in managerial economics refers to the general business environment in

which the firm operates. They refer to general economic, social and political atmosphere within
which the firm operates. A study of economic environment should include: a. The type of
economic system in the country. b. The general trends in production, employment, income, prices,
saving and investment. c. Trends in the working of financial institutions like banks, financial
corporations, insurance companies d. Magnitude and trends in foreign trade; e. Trends in labour
and capital markets; f. Government’s economic policies viz. industrial policy monetary policy, fiscal
policy, price policy etc. The social environment refers to social structure as well as social
organization like trade unions, consumer’s co-operative etc. The Political environment refers to the
nature of state activity, chiefly states’ attitude towards private business, political stability etc. The
environmental issues highlight the social objective of a firm i.e.; the firm owes a responsibility to
the society. Private gains of the firm alone cannot be the goal. The environmental or external
issues relate managerial economics to macro-economic theory while operational issues relate the
scope to micro economic theory. The scope of managerial economics is ever widening with the
dynamic role of big firms in a society.