Economic Concepts And Techniques 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.
1.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 categoriesroduction and consumptionirms 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.
2.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). 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). 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. 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 cost 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.
3.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 constraintsheir 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 systemhey send signals both to producers and consumers.
4.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 supplierf 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 industryhenever 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 principlet 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 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 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.
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. 7.FORECASTING. Forecasting is a method or a technique used to predict many future aspects of a business or any other operation. While the term "forecasting" may appear to be rather technical, planning for the future is a critical aspect of managing any organizationusiness, 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. 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 interestales, 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).
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