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Understanding Managerial Economics: Linking Economic Theory and Decision Sciences, Cheat Sheet of Economics

Arellano University (AU)Economics

An overview of managerial economics, explaining its definition, relationships with other disciplines, and its relevance in various situations. It delves into the elements of managerial economics, subject areas, presentation of topics, and methods. The document also discusses the tools and techniques of analysis used in managerial economics, such as numerical and algebraic analysis, optimization, statistical estimation and forecasting, analysis of risk and uncertainty, and discounting and time-value-of-money techniques. Particularly useful for university students studying business, economics, or management, as it serves as a comprehensive introduction to the subject.

Typology: Cheat Sheet

2022/2023

Uploaded on 03/20/2024

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raoul-reigo 🇵🇭

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MODULE 1: Nature, Scope and Methods of Managerial Econ.
Introduction
A. Definition and relationships with other disciplines
➢Definition
B. Relationship with economic theory
C. Relationship with decision sciences
D. Relationship with business functions
E. Elements of managerial economics
➢Subject areas and relationships
➢Presentation of topics
F. Methods
➢Scientific theories
➢Learning economics
➢Tools of analysis: demand and supply
Overview of Module 1
This module will tell us what is managerial economics about? What kind of issues does it
deal with? How can it help us make better decisions, in business or elsewhere? These are
fundamental questions which any student may ask when first approaching the subject. It is
therefore a good idea to make a start by examining a situation that has become increasingly
high on the economic and political agenda on a global basis over many years; yet it is not a
situation where it might seem at first sight that managerial economics is particularly relevant. We
shall see, to the contrary, that the methods studied and implemented in managerial economics
are vital to identifying solutions to the problems raised.
A. Definition and relationships with other disciplines
Definition
So, what is managerial economics? Many different definitions have been given
but most of them involve the application of economic theory and methods to business
decision-making. As such it can be seen as a means to an end by managers, in terms of
finding the most efficient way of allocating their scarce resources and reaching their
objectives. However, the definition above might seem to be a little narrow in scope when
applied to the case study involving global warming. This situation involves governments,
non-profit objectives, non-monetary costs and benefits, international negotiations and a
very long-term time perspective, with an associated high degree of uncertainty.
Therefore, it needs to be clarified that managerial economics can still be applied
in such situations. The term ‘business’ must be defined very broadly in this context: it
applies to any situation where there is a transaction between two or more parties.
Of course, this widens the scope of the concept beyond the bounds that many people
find comfortable: it includes taking someone on a date, playing a game with one’s
children in the park, going to confession in a church, asking a friend to help out at work,
agreeing to look after a colleague’s cat while they are away, taking part in a
neighborhood watch scheme. In all cases, costs and benefits occur, however intangible,
and a decision must be made between different courses of action.
B. Relationship with economic theory
The main branch of economic theory with which managerial economics is related
is microeconomics, which deals essentially with how markets work and interactions
between the various components of the economy.
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Download Understanding Managerial Economics: Linking Economic Theory and Decision Sciences and more Cheat Sheet Economics in PDF only on Docsity!

MODULE 1: Nature, Scope and Methods of Managerial Econ.

Introduction

A. Definition and relationships with other disciplines

➢ Definition

B. Relationship with economic theory

C. Relationship with decision sciences

D. Relationship with business functions

E. Elements of managerial economics

➢ Subject areas and relationships

➢ Presentation of topics

F. Methods

➢ Scientific theories

➢ Learning economics

➢ Tools of analysis: demand and supply

Overview of Module 1

This module will tell us what is managerial economics about? What kind of issues does it deal with? How can it help us make better decisions, in business or elsewhere? These are fundamental questions which any student may ask when first approaching the subject. It is therefore a good idea to make a start by examining a situation that has become increasingly high on the economic and political agenda on a global basis over many years; yet it is not a situation where it might seem at first sight that managerial economics is particularly relevant. We shall see, to the contrary, that the methods studied and implemented in managerial economics are vital to identifying solutions to the problems raised.

A. Definition and relationships with other disciplines

Definition

So, what is managerial economics? Many different definitions have been given but most of them involve the application of economic theory and methods to business decision-making. As such it can be seen as a means to an end by managers, in terms of finding the most efficient way of allocating their scarce resources and reaching their objectives. However, the definition above might seem to be a little narrow in scope when applied to the case study involving global warming. This situation involves governments, non-profit objectives, non-monetary costs and benefits, international negotiations and a very long-term time perspective, with an associated high degree of uncertainty. Therefore, it needs to be clarified that managerial economics can still be applied in such situations. The term ‘business’ must be defined very broadly in this context: it applies to any situation where there is a transaction between two or more parties. Of course, this widens the scope of the concept beyond the bounds that many people find comfortable: it includes taking someone on a date, playing a game with one’s children in the park, going to confession in a church, asking a friend to help out at work, agreeing to look after a colleague’s cat while they are away, taking part in a neighborhood watch scheme. In all cases, costs and benefits occur, however intangible, and a decision must be made between different courses of action.

B. Relationship with economic theory

The main branch of economic theory with which managerial economics is related is microeconomics, which deals essentially with how markets work and interactions between the various components of the economy.

In particular, the following aspects of microeconomic theory are relevant:

  1. theory of the firm
  2. theory of consumer behavior (demand)
  3. production and cost theory (supply)
  4. price theory
  5. market structure and competition theory These theories provide the broad conceptual framework of ideas involved; the nature of these theories and how theories are developed is discussed in the next topic. At this stage it is worth stating that these theories are examined and discussed largely in a neoclassical framework. This is essentially an approach that treats the individual elements within the economy (consumers, firms and workers) as rational agents with objectives that can be expressed as quantitative functions (utilities and profits) that are to be optimized , subject to certain quantitative constraints. This approach is often criticized as dated and unrealistic, but can be defended on three grounds. The first is that it is very versatile and can easily be extended to take into account many of the aspects which it is often assumed to ignore, for example transaction costs, information costs, imperfect knowledge, risk and uncertainty, multiperiod situations and so on. The implications of all these factors are considered in the next module. The second and third grounds of defense are explained in next topic and are related to scientific method and pedagogy. There is one main difference between the emphasis of microeconomics and that of managerial economics: the former tends to be descriptive , explaining how markets work and what firms do in practice, while the latter is often prescriptive , stating what firms should do, in order to reach certain objectives. At this point it is necessary to make another very important distinction: that between positive and normative economics. This is sometimes referred to as the ‘is/ought’ distinction, but this is actually somewhat misleading. Essentially positive statements are factual statements whose truth or falsehood can be verified by empirical study or logic. Normative statements involve a value judgment and cannot be verified by empirical study or logic. For illustration, compare the following two seemingly similar statements:
  6. The distribution of income in the Philippines is unequal.
  7. The distribution of income in the Philippines is inequitable. Normative statements often imply a recommendation, in the above example that income should be redistributed. For that reason, they often involve the words ought or should. However, not all such statements are normative, they may in fact be prescriptive. For example, the statement ‘Firm X should increase its price in order to increase profit’ is a positive statement. This is because the word ‘should’ is here being used in a different sense, a conditional one; there is no value judgment implied. In practice it can sometimes be difficult to distinguish between the two types of statement, especially if they are combined together in the same sentence. What is the relevance of the above to the study of managerial economics? It is often claimed, for example by those protesting against global capitalism, that economics is of no use in answering the fundamental questions involving value judgements, like reducing pollution. Indeed, economists themselves often admit that their science can only make positive, not normative statements. However, this can give a misleading impression of the limitations of economics; it can indeed be helpful in making normative statements. First, consider the following statement: governments should make use of market forces in order to achieve a more efficient solution in terms of reducing pollution. This might sound like a normative statement but it is actually a conditional use of the word should as described in the previous paragraph. Provided that the term efficiency is carefully defined, the statement is a positive one, since the concept of efficiency does not involve any value judgment. Of course, the example above only shows that economists can make positive statements that might appear to be normative statements. Now consider this statement: world governments should aim to reduce pollution by 90 per cent in the next ten years. This is a genuine normative statement. Economists might estimate the costs and benefits of such a policy and show the costs to vastly exceed the benefits. This in itself cannot determine policy because it ignores the distribution of these costs and benefits, both over space and time. However, it might in principle be possible to show empirically that both rich and poor countries would suffer overall from a policy of reducing pollution

Presentation of topics

Since the objectives of a business form the starting point of any analysis of its behavior, the theory of the firm is the subject of the next chapter. Traditionally, pricing has formed the central core of managerial economics, although this narrow focus is somewhat misleading in terms of the breadth of analysis that is possible. As the various topics are examined, further applications and extensions of analysis will be discussed. In order to examine pricing it is necessary to consider demand and supply forces; in managerial economics supply forces are discussed under the theory of costs. In order to consider demand we must first consider consumer theory and in order to consider costs we must first consider production theory. Consumer theory is included in the chapter on demand theory, but a separate chapter is dedicated to production theory, since otherwise the module on cost theory would be too long. The main reason for this difference in treatment is that many aspects of consumer theory relate to behavioral psychology, and these are not normally discussed in managerial economics, while production theory deals more in engineering concepts which economists traditionally have been more willing to examine. The topics of demand and cost analysis both involve separate chapters on theory and on estimation, which is again a traditional distinction, but sometimes the relationship between these two aspects is not fully explained. Since it is very important to understand this relationship in order to appreciate the objectives and methods involved in managerial economics, a section on methods now follows.

F. Methods

It is essential for anyone studying managerial economics to understand the methodology involved. This is not just an academic exercise it is essential for managers who have to make decisions. True, they are not generally believed to develop and test theories themselves, but in reality, this is part of their job. This is explained later on in this section after the meaning of the term theory and the process of testing theories have been discussed. There are two aspects of methods that need to be explained: first, the methods that professionals use to develop the subject; and, second, the methods used to present material to students learning the subject.

Scientific theories

In the previous section the term theory was used extensively, both in describing subject areas and in denoting a contrast with estimation. A scientific theory does two things: it describes or explains relationships between phenomena that we observe , and it makes testable predictions. Theories are indispensable to any science, and over time they tend to be gradually improved, meaning that they fit existing observations better and make more accurate forecasts. When a theory is initially developed it is usually on the basis of casual observation, and is sometimes called a hypothesis. This then needs to be tested and in order to do this an empirical study is required. An empirical study is one which involves real-world observations. Such studies can be either experimental or observational : the former involve a situation where the investigator can control the relevant variables to isolate the variables under investigation and keep other factors constant. This is often done in laboratory conditions, for example in testing the effect of heat on the expansion of a metal. In business and economic situations this is usually not possible, so an observational study must be performed. An investigator may for example be interested in the effect of charging different prices on the sales of a product. However, it may be difficult to isolate the effect of price from the effects of promotion, competitive factors, tastes, weather and so on, which also are affecting sales. The analysis of the data in the study involves statistical techniques, such as regression analysis, and then inferences are drawn from this regarding the initial theory, in terms of its acceptance or rejection. The whole process of testing economic theories is often referred to as econometrics. The procedure above is a repetitive one; further empirical studies are carried out, sometimes under different conditions, and as time goes on theories tend to become modified and refined in order to improve them. The process of the development of theories is illustrated in Figure 1.2. It is obviously of vital importance to managers to have good theories on which to base their decision-making.

A ‘good’ theory has the following characteristics:

  1. It explains existing observations well.
  2. It makes accurate forecasts.
  3. It involves mensuration , meaning that the variables involved can be measured reliably and accurately.
  4. It has general application, meaning that it can be applied in a large number of different situations, not just a very limited number of cases.
  5. It has elegance, meaning that the theory rests on a minimum number of assumptions. The better the theories used by managers the better their decisions will be, in terms of being more likely to achieve managerial objectives. However, it is not just a case of managers using other people’s theories. Consider the following situation: a marketing manager has just received sales figures for a particular product showing a considerable decline in the last quarter. She has a meeting with the sales manager, the advertising manager, the PR manager and the production manager. The sales manager claims that sales are down because of the recent price rise of 15 per cent; the advertising manager says that advertising was cut in one of the normal media, because it was thought to be ineffective; the PR manager says that customers reacted badly to the announcement in the papers that the firm was stopping its sponsorship of a local school sports team; finally the production manager admits that problems in quality control for the previous period might have put some customers off repeat purchase of the product. These are all competing theories; they may all have some element of truth, or maybe none at all. It is the marketing manager’s responsibility to determine how much each possible problem contributed to the decline in sales, or whether some other factors were involved. In effect the manager has to test various theories before she can make an appropriate decision. There is another important implication of the above criteria for a good theory: they apply very well to the neoclassical approach.

Learning economics

When students first study economics in introductory courses they often become disillusioned because it seems very abstract and theoretical; what do all these graphs and equations have to do with the real world? What possible use can they have, since they often seem to make incorrect conclusions? These understandable criticisms need to be addressed. Because economics is a difficult subject area, involving complex interactions among many people and variables, the pedagogical approach to learning the subject generally involves initially making many assumptions about behavior and relationships in order to build simple models. A model in general terms is a representation of a system, which is simplified in order to illustrate the important features and relationships involved. Economic models often involve diagrams, graphs or equations. Basic analysis is then performed with these models, and conclusions drawn. This again relates to the neoclassical approach. The first and second reasons for using this approach have now been discussed; the third reason is that it provides this very useful starting point, by making necessary assumptions. The conclusions from this simplified model often turn out to be erroneous, not because of errors of analysis, but because the assumptions on which the analysis was based were unrealistic. In order to make progress these assumptions must be gradually relaxed, thus making the situation more realistic, and