## Traditional Managerial Economics

(Research Starters)

Managerial economics pays attention to the firm in ways that other branches of economics never has. No longer seen as the 'black-box' buffeted by market forces alone, the firm and how it allocates resources and makes decisions has since become the focal point of quantitative analysis that real-world companies have welcomed. An amalgam of micro-economics, operations research and management science, the subject's emphasis on the practicalities of running a business day-to-day using applied mathematics has proven a welcome change of tack for many line managers.

Keywords Disequilibrium; Managerial Economics; Microeconomics; Perfect Information; Theory of the Firm

### Economics:Traditional Managerial Economics

### Overview

Economists build models, think abstractly and, whenever possible, generalize. Business people build customer bases and products-lines, think concretely and, whenever possible, quantify. To be sure, traditional economic concepts like supply and demand, profit and utility maximization, 'imperfect' information and marginal analysis sum up the underlying dynamics of markets so neatly that they have become the way business is inherently thought about. But, as a rule, business people are too preoccupied with the hundreds of practical decisions that directly affect their 'bottom-lines' to ponder economic theory much. And to be fair, there is, without exception, an awful lot to think about: Marketing plans, pricing, the size and timing of production runs, quality control, worker productivity, capital budgeting, etc.

The behavior of the firm, along with that of the consumer and a given industry, collectively comprise the subject matter of Microeconomics. In relation to business decision-making, its most relevant conceit is 'the Theory of the Firm'; a twentieth century formulation. In earlier times, classical economists thought exclusively in terms of markets and individual rational actors. When the existence of the 'firm' was formally recognized, it was considered a means of eliminating third-party purchases at each stage in the production process; nothing more and nothing less. The elimination of third party purchases occurs only if one entity owns the inputs and outputs required to systematically turn raw materials or component parts into finished goods. By doing so, the firm avoids the costs of researching supplier prices, bargaining and drawing up legal contracts (collectively referred to as transaction costs), thus improving market efficiency.

Strictly speaking, a firm is a production 'function' that maximizes its profits by turning labor and capital (its 'inputs') into goods and services (it 'outputs') (Williamson, 1996). To succeed at this, a firm must align prices and output levels with market demand and so generates the greatest amount of sales revenue at the least cost. Decision-making at the firm level, essentially, is so largely determined by market forces emanating from beyond its organizational boundaries, the theory insists, that what goes on inside the firm is immaterial. All that really matters is the observable effects of its decisions. For a long time then, economists indifferent to the inner workings of the firm treated it as an impenetrable 'black-box' (Loabsy, 1967).

Whether a firm has one, several or many direct competitors its disposition towards the marketplace is affected. A firm with only one major competitor enjoys a higher price structure and can market a relatively undifferentiated product. By contrast, a firm with a number of competitors enjoys no such luxury and fares better when it markets a more differentiated product. Likewise, a firm can indeed maximize its profits by setting its price exactly at the point where one additional dollar of sales, its marginal revenue, incurs one additional dollar of expense, its marginal cost.

When it comes to the nuts and bolts of *actually* allocating resources in a real-world firm, though, matters turn murkier. For starts, 'pure' microeconomic theory, critics contend, is built around a set of unrealistic core assumptions: Firms are not always the rational actors bent on maximizing profits nor do they always enjoy 'perfect information.' In reality, firms can and do make the 'irrational' decision to maximize utility instead of profits; preferring to lower prices to gain market share from competitors. And most decidedly, all firms do not have the same amount or quality of information about current market conditions upon which to base decisions (Hitch & McKean, 1961). Worse still, the markets they compete in are almost always in disequilibrium, subject to external macroeconomic shocks, the sudden introduction of new technologies, the unexpected intervention of government regulators, and the like. Most unrealistically of all, a kind of tunnel vision is necessary to model market behavior; the only way to see a fundamental market principle in action is to zero in on it to the exclusion of any other, effectively reducing a multi-dimensional dynamic to a one dimensional event.

For business people charged with making specific decisions about very complicated issues, then, microeconomic theories has appreciable limits. It's not that they are wanting too much, but rather, too many variables are at play in the real world market to see their outline all that clearly. The devil, as the saying goes, is in the details. Economists in this respect deal almost exclusively in observable transaction data (past sales, revenues and prices, etc.) which by rights must be historical data. Business people, on the other hand, are budgeters and strategic planners: Their concerns revolve around bring about desirable future outcomes (Calfee & Rubin, 1993). Since the transactions they're most concerned with have not taken place yet, what's more, there is no such data to work with. What data they do have is culled from the numerical minutiae of running a business day-to-day: Entries in accounting ledgers, number of components on order, variable costs of production, inventory of finished goods on hand, etc. Even more to the point, perhaps, the microeconomic models most commonly used do not really lessen the uncertainty surrounding future market conditions enough to be all that helpful. Simply put, they are too static, too simplistic, and too inexact.

By far, the most effective remedy for uncertainty is precision; precision in rendering real world events, in thinking through problems and in planning solutions. Fortunately, a means of achieving such precision has gained a considerable following among economists of every stripe in the last thirty years. It's mathematics, and it has given the 'dismal science' a powerful new language in which to restate and refine its fundamental tenants in light of the complexity and uncertainty a firm faces in a competitive marketplace everyday. A precursor, the graphical representation of key microeconomic phenomena like supply and demand as curves on a plot, has been widely used for a much longer period of time. Merely visual embodiments of the algebraic formula y = a(x)-b, these graphs plot the relative values of cost or price per quantity produced or sold. More importantly, because these are linear equations, values for one set of variables can be calculated when the values and rate of change of the other set of variables is known. Older and even more basic, as any accountant will tell you, is the use of addition and subtraction along with multiplication and division to calculate a firm's revenue, costs and profits. Simple arithmetic in the form of fractions expressed as either percentages or ratios also yield many insightful measures of a company's financial and operational performance.

All of these, of course, were the product of an equation of one sort or another, which raised a very interesting question: What other forms of equations might prove equally as useful in economic analysis? The answer, it turns out, encompasses statistics and probability theory, regression analysis, linear programming, exponentiation, and calculus, and, slightly farther a field, decision matrixes and game theory. Each has proven itself a useful adjunct to more traditional forms of microeconomic analysis. So much so, in fact, they collectively have given rise to the burgeoning new discipline of managerial economics. Be it the employment of statistical techniques in general and regression analysis in particular to test new hypothetical economic models, of maximization and minimization formulae from linear programming to improve the efficiency of production lines, supply ordering and inventory management or of derivatives from calculus to accurately calculate the marginal revenue and marginal cost of a particular product, the marriage of mathematics and microeconomics is proving fruitful indeed.

### Applications

The management of any firm requires constant attention be paid in equal measure to planning, operations and control. Mathematics, meanwhile, excels at describing and dealing with subtlety, complexity and disorder (Cooper, 1961). And, as we have seen, economics concerns itself with the production, distribution and consumption of goods and services. At the crossroads of management,...

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