Use of Managerial Economics in Finance
This article focuses on how financial professionals utilize managerial economics in making decisions to resolve business problems. Managerial economics highlights how financial professionals make decisions regarding resource allocation, strategic, and tactical issues that relate to all types of firms from an economic perspective. Profits and wealth maximization are key factors in managerial economics. Profits are very crucial to a firm's bottom line, and wealth maximization is a long term operational goal. Market structures take into consideration: The number of firms in an industry, the relative size of the firms (industry concentration), demand conditions, ease of entry and exit, and technological and cost conditions.
Keywords Accounting Profits; Capital Budgeting; Discounted Cash Flow Analysis; Economic Profits; Managerial Economics; Present Value Analysis; Pricing Analysis; Production Analysis; Profit Maximization; Risk analysis; Time Value of Money; Wealth Maximization
Finance: Use of Managerial Economics in Finance
Managerial economics highlights how financial professionals make decisions regarding resource allocation, strategic, and tactical issues that relate to all types of firms from an economic perspective. These professionals use a series of techniques in order to find the most efficient way to reach the best decisions for the firm. The major emphasis is to provide the analytical tools and managerial insights essential to the analyses and solutions of those problems that have significant economic consequences, both for the firm and for the world economy.
Managerial economics occurs when the fundamental principles of microeconomics is applied in the decision making process of business and managerial problems. It can be applied to problems in private, public and non-profit organizations. According to Skim and Siegel (1998), the basic steps in the decision making process are:
- Recognize and define the problem. Once a problem has been identified, an exact statement describing the problem should be prepared.
- Select a goal. Is it profit maximizing or cost minimizing?
- Identify any constraints. All possible constraints need to be identified.
- Select the alternative consistent with the firm's objectives or determine the optimal solution (i.e. profit-maximizing or cost-minimizing solution), p. 3. Managerial economics connects the practical and theoretical aspects of economics. Many economists will utilize a variety of techniques from other business fields such as finance and operations management. Most business decisions can be analyzed with the techniques used in managerial economics. However, it is most often used in:
- Risk Analysis Assorted uncertainty models, decision guidelines, and risk quantification methods help to interpret how much risk is involved in a given arrangement of decision.
- Production Analysis Microeconomics methods help to assess the effectiveness of production, the best factor distribution, the costs involved, the frugality of scale and the company’s estimated cost function.
- Pricing Analysis — Microeconomic methods facilitate the analysis of multiple pricing options that involve transfer costs, joint product costs, cost discrimination, cost elasticity approximations, and deciding upon the right pricing technique for the job.
- Capital Budgeting — Investment theory allows for the examination of a corporation's capital purchasing decision.
Managerial economics is "the systematic studies of how resources should be allocated in such a way to most efficiently achieve a managerial goal" (Shim & Siegel, 1998, p. 2).
Profits are very crucial to a firm's bottom line. When a firm is able to make a profit, there is an assumption that the company has done a good job of effectively and efficiently in controlling cost while producing a quality product or performing a quality service. However, there are different types of profits. Two types of profits are accounting profits and economic profits. Accounting profits are determined by the difference between the total revenue and the cost of producing products or services, and they appear on the firm's income statement. Economic profits are determined by the difference between total revenue and the total opportunity costs. The opportunity costs tend to be higher than accounting and bookkeeping costs.
Profits tend to vary across industries, and there are a number of theories that attempt to provide an explanation as to why this occurs. Five of the most discussed theories in this area are:
- Risk-Bearing Theory. When the owners of a company make investments into the firm, they take on a certain amount of risk. In order to compensate them for their investment, the company will need to have an above average return on economic profits. An example would be a firm that has investors such as venture capitalists or angel investors.
- Dynamic Equilibrium Theory. Every firm should strive to have a normal rate of profit. However, each firm has the opportunity to earn returns above or below the normal level at any time.
- Monopoly Theory. There are times when one firm may have the opportunity to dominate in its industry and earn above normal rates of return over a long period of time. These firms tend to dominate the market as a result of economies of scale, control of essential natural resources, control of crucial patents and/or government restrictions. An example would be utility companies.
- Innovation Theory. A firm may earn above normal profits as a reward for its successful innovations, such as patents. An example would be a pharmaceutical organization such as Astra Zeneca.
- Managerial Efficiency Theory. A firm may be able to earn above average profits based on its strong leadership team. This type of organization gains profits as a result of being effective and efficient. An example would be General Electric under Jack Welch's leadership.
Wealth maximization is a long term operational goal. Shareholders have a residual claim on the firm's net cash flows after expected contractual claims have been paid. All other stakeholders (i.e. employers, customers) have contractual expected returns. There tends to be a preference for wealth maximization because it takes into consideration (Shim & Siegel, 1998):
- Wealth for the long term
- Risk or uncertainty
- The timing of returns
- The stockholders' return.
Criterion for this goal suggests that a firm should review and assess the expected profits and or cash flows as well as the risks that are associated with them. When conducting this evaluation, there are three points to keep in mind. First, economic profits are not equivalent to accounting profits. Second, accounting profits are not the same as cash flows. Lastly, financial analysis must focus on maximization of the present value of cash flows to the owners of the firm when attempting to maximize shareholder wealth.
When making decisions, the financial management team has to anticipate certain factors and realize that they may not have control over some of them. Factors outside of their control tend to be ones that are a part of the economic environment.
- Factors under administrative command
- Products and services made available
- Production technology
- Marketing and distribution
- Investment plans of action
- Employment policies and compensation
- Ownership form
- Capital structure
- Successful capital management tactics
- Dividend policies
- Alliances, mergers, spinoffs
- Factors not under management control
- Level of economic activity
- Tax rates and regulations
- Laws and government regulations
- Unionization of employees
- International business conditions and currency exchange rates
In order for wealth maximization to be at the optimal level, certain conditions need to be in place. The process has a good chance to be successful when:
- Complete markets are secure. Liquid markets are needed for the firm's inputs, products and by-products.
- There is no asymmetric information. Buyers and sellers have the same information and no information is hidden from either group.
- All re-contracting costs are known. Managers know or expect the exact impending input costs as a...
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