Managerial economics is the discipline, which deals with the application of economic theory to business management. Managerial Economics thus lies on the margin between economics and business management and serves as the bridge between the two disciplines.
The application of economics to business management or the integration of economic theory with business practice, as Spencer and Siegelman have put it, has the following aspects:
(i) Reconciling traditional theoretical concepts of economics in relation to the actual business behavior and conditions
In economic theory, the technique of analysis is that of model building. This involves making some assumptions and, drawing conclusions on the basis of the assumptions about the behavior of the firms. The assumptions, however, make the theory of the firm unrealistic since it fails to provide a satisfactory explanation of what the firms actually do. Hence, there is need to reconcile the theoretical principles based on simplified assumptions with actual business practice and develop appropriate extensions and reformulation of economic theory. For example, it is usually assumed that firms aim at maximizing profits. Based on this, the theory of the firm suggests how much the firm will produce and at what price it would sell. In practice, however, firms do not always aim at maximum profits (as they may think of diversifying or introducing new product etc.) To that extent, the theory of the firm fails to provide a satisfactory explanation of the firm’s actual behavior. Moreover, in actual business language, certain terms like profits and costs have accounting concepts as distinguished from economic concepts. In managerial economics, an attempt is made to merge the accounting concepts with the economics, an attempt is made to merge the accounting concepts with the economic concepts. This helps in a more effective use of financial data related to profits and costs to suit the needs of decision-making and forward planning.
(ii) Estimating economic relationships
This involves the measurement of various types of elasticities of demand such as price elasticity, income elasticity, cross-elasticity, promotional elasticity and cost-output relationships. The estimates of these economic relationships are to be used for the purpose of forecasting.
(iii) Predicting relevant economic quantities
Economic quantities such as profit, demand, production, costs, pricing and capital are predicated in numerical terms together with their probabilities. As the business manager has to work in an environment of uncertainty, the future needs to be foreseen so that in the light of the predicted estimates, decision-making and forward planning may be possible.
(iv) Using economic quantities in decision-making and forward planning
This involves formulating business policies for establishing future business plans. This nature of economic forecasting indicates the degree of probability of various possible outcomes, i.e., losses or gains that will occur as a result of following each one of the available strategies. Thus, a quantified picture gets set up, that indicates the number of courses open, their possible outcomes and the quantified probability of each outcome. Keeping this picture in view, the business manager is able to decide about which strategy should be chosen.
(v) Understanding significant external forces
Applying economic theory to business management also involves understanding the important external forces that constitute the business environment and with which a business must adjust. Business cycles, fluctuations in national income and government policies pertaining to taxation, foreign trade, labor relations, anti-monopoly measures, industrial licensing and price controls are typical examples. The business manager has to appraise the relevance and impact of these external forces in relation to the particular business unit and its business policies.