Application of M E

ECONOMIC CONCEPTS 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:

The theory of the firm, which describes how businesses make a variety of decisions The theory of consumer behavior, which describes decision making by consumers The theory of market structure and pricing, which describes the structure and characteristics of different market forms under which business firms operate.

Role of Managerial Economics

Managerial economics, or business economics, is a division of microeconomics that focuses on applying economic theory directly to businesses. The application of economic theory through statistical methods helps businesses make decisions and determine strategy on pricing, operations, risk, investments and production. The overall role of managerial economics is to increase the efficiency of decision making in businesses to increase profit.

Pricing

Managerial economics assists businesses in determining pricing strategies and appropriate pricing levels for their products and services. Some common analysis methods are price discrimination, value-based pricing and cost-plus pricing.

Elastic vs. Inelastic Goods

Economists can determine price sensitivity of products through a price elasticity analysis. Some products, such as milk, are consider a necessity rather than a luxury and will purchase at most price points. This type of product is considered inelastic. When a business knows they are selling an inelastic good, they can make marketing and pricing decisions easier.

Operations and Production

Managerial economics uses quantitative methods to analyze production and operational efficiency through schedule optimization, economies of scale and resource analyses. Additional analysis methods include marginal cost, marginal revenue and operating leverage. Through tweaking the operations and production of a company, profits rise as costs decline.

Econlib

The most basic laws in economics are the law of supply and the law of demand. Indeed, almost every economic event or phenomenon is the product of the interaction of these two laws. The law of supply states that the quantity of a good supplied the amount owners or producers offer for sale) rises as the market price rises, and falls as the price falls. Conversely, the law of demand (see demand) says that the quantity of a good demanded falls as the price rises, and vice versa. (Economists do not really have a “law” of supply, though they talk and write as though they do.)

One function of markets is to find “equilibrium” prices that balance the supplies of and demands for goods and services. An equilibrium price (also known as a “market-clearing” price) is one at which each producer can sell all he wants to produce and each consumer can buy all he demands. Naturally, producers always would like to charge higher prices. But even if they have no competitors, they are limited by the law of demand: if producers insist on a higher price, consumers will buy fewer units. The law of supply puts a similar limit on consumers. They always would prefer to pay a lower price than the current one. But if they successfully insist on paying less (say, through price controls), suppliers will produce less and some demand will go unsatisfied.

Economists often talk of “demand curves” and “supply curves.” A demand curve traces the quantity of a good that consumers will buy at various prices. As the price rises, the number of units demanded declines. That is because everyone’s resources are finite; as the price of one good rises, consumers buy less of that and, sometimes, more of other goods that now are relatively cheaper. Similarly, a supply curve traces the quantity of a good that sellers will produce at various prices. As the price falls, so does the number of units supplied. Equilibrium is the point at which the demand and supply curves intersect—the single price at which the quantity demanded and the quantity supplied are the same.

Markets in which prices can move freely are always in equilibrium or moving toward it. For example, if the market for a good is already in equilibrium and producers raise prices, consumers will buy fewer units than they did in equilibrium, and fewer units than producers have available for sale. In that case producers have two choices. They can reduce price until supply and demand return to the old equilibrium, or they can cut production until the quantity supplied falls to the lower number of units demanded at the higher price. But they cannot keep the price high and sell as many units as they did before.

Why does the quantity supplied rise as the price rises and fall as the price falls? The reasons really are quite logical. First, consider the case of a company that makes a consumer product. Acting rationally, the company will buy the cheapest materials (not the lowest quality, but the lowest cost for any given level of quality). As production (supply) increases, the company has to buy progressively more expensive less efficient) materials or labor, and its costs increase. It charges a higher price to offset its rising unit costs.

Are there any examples of supply curves for which a higher price does not lead to a higher quantity supplied? Economists believe that there is one main possible example, the so-called backward-bending supply curve of labor. Imagine a graph in which the wage rate is on the vertical axis and the quantity of labor supplied is on the horizontal axis. It makes sense that the higher the wage rate, the higher the quantity of labor supplied, because it makes sense that people will be willing to work more when they are paid more. But workers might reach a point at which a higher wage rate causes them to work less because the higher wage makes them wealthier and they use some of that wealth to “buy” more leisure—that is, to work less. Recent evidence suggests that even for labor, a higher wage leads to more hours worked.

Or consider the case of a good whose supply is fixed, such as apartments in a condominium. If prospective buyers suddenly begin offering higher prices for apartments, more owners will be willing to sell and the supply of “available” apartments will rise. But if buyers offer lower prices, some owners will take their apartments off the market and the number of available units will drop.

History has witnessed considerable controversy over the prices of goods whose supply is fixed in the short run. Critics of market prices have argued that rising prices for these types of goods serve no economic purpose because they cannot bring forth additional supply, and thus serve merely to enrich the owners of the goods at the expense of the rest of society. This has been the main argument for fixing prices, as the United States did with the price of domestic oil in the 1970s and as New York City has done with apartment rents since World War II (see rent control).

Economists call the portion of a price that does not influence the amount of a good in existence in the short run an “economic quasi-rent.” The vast majority of economists believe that economic rents do serve a useful purpose. Most important, they allocate goods to their highest-valued use. If price is not used to allocate goods among competing claimants, some other device becomes necessary, such as the rationing cards that the U.S. government used to allocate gasoline and other goods during World War II. Economists generally believe that fixing prices will actually reduce both the quantity and the quality of the good in question. In addition, economic rents serve as a signal to bring forth additional supplies in the future and as an incentive for other producers to devise substitutes for the good in question.

About the Author Al Ehrbar is a principal in EVA Advisers LLC, an investment advisory firm. He formerly was editor of Corporate Finance magazine and a senior editor of Fortune magazine.

Further Reading Alchian, Armen. “Costs and Outputs.” In Choice and Costs under Uncertainty. Vol. 2 of The Collected Works of Armen A. Alchian. Indianapolis: Liberty Fund, 2006. Pp. 161–179. Robinson, Joan. “Rising Supply Price.” Economica 8 (1941): 1–8.

Footnotes

Ten Fundamental Laws of Economics

Tags

In the midst of so many economic fallacies being repeatedly seemingly without end, it may be helpful to return to some of the most basic laws of economics. Here are ten of them that bear repeating again and again.

1. Production precedes consumption

Although it is obvious that in order to consume something it must first exist, the idea to stimulate consumption in order to expand production is all around us. However, consumption goods do not just fall from the sky. They are at the end of a long chain of intertwined production processes called the “structure of production.” Even the production of an apparently simple item such as a pencil, for example, requires an intricate network of production processes that extend far back into time and run across countries and continents.

2. Consumption is the final goal of production

Consumption is the objective of economic activity, and production is its means. The advocates of full employment violate this obvious idea. Employment programs turn production itself into the objective. The valuation of consumption goods by the consumers determines the value of production goods. Current consumption results from the production process that extends to the past, yet the value of this production structure depends on the current state of valuation by the consumers and the expected future state. Therefore, the consumers are the final de facto owners of the production apparatus in a capitalist economy.

3. Production has costs

There is no such thing as a free lunch. Getting something apparently gratis only means that some other person pays for it. Behind every welfare check and each research grant lies the tax money of real people. While the taxpayers see that government confiscates part of one’s personal income, they do not know to whom this money goes; and while the recipients of government expenditures see the government handing the money to them, they do not know from whom the government has taken away this money.

4. Value is subjective

Valuation is subjective and varies with the an individual’s situation. The same physical good has different values to different persons. Utility is subjective, individual, situational and marginal. There is no such thing as collective consumption. Even the temperature in the same room feels differently to different persons. The same football match has a different subjective value for each viewer as can be easily seen the moment when a team scores.

5. Productivity determines the wage rate

The output per hour determines the worker’s wage rate per hour. In a free labor market, businesses will hire additional workers as long as their marginal productivity is higher than the wage rate. Competition among the firms will drive up the wage rate to the point where it matches productivity. The power of labor unions may change the distribution of wages among the different labor groups, but trade unions cannot change the overall wage level, which depends on labor productivity.

6. Expenditure is income and costs

Expenditure is not only income, but also represents costs. Spending counts as costs for the buyer and income for the seller. Income equals costs. The mechanism of the fiscal multiplier implies that costs rise with income. In as much as income multiplies, costs multiply as well. The Keynesian fiscal multiplier model ignores the cost effect. Grave policy errors are the result when government policies count on the income effect of public expenditures but ignore the cost effect.

7. Money is not wealth

The value of money consists in its purchasing power. Money serves as an instrument of exchange. The wealth of a person exists in its access to the goods and services he desires. The nation as a whole cannot increase its wealth by increasing its stock of money. The principle that only purchasing power means wealth says that Robinson Crusoe would not be a penny richer if he found a gold mine on his island or a case full of bank notes.

8. Labor does not create value

Labor, in combination with the other factors of production, creates products, but the value of the product depends on its utility. Utility depends on subjective individual valuation. Employment for sake of employment makes no economic sense. What counts is value creation. In order to be useful, a product must create benefits for the consumer. The value of a good exists independent from the effort of producing it. Professional marathon runners do not earn more prize money than sprinters because running the marathon takes more time and effort than a sprint.

9. Profit is the entrepreneurial bonus

In competitive capitalism, economic profit is the extra bonus that those businesses earn that fix allocative errors. In an evenly rotating economy with no change, there would be neither profit nor loss and all companies would earn the same rate of interest. In a growing economy, however, change takes place and anticipating changes is the source of economic profits. Business that does well in forecasting future demand earn high rates of profit and will grow, while those entrepreneurs who fail to anticipate the wants of the consumers will shrink and finally must shut down.

10. All genuine laws of economics are logical laws

Economic laws are synthetic a priori reasoning. One cannot falsify such laws empirically because they are true in themselves. As such, the fundamental economic laws do not require empirical verification. Reference to empirical facts serve merely as illustrative examples, they are not statements of principles. One can ignore and violate the fundamental laws of economics but one cannot change them. Those societies fare best where people and government recognize and respect these fundamental economic laws and use them to their advantage.

German-born Antony Mueller teaches economics at the Federal University of Sergipe (UFS) in Brazil. See his website, blog, youtube channel, tumblr.