Updating managerial economics

Business Economics, July, 1995 by Thomas P. Egan

The traditional Theory of the Firm taught Managerial Economics courses has a relevance problem today to the extent that it overemphasizes the optimization of quantity, price, costs and profits in a single time period for a single kind of "widget" produced in a single facility. Such optimization issues are still important to small farms, small natural resource producers or small factories serving local markets. However, the planning challenge for business units in most midsized and large corporations is how to optimize the growth in profits over several time periods by providing multiple products, each with unique quality and customer service elements. Furthermore, such multiple products and associated customer service elements are usually provided from multiple, shared product facilities to multiple market segments in multiple regions.

In spite of the relevance problem and the recommendations made below to address it, this paper is not an attempt to disparage the high value that the traditional Theory of the Firm contributes to economic theory and public policy debates. Applied economic models based on the single-product, single-production function, comparative static analysis framework will certainly remain highly useful for aggregated industry or economy-wide policy analyses well into the future. However, to managers in corporate business units, such analyses apply to highly aggregated special cases seldom encountered in day-to-day decision environments.

PAPER ORGANIZATION AND ASSUMPTIONS

The paper begins by setting out some assumptions and definitions useful in understanding the organizational, decision and market environments that typical business units in mid- and large-sized firms face. It then makes recommendations on how the Theory of the Firm can be extended to respond to such environments. Four aspects of the Theory of the Finn are considered, in turn:

1. Profit maximization

2. Demand and price

3. Production and factor utilization

4. Cost minimization

The paper concludes with some brief recommendations on how Managerial Economics might grow even further in value and use by aggressively setting a more cross-disciplined language and model-development direction. Whether a business economist is employed as a staff economist or line manager, his or her value to the finn can only increase as the applicability and perceived value of Managerial Economics tools increase.(1)

Corporate Organization and the Location of

Economic Decisions

The decision environment in which Managerial Economics is applied in large corporations has the following characteristics:

1. The modern corporation is typically organized into business units (BU). Bus are typically self sufficient in that they design, sell, produce, deliver and provide pre-and post-order supporting services for a number of products or services, through a number of facilities, to customers around the globe. However, any of these BU controlled functions can be "outsourced" to "partners" in other Bus or other companies. 2. Each BU is typically accountable for its own profits or losses. This gives incentives to each BU to develop, promote, etc., in its own facilities or using its own partners, to gain as much financial control over its activities as possible. However, cross-BU facility sharing and "synergistic" attacks on new markets are often "encouraged" by headquarters organizations. Thus, cross-BU transfer pricing issues receive considerable management attention and often are highly politicized. 3. Planning is considerably decentralized. Corporate headquarters strategic planners (sometimes called business planners or long-range planners) typically focus on which multiproduct business units to enter and exit, while business unit strategic planners focused on dynamic rates of change in profits, revenues, prices and costs for entire product families over several years. Neither focuses very often on profit maximization for a single product or product family over a single year. 4. Business unit product line managers (sometimes called product marketing managers), do focus on profits for single products over the shorter term. However, the products and associated support services they manage are usually produced in multiproduct facilities, and product managers seldom have access to the kind of single-product cost versus quantity data needed to apply microeconomic tools effectively. Standard cost accounting systems do not forecast costs for individual products very Well.(2) 5. Rapid advances in information technology will continue to change underlying production functions and the very nature of what "product" or "service" is delivered to customers. Such dynamics must be explicitly considered in selecting planning approaches, particularly at the strategic planning level.

The Output of a Typical BU

The output of a single BU is no longer a microeconomic "widget." Today, more typically it is a large number of products and/or services, each one of which might be depicted as a cell in a three dimensional BU output matrix. The axes of the matrix would be units, support services and quality. At the BU level, the number of "products" can be quite large. Figures 1a and 1b and depict how the concept of "product" or "service" is increasingly viewed in the modern enterprise and is viewed in this paper.