Managerial economics is a branch of economics involving the application of economic methods in the organizational decision-making process.^[1] Economics is the study of the production, distribution, and consumption of goods and services. Managerial economics involves the use of economic theories and principles to make decisions regarding the allocation of scarce resources.^[2] It guides managers in making decisions relating to the company's customers, competitors, suppliers, and internal operations.^[3]

Managers use economic frameworks in order to optimize profits, resource allocation and the overall output of the firm, whilst improving efficiency and minimising unproductive activities.^[4] These frameworks assist organisations to make rational, progressive decisions, by analysing practical problems at both micro and macroeconomic levels.^[5] Managerial decisions involve forecasting (making decisions about the future), which involve levels of risk and uncertainty. However, the assistance of managerial economic techniques aid in informing managers in these decisions.^[6]

Managerial economists define managerial economics in several ways:

1. It is the application of economic theory and methodology in business management practice.
2. Focus on business efficiency.
3. Defined as "combining economic theory with business practice to facilitate management's decision-making and forward-looking planning."
4. Includes the use of an economic mindset to analyze business situations.
5. Described as "a fundamental discipline aimed at understanding and analyzing business decision problems".
6. Is the study of the allocation of available resources by enterprises of other management units in the activities of that unit.
7. Deal almost exclusively with those business situations that can be quantified and handled, or at least quantitatively approximated, in a model.

^[3]

The two main purposes of managerial economics are:

1. To optimize decision making when the firm is faced with problems or obstacles, with the consideration and application of macro and microeconomic theories and principles.^[7]
2. To analyze the possible effects and implications of both short and long-term planning decisions on the revenue and profitability of the business.

The core principles that managerial economist use to achieve the above purposes are:

• monitoring operations management and performance,
• target or goal setting
• talent management and development.

In order to optimize economic decisions, the use of operations research, mathematical programming, strategic decision making, game theory^[8][9] and other computational methods^[10] are often involved. The methods listed above are typically used for making quantitate decisions by data analysis techniques.

The theory of Managerial Economics includes a focus on; incentives, business organization, biases, advertising, innovation, uncertainty, pricing, analytics, and competition.^[11] In other words, managerial economics is a combination of economics and managerial theory. It helps the manager in decision-making and acts as a link between practice and theory.^[12] Furthermore, managerial economics provides the tools and techniques that allow managers to make the optimal decisions for any scenario.

Some examples of the types of problems that the tools provided by managerial economics can answer are:

• The price and quantity of a good or service that a business should produce.
• Whether to invest in training current staff or to look into the market.
• When to purchase or retire fleet equipment.
• Decisions regarding understanding the competition between two firms based on the motive of profit maximization.^[13]
• The impacts of consumer and competitor incentives on business decisions^[14]

Managerial economics is sometimes referred to as business economics and is a branch of economics that applies microeconomic analysis to decision methods of businesses or other management units to assist managers to make a wide array of multifaceted decisions. The calculation and quantitative analysis draws heavily from techniques such as regression analysis, correlation and calculus.^[15]

Microeconomics is the dominant focus behind managerial economics, some of the key aspects include:

• Supply and Demand

The law of supply and demand describes the relationship between producers and consumers of a product.^[16] The law suggests that price set by the producer and quantity demanded by a consumer are inversely proportional, meaning an increase in the price set is met by a reduction in demand by the consumer.^[16] The law further describes that sellers will produce a larger quantity of the good if it sells at a higher price.^[16]

Excess demand exists when the quantity of a good demanded is greater than the quantity supplied. Where there is excess demand, sellers can benefit by increasing the price. The inverse applies to excess supply.

• Production theory

Production theory describes the quantity of a good a business chooses to produce.^[17] This decision is informed by a variety of factors, including raw material inputs, labor, and capital costs like machinery.^[17] The production theory states that a business will strive to employ the cheapest combination of inputs to produce the quantity demanded. The production function can be described in its simplest form by the function ${\displaystyle Q=F[L,K]}$ where Q denotes the firm's production, L is the variable inputs and K is the fixed inputs.^[18]

• Opportunity cost

The opportunity cost of a choice is the foregone benefit of the second best choice.^[19] Determining the opportunity cost requires detailing the costs and benefits of each action the business is considering to pursue, and the cost of choosing one activity over another.^[20] The decision-maker is then in the position to choose the action with the highest payoff.

• Theory of Exchange or Price Theory

The principle uses the conjecture of supply and demand to set an accurate price for a good.^[21] The aim of price theory is to allocate a price for a good such that the supply of a good is met with equal demand for the product.^[21] If a manager sets the price of a good too high, the consumer may think it is not worth the cost and decide not to purchase the good, hence creating excess supply. The opposite occurs when the price is set too low, causing demand for a good to be greater than supply.^[21]

• Theory of Capital and Investment Decisions

Capital investment decisions are a critical factor in an enterprise. They involve determining the rational allocation of funds that will enable an organization to invest in profitable projects or enterprises to improve the efficiency of organizations.^[22] The rational allocation of funds may include acquiring business, investing in equipment, or determining whether an investment will improve the business at all.^[22]

• Elasticity of demand

The elasticity of demand is a prominent concept in managerial economics. Established by Alfred Marshall, elasticity of demand describes how sensitive a change in the quantity demanded is given a unit change in price. In his own words, Marshall describes the concept as ‘The elasticity of demand in a market is great or small according to as the amount demanded increases much or little for a given fall in price and diminish much or little for a given rise in price.^[23]

The microeconomic principles are useful principles to inform manager's decision making. Managerial economics draws upon all of these analytical tools to make informed business decisions.

• Price Elasticity of Demand Analysis

The price elasticity of demand is a highly useful tool in managerial economics as it provides managers with the predicted change in demand associated with an increase in the price charged for its goods and services.^[24] The price elasticity principle also outlines the changes in demand for goods with changes in the income of a populous.^[24]

${\displaystyle Elasticity(p)=E_{\langle p\rangle }={\frac {\Delta Q/Q}{\Delta P/P}}}$

Where ${\displaystyle \Delta Q}$ is the change in quantity demand for the respective change in price ${\displaystyle \Delta P}$, with Q and P representing the quantity and price of the good before a change was made.^[25] The price elasticity is important for managerial economics as it aids in the optimization of marginal revenue of firms.^[25]

• Marginal analysis

In economics, marginal refers to the change in revenue and cost by producing one extra unit of output. Both the marginal cost and marginal revenue are extremely important in economics as a firm's profit is maximized when the marginal cost is equal to the marginal revenue.^[26] Managers can make business decisions on the output level based on this analysis in order to maximize the profit of the firm.

Marginal Analysis is considered the one of most chief tools in managerial economics which involves comparison between marginal benefits and marginal costs to come up with optimal variable decisions. Managerial economics uses explanatory variables such as output, price, product quality, advertising, and research and development to maximise net benefits.

• Mathematical model analysis

The use of econometric analysis has grown with the development of economics and management, as has the use of differential calculus to determine profit maximisation.^[27]

By taking the derivative of a function, the maximum and minimum values of the function are easily determined by setting the derivative equal to zero. This can be applied to a production function to find the quantity of production that maximizes the profit of the firm.^[28] This concept is important for managers to understand in order to minimize costs or maximize profits.^[29]

The main applications of mathematical models are:

• Demand forecasting. Before determining the scale of production of a certain product, enterprises need to forecast the development potential of the market. Relevant mathematical models can be created to represent the quantitative changes in the various factors affecting the development of the market, and then analyse the magnitude of the impact of these changes on demand.
• Production analysis. The input of production factors, the choice of the form of production organisation and the determination of the product structure can all be analysed and decided by creating mathematical models.
• Cost decision. Cost is a factor that directly affects profit, and is one of the most important concerns for enterprise development. An enterprise's cost level can be determined by applying mathematical models. When an enterprise changes the direction of production and operation, or expands its scale these methods can help determine the optimal level under the goal of maximising profit.
• Market analysis. The market is a fundamental concept in economics and in practice manifests itself in many different forms. Mathematical models can be created to analyse the size, price and competitive strategies that a company may choose under various market conditions.
• Risk analysis. Risk analysis is the prediction of future states. Mathematical models can be created to represent the magnitude of the various factors involved in an investment and the impact that changes in magnitude may have on the benefits.

As "the application of economic theory and methods to business decision-making",^[30] managerial economics is fundamentally about making decisions. The discipline is partially prescriptive in nature because it suggests a course of action to a managerial problem.^[4] Managerial economics aims to provide the tools and techniques to make informed decisions to maximize the profits and minimize the losses of a firm.^[4] Managerial economics has use in many different business applications, although the most common focus areas are related to the risk, pricing, production and capital decisions a manager makes.^[31] Managers study managerial economics because it gives them the insight to control the operations of their organizations. Organizations will function well if managers rationally apply the principles that apply to economic behavior.^[3]

Managerial economics as a science

1. Define the Problem
   The first step in making a business decision is to understand the problem in its entirety. Without correct analysis of the problem, any solution developed will be inadequate.^[32]
   Incorrect problem identification can sometimes cause the problem that is trying to be solved.^[33]
2. Determine the Objective
   The second step is evaluating the objective of the decision, or what the decision is trying to achieve.^[33]
   This step is determining a possible solution to the problem defined in step 1. Multiple possible solutions to the problem previously identified may be established.
3. Discover the Alternatives
   After in depth analysis into what is required to solve the problem faced by a business, options for potential solutions can be collated.^[32]
   In most cases, more than one possible solution to the problem exists. For example, a business striving to gain more attraction on social media could improve the quality of their content, collaborate with other creators or a combination of the two.^[32]
4. Forecast the Consequences
   This step involves assessing the consequences of the problem's solutions detailed in step 3. Possible consequences of a business decisions could include; productivity, health, environmental impacts and risk.^[34]
   Here, managerial economics is used to determine the risks and potential financial consequences of an action.
5. Make a Decision
   After the consequences and potential solutions to the problem at hand have been analyzed, a decision can be made. At this point, the potential decisions should be measurable values which have been quantified by managerial economics to maximise profits and minimise risk and adverse outcomes of the firm.^[33] This step includes a sensitivity analysis of the solution. A sensitivity analysis of the selected solution details how the output of the solution changes with changes to the inputs.^[35] The sensitivity analysis allows the strengths and weaknesses of the designed solution to be analyzed.^[33]

It is important to understand what pricing decisions should be made regarding the products and services of the firm. Efficient pricing is required to maintain desired levels of revenue and profit, whilst also maintaining customer satisfaction.^[36] Setting a price too low reduces profitability, negatively affects the perceived quality of the product, and sets an expectation of price for the consumer. Setting a price too high may negatively affect the image of an organisation from the perspective of the consumer.^[37]

Managers may price using intuitive or technocratic decision-making styles. A technocratic approach relies on quantitative analysis and optimisation, and typically involves a compensatory method of evaluation.^[38] Compensatory evaluation allows one attribute to compensate for another attribute. For example, a manager may price a product at a lower price to compensate for its lower quality.^[39] Intuitive decision-making relies on consumer heuristics, defined as cognitive processes of fast decision-making, which occur by limiting the amount of information analysed.^[40]

Economic concepts such as competitive advantage, market segmentation, and price discrimination are relevant to pricing strategy.^[30] In order to set a price that drives sales and firm performance, managers must understand the economic environment in which they are operating.^[41]

In order to successfully make organisational decisions, management must have an understanding of consumer behaviour and decision-making. Consumer behaviour relates to buying, using and selling goods, services, time and ideas by decision-making units.^[51]

Monetary and non-monetary incentives are used by managers to motivate employees to achieve results aligned with firms' objectives.^[60] The outcome of incentives depends on the design and the implementation process of the incentives, their interaction with intrinsic and social motivations, and the behavioural effects of their removal.^[61]

In a field experiment analyzing the effects of performance-based monetary incentives, it was shown that productivity improved in line with employees' ability, however, there was an increase in neglect of non-incentivised tasks.^[62]

Monetary incentives generally have two kinds of effects, known as the standard direct price effect, and the indirect psychological effect. The standard direct price effect makes incentivised behavior more attractive; and the indirect psychological effect makes incentivised behavior less appealing by relaying important information from principals (manager) to agents (worker) surrounding quality expectations, which can provoke unexpected behavioural outcomes.^[61]

Agents receive information from both the size and existence of incentives. For example, offering members of the community high monetary compensation to be in the presence of a nuclear waste site, indicates that there are high risks involved with the plant, making community members less willing to accept the plant even in the presence of monetary incentives.^[63] Contrarily, in a famous experiment, a childcare centre introduced a fee of $3 for parents who picked their children up late. The information conveyed to the parents from this incentive was that the small fine indicated being late is not too bad, and in the short run the number of late pick-ups increased. This information persisted when the fee was removed, and parents who had experienced the fine were more likely to pick their child up late than those who had not received the information given by the incentive.^[64]

As a general rule however, when incentives are high enough, the standard direct price effect tends to take precedence over the indirect psychological effect, unless incentives are so high that agents form a negative inference of the circumstances.^[65]

Demand forecasting assists management in predicting future sales and revenue projection, which inform operations and marketing decisions as well future financial planning.^[87] The process of demand forecasting often uses business analytics, particularly predictive analytics, with respect to historical data and other analytical information, to make an accurate estimation. For example, using an estimate of a firm's capital expenditure and cash flow, managers can create forecasts that assist in financial planning and improve the financial health of the firm.^[88]

Effective demand management considers factors which are both within and beyond the firm's control, such as disposable income, competition, price, advertising and customer service.^[87]

Consumer choice is highly influential on demand analysis, as each consumer aims to maximise their satisfaction with a combination of goods and services, subject to their personal budget constraint.^[87] Costs of production

Production costs directly affect a firm's profitability. In order to maximise profits, firms identify the cost minimising output level for a firm where marginal cost equals marginal revenue. The most common types of costs that are factored into this decision include:^[89]

• Fixed costs
• Variable costs
• Marginal cost
• Average total cost
• Sunk costs

The impact of short-run and long run costs are important in determining production in a certain firm . It is assumed some costs are fixed in the short-run and are thus considered "fixed costs". Thus production costs are determined by variable costs. However, in the long run, all costs are variable, which allows more flexibility in changing inputs to determine the optimal level of inputs for a profit maximising output.^[30]

Profitability management is understanding what makes a firm profitable, and what can be done to improve its profitability.^[90] It integrates finance and sales, and aims to optimize sales revenue and marginal cost of the firm. Profit management is technology enabled, as firms must be quick to respond to rapid changing market and to know the true economic cost of its products and services. Management needs to drive cooperation between different functions of the firm such as sales, marketing, and finance, to ensure the teams recognize the importance of coordinated effort. Proper planning and profitability management is key to good business management.^[91]

Capital management is the planning, monitoring, and controlling of the assets and liabilities of a firm, particularly, in an effort to maintain cash flow to meet the firm's short-term and long-term financial obligations. Proper capital management is important to the financial health of a firm, with efficient resource allocation through capital management, firms can improve its cash flow and profitability. Capital management involves tracking various ratios within the firm, most important ones include:^[92]

• Capital ratio
• Inventory turnover ratio
• Collection ratio

Rate of return and cost of capital (i.e. interest rate) are important factors of capital management.^[93]

When making decisions, managerial economics is used to analyze the micro and macroeconomic environments relating to an organization. Microeconomics considers the actions of individual firms surrounding utility maximization, whilst Macroeconomics considers the actions and behaviour of the economy as a whole.^[5] As such, both area of economics have influence in the development of managerial economic frameworks.

From a management perspective, managerial economics techniques are useful in many areas regarding business decision-making, most commonly including:

• Risk analysis – various models are used to quantify risk and asymmetric information and to employ them in decision rules to manage risk.^[100]
• Production analysis – microeconomic techniques are used to analyze^[101] production efficiency, optimum factor allocation, costs, economies of scale and to estimate the firm's cost function.
• Pricing analysis – microeconomic techniques are used to analyze various pricing decisions including transfer pricing, joint product pricing, price discrimination, price elasticity estimations, and choosing the optimum pricing method.^[102]
• Capital budgeting – investment theory is used to examine a firm's capital purchasing decisions.^[103]

• Computational Economics. Aims and scope.
• Journal of Economics & Management Strategy. Aims and scope.
• Managerial and Decision Economics