Economics

for
Decision making
MBA 641
1
 Chapter I: Introduction
1.1.Business Decision and the Role Economic
Analysis

What is a Business Decision-Making

 Is a process of selecting the best course
of action
 out of available alternatives open to the
firm
What are steps/phases of decision-
making?
 The process of decision-making
comprises of the following phases:
1.Identifying the issue
2.Defining objective 2
 Phases of Decision Making
3.Collecting of relevant information
Information (both internal and external),
• Technical issues
• Economic,
• Social
• Political, and
• Technological
4.Analysing and developing alternative
course of actions
5.Evaluate and Compare each course of
action and select the best action 3
 Phases of Decision Making (Cont…)

However, these process are not as simple

as it appears.
Particularly,
Steps (4) and (5) are crucial in business
decision-making
They demand,
analytical ability
the application of wide range of economic
theory
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 Phases of Decision Making (Cont…)
I.e., It is in these area,
 economic theories and
 tools of economic analysis contribute a
great deal

For instance,
suppose a firm plans to introduce a new
product.
The decision can be made using two
approaches.
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 Introducing new product?
a) One approach is to seek expert opinion.
 to obtain services of business consultants
b) The managers of the firm do it themselves.
In which case two issues need to be
investigated
i. Production related issues, and
ii. Sale related issues
i. Production issues:
 managers are required to collect and
analyze information like,
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 Production related issues
 available techniques (technology) of
production (Alternatives)
 cost of production associated with each
production technology
 Inputs required and status of input
supply
 price of inputs
 availability of foreign exchange
 cost structure of competitive products
 And many other technical information
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 Sales related issues

ii. The sales aspects:

In this regard we need to collect and analyze
information related to:
 general market trends
 trends in the industry to which the planned
products belongs
 market structure and degree of competition
 major (expected) competitors and their market
share
 prices of the competing products
 pricing strategy of the prospective competitors
 supply position of complementary goods 8
 In short
In general managers need to have a good
knowledge of economic tools in order to
allocate firms scarce resource
efficiently.
Example
Suppose a marketing manager of say, General
Trading is considering both
 “TV advertising” and
 “Guerilla" advertising.
The marketing budget is scarce resources that
must be allocated wisely.
 Example (Cont …)
Economics provides a scientific method
for making business decisions.
 Where to Advertise decision

The Steps involved are,

Step 1. Define objective
 maximizing sales, i.e.,

 to get the highest possible sales out of

each birr spent on marketing activities.
 Example (Cont …)
It is reasonable to assume that
diminishing returns exist
as more and more advertisements are
made,
 each additional birr gives less and less
additional sales.
The first “ad” is fresh and reaches many
previously unaware consumers.
The 100th “ad” generates little additional
sales, as everyone is familiar with the
product.
 Example (Cont …)
Here is an objective function that has
diminishing returns:
S = a + b1Tv – b2Tv2 + b3Gr – b4Gr2
Where, Tv and Gr are advertising
expenses on two methods of
advertisement,
S is sales, and ,
b1,b2 and b3 are unknown parameters,
 parameter is a variable which the
manager cannot change.
 Example (Cont …)
Step 2. Collect necessary information.
The firm has data on
 past sales and
 advertising expenditures.
We also need to know the cost of TV ad
and the cost of a guerilla “ad”.
Step 3. Analyze the data
We use fancy statistics to find the
unknowns parameters, b1, b2 and b3
We have estimated (sales are in mill. Birr)
S = 22 + 5Gr – 1.5 Gr2 + 24Tv - 0:5Tv2
 Example (Cont …)
The firm’s budget is, 0.5 million,
 a block of TV ads costs 5 million,
 while a set of guerilla ads costs 1
million.
So TV ads are more expensive, but reach a
wider audience.
Our budget constraint will be,
0.5 = 5Tv + 1Gr
Step 4, we use calculus to find the values of
Tv and Gr that maximize Sales, given our
scarce resources (budget birr).
 Example (Cont …)
Max S = 22 + 5Gr – 1.5 Gr2 + 24Tv – 0.5Tv2
Subjected to
0.5 = 5Tv + 1 Gr
L=22 + 5Gr – 1.5 Gr2 + 24Tv - 0:5Tv2 – ٨(5Tv + Gr-0.5)
We would find that,
 Tv = 0.086 ad blocks or about Birr 430,000
 Gr = 0.07 ad blocks or about Birr70,000

Although TV ads are more expensive, the

extra expense is more than offset by the
larger audience.
In such and the like analysis,
 knowledge of economic theories and

 tools of economic analysis is necessary

 so that the decision-making process
would be smooth and successful.
Generally,
The economic theory can be directly applied
at,
 Operational (internal) level /Micro level

 Environmental or (Macro level)

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 Operational (Internal) or Micro
Issues
i. Operational level /Micro level
Some of the basic internal issues are,
 choice of commodity, ( what to produce?)

 choice of size of the firm, (how much to

produce?)
 Choice of technology, (how to produce?)

 Choosing the factor-combination; (how?)

 Choice of price ( pricing decision commodity?)

 How to promote sales?

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 Operational (Internal) or Micro
Issues (cont…)
 how to face price competition?
 how to decide on new investments?
 how to manage profit and capital?
Microeconomics deals with these and the like
questions.
The microeconomic theories related to the
above questions are,
 Theory of demand
 Theory of production
 Theory of exchange or price theory
 Theory of capital and investment
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 Environmental or external issues
(macro issues)
ii. Environmental or external issues (Macro
level)
These are issues related to the
environment in which a business operates.
They are related to the overall economic
performance, social and political
atmosphere of the country.
These are issues like.
The type of economic system of the
country
General trends in,
 production, 19
 Environmental or external issues
(macro issues) (cont…)
 employment,
 Level of national income,

 prices ,

 saving and

 investment, etc.

Structure and trends in the working of

financial institutions,
Magnitude and trends in foreign trade,
Trends in labor and capital markets,
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 Environmental or external issues (macro
issues) (cont…)
Political environment
Government’s economic policies, e.g.,
• industrial policy,
• monetary policy,
• tax policy,
• price policy, etc.
Social factors like value systems of the society,
property rights, customs and habits,
Social organizations like trade unions, consumers’
cooperative and producers’ union, etc.
Social structure and class character of the
various social groups.
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 Environmental or external issues (macro issues)
(cont…)

How large a firm may be, it can not

determine and guide the course of,
 economic,

 social and

 political factors of the nation,

As a result the economic, social and

political factors are to be treated as
business parameters
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 Concluding Remarks
Economic theories, both micro and macro,
have wide application to the business
decision-making
But bear in mind that
 economic theories,
 models and

 tools of analysis

do not offer readymade answers to the

problems of individual firms.
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 Concluding Remarks (cont…)
They provide logic and methods to find
answers,
 not the answers as such.
It depends on the managers’
 own understanding,
 experience and

 intelligence

as to how to use the tools of economic

analysis to find a correct answer to the
practical problems of business. 24
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