Showing posts with label Managerial decision making. Show all posts
Showing posts with label Managerial decision making. Show all posts

Risk and Uncertainty in Managerial Decision Making

Risk means a low probability of an expected outcome. From business decision-making point of view, risk refers to a situation in which a business decision is expected to yield more than one outcome and the probability of each outcome is known to the decision-makers or it can be reliably estimated. For example, if a company doubles its advertisement expenditure, there are four probable outcomes such as; 

(i) its sales may more-than-double,
(ii) they may just double,
(iii) increase in sales may be less than double and
(iv) sales do not increase at all.

The company has the knowledge of these probabilities or has estimated the probabilities of the four outcomes on the basis of its past experience as:
(i) more-than double – 20 percent (or 0.2),
(ii) almost double – 40 percent (or 0.4),
(iii) less than double – 50 percent (or 0.5) and
(iv) no increase – 10 percent (or 0.1).

It means that there is 80 percent risk in expecting more than doubling of sales, and 60 percent risk in expecting doubling of sale, and so on.

There are two approaches to estimating probabilities of outcomes of a business decision, viz.
(i) a priori approach, i.e., the approach based on deductive logic or intuition
(ii) posteriori approach, i.e., estimating the probability statistically on the basis of the past data.

In case of a priori probability, we know that when a coin is tossed, the probabilities of ‘head’ or ‘tail’ are 50/50, and when a dice is thrown, each side has 1/6 chance to be on the top. 

The posteriori assumes that the probability of an event in the past will hold in future also. The probability of outcomes of a decision can be estimated statistically by way of ‘standard deviation’ and ‘coefficient of variation’.

Uncertainty refers to a situation in which there is more than one outcome of a business decision and the probability of no outcome is known nor can it be meaningfully estimated. The unpredictability of outcome may be due to lack of reliable market information, inadequate past experience and high volatility of the market conditions. For example, if a Nepalese firm, highly concerned with population burden on the country, invents an irreversible sterility drug, the outcome regarding its success is completely unpredictable. Consider the case of insurance companies. It is possible for them to predict fairly accurately the probability of death rate of insured people, accident rate of cars and other automobiles, rate of buildings catching fire, and so on, but it is not possible to predict the death of a particular insured individual, a particular car meeting an accident or a particular house catching fire, etc.

The long-term investment decisions involve a great deal of uncertainty with unpredictable outcomes. But, in reality, investment decisions involving uncertainty have to be taken on the basis of whatever information can be collected, generated and ‘guesstimated’. For the purpose of decision-making, the uncertainty is classified as:
(a) complete ignorance and
(b) partial ignorance.

In case of complete ignorance, investment decisions are taken by the investor using their own judgment or using any of the rational criteria. What criterion he chooses depends on his attitude towards risk. The investor’s attitude towards risk may be that of:
(i) a risk averter,
(ii) a risk neutral,
(iii) a risk seeker or risk lover.

In simple words, a risk averter avoids investment in high-risk business. A risk-neutral investor takes the best possible decision on the basis of his judgment, understanding of the situation and his past experience. He does his best and leaves the rest to the market. A risk lover is one who goes by the dictum that ‘the higher the risk, the higher the gain’. Unlike other categories of investors, he prefers investment in risky business with high expected gains.

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Uses of Price Elasticity of Demand in Managerial Decision-making

The concept of price elasticity of demand has important practical applications in managerial decision-making. A business man has often to consider whether a lowering of price will lead to an increase in the demand for his product, and if so, to what extent and whether his profits would increase as a result thereof. Here the concept of elasticity of demand becomes crucial.

Knowledge of the nature of the elasticity of demand for his products will help a business to decide whether he should cut his price in a particular case. Such knowledge would also help a businessman to determine whether and to what extent the increase in costs could be passed on to the consumer. In general for items those whose demand is elastic it will pay him to charge relatively low prices, while on those whose demand is elastic, it would be better off with a higher price. A monopolist would not be able to increase his price if the demand for his product is elastic.

In practice, an accurate estimate of the probable response of volume of sales to price changes is extremely difficult. Moreover, the cost of the statistical analysis required may in some cases, exceed the benefit especially when uncertainty is great or when the volume is too small to provide a reason also return on the amount spend on research. The subjective judgment of certain managers, beyond on years of experience, sometimes exceeds in accuracy the best of the present statistical techniques. Uses of price elasticity can be point out as below:

1. Price Distribution

A monopolist adopts a price discrimination policy only when the elasticity of demand of different consumers or sub-markets is different. Consumers whose demand is inelastic can be charged a higher price than those with more elastic demand.

2. Public Utility Pricing

In case of public utilities which are run as monopoly undertakings e.g. elasticity of water supply railways postal services, price discrimination is generally practiced, charging higher prices from consumers or users with inelastic demand and lower prices in case of elastic demand.

3. Joint Supply

Certain goods, being products of the same process are jointly supplied, e.g. wool and mutton. Here if the demand for wool is inelastic compared to the demand for mutton, a higher price for wool can be charged with advantage.

4. Super Markets

Super markets are a combined set of shops run by a single organization selling a wide range of goods. They are supposed to sell commodities at lower prices than charged by shopkeepers in the bazaar. Hence, price policy adopted is to charge slightly lower price for goods with elastic demand.

5. Use of Machine

Workers often oppose use of machines out of fear of unemployment. Machines need not always reduce demand for labor as this depends on price elasticity of demand for the commodity produced. When machines reduce costs and hence price of products, if the products demand is elastic, the demand will go up, production will have to be increased and more workers may be employed for the product is inelastic, machines will lead to unemployment as lower prices will not increase the demand.

6. Factor Pricing

The factors having price inelastic demand can obtain a higher price than those with elastic demand. Workers producing products having inelastic demand can easily get their wages raised.

7. International Trade

(a) A country benefits from exports of products as have price inelastic demand for a rise in price and elastic demand for a fall in price. 
(b) The demand for imports should be inelastic for a fall in price and elastic for a rise in price. 
(c) While deciding whether to devalue a country’s currency or not, price elasticity of demand for a country’s exports would be an important factor to be taken into consideration. If the demand is price elastic, it would lead to an increase in the country’s exports and devaluation would fail to achieve its objective.

8. Shifting of Tax Burden

It is possible for a business to shift a commodity tax in case of inelastic demand to his customers. But if the demand is elastic, he will have to bear the tax burden himself, otherwise demand for his goods will go down sharply.

9. Taxation Policy

Government can easily raise tax revenue by taxing commodities which are price inelastic.
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Value of Maximization Theory of Firm | Superiority of Maximization Theory

In managerial economics, the primary objective of management is assumed to be maximization of the firm’s value. The value can be defined as the present value of the firm’s expected future cash flows. Cash flows may be for now, be equated to profits, therefore the value of the firm today, its present value, is the value of its expected future profits, discounted back to the present at an appropriate interest rate.

The essence of the model with which are concerned expressed as follows:
 
Value of the firm = PV of expected future profits


Where,
PV is the abbreviation for the present value, and so forth represent the expected profits in each year ‘t’, ‘i’ is the appropriate interest rate.
 
Since profits are equal to total revenue (TR) minus total cost (TC), equation (i) may be written as


Maximizing equation (ii) involves the determinants of revenues, costs and the discount rates in each future year of some unspecified time. Revenues, costs and the discount rates are interrelated, complicating the problem even more.

A firm’s total revenues are directly determined by the quantity of its products sold and the process received, for managerial decision making, the important considerations relate to factors that affect prices and quantities, and to the interrelationships between them. These factors include the choice of products of the firm designs, manufactures and sells the advertising-strategies, it employs, the pricing it established, the general state of the economy it encounters and the nature of the competition it faces in the market place. In short, revenue relationship encompasses both demand and supply considerations.

The cost relationships involved in producing a firm’s products are similarly complex. Costs require examination of alternative production systems, technological options, input possibilities, and so on. The prices of the factors of production play an important role in cost determination, and thus factors supply considerations are important.

Finally, there is the relationship between the discount rate and the company’s production mix, physical assets and financial structure. These factors affect the cost of availability of financial resources for the firm and ultimately determine the discount rate used by investors to establish a value of the firm.

To determine the optional course of action requires that marketing, production and financial decisions as well as decisions related to personnel, product distribution and so on be combined into a single integrated system, one which shows how any action affects all parts of the firm. The economic model of the firm provides a basis for this integration and the principles of economic analysis enable to analyze the important interrelations.

Superiority of Maximization Theory


Shareholder wealth maximization is the basic goal of any business firm because of the following reasons:
  1. Efficient allocation of resources: It provides guideline for making decision of firm and also promotes an efficient allocation of resources. Resources are generally allocated by taking into consideration the expected return and risk associated to course of action. The market value of stock itself reflects the risk return trade off associated to any investor in the capital market. 
  2. Separation between ownership and management: The goal of shareholder wealth maximization is also justifiable from the view point of separation of ownership and management in a business firm. Stockholders provides funds to operate a business firm and they appoint a team of management to run the firm. 
  3. Residual owners: Shareholders are the last to share in earnings and assists of the company. Therefore, shareholders wealth is maximized, and then all other with prior claim that shareholder could be satisfied. 
  4. Emphasis on cash flow: Wealth maximization goal uses cash flows rather than accounting profit as the basic input for decision making. The use of cash flow is clearer because it uniformly means profit after tax plus non-cash outlays to all. 
  5. Recognizes time value of money: It also recognizes the time value of money. All the cash flow generated over the life of the business firms are discounted back to present value using required rate of return and decision is based on the present value of future returns.
  6. Consideration risk: Wealth maximization objective also considers the risks associated to the streams of future cash flows. Depending on the degree of risk, a proper required rate of return is determined to discount back the future streams of cash flows. Greater the risk larger will be the required rate of return and vice-versa.

The complexities involved in the fully integrated decision making analysis limit its use to major planning decisions. The decision process involved in both fully integrated and partial optimization problems takes place in two steps, one must apply various techniques to determine the optimal decision.

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Meaning of Managerial Economics | Difference between Managerial Economics and Traditional Economics

Managerial economics is an application of economic theory and method to practice the managerial decision-making or solving business problems. It uses the tools and techniques of economic analysis to solve managerial problems or to achieve the firm’s desired objectives. So that managerial economics is very important to entrepreneurs in decision making and forward planning of a business.

Managerial economics is economics applied in decision making. It is a branch of economics that serves as a link between abstract theory and managerial practice. It is based on economic analysis for identifying problems, organizing information and evaluating alternatives.

Managerial economics is by nature goal oriented and prescriptive and aims at maximum achievement of objectives. Many economists and thinkers have given various definitions of managerial economics in their words. According to Prof. Pappas and Brigham, “Managerial economics is designed to provide a rigorous treatment of those aspects of economic theory and analysis that are most useful for managerial decision analysis.” They more added that, “Managerial economics is the application of economic theory and methodology to business administration practice. More specifically, managerial economic analysis and solve the managerial problems.”

In the words of Prof. D.C. Hague, “Managerial economics is a fundamental academic subject which seeks to understand and to analyze the problems of business decision making.” This definition states that it should be finalized the business problem for decision-making. 

Prof. Savage and Small defined as, “Managerial economics is concerned with business efficiency, the function of managerial economists being the efficient direction of business organization to make a productive enterprises out of material and human resources.”

In the words of Hynes, “Managerial economics is the study of allocation of resources available to a firm among the activities of that unit.” Managerial economics is the integration of economic theory with business practice for the purpose of facilitating decision-making and forward planning by management.

Most of the definitions of managerial economics is related to decision making are more acceptable. Managerial economics is the science of decision making which provides a link between two disciplines that are economics and business management.

In short, the use of economic theory and methods to analyze and improve the managerial decision-making process combines the study of theory and practice to gain a useful and practical perspective. From both economics and decision sciences, managerial economics provides an integrative and comprehensive framework for solving managerial decision.

Managerial economics links traditional economics with the decision sciences to develop important tools for managerial decision-making. Although managerial economics is comparatively a new subject in the early part of 1950s, it was known as business economics in the beginning. The term of managerial economics gradually has become popular and displaced the business economics.

It is closely related to traditional economics that is based on the theories and principles such as demand analysis, production analysis, price theories and practice, theory of profit and market structure which are the subject matter of micro economic theory. But there is little bit differences between managerial economic and traditional economic theory because managerial economics seeks the help of other disciplines such as accounting, management, statistics, mathematics to get optimal solutions to the decision problems.

The difference between managerial economics and traditional economics can be summarized as follows:
Managerial EconomicsTraditional Economics
  • Managerial economics concerns with the application of economic principles to the problems of the firm.
  • Managerial economics is only microeconomics in character. It studies the problems of a firm but it does not concern with the individual unit. It does not also study the macroeconomic phenomenon.
  • Only the theory of profit is studied in managerial economics. Because it is concerned primarily with entrepreneurial decision and value theory.
  • Managerial economics adopts, modifies and reformulates economic models to suit the specific conditions and serves the specific problem solving process and it also modifies and enlarges it.
  • Managerial economics introduces certain feedback such as objectives of the firm, multi-product nature of manufacture, behavioral constraints, environmental aspects, legal constraints, constraints on resources availability etc. It attempts to solve the real life, complex business problems with the aid of tool subjects, e.g., mathematics, statistics, econometrics, accounting, operation research and so on.
  • Traditional economics deals with the body to the principles itself.                                          
  • But traditional economics consists of both micro and macroeconomics. It studies the individual unit and the economy as a whole.
  • In traditional economics, the microeconomics is a branch under which are studied all the theories of factor pricing such as rent, wages, interest and profit.
  • Economic theory hypothesizes economic relationships and builds economic models and it also give the simplified model.
  • Economic theory makes certain assumptions, thus, embodying a combination of certain complexities assumed away in economic theory.                                                                                                                                                                                                                                                                                 

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