Economic decision making is based on five elements. First, we need to define what decisions we want to take. Second, we have to outline the choices. Third, a measurable objective must be defined. Fourth, we focus on only a small set of variables and finally, we have to define the relationship between those variables.
- Managerial economics is a way to make better decisions. Those decisions don't have to be about the monetary policy of the United States. They can be very personal decisions, like whether you should buy or rent an apartment. When you face such a decision in your life, your are confronted with many different questions, options, constraints, and variables. You can address this question from a psychological point of view. For example, which living situation would make you more happy? Traditional economists would not ask that question.
They would ask a simple question: is it cheaper to rent or to buy? Of course, you can counter-argue that the cheapest option might not be the one that makes you happy, and I'm sure you deserve to be happy, but whatever decisions you're going to make, it it still important to know whether it's cheaper to rent or to buy. Entrepreneurs face economic decisions all the time. I remember when my father started his own tortilla business. He was the only producer of flour tortillas in Switzerland. One of his specialities were tortillas in three different colors: red, white, and green, the colors of the Mexican flag.
When my father started his business, he had to decide whether he should hire a salesperson, whether he should pay commission to salespeople who would also sell other products to restaurant owners, or whether he should devote a part of his time to visit chefs and restaurant owners. Sometimes, like in the case of Netflix, some of the most innovative ideas are triggered by an economic dilemma. In 2011, Netflix realized that the licensing fee for their content was about to increase from 200 million per year to over two billion per year.
New market entrants such as Amazon Prime and Apple's iTunes Store were bidding for the same licenses for TV shows and movies. Netflix had to make a decision. Should they buy those expensive licenses? Should they accept a less attractive program? Or should they try to make their own series? Most of you will know that they went for option three. Netflix invested $100 million to produce House of Cards, which was a huge success in almost every dimension.
Using these three examples as a starting point, let's define the common elements of economic decisions. First, we need to define what decision we wanna take. Second, we have to clearly outline at least two choices or alternatives. Third, we need to define a measurable objective. Fourth, we have to define a small set of variables that we are going to use for our analysis. Finally, we need to have a theory of how the different variables are related.
We can illustrate these five elements by looking at my father's sales approach. First, what is the decision he has to take? The question is whether he should hire a salesperson or not. Second, his choices are hire a salesperson, pay someone a commission, or do it by himself. The measurable objective could be revenues minus sales cost. However, this might affect the decision, because he wouldn't pay a salary to himself. But if he took over the sales function, he would probably need to hire someone for the production.
Therefore, the best measurable objective is overall profitability of his firm. The most important input variables are revenues and total costs, which include salaries and commissions. Finally, the relationship between the objective profitability and revenues and costs is straightforward. Given the small size of his business and his network among restaurant owners, he decided to take over the sales function by himself. It would have been too expensive to hire a fully dedicated salesperson.
I can imagine that some of you wonder whether managerial economics is really that simple. Indeed, economists are sometimes criticized for making a difficult problem too simple. However, the simplicity often helps to define a few variables that really matters. Forcing a group of decision maker to formalize the decision within the structure of these five elements often creates clarity and triggers an important discussion about what the heck is really going on.
- What are customers buying? (demand theory)
- What should we produce? (production theory)
- Which costs do I need to worry about now? (cost theory)
- What market am I in? (competition theory)
- What should we charge for it? (pricing theory)
To understand what managerial economics looks like in practice, Stefan explains how Google's auction-based advertising system employs the principles of game theory and how understanding this can help decision makers to outmaneuver their competitors.
- Using economics to solve business problems
- Understanding price elasticity
- Demand curve shifts
- Economics of scale vs. scope
- Break-even and what-if analysis
- Profit maximization
- Economics in action