The basis of successful management is the effective practice of decision-making. Effective decision-making occurs by accident rarely enough to make these decision-makers legendary — the exceptions that prove the rule. In the majority of successful organisations (and the organisations most likely to be durable), effective decision-making must build upon the firm foundations of training and experience.
Economists have at their disposal a set of techniques that can be applied to particular decision problems. Whilst these techniques are powerful, they may also be restrictive in the sense of only being applicable in clearly defined specific circumstances. Much more fundamental are a range of concepts which can be called decisiontools. The purpose of this chapter is to introduce these general concepts which provide the basic foundation on which economic decision-making is built. In a sense this chapter, together with Chapter 1, are the most important in the book since an understanding of these concepts taken with the basic framework of decision-making should enable decision-making to be transformed to a scientific level.
‘A business firm is an organisation designed to make profits, and profits are the primary measures of its success. Social criteria of business performance usually relate to quality of products, rate of progress and behaviour of prices. But these are tests of the desirability of the whole profit system. Within that system, profits are the acid test of the individual firm’s performance.’1
A fundamental problem for all decision-makers is the absence of complete information about the decision environment. If all possible actions, events and conditional outcomes could be predicted with complete confidence, then decision-making would be the simple mechanical exercise of calculating the optimal action according to some predetermined criteria. In practice, of course, the decision environment is characterised by uncertainty — or the absence of perfect and complete information. Decisions must be made on the basis of estimates and expectations, the former of which may be inaccurate, whilst the latter are often unfulfilled. The ‘art’ of management cannot be replaced by the ‘science’ of decision theory. What decision theory can do is to give structure to the decision-making process in a manner that focuses attention on the decision variables that are most important, so that resources can be devoted to their estimation. At the same time, a well-formulated decision model will not only provide a solution guide, it will also include some measure of the sensitivity of solutions to the estimated variables.
In a commercial environment, the success of the organisation is dependent on its ability to produce the goods customers want, and sell them at a price customers are prepared to pay. A knowledge of the firm’s demand conditions is then essential decision information, controlling the decisions of what and how much to produce, as well as the more obvious marketing decisions such as price and advertising. New investment decisions, whether to replace equipment, the quantity of labour to employ, are each related to the anticipated level of sales. It is then vital that the decision-maker understands the relationship between the likely level of sales and the internal and external variables that influence sales. Moreover, any decision involves a comparison of the anticipated costs and benefits of following a particular action. In the business context, the benefits from that action are usually expressed in the form of revenues.
The previous chapter took a close look at demand theory and estimation, on the grounds that decision-making requires careful consideration of the likely benefits of any action, usually expressed in terms of revenue. The other side of the decision equation is evaluation of the costs of an action, to which the benefits can be compared. It is to the costs that we now turn, using as a starting point the economic analysis of production. The primary activity of any commercial organisation is the transformation of inputs into outputs. It is this transformation process that now concerns us. In a general sense ‘production includes all economic activity, other than ultimate consumption’.1
The motivation in considering the theory and estimation of costs is to provide cost estimates that are relevant to decision-making. Optimal decision-making requires the careful comparison of the costs and benefits of any action. In evaluating these costs, it is essential to have regard to the cost concept relevant to decision-making. The adoption of any particular course of action or the use of any resource imposes a cost in terms of opportunities foregone. It is this opportunity cost which is the relevant cost concept in deciding on a particular course of action.
Whilst demand and cost information are crucial to the firm’s decision-making process, the extent and nature of competition define the external environment in which the firm operates. An understanding of this competitive environment will enable cost and demand analysis to be put together to determine an economic theory of the firm, which can offer significant insights into the decision-making process. Each and every business decision must be made in the light of anticipations about competitors’ actions and reactions. The extent of competition influences the nature of both cost and demand conditions. Moreover, the competitive environment defines the discretion that the firm’s managers have over pricing, marketing, input purchase and other decisions. An understanding of that decision environment is essential for both describing the limitations of market behaviour, and analysing the opportunities available in the market. The competitive environment is not stable, but rather is continuously changing. The relationship of the firm to its environment is both reactive and proactive — reactive in that the firm must respond to changes in that environment, and proactive in that the firm, by a judicious choice of policies, may influence that environment in ways that can increase the market opportunities available.
Pricing is a decision area which draws together contributions from the theories of demand, cost and market structure. The pricing decision has been the major focus of economic theory in the analysis of resource allocation, but its position in managerial economics is more limited. In the analysis of business decision-making, pricing is just one element in a comprehensive competitive strategy. Moreover, the pricing decision is a means to an end, and not the end in itself, so that decisions about price must be considered in the context of overall business objectives. As we shall see, price is a strategic as well as an operational variable, so that pricing decisions can have a profound effect on future as well as present performance. Because of this time dimension, pricing objectives need to be carefully defined. For example, setting a low current price may be an optimal decision if the consequent establishment of a dominant market position leads to long-run profits sufficient to outweigh any short-run profit sacrifice.
According to this definition, the purpose of marketing is to translate the buying ability of consumers into sales of the firm’s products. Marketing decisions are concerned with the allocation of resources to this effort, and the effective utilisation of these resources. In practice, marketing decisions encompass decisions about market segmentation, product quality and design, the choice of distribution channels, corporate image-building, advertising budgets, sales promotions, etc. — that is, all the firm’s decisions which can be expected to have an impact upon present and future sales. In this sense, marketing decisions cannot be divorced from the output, price and competitive strategy decisions discussed in previous chapters. Thus marketing decisions, like all business decisions, need to be considered within the overall context of company strategy and objectives.
Inventories are the physical stocks held by the firm, and may include raw materials, components, spare parts, work in progress and finished goods. Inventories appear on the company balance sheet as a current asset, and may form a substantial proportion of the value of the firm. From a managerial perspective, large stock-holdings may prove to be more of a liability than an asset, with the high costs of carrying stock being a primary reason for many business failures.
In Chapter 6 we saw that the profit maximising firm will choose the particular input combination that minimises the cost of output, determined by the productivity of inputs and their relative prices. Later chapters have considered the relationship of the firm to its competitive environment in terms of output, price and marketing decisions. It is now time to take a step back, and examine the competitive environment surrounding input purchase decisions, and in particular the special problems and opportunities encountered in the employment and deployment of labour.
Previous chapters have considered the shorter term operational decisions of the firm, such as price, output and advertising decisions, with the occasional look at the longer term implications of those decisions. It is now necessary to examine explicitly the longer term strategic decisions that affect the future viability of the organisation: including financing, growth and investment decisions. In doing so, the emphasis of our attention will shift from the optimal allocation of existing resources to the determination of an optimal level of current and future resources.
The necessary conclusion to any book on decision-making must be that the theory of decisions needs to be combined with practical experience before it can become operationally useful. This may seem a meagre reward for the effort involved in reaching this far — but any higher expectations are the result of a false illusion. This book is not a do-it-yourself guide to company chairmanship, but the embodiment of a belief that a logical and structured approach to decision problems, taking proper cognisance of the realistic constraints imposed by the decision environment, will ultimately lead to better decisions.
