People have long made condescending declarations that theories do not have any practical application to real world problems. But, the problem with people who make comments such as those is that they have not learned how to properly use theories to aid in breaking down real world processes. Profitable solutions usually require that people understand how the real world functions, which is often far too complex to comprehend without making the simplifying assumptions used in theories (Thomas and Maurice, 2011, p. 3).
Economic theories allow us to make the complex a little less complicated by using the streamlined hypotheses that the theories provide. In this sense, managers can use an economic way of thinking about business problems to make predictions and explanations that are valid in the real world, even though the theory may ignore many of the actual characteristics of the real world (Thomas and Maurice, 2011, p. 4). Supply and demand is perhaps one of the most fundamental concepts of economics and is considered the backbone of a market economy (Investopedia, 2011, 1).
With the simplicity of the laws of supply and demand, it is widely used by highly experienced market analysts and forecasters to make decisions that can greatly affect the profitability of a business (Thomas and Maurice, 2011, p. 36). Although the general concept of supply and demand is usually thought of when referring to consumer goods and services, it is also applied to other areas for resources such as labor, raw materials, and capital equipment.
There are six principal variables that influence the quantity demanded of goods and services: the price of the good or service, the incomes of consumers, the prices of related goods and services, the tastes or preference patterns of consumers, the expected price of the product in future periods, and the number of consumers in the market (Thomas and Maurice, 2011, p. 37).
The law of demand states that quantity demanded increases when price falls and quantity demanded decreases when price rises, other things held constant. Economists refer to the inverse relation between price and quantity demanded as a law, not because this relation has been proved mathematically but because examples to the contrary have never been observed (Thomas and Maurice, 2011, p. 45).
Similar to demand, the quantity, or supply, of a good offered for sale depends on six major variables: the price of the good itself, the prices of the inputs used to produce the good, the prices of goods related in production, the level of available technology, the expectations of the producers concerning the future price of the good, and the number of firms or the amount of productive capacity in the industry (Thomas and Maurice, 2011, p. 0). In both these functions, all of the variables interact jointly to determine both the quantities demanded and the quantities supplied. The illustration below demonstrates the correlation between the demand and supply of a particular good, and the effects that a shift in those variables can have on the price and quantity of the good. These theories can be easily applied to what is happening in nearly every profession right now in America.
The economic depression is causing everyone to suffer, of course some less than others, but none the less, the entire market is being stifled. There is a general reduction in demand for nearly everything as the entire demand decreases with cutbacks on spending, while the human resource supply constantly rises as new personnel enter the market stream every day. The economic value of every specific unit, or person in this case, would decrease as the supply increases (Maurice & Thomas, 2011, p. 5), unless the productive capacity of the firms was to decrease, which is not happening. This is causing a period of stagnation for many employees across the nation, while others are seeing a deflation, or undervaluation, of their employment positions. Any decision a manager makes could be considered the most advantageous if the result is truly the most ideal outcome available. Coming to that conclusion is the purpose of the optimization theories, more commonly referred to as the marginal analysis.
Managers benefit from understanding marginal analysis because it enables them to make better decisions while avoiding some rather common errors in business decision making (Maurice & Thomas, 2011, p. 87). People instinctively make these types of commonsense decisions in everyday life, but without all of the imposing analysis that usually comes with grandiose strategic and tactical business decisions. Optimizing behavior on the part of a decision maker involves trying to maximize or minimize an objective function (Maurice & Thomas, 2011, p. 7).
These theories are utilized by managers to analyze how a change in activity for the organization would affect the costs and benefits accordingly to the actions of the adjustments. The level of activity that maximizes net benefit is called the optimal level of activity, and is strived for in every optimization function. However, the most essential purpose for learning the proper use of the marginal analysis is because economists regard it as “the central organizing principle of economic theory” (Maurice & Thomas, 2011, p. 92).
Utilizing these theories and understanding the economic approach to business will allow us to reduce business problems to their most essential attributes, simplifying analysis, and allowing those who utilize them to reach profitable solutions. Those who follow sound economic rules by calculating the net benefits of alternative courses of action, writing off past costs that can’t be recovered, and weighing the opportunity to use future time and effort more profitably elsewhere, can provide confident information to cut their losses and ensure profitability (Otten, 1992).