Finance and Economics

The relevance of economics to financial management can be described in the light of the two broad areas of economics: macroeconomics and microeconomics.

Macroeconomics is concerned with the overall institutional environment in which the firm operates. It looks at the economy as a whole. Macroeconomics is concerned with the institutional structure of the banking system, money and capital markets, financial intermediaries, monetary, credit and fiscal policies and economic” policies dealing with, and controlling level of, atrocity within an economy. Since business firms operate in the macroeconomic environment, it is important for financial managers to understand the broad economic environment. Specifically, they should (1) recognize and understand how monetary policy affects the cost and the availability of funds; (2) be versed in fiscal policy and its effects on the economy; (3) be ware of the various
financial institutions/financing outlets; (4) understand the consequences of various levels of economic activity and changes in economic policy for their decision environment and so on.

Microeconomics deals with the economic decisions of individuals and organisations. It concerns it<elf with the determination of optimal operating strategies. In Other words, the theories ‘Of microeconomics provide for effective operations of business firms. They are concerned with defining actions that will permit the firms to achieve success. The concepts and theories of microeconomics relevant to financial management are, for in. Jounce,those involving (1) supply and demand relationships and profit maximization strategy, (2) issues related to the mix of productive factors. ‘optimal’ sales level and product pricing strategies, 3) measurement of utility preference, risk and the determination of value, and (4) the rationale of depreciating assets. In addition, the primary principle that applies in financial management is marginal analysis; it suggests that financial decisions should he made on the basis of comparison of ‘marginal revenue and marginal! cost. Such decisions will lead to an increase in profits of the firm. It is, therefore, important that financial managers must be familiar with basic microeconomics.

To illustrate. the financial manager of a department ‘Store is contemplating to replace one of its online computers with a new, more sophisticated one that would both speed up processing time and handle a large volume of transactions. The new computer would require a cash outlay of Rs 8,00;000 and the old computer could be sold to net Rs 2,80,000. The total benefits from the new computer and the old computer would be Rs 10,00,000 and R.s 3,50,000 respectively. Applying marginal analysis, we get:


As the store would get a net benefit of Rs 1,30,000, the old computer should, be replaced by the new one

Thus, a knowledge of economics is necessary for a financial manager to understand both the financial environment and the decision theories which underline contemporary financial management. He should he familiar with these two areas of economics. Macroeconomics provides the financial manager with an insight into policies by which economic activity is controlled. Operating within that institutional framework, the financial manager draws on macroeconomic theories of the operation of firms and profit maximization. A basic knowledge of economics is, therefore, necessary to understand both the environment and the decision techniques of financial management.

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