Every organization faces numerous problems and challenges. Some of them are minor, the others are crucial. Many come as a part of the company’s planning process, and some are brought due to certain new opportunities. Whatever they are, decision-making process lies at the very core.
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It is always a delicate balance between a desire to maximize company’s revenue and success and an increased risk to make things worse. Managerial economics ‘largely uses the body of economic concepts and principles’, which can help to make a decision making easier by considering such factors as supply and demand, cost-benefit, market structure, efficiency and others (Atmanand 2009, p. 11).
In this paper, I will describe and analyze according to managerial economics concepts a challenge that an organization I have worked in once faced.
A Challenge Description
A pharmaceutical company faces a significant research and development decision (so-called R&D). To get a new drug to merchandise, a company has to invest in medical research. Moreover, the firm can choose between two different research approaches and, accordingly, get either low fixed costs and high variable costs or vice versa.
Why is This Decision Complicated?
In the situation described above, a decision that needs to be taken is whether to commercialize the research or not. Besides, if the company does decide to invest, which approach should it choose?
The biggest difficulty here is a period of time since nobody can be sure when the research would be completed – it can take a decade or even more. Besides, no guarantees about the outcomes can be made because all efforts still can come to nothing.
Moreover, ‘even after significant investment and results the launch of a firm’s product in a market is not certain … because the Food and Drug Administration (FDA) … can approve or reject a firms petition to launch in the market’ (Rao 2014, p. 2). There are also other factors to take into consideration, such as the market value of a future product and the costs of the research. Additionally to the question of costs, there is a dilemma about fixed and variable expenses.
Six Steps of Managerial Economics
To understand this problem better and find an adequate solution, let us define six steps of a decision-making process of managerial economics.
Defining a Problem
The first step is determining a question and clarifying a decision that has to be made. According to Samuelson and Marks (2012, p. 6), at this stage, it is important to answer the following questions: ‘What is the problem the manager faces? Who is the decision maker? What is the decision setting or context, and how does it influence managerial objectives or options?’.
The problem is already accurately described above. It is whether to invest or not and what exactly approach to choose. The decision maker is a director of the company. Finally, this issue has a direct impact on business objectives and options because if the company does not invest, it has to find alternative ways to get a new product to market.
Defining the Objective
At the second step, an organization has to determine precisely its goals and objectives, as well as consider possible outcomes (Samuelson and Marks 2012, p. 7). The goal of the pharmaceutical company, first of all, is to succeed and increase its revenue. Since the pharmaceutical industry is ‘fundamentally based in research and development (R&D)’, for this purpose, an organization is planning to commercialize a particular study and get a unique and brand new product to sell (Schweitzer 2007, p. 21).
There are three major outcomes here: research does not succeed at all, it succeeds but does not meet the company’s demands (such as the period of time or the quality of an end-product), or the result of the research satisfies the company completely. Consequently, the R&D decision can become either a valuable investment (in a varying degree) or a waste of the company’s budget.
Finding and Exploring the Alternatives
Investments are always the ‘trade-offs between present and future benefits and costs’ (Samuelson and Marks 2012, p. 8). Commercializing the project means sacrificing profits today in order to get possible greater benefits in several years (from 5 to 10 in this case). Hence, it is the main alternative – to get the profit quicker, but less of it.
At this step, a decision maker should also determine the variables that are under his or her control (Samuelson and Marks 2012, p. 9). The research outcome is unpredictable while earnings that can be made in not so distant future are more accurate and specific. On the other hand, without a new product to sell a drug company usually gets only average incomes.
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Besides the biggest dilemma, there are also several others. For example, if an organization decides to invest, it, in its turn, brings a lot of alternatives, such as the sphere of investigation, the expenses of the research, a firm or company to invest in and so on. An organization has different options, actually: considering a biochemical R&D program, biogenetic program, etc.
Samuelson and Marks (2012, p. 9) state that ‘most managerial decisions involve more than a once-and-for-all choice from among a set of options’, and that is true. To increase its chances, the company can pursue various programs at the same time or in sequence. There is also an option to invest in several programs but commercialize the one that turns up to be more promising after some time of observation. The last alternative is about fixed and variable costs. Besides, an organization can always conduct research in-house if it has enough facilities and resources for that.
Predicting the Consequences
The obvious next step is building a model based on the impact every possible company’s decision will have on its regular work. In case the pharmaceutical firm does not invest at all and can not conduct its own in-house research, it has no chances to provide a new drug; therefore, there is a risk of business decline.
On the other hand, if it invests and loses the money (entirely or partly), this will hit on the budget. A situation in which the company focuses on several projects either to invest in them simultaneously or to supply both of those and then commercialize the most promising one has the least adverse effects in the future.
The last consequence to predict is the one of choosing fixed and variable expenses. According to Sexton (2015, p. 296), ‘fixed costs are those costs that do not vary with the level of output’. Variable costs, respectively, depend on the company’s production volume. Therefore, by choosing small variable costs, the drug company will be in pole position if the research succeeds.
On the other hand, if an investigation comes to nothing or does not meet the company’s demands completely, an organization can minimize the negative impact of that by choosing low fixed costs. Besides, this decision should depend on the ratio between the costs needed to produce the drug and its price on the market. The demand for an end-product should also be taken into consideration.
Making a Choice
According to Samuelson and Marks (2012. p. 11), ‘this step (along with step 4) occupies the lion’s share of the analysis and discussion’. When all possible outcomes and their impacts on business are already predicted, a decision maker can determine a preferred course of action. So, the pharmaceutical company chooses the research approach with low variable costs. Besides, it also decides to conduct its own study.
Performing Sensitivity Analysis
‘In tackling and solving a decision problem, it is important to understand and be able to explain to others the “why” of your decision’ (Samuelson & Marks 2012, p. 12). Firstly, the drug company considers the R&D productivity, which can be defined ‘as the relationship between the value (medical and commercial) created by a new medicine… and the investments required to generate that medicine’ (Paul et al. 2010, p. 204).
Since the research the company is going to invest in is aimed to develop a medication to dissolve blood clots, it has high both medical and commercial value. Secondly, to minimize its risks in case the research does not succeed, an organization chooses low fixed costs. Finally, as far as the company has enough recourses to do this, it also decides to conduct the in-house research as well. So, all possible risks are calculated and prevented, and the decision is adequate.
Atmanand. 2009. Managerial Economics. 2nd ed. New Delhi: Excel Books India.
Paul, S. M., Mytelka, D. S., Dunwiddie, C. T., Persinger, C. C., Munos, B. H., Lindborg, S. R. & Schacht, A. R. (2010) How to improve R&D productivity: the pharmaceutical industry’s grand challenge. Nature Reviews Drug Discovery. 9, pp.203-214.
Rao, A. 2014. Entry and Investment Decisions in the Pharmaceutical Industry Web.
Samuelson, W. F. & Marks S. G. 2012. Managerial Economics. 7th ed. Hoboken: John Wiley & Sons.
Schweitzer, S. O. 2007. Pharmaceutical Economics and Policy. Oxford: Oxford University Press.
Sexton, R. 2015. Exploring Economics. 7th ed. Boston: Cengage Learning.