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Managerial Economics: Lecture 3. Carlos A. Ulibarri Department of Management New Mexico Tech. Resource allocation problem. Allocate 3000 man hrs among fixed set of competing uses Choice of 6 alternative production plans lives saved per 1,000 man hrs.?. Q= lives saved, L = man hrs.
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Managerial Economics:Lecture 3 Carlos A. UlibarriDepartment of ManagementNew Mexico Tech
Resource allocation problem • Allocate 3000 man hrs among fixed set of competing uses • Choice of 6 alternative production plans lives saved per 1,000 man hrs.?
Q= lives saved, L = man hrs. • L=800, Q=2 -> (2/800)x1000=2.5 • L=1,300, Q=2 -> (2/1300)x1000=1.54 • L=700, Q =1 -> (1/700)x1000=1.43 • L=900, Q= 3 -> (3/900)x1000= 3.33 • L=800, Q= 4 -> (4/800)x1000=5.00 • L=500, Q= 1 -> (1/500)x1000=2.00
ranking • Apply 3,000 man hrs to highest valued uses. Economic efficiency => • Accept #5, #4, #1, #6 • Reject #2, #3 • P=MC= 2 lives per 1,000 man hrs • Illustrates how price is expressed in virtually any units, provided all costs-benefits are expressed in the same units.
Role of pricing • A well-functioning price system directs privately owned resources towards most efficient uses. • Prices motivate and coordinate • “discipline agents in economic life to provide their goods and services skillfully and cheaply” ~ Stigler
Price-taker? • Single seller faces an infinitely elastic demand curve • Single buyer faces an infinitely elastic supply curve • At the other extreme, agents possess some degree of market power • monopoly seller • Monopsony buyer
Market competition • Large number of well-informed market participants disciplines agents, diffusing the market power of any one buyer or seller.
Market power? • barriers to entry, or increasing returns to scale can confer monopoly market power. • Theory of the natural monopoly: • technological possibilities result in significant economies-of-scale • Unit costs of activity fall continuously over the relevant range of market demand
example • P=$16 X < 100; P=0 X > 100 • Fixed cost = $1,000, Variable cost = $5X • If x= 1, AC = 1,005; If x = 100 AC = 15 • Value-max solution: R-C =$100 • Note P> MC
External costs/benefits? • Negative or positive effects from an agent’s economic behavior not reflected in market prices. • Here again, P ≠ MC • Decision maker doesn’t take full account of the benefits-costs associated with their choices. • break
Revisiting Coase • If agent’s property rights are well-defined, and there are zero transaction costs then agents can bargain with one another to reach p=MV=MC.
Arrow: incomplete or missing markets • Agents cannot define property rights • Agents cannot arrange transactions • Agents lack information, knowledge • In these cases markets fail to assign meaningful prices, precluding transactions.
Search, matching and coordination problems • Akerloff ~ “markets for lemons” • Assume buyers cannot observe quality • MCH = $1.00 for high quality milk • MCL = $0.60 for low quality milk • WTPH = $1.20 for high quality milk • WTPL = $0.80 for low quality milk
Transaction prices? • If quality was observed, transactions would take place between • $0.60 and $0.80 for low quality • $1.00 and $1.20 for high quality • What happens when quality cannot be observed?
Cont. • With quality unobservable the goods would sell at the same price. • Suppose buyers believe 60% of the producers water down their milk. How much would they be WTP on average?
Cont. • .60($0.80)+.40($1.20) = $.96 on avg • But since it costs $1.00 to mfg the high quality product, Gresham’s law applies: “low quality goods drive out high quality goods from the market.”
Stigler and search cost • “Price dispersion (non-uniformity of price) for a homogenous good is an indication of ignorance in the market.” • In a well informed market, the price at one location will differ from the price at another by the transportation costs between the two.
Optimum search? • Up to the point where MC = MB, and MC varies by agent. • Search cost (MC) is proportional to the number of sellers canvassed • Savings (MB) will be greater the more frequent and larger the amount of expenditures on the commodity
summary • Agents rely on markets to satisfy myriad economic needs. • Yet, agents also use non-market organizational forms, e.g. a mfg setting up an IT department instead of outsourcing these services to a vendor. • break
Price system within business organization? • Multidivisional firm: divisions assume responsibility for a given product, market region or technology. • The more decentralized the org structure, the greater autonomy given to divisions over R&D, design, engineering, procurement, personnel, mfg, marketing and sales.
Defining divisions • Defense product divisions • ( customer-defined) • Biotech division • (technology-defined) • International division • (geographically-defined) • Other divisions may be product-based
Transfer prices • Pricing goods and services that are transferred within organizations, e.g. “integrated petroleum company” • Production -> transportation -> refining • Two transfer prices • Transfer prices determine cost-revenue performance of divisions
Transfer pricing • … if the product or service is equivalent to one sold in the market then the division should set a market-based transfer price • …if the product or service is specialized then the division should set a cost-based transfer price
shortcomings • Internal pricing is prone to ad-hoc manipulation, e.g. assigning overhead costs to products with inelastic internal demand (i.e. no alternative source of supply), thus inflating the margin on other products.