Managerial Economics: Lecture 4

1. Managerial Economics:Lecture 4 Carlos A. UlibarriDepartment of ManagementNew Mexico Tech

2. Arrow on organizations • Transactions within organizations arise when they are most efficient way of coordinating activities and motivating agents to carry out activities.

3. Agent decision-making • Senior Mgt: raise capital, allocate resources among divisions, monitor performance, set policy/strategy. • Division Mgt: product R&D choice, mfg operations choice, equipment procurement choice. • Decisions should be made at levels where information resides and actual operations take place.

4. principles • Choose coordination/motivation system which maximizes net benefits from transactions. • Assumes information on benefits-costs

5. Coordination: price or qnty? • i) specify marginal value of an activity price-signal. • ii) specify level of an activity quantity signal

6. Information is key With complete information (marginal benefits and costs) an efficient decision outcome results from either i or ii. With incomplete information slopes of marginal benefit-cost functions determine which approach maximizes net benefits. See overheads

7. 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.

8. Defining divisions • Defense product divisions • ( customer-defined) • Biotech division • (technology-defined) • International division • (geographically-defined) • Other divisions may be product-based

9. Transfer prices • Coordinate movement of product-services within firm • Pricing products-services within firm, e.g. “integrated petroleum company” • Production -> transportation -> refining • Two transfer prices (P1, P2) • Transfer prices determine cost-revenue performance of divisions (P1X, P2X)

10. 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 product-service is specialized then the division should develop internal cost estimates to set transfer price (cost-based transfer price)

11. 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.

12. economies of scope • reducing TC by designing and mfg a “group” of products within a firm as opposed to them being produced separately by independent firms.

13. core competency • firm’s ability to design-mfg a certain product (or group of products).

14. complementarity • let Xi be the level at which activity i is conducted, and π(xi) the resulting profits. • increasing activity level xj raises marginal profits from activity xi • See overhead

15. Modern mfg strategy • Applies to multi-product firm with focus on quality leadership/product innovation • Illustrates concept of complementarities across decisions • Product design choice • Mfg plant & equipment choice • Mfg & inventory policy

16. Modern mfg strategy cont. • Demand for specific product is relatively small. • frequent product redesign • Small mfg batch size • Short production runs • Economies in inventory holding • Flexible plant & equipment (Ford’s new Chicago plant)