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. 1. L=800, Q=2 -> (2/800)x1000= L=1,300, Q=2 -> (2/1300)x1000= L=700, Q =1 -> (1/700)x1000= L=900, Q= 3 -> (3/900)x1000= L=800, Q= 4 -> (4/800)x1000= 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=$16X 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.

Search and the market price N$200$300Expected min price 11-(1-p) 1 =. 5(1-p) 1=. 5$ (1-p) 2=.75(1-p) 2=. 25$ (1-p) 3=.875(1-p) 3=. 125$ ∞10$200

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.