Managerial Economics: Lecture 4 Carlos A. Ulibarri Department of Management New Mexico Tech

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

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.

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

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

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

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 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)

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)

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.

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.

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

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

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

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)