Managerial Economics: Lecture 5

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Managerial EconomicsLecture 5

• Carlos A. UlibarriDepartment of ManagementNew
  Mexico Tech

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efficiency loss from decision-making with
incomplete information

• Measured as a welfare loss triangle in the
  marginal benefit (MB) - marginal cost (MC)
  diagram.
• Horizontal axis Q No. of units per day in
  1000s.
• Vertical axis P dollars per unit (/Q).

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quantity-setting

• Qnty Qo based on over-estimate of MC, say
  E(MC).
• Allocation decision under incomplete information
  at point b, on the actual marginal cost curve
  (MCa).
• Efficiency loss ?abc, since MB remains greater
  than actual marginal cost.
• See overhead.

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Overhead 1
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price-setting

• Price Po based on overestimate of MC.
• Allocation decision under incomplete information
  at point f, on the actual marginal cost curve
  (MCa).
• Efficiency loss ?cfe, since actual marginal
  cost exceed marginal benefit.
• See overhead.

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Overhead 2
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comparing efficiency of decisions

• Whether Q or P signaling is most efficient
  depends on the relative slopes of the MB and MC
  curves.

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decentralized v centralized decision-making
under uncertainty
Decentralized decision-making localized at each
division (risk coordination failure?)
Centralized decision-making localized
information from each division must be
communicated to HQ, where centralized decision is
made.
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question 1 p. 120 P. Milgrom J. Roberts

• Assume division 1 supplies an input to division
  2. Division 1 has complete information over
  its marginal cost MC1.
• At division 2 there is incomplete information,
  i.e. the marginal benefit from using the input is
  uncertain.
• What quantity of the input will be produced-used
  if quantity setting is applied in allocating the
  input?
• What quantity of the input will be produced-used
  if price setting is applied in allocating the
  input?

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underestimation of marginal benefit

• Under qnty-setting at Qo division 1 supplies Qo
  units of the input at marginal cost MC1.
  Division 2 uses the input at expected marginal
  benefits E(MB) MC1. Efficiency loss ?abc
  since actual MB MC1.

• Under price-setting at Po, division 1 supplies
  Q2 units of the input at marginal cost MC2.
  Division 2 uses this quantity of the input,
  resulting in an efficiency loss ?ade, since
  actual MB MC2.

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Overhead 3
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break
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product launchQ2, p. 120 Milgrom and Roberts

• New product introduced in competition with
  another form. HQ estimates there is 1st mover
  advantage, as represented by winner-take-all
  profits

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3 divisions must coordinate

• Div 1 ABQ Socorro Dept A (mfg component)
• Div 2 Socorro Dept B (mfg finished product)
• Div 3 All other off-site Depts.
  (transport/distribute)
• Each division incurs sunk costs preparing for
  launch
• C13(12-t)
• C24(12-t)
• C35(12-t)

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questions

• 1. What is the optimal launch time and
  corresponding level of net profits?
• 2. What are your divisions sunk costs?
• 3. What will be the firms level of net profits
  if divisions 1 and 3 meet the optimal target
  date, while division 2 is pushed into being ready
  one month beforehand?

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Questions cont.

• 4. Does a small timing error in division 2 yield
  a larger loss than a centralized timing error of
  the same magnitude (e.g. t 5 instead of t6)?