Managerial Economics: Lecture 5

1. Managerial Economics:Lecture 5 Carlos A. UlibarriDepartment of ManagementNew Mexico Tech

2. 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 1’000s. • Vertical axis P ~ dollars per unit ($/Q).

3. 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.

4. Overhead 1

5. 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.

6. Overhead 2

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

8. 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.

9. 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?

10. 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.

11. Overhead 3

12. break

13. product launchQ#2, 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:

14. 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: • C1=3(12-t) • C2=4(12-t) • C3=5(12-t)

15. 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 firm’s 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?

16. 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 t*=6)?