For this assignment, choose a major publicly traded automotive producer, such as
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Question
For this assignment, choose a major publicly traded automotive producer, such as General Motors, Ford, Toyota, or Volkswagen. Then, research this companyExplanation / Answer
The Big Three, when used in relation to the automotive industry, most generally refers to the three major American automotive companies: Ford, General Motors, and Chrysler.[1] The term is also sometimes used in relation to the three major automakers of other countries. Ford, General Motors, and Chrysler are often referred to as the "Big Three" or, more recently the "Detroit Three",[2] being the largest automakers in the United States and Canada. They were for a while the largest in the world and two of them are still a mainstay in the top five. Ford has held the position of second-ranked automaker for the past 56 years, being relegated to third in North American sales, after being overtaken by Toyota in 2007. That year, Toyota produced more vehicles than GM, though GM still outsold Toyota that year, giving GM 77 consecutive calendar years of top sales. For the first quarter of 2008, however, Toyota overtook GM in sales as well.[3][4] In the North American market, the Detroit automakers retained the top three spots, though their market share is dwindling.[5] Honda passed Chrysler for the fourth spot in 2008 US sales.[6][7] Since then, because of Toyota's woes with their recent unintended acceleration recall, Toyota has fallen back to fourth place in sales, with Honda trailing in fifth place, allowing the Detroit Three reclaim their Big Three title. The Big Three are also distinguished not just by their size and geography, but also by their business model. The majority of their operations are unionized (United Auto Workers and Canadian Auto Workers), resulting in higher labor costs than other multinational automakers, including those with plants in North America.[8] The 2005 Harbour Report estimated that Toyota's lead in labour productivity amounted to a cost advantage of $350 US to $500 US per vehicle over American manufacturers.[2] The UAW agreed to a two-tier wage in recent 2007 negotiations, something which the CAW has so far refused.[9] Delphi, which was spun off from GM in 1999, filed for Chapter 11 bankruptcy after the UAW refused to cut their wages and GM is expected to be liable for a $7 billion shortfall.[10][11][12] In order to improve profits, the Detroit automakers made deals with unions to reduce wages while making pension and health care commitments. GM, for instance, at one time picked up the entire cost of funding health insurance premiums of its employees, their survivors and GM retirees, as the US did not have a universal health care system.[13] With most of these plans chronically underfunded in the late 1990s, the companies have tried to provide retirement packages to older workers, and made agreements with the UAW to transfer pension obligations to an independent trust.[14] In 2009, the CBC reported that the non-unionized Japanese automakers, with their younger American workforces and fewer retirees will continue to enjoy a cost advantage over the Big Three.[2] Despite the history of their marques, many long running cars have been discontinued or relegated to fleet sales[15] [16] ,[17] as the Big Three shifted away resources from midsize and compact cars to lead the "SUV Craze". Since the late 1990s, over half of their profits have come from light trucks and SUVs, while they often could not break even on compact cars unless the buyer chose options. [18] Ron Harbour, in releasing the Oliver Wyman’s 2008 Harbour Report, stated that many small “econoboxes” of the past acted as loss leaders, but were designed to bring customers to the brand in the hopes they would stay loyal and move up to more profitable models. The report estimated that an automaker needed to sell ten small cars to make the same profit as one big vehicle, and that they had to produce small and mid-size cars profitably to succeed, something that the Detroit three had trouble doing.[19] SUV sales peaked in 1999 but have not returned to that level ever since, due to high gas prices. The Big Three have suffered from perceived inferior initial quality and reliability compared to their Japanese counterparts, which has been difficult to overcome. They have also been slow to bring new vehicles to the market, while the Japanese are also considered the leader at producing smaller, fuel-efficient cars.[2] Falling sales and market share have resulted in the Big Three's plants operating below capacity (GM's plants were at 85% in November 2005, well below the plants of its Asian competitors), leading to production cuts, plant closures and layoffs. They have been relying heavily on considerable incentives and subsidized leases to sell vehicles. which was crucial to keeping the plants running, which in turn drove a significant portion of the Michigan economy.[20] These promotional strategies, including rebates, employee pricing and 0% financing, have boosted sales but have also cut into profits. More importantly such promotions drain the automaker's cash reserves in the near term while in the long run the company suffers the stigma of selling vehicles because of low price instead of technical merit. Automakers have since been trying to scale back on incentives and raise prices, while cutting production. The subprime mortgage crisis and high oil prices in 2008 resulting in the plummeting popularity of best-selling trucks and SUVs, perhaps forcing automakers to continue offering heavy incentives to help clear excess inventory.[2][21] The Big Three sued California Governor Arnold Schwarzenegger to prevent a tailpipe emissions requirement. In response, Governor Schwarzenegger told the Big Three to "get off their butt".[22] In 2008, with high oil prices and a declining US economy due to the subprime mortgage crisis, the Big Three are rethinking their strategy, idling or converting light truck plants to make small cars.[8][23][24][25] Due to the declining residual value of their vehicles, Chrysler has stopped offering leases on its vehicles.[26] In 2009, General Motors and Chrysler filed for and emerged from Chapter 11 restructuring in the United States. General Motors of Canada did not file for bankruptcy. The United States and Canadian government control are reported as temporary. On June 10, 2009, Chrysler Group LLC emerged from a Chapter 11 reorganization bankruptcy and was sold to the Italian automaker Fiat.[27][28] On June 3, 2011, Fiat bought out the remaining U.S. Treasury’s stake in Chrysler for $500 million increasing its ownership of the automaker to 53%.[29] In April 2012, GM and Ford continued to lose market share as sales were down 8.2% and 5.3% year over year respectively.[30]. There have no independent car makers other than Ford, GM, and Chrysler since the last independent automaker, American Motors, was bought by Chrysler in 1987. The "Big Three" were also responsible for the infamous destruction of the Tucker Corporation in 1948. It is common knowledge that marketing has lately developed into a separate discipline that is being taught at universities now. When did it really come into existence? This century, last century, or in the Middle Ages? – Wrong on all three counts. The transfer of goods from one person to another was probably one of our earliest social acts. Whether through violence or barter, this transfer established that few people can satisfy all their desires alone. The inability to produce everything desired creates reliance on others for both necessities and luxuries. As societies grow more complex, so does the transfer of goods. The basic motive for trading is that someone has something you want more than what you already have. When that someone is willing to exchange what you want for what you have, a mutually satisfactory transaction can be arranged. Generally speaking, then, trade is the exchange of surplus items for shortages of items. The reasons for having surplus items range from geographic and resource variations to division and amount of labor, skill variation, and differences in taste. One group or person may create a surplus of some product in the hope of profitably exchanging it for other products. As society and production expanded, so did the limits of trade, the range of goods, and the distance between the traders. It became increasingly difficult for the producers to locate each other and arrange mutually satisfactory exchanges without the help of intermediaries or "middlemen." These intermediaries, in the role of bringing together interested parties, must perform a variety of tasks which can be called marketing. As defined by the American Marketing Association, marketing is "the performance of business activities directed toward, and incident to, the flow of goods and services from producer to consumer or user " Marketing, therefore, is made up of such physical activities as transporting, distributing, storing, and selling goods, and of the decisions which must be reached by individuals or groups who want to move goods from production to use. Of course, not all producers engage in every marketing activity. The local carpenter in Guatemala or the supermarket manager in Japan does not do product planning; most retail stores around the world have few or no storage facilities. However, most products are repeatedly subjected to all marketing operations. In addition to an analysis of these activities, marketing involves understanding the consumer circumstances and attitudes that determine why certain people want certain products. Marketing trends, activities, and organizations are constantly changing and developing. In the role of bringing together interested parties, the intermediary may also be involved in grading, financing, assembling, packaging, refining, or altering the form of the goods Indeed, a large portion of the working population in many countries is involved in some form of marketing. In West Germany today, for example, manufacturing and the marketing activities of retail and wholesale trade account for one-third of the national income, while twenty-five percent of the work force is engaged in full-time marketing activities. The contribution of marketing to society is a subject of controversy among economists. Contributions such as refining, transporting, assembling, and packaging are considered productive; speculating, storing, accepting commissions, and merchandising activities such as advertising are considered parasitic and of little value to society The general belief is that prime costs of distribution should be eliminated and supplemental cost excesses should be reduced. Supplementary costs of distribution such as packaging, storing, and selling are generally considered to be continuations of the production process, and are thus acceptable as an added value to the product. In the free enterprise system, the full range of marketing activities operates with little control. Other more controlled economies regulate and limit some of these functions. Capitalist economies do acknowledge that marketing has its excesses, as in cases where a product is stored for an undue period of time merely to raise the price. Consumerism has arisen out of a belief that consumers have rights which are often abused. People like consumer advocate Ralph Nader have fought to have laws enacted which would protect these rights. On the whole, however, functions can continue only if they perform a service and fulfill a need. If unnecessary marketing activities raise the cost of goods above that of the competition, the product will be priced out of the market. The corollary to this is that marketing functions will only produce a profit—the basic motive for doing business—if they provide a service worth the money. It is argued that almost all marketing activities thus contribute to the real value of a product. Whether or not this is true, the aim of this text is to explore those marketing activities and functions which do exist and which are practiced. The following questions face those involved in marketing: How should the product be designed? How should it be packaged? What retail and/or wholesale channels should be used? Is advertising advisable? If so, how much and what kinds? What prices should be set? Will it sell, and to whom? Although marketing activities have expanded tremendously in the past hundred years, there was little formal study of them until the past few decades. Today, there are many publications on the various aspects of marketing and colleges give courses and degrees in this field. Marketing research has developed into a highly specialized activity employing tens of thousands of people around the world. There is general agreement among marketing people that, in many cases and countries, marketing activities account for more than half the cost of the product to the consumer. In many countries, those engaged in marketing activities outnumber those engaged in manufacturing or production. We have noted that, in general, marketing directs the flow of goods and services from producers to consumers or users. Marketing is not confined to one particular type of economy; goods in all but the most primitive societies must be marketed. Indeed, a broader concept of marketing does not limit its application to business enterprises. Schools, hospitals, libraries, and many other services must also be marketed to be used. Marketing starts in a market, where individuals or organized groups who want to buy goods or services meet people who want to sell them. The buyers must have money to spend and a willingness to spend it, or a product or service they themselves are willing to trade. The sellers must have what the buyers want. The first step in marketing is to understand these groups. The marketers must determine the number of buyers, what they want to buy, how, when, and where they want to buy it, at what price and what they expect from it. Elaborate techniques of research have been developed to supply this information. Of course, marketers have to decide which needs they want to meet. A concept for a product or service may develop long before any marketing research is done, or it may be a response to identifying need. In part, at least, marketing determines what products and services are to be offered. Historically, marketing experts were supposed to sell any product in any way possible. The techniques of marketing research have now given marketers new ways to learn and analyze the needs and wants of consumers. They can now play a critical role in determining what—as well as how — to market. Most large companies now produce only what their market researchers tell them will profitably sell. All products were new at one time. Today, a product is new if it is unique—a "first"—or if it is new for the manufacturer who is entering the market to challenge the existing competition, or if it has had enough substantial design modifications to make it a new product issue. For the manufacturer, merchandising includes selecting the products to be produced; deciding on the size, appearance, form, and packaging; and "having the right goods at the right place at the right time at the right price." The product planners try to determine whether there will be a demand for a given product, and if so, how much. Marketing managers then, working closely with top management, integrate these predictions with an analysis of all the areas of the business which will be affected. Does the firm possess the capacity and the funds to enter into the new product area? What are the existing marketing strengths, skills, and resources? How strong is the competition? The commitment of a company's energies and funds may be far- reaching. Not only may substantial investments be required to develop and market new products, but contracts or even mergers with other firms may be necessary. Professional marketing managers know that appraising new products and changing an existing product line are ongoing processes. There are many motivations for constant surveillance of the product line. Scrutiny may reveal opportunities to increase sales by offering customers more functional products, greater convenience, more prestige, greater value, or some combination of these qualities. Volkswagen of Germany, for example, introduced three entirely new models in a few years in an attempt to fill the needs of a more affluent market seeking different qualities in an automobile. Additional products added to the line may reduce certain costs by more fully utilizing the firm's production or marketing capabilities. The airline which gets into the business of car rental for its passengers requires minimal extra cost while making fuller use of its personnel and company resources. At the same time, the existing sales pitch is easily integrated. Sometimes a new product will enhance those already in the line. Lipstick and nail polish sales rise when their manufacturers add perfume to the line, and libraries seem to lend more books when they also offer records, paintings, and films to the community. Regardless of the motivation for new or additional products, marketing managers must consider the full range of effects the products will have on the business. Prime considerations are the similarity of the proposed product to the existing product line of the company, the similarity to the competition's products, and the resources of the firm. Marketing people determine if the products are suitable for distribution through normal or existing channels. They ask if the regular sales methods are appropriate and if the new products can be linked to others in the line. They make whatever changes are necessary in the promotion or advertising policies, while carefully thinking out the costs of production and the final pricing. At one extreme, a new product will be sold to current customers by the existing sales force, using the distribution channels previously developed and the same price and advertising appeals. In this case, the only major question is whether or not the product will result in additional sales or merely siphon off sales from existing company products. Frozen vegetable marketers, for example, saw their products' sales rise with a proportionate dip in sales of their canned produce. But when the major soft drink manufacturers added low-calorie diet sodas to their line, new sales were generated without detriment to the existing line. In contrast, some new products appeal to previously untapped markets. When Pierre Cardin introduced its first products for women, the firm's marketers were presented with new and complex problems. Distribution channels were different, a specialized sales force was required and unfamiliar promotion and pricing problems arose. It is between these two extremes that most marketers find themselves. While pioneering is risky, some firms seek to develop and market radically new products. Trusting that, as leaders in a field, they will reap rewards for being first, some firms invest large sums on new product research and development. The failure rate for this approach is high, so not all companies have such inclinations. In a less expensive way, some firms monitor the product development of others to see if an item is demonstrably salable. Similar to this approach is the strategy wherein firms spend nothing on research and development and introduce products only into mature markets. This kind of business has low overhead and usually manufactures large volumes at low cost, relying on price as its only important sales advantage. After deciding to produce a product, the planners carefully weigh all of the input. Settling on a final design involves many processes, taking into account the style, fashion, quality, packaging, and complexity of the product. Marketing a new product is always a gamble, but information and planning greatly reduce the risk of failure. Cost of production that does change with changes in the quantity of output produced by a firm in the short run. Total variable cost is one part of total cost. The other is total fixed cost. Variable cost depends on the level of output. If a firm produces more output, then variable cost is greater. If a firm produces no output, then variable cost is zero. A cost measure directly related to total variable cost is average variable cost. Total variable cost is the opportunity cost incurred in the short-run production that depends on the quantity of output. As the name clearly implies, total variable cost is variable, it changes. If a firm produces a little output, then total variable cost is less. If a firm produces a lot of output, then total variable cost is more. A firm can avoid variable cost in the short run by reducing production to zero. This bit of information often comes in handy when the price received by a firm is so low that it falls short off covering variable cost at any positive quantity of production. As such, the firm might find it most "profitable" to cut losses by shutting down production and avoiding variable cost, until the price increases. Variable Inputs Total variable cost is usually, not always but usually, associated with inputs that are variable in the short run. For example, The Wacky Willy Company operates in the short run with labor (the workers) as a variable input and capital (the building and equipment) as a fixed input. The cost associated with labor is a prime candidate to be a variable cost. This includes hourly wage payments to the workers and any hourly fringe benefits paid on behalf of the workers. While labor is usually isolated as THE variable input in the short run, most short-run production has other variable inputs, too. The Wacky Willy Company uses an assortment of other variable inputs, all of which are part of variable cost--including cuddly cloth, squeezeably soft stuffing, and thread that make up the Stuffed Amigos; electricity needed to run the machinery; and boxes, plastic wrapping, and other packing materials used to ship the Stuffed Amigos to customers. When The Wacky Willy Company makes more Stuffed Amigos, they incur a greater cost for these variable inputs. The Cost of Stuffed Amigos Total Variable Cost Total Variable Cost The table to the right summarizes the total variable cost of producing Wacky Willy Stuffed Amigos. The left-hand column is the quantity of Stuffed Amigos coming off the assembly line each minute, ranging from 0 to 10. For reference, the right-hand column is the total cost of producing Stuffed Amigos, the combination of total variable and total fixed cost. The center column is the total variable cost of producing each quantity, which is exactly $0 if no Stuffed Amigos are produced and rises to $43 if 10 Stuffed Amigos are produced. This is the essence of variable cost. Greater production entails greater total variable cost. The most obvious point is that total variable cost increases with increased production. Producing more Stuffed Amigos means higher total variable cost. This makes sense. To produce more Stuffed Amigos, The Wacky Willy Company needs to hire more labor and buy more materials. Because these inputs incur a cost, total variable cost rises with extra production. Moreover, total variable cost is zero when no Stuffed Amigos are produced. The Wacky Willy Company incurs no variable cost when they employ no workers and buy no materials--their variable inputs. A last note is that the incremental increase in total variable cost is NOT the same for each quantity. In other words, total variable cost does not rise at a constant rate. This incremental change in total variable cost reflects marginal cost, a key concept in the short-run production and supply decision of a firm. The Total Variable Cost Curve Total Variable Cost Curve Total Variable Cost Curve The total variable cost curve graphically represents the relation between total variable cost incurred by a firm in the short-run product of a good or service and the quantity produced. The total variable cost curve (TVC) for Wacky Willy Stuffed Amigos production is illustrated in the graph to the right. Because total variable cost increases with the quantity produced, the total variable cost curve has a positive slope. The most striking feature of the total variable cost curve is its shape. The total variable cost curve emerges from the origin, then twists and turns its way to $43. This curve begins relatively steep, then flattens, before turning increasingly steep once again. The slope of the total variable cost curve flattens as the first four Stuffed Amigos are produced due to increasing marginal returns found in Stage I of production. The slope of the total variable cost curve becomes increasingly steeper after the fourth Stuffed Amigo is produced. This range of output corresponds with decreasing marginal returns, and the extremely important law of diminishing marginal returns, found in Stage II of production. Average Variable Cost Total variable cost can be used to derive a related variable cost concept--average variable cost. Average variable cost is simply variable cost per unit of output, which can be found by dividing total variable cost by the quantity of output. If, for example, total variable cost is $43 and the quantity of output produced is 10 Stuffed Amigos, then average variable cost, that is the variable cost per unit produced, is $4.30 (= $43/10). The connection between total variable cost and average variable cost is mathematically represented by this equation: average variable cost = total variable costquantity of output A Fixed Alternative Total variable cost is one of two components of total cost. The other is total fixed cost. Total fixed cost is the opportunity cost incurred in the short-run production by a firm that does NOT depend on the quantity of output. A firm can produce a little output or a lot, increase or decrease production, or even stop producing altogether, but fixed cost remains unchanged. Total fixed cost is closely connected to the use of fixed inputs. This means that total fixed cost is unaffected by the law of diminishing marginal returns. In this chapter, we explore how production links inputs and outputs to determine costs and shape managerial decisions about how much to produce and which technology to use. This chapter is important because an understanding of how costs vary with output is important in order for us to be able to predict how firms will respond to price changes. Our descriptions of production and cost may often make it seem as though business decisions are as mechanical as following a recipe---hire a few workers, buy machinery and raw materials, then heat iron ore to 3,000oF. "Voila! Steel!" But the world of business is never so simple. Entrepreneurs and managers often face enormous uncertainty while making decisions that can put millions of dollars at risk. Anyone who has implemented a new technology or written a computer program knows from experience that everything new takes twice as long as planned (no matter how conservative the plan) and that countless bugs, glitches, and bad breaks will be encountered along the way. The idealized relationships presented in this chapter characterize production processes that use mature technologies, but these concepts may seem very abstract at times because we often ignore specifics to highlight more important relationships. Nevertheless, you need a starting point to understand the complexities of everyday business decision making. Production and costs are detailed in this chapter. We begin by surveying economic facets of typical production processes. This leads to a discussion of various production costs in both the short run and the long run and, finally, to a brief overview of the mysteries of technological change. Production Functions A firm can vary all productive resources in the long run, but at least one resource is fixed in the short run. Linkages between inputs and outputs are formalized in production functions. Production functions summarize relationships between combinations of inputs and the maximum outputs that each combination can produce. Output = f(inputs) is an example of a production function, and is read as "output is a function f of inputs." The function f summarizes how current technology translates various combinations of inputs into specific amounts of output. In this context, technology encompasses current knowledge about production techniques, as well as such things as government regulations, weather, and the laws of physics and chemistry. Production functions are commonly written q = f(K, L) where q equals output, K equals capital services, and L equals labor services used per production period. (For simplicity, land and entrepreneurship are ignored for now.) Suppose that production engineers indicate that 1,000 swimsuits can be sewn daily using 600 machine hours (75 sewing machines per 8-hour shift) and 800 labor hours (100 workers each 8-hour shift). The function f summarizes a production relationship of this type. Technological advances boosting productivity 50 percent would require switching from the f production function to, say, g. Now, q= g(K, L), and 600 machine hours plus 800 labor hours yield 1,500 swimsuits. Complete production functions identify output possibilities in the long run, when a firm can vary all resources. In the short run, however, at least one resource is fixed. Part 2 Core Concepts in Microeconomics Chapter 8: Production and Costs page 2 Part 2 Core Concepts in Microeconomics Chapter 8: Production and Costs page 3 Production in the Short Run Imagine that 5 years after you finish your degree you are in the sand-and-gravel business. Most firms can vary labor more easily than any other basic resource. Thus, to keep things simple for now, suppose that you control the amount of labor hired in the short run, while all other resources are constant because you have long-term leases on fixed amounts of capital equipment (trucks and bulldozers) and land. If no one works in your business, production and revenue obviously will both be zero. Working alone, you might excavate and sell 10 tons of earth material daily. Suppose that you hire an assistant and find that output expands to 22 tons daily. In this case, production more than doubled while labor inputs only doubled. Does this mean your assistant is the better worker? Not at all. Working alone, you must run the truck, handle all marketing, operate the bulldozer, keep the books---the list goes on and on. The cliché "Chief Cook and Bottlewasher" fits too closely for comfort. After hiring an assistant, you can drive the truck while your helper excavates, keep the books while your employee runs the bulldozer, and so on. You are able to produce much more as a team than as separate individuals because of gains from the division of labor. As you hire even more workers, you might find that specialization enables output to continue to rise more than proportionally for the first few extra workers. Eventually, however, the gains from specialization will be overwhelmed as the law of diminishing marginal returns comes into play, and each extra worker adds less than the preceding worker did to total production. The law of diminishing marginal returns is a specific application of the more general law of diminishing returns described in Chapter 1. Marginal and Average Physical Products of Labor Suppose that your work force is becoming so specialized that you decide to apply some concepts you learned in college. The data in columns 1 and 2 of Table 1 relate production and various levels of labor inputs, holding other resources constant. This data represents the total product curve. Note that total product curves and production functions are not the same things. A production function allows all inputs to vary, while the total product curve assumes that only one input changes. We are using labor as the variable input, but had we held labor constant and varied capital (or land), the analysis would be quite similar, although the specific curves would differ. If you know total output for each level of labor hired (columns 1 and 2), output per worker is calculated by dividing total output (q) by labor (L). The average physical product of labor (APPL) equals total output divided by labor (q/L). These figures are entered in column 3 of the table. You will also want to know how much each extra worker adds to total output. The marginal physical product of labor (MPPL) is the additional output produced by an additional unit of labor, computed by dividing the change in total output (?q) by the change in labor (?L): ?q/?L. Hiring decisions intended to maximize profit hinge on labor's marginal physical product. Extra workers will not be hired unless the extra revenue from their marginal physical products would exceed the extra costs of hiring them. Only workers generating at least as much revenue as it costs to hire them will be employed, a decision we detail in Chapter 13. In most cases, each worker's productivity (the MPPL) will be higher as the amounts of other resources used rise---a worker operating a bulldozer on a dry riverbed will produce more sand and gravel than a shovel wielder digging on a city lot. The MPPL is calculated by looking at small changes in labor hired and the resulting changes in output. With large numbers of workers (as at a steel mill), a given change in the amount of labor (?L) is divided into the resulting change in output (?q) to approximate the MPPL. One worker = ?L for a small firm like your operation. Labor's marginal physical products (?q/?L) for your firm are listed in column 4 of Table 1. The total product curve graphed in Panel A of Figure 1 (from columns 1 and 2 of Table 1) for your sand-and-gravel operation relates production and various levels of labor inputs, holding other resources constant. Panel B shows the corresponding marginal and average physical products of labor. Part 2 Core Concepts in Microeconomics Chapter 8: Production and Costs page 4 The Short Run Law of Diminishing Marginal Returns A problem of congestion emerges as your organization grows. Your dump trucks' passenger compartments become crowded and more time is wasted at the excavation site waiting to load trucks that arrived earlier. A second challenge emerges from coordinating increased work effort---ensuring that the left hand knows what the right hand is doing, limiting coffee breaks to 15 minutes, and so on. Table 1 and Figure 1 indicate that congestion and loss of coordination eventually become so severe that the seventeenth worker adds only one ton of material per day, the eighteenth's contribution is nil, and hiring the nineteenth worker actually yields a drop in output. The decline in extra output as extra workers are employed might seem a consequence of hiring better workers first and then hiring mediocre or inferior workers. This is unnecessary to explain diminishing marginal returns. In fact, we might assume that all workers were clones from a robot factory. As more and more workers are added to a fixed amount of resources such as capital, land, and supervision, workers’ marginal physical products tend to diminish regardless of the qualities of the individual workers. The law of diminishing marginal returns occurs when equal increases of variable resources are successively added to some fixed resource; marginal physical products eventually decline. The fixity of at least one resource in the short run makes diminishing marginal returns unavoidable: Not all resources can be varied proportionally, so capital and land per worker fall as more workers are hired, inevitably leading to diminishing additions of output as extra labor is hired. This basic economic law is without exception. Were it not for diminishing returns, enough food might be grown in a flower pot to feed the world I. The Concept of Profit Maximization Profit is defined as total revenue minus total cost. ? = TR – TC (We use ? to stand for profit because we use P for something else: price.) Total revenue simply means the total amount of money that the firm receives from sales of its product or other sources. Total cost means the cost of all factors of production. But – and this is crucial – we have to think in terms of opportunity cost, not just explicit monetary payments. If the owner of the business also works there, we must include the value of his time. If the firm owns machines or land, we must include the payments those factors could have earned if the firm had chosen to rent them out instead of using them. If only explicit monetary costs are considered, we get accounting profit. But to find economic profit, we need to take into account the opportunity cost, implicit or explicit of all resources employed. The main constraints faced by the firm are: • technology, as summarized in the cost curves of the last lecture; • the prices of factors of production, also taken into account by the cost curves; and • the demand for its product. II. Demand Curve Facing the Firm The firm’s demand curve tells how much consumers will buy at each price from a particular firm. (This is distinguished from other kinds of demand curve, such as the market demand curve, which shows how much consumers will buy at each price from all firms put together.) The shape of the firm’s demand curve is related to the degree of competition in the market. Loosely speaking, more competition causes the firm’s demand curve to be more elastic (flatter), because consumers can respond to price increases by shifting their purchases to other firms. Less competition, on the other hand, implies a more inelastic (steeper) demand curve. Perfect competition and monopoly turn out to be the extreme ends of the spectrum: • a perfectly competitive firm faces a perfectly horizontal demand curve; • a monopoly faces the whole market demand curve. III. Total and Marginal Revenue Total revenue (TR) is the total amount of money the firm collects in sales. Thus, TR = pq if p is the price and q is the quantity the firm sells. Notice that I’m using a small q, because this is just one firm (Q is reserved for the market as a whole). If the firm faces a downward-sloping demand curve, picking a quantity q automatically implies picking a price p. Why? Because the firm must be operating on the demand curve. Any chosen price corresponds to a specific quantity that consumers will buy at that price, and any chosen quantity corresponds to a specific price that will induce consumers to buy the chosen quantity. To sell more, the firm must lower its price. Graphically, TR is represented the rectangle created by p and q. Marginal revenue is the change in total revenue from increasing quantity by one unit. That is, MR = ?TR/?q, where the change in q is usually one. Now, you might think that MR must be equal to the price, p, because that’s how much you get paid for selling one more unit. But this is not true in general. Why not? Because if you face a downward-sloping demand curve, you have to lower your price to sell more. So if you increase your quantity, you’re also lowering your price for all the previous units of the good. Example: Suppose you’re currently selling 10 units at $20 each. To sell an 11th unit, you’ll have to lower the price to $19. So, you gain $19 from the additional unit. But you also lose $1 each on the previous ten units that you could have sold at $20 each. So your marginal revenue from the 11th unit is not $19, but rather $9. You can see this from looking at the total revenue: before, TR = 20(10) = 200, but now TR = 19(11) = 209. Thus, TR rose by only $9. This analysis leads to the following general conclusion: that MR is always below the demand curve. Why? At any quantity, the demand curve tells us the price corresponding to that quantity. But we’ve just shown that the MR must be less than the price, and hence below the demand curve. The only place MR and the demand curve are equal is the point where the cross the vertical axis. In general, any time a firm lowers its price, there are two effects: the “people buy more units” effect, and the “people pay less per unit” effect. Which effect is larger determines whether MR is positive or negative. It turns out this is closely related to the price elasticity of demand. IV. A Digression: Price Elasticity of Demand Elasticity refers to the degree of responsiveness of one variable to another. It's not enough to say, for instance, that a rise in price leads to a fall in quantity demanded (the Law of Demand); we want to know how much quantity changes in response to price. A simple way to see the degree of responsiveness is simply to look at the slope. A flatter demand curve represents a greater degree of responsiveness (for a supply or demand curve), as shown in the above graphs: the flatter demand curve produces a larger change in quantity for the same change in price. Using just the slope is the quick-and-dirty way to think about elasticity. The extremes are easy to remember: A perfectly elastic demand curve is horizontal, because an infinitely small change in price corresponds to an infinitely large change in quantity; the graph looks like the letter E for elastic. A perfectly inelastic demand curve is vertical, because quantity will never change regardless of the change in price; the graph looks like the letter I (for inelastic). But using the slope can be misleading, because it doesn't tell us the significance of the quantities. Suppose a $1 dollar increase in price leads to almost everyone choosing not to buy the good. That would not surprise us for gumballs, but it would certainly surprise us for televisions. The point is that a $1 increase is not much relative to the total price of TVs, but it is huge relative to the total price of gumballs. This is why we use elasticity instead of just the slope. Definition of price elasticity of demand: the percentage change in quantity demanded divided by the percentage change in price. That is, Ed = |%?Qd/%?P| How do you find the percentage change in something? You find out how much it changed, and divide by the initial value. For example, suppose your income rises from $400 a week to $500 a week. The change is $100, so the percentage change is $100/$400 = .25 or up 25%. N.B.: The percentage change depends on the direction you're going. If your income went from $500 to $400, the percentage change would be - $100/$500 = -.2 or down 20%. [Note: For this reason, some textbooks use a slightly different formula. When calculating the percentage change in a variable, instead of dividing by the original point, they divide by the average of the two endpoints. In this class, we will use the original point as described above.] Thus, we can also write Ed = |(?Qd/Qd)/(?P/P)| Example: Suppose that at a price of $10, consumers will buy 80 units. If the price rises to $10.50, the consumers will reduce their purchases to 72 units. The percent change in quantity is (80 – 72)/80 = .1 or 10%. The percent change in price is (10.50 – 10)/10 = .05 or 5%. So the price elasticity of demand on this section of the demand curve is 10%/5% = 2. In words, this means that a 1% increase (decrease) in price corresponds to a 2% decrease (increase) in quantity. Now, we can rearrange the formula for elasticity like so: Ed = |(?Qd/?P) × (P/Qd)| Look at the first term, change in Q over change in P. This is basically the slope of the curve. I say “basically” because when we talk about the slope of a line, we usually measure the rise (vertical distance) over the run (horizontal distance). In a supply and demand graph, we usually measure price vertically. So actually, the slope is change in P over change in Q. What we have here is the inverse of the slope. If we use m to stand for the slope, we have: Ed = |(1/m) × (P/Qd)| This is the easiest formula to use when you have a straight line for a demand curve. Example: You have the demand curve P = 50 –.1Qd. The slope is –.1. Using our formula, the slope at the point (100, 40) is given by Ed = |(-1/.1)(40/100)| = 4. The slope at the point (200, 30) is given by Ed = |(-1/.1)(30/200)| = 1.5. Notice that the slope is not the same at every point on a line. Note: The previous method for calculating elasticity, in which we considered a discrete change in price and quantity, gives us “arc elasticity.” With arc elasticity, you are finding the elasticity over a section of the demand curve. The method just demonstrated, on the other hand, gives us “point elasticity.” Point elasticity tells you the elasticity at a single point – specifically, at the (P, Qd) point you plug in. Think of point elasticity as the elasticity for an interval (change in price) that is very, very small. We have the following definitions: When Ed > 1, we say the curve is elastic at that point. When Ed < 1, we say the curve is inelastic at that point. When Ed = 1, we say the curve is unit elastic at that point. [Note: Textbooks differ on whether to take the absolute value or not. If you don’t take the absolute value, you’ll get a negative elasticity, which means that the demand curve is downward sloping. But to keep things positive, we’ll always take the absolute value.] In general, any demand curve will have one point that is unit elastic, which means that a one percent change in price corresponds to a one percent change in quantity. Example: continued from above. We can find the unit elastic point by setting Ed = 1 |(-1/.1)(50 - .1Q)/Q| = 1 (50 - .1Q)/Q = .1 50 - .1Q = .1Q 50 = .2Q Q = 250 So the point Q = 250, P = 25 is the unit elastic point. How does all of this relate to the firm’s MR curve, which is what we were talking about? It turns out that whether the MR is positive or not depends on whether the demand curve is elastic or not, as shown in the following grid. elastic demand 1%? in price ? more than 1%? in quantity “people buy more” outweighs “people pay less” MR > 0 (above horizontal axis) unit elastic demand 1%? in price ? 1%? in quantity effects exactly cancel out MR = 0 (crossing horizontal axis) inelastic demand 1%? in price ? less than 1%? in quantity “people pay less” outweighs “people pay more” MR < 0 (below horizontal axis) When the demand curve is a straight line, the MR always has a slope exactly twice that of the demand curve, so that it crosses the horizontal axis exactly half-way between the origin and the point where the demand curve does crosses the axis. Why? Because it turns out that a linear demand curve is always unit elastic exactly half-way down its length, and therefore MR crosses the horizontal axis at a quantity exactly half-way down the demand curve. So, if I give you a demand curve P = b – mq, what’s the MR? MR = b – 2mq. V. The Profit-Maximizing Decision The firm uses MR and MC to decide how much to produce. • Suppose increasing output by one unit will bring in more additional revenues than it costs to produce. That is, MR > MC. Then it makes sense to produce the unit, because doing so will create more added benefit than added cost. • On the other hand, suppose your last unit cost more to produce than it brought in additional revenue. Then MR TVC p×q > AVC×q p > AVC This shows that the firm should stay open if the price (at its optimally chosen quantity) is greater or equal to its average variable cost. But if the price is below the average variable cost, the firm should shut down. Note that this is a short-run shut-down decision. In the long run, there are no fixed costs, only variable costs. That means the firm can avoid making any losses at all by shutting down, so the firm should shut down any time it’s making economic losses -- unless there are changes the firm can make to its scale that allow it to escape those losses. This may be possible because the firm can shift to a different SRATC curve via a different capital choice.Related Questions
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