Transcript PowerPoint File

Economics 310, Fall 2001
Second Exam
Prof. Kenneth Ng
Dept. of Economics
COBAE
Problem 1 (9:30 AM Class)
 State Landsburg’s equimarginal principle. Economists talking about a firm’s
production decision also frequently say that “fixed costs don’t matter.” Do
these two principles contradict each other? Explain how each of these
principles apply to the behavior of the firm and describe an example where
your logic applies. Do not use an example from the lecture notes.
 Landsburg's Equimarginal Principle: If an activity is worth pursuing at all, then it
should be pursued up to the point where marginal cost equals marginal benefit
OR if circumstances change in way that does not affect anything on the margin,
and if an activity remains worth pursuing at all, then the optimal amount of that
activity is unchanged.
 Short run output rule is to produce where P=MC.
 In the short run, the fixed costs of the firm do not enter into the firms decision to
produce or not produce and the decision how much to produce.
 The firm will produce if P> min. AVC and if it does produce, it will produce where
P=MC.
Problem 1 (2 Pm Class)
 True, false, uncertain, explain and depict graphically.
 When the MRS > relative price of labor the firm is using a
production process that is too capital intensive.
 Cost minimization and output maximization lead to different ways
of producing a good.
When the MRS > relative price of labor the firm is
using a production process that is too capital
intensive.
At point B, the MRS > relative price. You know
this because the slope of the iso-output curve is
steeper than the slope of the iso-cost curve.
Capital
The firm is not producing efficiently at B and
would produce the same output at a lower total
cost by moving to A.
B
1000
This would involve reducing capital and
increasing labor, i.e. switching to a more labor
intensive production process.
A
750
100 Units
0
400
500
Labor
Cost minimization and output maximization
lead to different ways of producing a good.
The firm is not producing efficiently at B and
would produce the same output at a lower total
cost by moving to A.
Capital
This would involve reducing capital and
increasing labor, i.e. switching to a more labor
intensive production process.
B
It could also keep total cost constant and
produce more my moving from B to C.
1000
C
A
750
In both cases, the firm is moving to point where
the iso-cost and iso-ouput curves are tangent
and the MRS=relative price.
150 Units
100 Units
0
400
500
Labor
Problem 2
 Use the graph on the following page for your answer. Suppose a
firm is efficiently producing 10,000 units of a good using two inputs,
capital and labor and an average variable cost of $50 per unit and
an average total cost of $75 per unit.
 Depict the situation on the graph below if the firm is using 500
units of capital.
 Suppose the firm wanted to increase output in the short run to
20,000 units. If it did so it would produce at an average variable
cost of $100 per unit. Depict the situation on the graph.
 What is the average total cost of producing 20,000 units in the
short run.
 What is the price of capital? Compute and explain.
 Suppose in the long run, the firm could produce 20,000 units
using 1000 units of capital at an average total cost of $50 per
unit. Depict the situation on your graph.
 Is the firm producing efficiently if it is producing 20,000 units as
described in part (B).
 Draw and label the SRATC, AVC, and MC curves on the graph.
Capital
750,000  (10,000 * 50)
Pcapital 
500
 500
1000
B
500
A
$750,000
0
(500 * 500)  (20,000 *100)
20,000
2,250,000

20,000
 $112.5
SRATC20,000units 
C
20,000 units
10,000 units
$2,250,000
$1,000,000
TC
Q
2,250,000  750,000

10,000
 150
Labor
To compute fixed costs at point A :
MC 
$/unit
ATC  AVC  AFC
75  50  $25
FC  $25 * 10,000
 $250,000
The price of capital :
$250,000
 $500 / unit
500
SRATC
112.5
100
75
50
0
10,000
20,000
Output
Problem 3
 Use the graph on the following page for your answer. The graph
shows the airline industry before the collapse of the World Trade
Center in New York.
 Depict the short run changes in the airline market that are
occurring as a result of the attack. Show changes in price,
output, profits, on your graph. Provide a narrative explaining the
effects you depict on your graph.
 Specifically relate relevant passages from the article to the short
run changes you depict and describe.
 Suppose the demand for airline travel follows the pattern
followed during the Gulf War. Depict the changes on your graph
and provide a narrative explaining the effects you depicted on
your graph.
 Suppose the demand for airline travel doesn’t rebound as it did
during the Gulf War. Compare, contrast, depict, and explain the
changes on your graph. How are the effects different than you
answer to (C)?
Capital
The terrorist attack causes the demand for air travel
to decrease (D1 to D2). This lowers the price (P1 to
P2) and cause a short term supply response by
existing firms.
B
A
The existing firms cut back production by decreasing
use of the variable input. Notice that the firm, at point
B is not producing efficiently because the iso-cost and
iso-ouput curves are not tangent.
Before Attack
After Attack
If P2 is below the min AVC, an airline will shutdown.
Labor
Price
Price
Representative Firm
MC
Market
ATC
S1
A
P1
P1
Loss
B
P2
D1
D2
0
Quantity
(firm)
0
Q1
Quantity
(market)
Capital
If the demand for air travel stays at D2 firms will exit
the industry and the short run supply curve will shift to
S2.
The price will rise as output falls. The final price will
be determined by whether the industry is a constant
or increasing cost industry.
B
A
If the demand for air travel does recover, the demand
will shift from D2 back to D1.
Before Attack
After Attack
If this is the case, the result will be a short period in
which the airlines produce at a loss.
Labor
Price
Price
Representative Firm
Market
S2
MC
ATC
S1
A
P1
Long Run Supply
P1
Loss
B
P2
D1
D2
0
Quantity
(firm)
0
Q1
Quantity
(market)
Capital
The terrorist attack causes the demand for air travel
to decrease (D1 to D2). This lowers the price (P1 to
P2) and cause a short term supply response by
existing firms.
B
A
The existing firms cut back production by decreasing
use of the variable input. Notice that the firm, at point
B is not producing efficiently because the iso-cost and
iso-ouput curves are not tangent.
Before Attack
After Attack
If P2 is below the min AVC, an airline will shutdown.
Labor
Price
Price
Representative Firm
Market
S2
MC
ATC
S1
P1
P1
Loss
D 1 =D
2
D2
0
Quantity
(firm)
0
Q1
Quantity
(market)
The Economist
September 25, 2001
ANOTHER crisis for the airline industry seems to have been averted, with governments in America and Europe, at least,
agreeing to underwrite war-risk insurance cover. At one stage, it looked as if new terms from insurance companies would
cause the suspension of all commercial flights from September 25th; the extra government help means that is avoided.
But the job losses continue to mount in the disaster-hit industry. In America, more than 60,000 lay-offs have now been
announced by the big airlines, which have lost hundreds of millions of dollars in the days since the attacks. Bookings in
America have fallen by more than half since September 11th, and schedules have already been cut by 20%. The crisis has
spread to Boeing, the world's biggest aircraft maker, which expects a sharp fall in demand for its planes, from more than 500
this year, to 350 by 2003. On September 19th, it said it will lay off up to 30,000 workers by the end of next year; that's nearly a
third of its commercial-aircraft division, and more redundancies could be on the way.
And the picture looks bleak for many other airlines around the world. European carriers are currently worst affected, with many
of them cutting back on their, until recently, lucrative transatlantic travel. Flight schedules are being cut, planes grounded, and
jobs lost. British Airways announced a further 5,200 job losses on September 20th. Lufthansa, which has already curbed its
routes to North America by 8% and is now apparently considering further cuts. Swissair and Sabena have both admitted they
are in a struggle for survival. Skies were already cloudy
Once the terrorists had struck, it was obvious that the travel business would never be the same again. The industry was
already reeling from a dramatic fall in business travel because of the economic slowdown, particularly in America. Now much
of the industry, in America and Europe, is expected to make record losses. Some airlines in America might file for bankruptcy
within days. The situation is so serious that American airlines have asked the government for a $ 17.5 billion package of aid.
They look likely to get about $ 8 billion, plus $ 10 billion in loan guarantees and an agreement by the government to take on
the huge potential legal liability faced by those airlines whose planes were involved in the attacks. Both British Airways and
Virgin Atlantic are seeking help from the British government, and European industry leaders are talking to the European
Commission. The help they are seeking would be in addition to any they might be given to deal with the insurance-cover
problems which have emerged.
Airlines cannot cope with a sharp fall in revenues of the kind they are now experiencing.
They are capital-intensive and need to maintain a network, which means high fixed costs. Aircraft cost up to $ 200m each
and an airline needs to fill three-quarters of its seats to make any money: even a fall of five percentage points in traffic can
wreck operating profits. So a short-term fall of more than two-thirds is crippling, even if it is reversed later in the year.
But even before the attacks, America's airlines were forecasting losses approaching $ 3 billion; that figure is now expected
to be $ 5 billion. For losses worldwide the International Air Transport Association (IATA) has suggested a figure of $ 10
billion. This implies, though, that the non-American half of air travel will be as badly affected as the American half, and that
will not be the case: Europe will be hurt, but East Asia may suffer less.
Because nobody can predict how long an anti-terrorist war will last, nobody can predict the airlines' future. One possible
parallel is the 1991 Gulf war, when air travel fell by 25% across the Atlantic, by 55% to the Middle East from Europe, by 12%
inside Europe and by 4% inside America. If this is the right comparison, it may be comforting: the airlines bounced back in
1992. Nevertheless, the world's big carriers lost as much as $ 15 billion between 1990 and 1993, as a result of the war and
the recession. And the recession that has been engulfing American airlines since the late spring was already going to be
worse than it was then.
In America, airline schedules may never be the same again. The Federal Aviation Administration has ordered tougher safety
procedures for all flights. These include an end to kerbside and other off-airport check-ins, boarding areas to be restricted to
passengers with tickets, and armed, plain-clothed air marshals--who already travel incognito on some overseas flights--to be
used on domestic services too. In addition, passengers will no longer be able to take blades or knives made from any
material on board. Metal knives will also be banned for food service. The hijackers are believed to have used box cutters.
Although many of these precautions are already familiar to international travellers, they have not been a feature of domestic
air travel in America. This means beefing up security at America's airports will have a direct effect on the capacity and cost
of air travel. To cope with more stringent security measures, and the delays they will cause, flights will have to be
rescheduled. The hub and spoke system favoured by most of America's large carriers will have to adapt, because
turnaround times will be longer. The airlines will get fewer flights out of each jet per day, which, along with the extra security,
will raise their costs.
One possible consequence of all this could be consolidation of airlines in America and Europe. The industry was in the midst
of much restructuring when disaster struck. United Airlines' proposed takeover of struggling US Airways, blocked by
regulators, had left its target exposed. Northwest Airlines and Continental were also threatened by the national dominance
that American Airlines had acquired once it had swallowed TWA this spring, and were said to be considering merging.
With the industry in distress, regulators seem sure to be more tolerant of mergers than in the past. United was forbidden to
buy US Airways on competition grounds. That prohibition might now be waived. In Europe, the financial pressures on
Swissair, Sabena, KLM and BA could lead to renewed efforts by these four to form new combinations. It is even possible
that regulations limiting foreign stakes to 49% will be loosened, expecially as the European Union is seeking to take over the
powers of member countries in international aviation negotiations.
Like Boeing, Airbus, the world's second-biggest aircraft maker, could find demand for its planes falling. Its super-large A380,
launched last year, will almost certainly not get the 100 orders expected by the end of this year. Lufthansa has already
decided to postpone its orders of the A380. Airbus's parent company, EADS, said on September 20th that it was sticking to
its profit targets.
The huge uncertainty surrounding the short-term future of air travel makes it difficult to predict when, if ever, it will return to
its long-term growth path. Long before it does, the colours on the jet tails may have changed and some familiar names may
have disappeared.
The Curve.
Mean
Standard Deviation
Students Taking Exam
Students Enrolled in Class
Grade
A
B
C
D
F
Required
Score
63
43
31
23
Without
Homework
33.7
19.6
Normalized
Score
1.5
0.5
-0.1
-0.5
With
Homework
38.7
19.6
73
86
Number
Receiving
Grade
14
11
20
15
14
Percent
Receiving
Grade
19%
15%
27%
21%
19%
11 out of 14 students receiving an F had points subtracted as a result of homework and quizzes.
6 out of 15 students receiving a D missed at least one quiz of homework.
Questions about exam?
ONE WEEK MANDATORY
COOLING OFF PERIOD.
No questions answered about
exam until next Tuesday.