Transcript lecture2_2009 - Dr. Rajeev Dhawan

Lecture 2: Control on Prices, Production &
Profits
Dr. Rajeev Dhawan
Director
Given to the
EMBA 8400 Class
Buckhead Center
March 20, 2009
Chapter 6
Controls on Prices
Controls on Prices
Price Ceiling (e.g. rent control)
– A legal maximum on the price at which a good
can be sold.
– If the price ceiling is set below the equilibrium
price, it leads to a shortage.
Price Floor (e.g. minimum wage)
– A legal minimum on the price at which a good
can be sold.
– If the price ceiling is set above the equilibrium
price, it leads to a surplus.
Price Ceiling: Beer Shortage
…Rent Control Too
Beer
Supply
Equilibrium
price
$3
2
Price
ceiling
Shortage
Demand
0
75
125
Quantity
supplied
Quantity
demanded
Pints
Price Floor: Beer Surplus
Price of
Beer
Supply
Surplus
Equilibrium$4
price
Price
floor
$3
Demand
0
75
125
Quantity
demanded
Quantity
supplied
Quantity of
Beer
Article: Too Many Cars, WSJ; by: Paul Ingrassia
 Overcapacity is the biggest problem for any automobile
company in the world




GM buys Daewoo Motor, Fiat Auto, Saab
Ford motor owns Mazda, Land Rover
Daimler Chrysler is riding to rescue Mitsubishi
Oldsmobile and Chrysler’s Plymouth, are the first major automobile
companies in 40 years
 Why do ailing automobile companies who decry overcapacity
keep ailing car companies?
•
•
•
National pride plays a big role
More brands mean more dealerships mean more sales.
But this also means more costs and complexity in business operations.
In reality, overcapacity is not really a problem.
One man’s overcapacity is other’s bargain.
Thus, lower priced leases and generous rebates abound in today’s
car market.
Chapter 2
Production
Production
What is production?
– The activity by which we convert inputs (labor,
land & capital) into goods and services
What limits production?
– Inputs (resources)
– Technology
Government interference
Production Possibilities Frontier
Definition: the amount of goods a firm or
society can produce given a fixed amount of
land, labor and other inputs.
Production Possibilities Frontier
Quantity of
Pretzels
Produced
4,000
D
3,000
a
C
2,200
2,100
2,000
E
A
b
B
1,000
0
300
d
.
600 700 750
Production
possibilities
frontier
c
1,000
Quantity of
Beer Produced
Production Function I
Input Y
0
0
MP
Y (Production) = F (Inputs)
1.00
1
Production Function
1
12
10
1.00
2
1.00
3
5
4
6
4
2
0
3
0
1.00
4
8
Y
2
Y=I
2
4
6
8
Input
Marginal Product: it is the increase in output that
1.00 arises from an additional unit of input.
5 Marginal Product (MP) = ∆ Output / ∆Input
10
Production Function II
Input Y
0
0
Y = I2
MP
1.00
1
Production Function
1
120
3.00
80
4
5.00
3
9
Y
2
100
60
40
20
7.00
0
0
2
4
6
8
4
16
5
9.00
Marginal Product (MP) = ∆ Output / ∆Input
25
Input
10
Production Function III
Input Y
0
0
Y = √I
MP
1.00
1
Production Function
1
3.5
0.41
2.5
1.4
Y
2
3
0.32
3
1.7
5
2
1.5
1
0.5
0.27
4
2
0
0
2
4
6
8
Input
0.24
Marginal Product (MP) = ∆ Output / ∆Input
2.2
10
Returns to Scale
 Returns to Scale: the property of the production function
that when you double your inputs, your output either
doubles, more than doubles, or less than doubles.
9
DRS
Y=I
8
MP ↑  IRS
MP ↓  DRS
7
6
CRS
Y = √I
5
4
Y=I2
3
2
IRS
1
0
0
1
2
3
4
5
6
7
8
9
10
Chapter 13
Costs & Profits
Cost of Production
Cost of production includes all the
opportunity costs of making the output of
goods and services.
– Explicit costs: input costs that require a direct
outlay of money by the firm.
– Implicit costs: input costs that do not require an
outlay of money by the firm.
Profits
 The firm’s objective is to maximize profits
Profit = Total revenue - Total cost
 Economic Profit: total revenue minus total cost,
including both explicit and implicit costs.
 Accounting Profit: total revenue minus only the
firm’s explicit costs.
Profits
How an Economist
Views a Firm
How an Accountant
Views a Firm
Economic
profit
Accounting
profit
Revenue
Implicit
costs
Revenue
Total
opportunity
costs
Explicit
costs
Explicit
costs
Copyright © 2004 South-Western
Article: Economic Profit vs. Accounting Profit
WSJ; by: Robert Bartley
 Profit is any income to a proprietor—Marxist Labor View—which is
fallacious
 The economist is interested in the dynamic forces of production while: The
accountant is interested in proprietorship….cost as a deduction from the
owner’s income
 Economic profit is the unimputable income i.e. “the residium of product
remaining after payment is made at rates established in competition with
all comers for all services of men or things for which competition exists”
 The highest uses depend on economic profit-rate of return on assets-not
on accounting profits.
 The issue of interest on equity has tended to constitute an issue between
accountants and economic theorists
 EPS measures the corporate profit and is called the accounting profit
 Peter Drucker: EPS represents taxable earnings i.e. after all deductions, is
purely arbitrary concept and has nothing to do with business performance
 NET-NET: Takes skill to convert EPS into meaningful economic profit
concept.
Marginal Product
 Marginal Product: for any input, it is the increase in output
that arises from an additional unit of that input.
 Diminishing Marginal Product: the marginal product of an
input declines as the quantity of the input increases.
I
0
Y
0
MP
Y = √I
1.0
1
3.5
1
0.4
2
1.4
2.5
0.3
3
1.7
2
2.2
1
0.5
0.2
5
2
1.5
0.3
4
3
0
0
2
4
6
8
10
Diminishing Marginal Product
Quantity of
Output
(cookies
per hour)
Production function
150
I
0
Y
0
50
140
130
1
120
50
40
110
2
100
90
90
30
80
3
70
120
60
20
50
4
40
140
30
10
20
5
10
0
MP
1
2
3
4
5
Number of Workers Hired
150
Fixed & Variable Costs
 Fixed costs: those costs that do not vary with the quantity
of output produced.
 Variable costs: those costs that do vary with the quantity of
output produced.
TC = TFC + TVC
 Total Costs
–
–
–
–
Total Fixed Costs (TFC)
Total Variable Costs (TVC)
Total Costs (TC)
TC = TFC + TVC
Total Cost Curve
Shows the relationship between the quantity
a firm can produce and its costs.
Total Cost Curve
Total
Cost
100
90
80
70
60
50
40
30
20
10
0
0
10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 160
Quantity
of Output
(cookies per hour)
Marginal Cost
Marginal Cost (MC): measures the increase
in total cost that arises from an extra unit of
production.
(change in total cost) TC
MC 

(change in quantity)
Q
EMBA 2007 Tavern
(Lemonade Example)
MC 
(change in total cost) TC

(change in quantity)
Q
Tavern’s Total-Cost Curve
Total Cost
$15.00
Total-cost curve
14.00
13.00
12.00
11.00
10.00
9.00
8.00
7.00
6.00
5.00
4.00
3.00
2.00
1.00
0
1
2
3
4
5
6
7
8
9
10
Quantity of Output
(pints of beer per hour)
Average Costs
Average costs can be determined by
dividing the firm’s costs by the quantity of
output it produces.
The average cost is the cost of each typical
unit of product.
– ATC
– AFC
– AVC
Tavern’s Various Cost Curves
Costs
$3.50
3.25
3.00
2.75
2.50
2.25
MC
2.00
1.75
1.50
ATC
1.25
AVC
1.00
0.75
0.50
AFC
0.25
0
1
2
3
4
5
6
7
8
9
10
Quantity of Output
(pints of beer per hour)
Returns/Economies of Scale
 Increasing Returns to Scale/Economies of scale
(IRS): long-run average total cost falls as the
quantity of output increases.
 Decreasing Returns to Scale/Diseconomies of scale
(DRS): long-run average total cost rises as the
quantity of output increases.
 Constant returns to scale (CRS): long-run average
total cost stays the same as the quantity of output
increases
Economies of Scale (P 280)
Average
Total
Cost
ATC in long run
$12,000
10,000
Increasing
returns to
scale
0
Constant
returns to
scale
1,000 1,200
Decreasing
returns to
scale
Quantity of Cars per Day
Chapter 14
Competitive Firms
Total Revenue
Total Revenue: for a firm, is the selling
price times the quantity sold.
TR = (P  Q)
Total revenue is proportional to the amount
of output.
Average Revenue
Average Revenue: how much revenue a
firm receives for the typical unit sold.
Total revenue
Average Revenue =
Quantity
Price  Quantity

Quantity
 Price
Marginal Revenue
Marginal Revenue: the change in total
revenue from an additional unit sold.
MR =TR/ Q
For competitive firms, marginal revenue
equals the price of the good.
Profit Maximization
Firms will produce where TR-TC is greatest
MR=MC
Profit Maximization
Costs
and
Revenue
The firm maximizes
profit by producing
the quantity at which
marginal cost equals
marginal revenue.
Suppose the market price is P.
MC
If the firm produces
Q2, marginal cost is
MC2.
ATC
MC2
P = MR1 = MR2
P = AR = MR
AVC
If the firm
produces Q1,
marginal cost is
MC1.
MC1
0
Q1
QMAX
Q2
Quantity
Measuring Profits Graphically
Price
MC
ATC
Firm with
Profits
P
ATC
P = AR = MR
0
Quantity
Q
(profit-maximizing quantity)
Decision to Shut Down
Shut Down: a short term decision to stop
production (not to exit the market)
– Fixed/Sunk costs are ignored
Shut down if TR < VC
Shut down if TR/Q < VC/Q
– TR/Q = Average Revenue
In equilibrium
– VC/Q = Average Variable Cost
P = MR
Shut down if P < AVC
Decision to Shut Down
Costs
If P > ATC, the firm
will continue to
produce at a profit.
Firm’s short-run
supply curve
MC
ATC
If P > AVC, firm will
continue to produce
in the short run.
AVC
Firm
shuts
down if
P < AVC
0
Quantity
Decision to Exit
Exit: a long run decision to leave the market
The firm exits if the revenue it would get
from producing is less than its total cost.
Exit if TR < TC
Exit if TR/Q < TC/Q
Exit if P < ATC
Decision to Exit
Costs
Firm’s long-run
supply curve
Firm
enters if
P > ATC
MC = long-run S
ATC
Firm
exits if
P < ATC
0
Quantity
Measuring Profits Graphically
Price
MC
ATC
ATC
P
P = AR = MR
Loss
0
Q
(loss-minimizing quantity)
Quantity
Efficiency of Automakers
Comparative Efficiency of US & Japanese Automakers:
A Stochastic Frontier Production Function Approach
(March 2000, published in Management Science 2005)
Rajeev Dhawan
Georgia State University
Marvin Lieberman
The Anderson School at UCLA
2003 Market Share of U.S. Retail
Light Truck Sales
1%
0%
5%
Company
6%
26%
3%
Ford
GM
Daimler/Chrysler
9%
Toyota
Nissan
Honda
Isuzu
19%
31%
Mazda
Other
Macroeconomic Factors
Key macroeconomics factors that influence new
truck demand :

Consumer income; Unemployment level

Inflation and interest rates

Exchange Rates (U$, ¥, €)

Extraneous forces - OPEC oil prices
Auto Sales
(%)
18
16
14
12
Down 40%
10
8
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Figure 1. Real Value Added per Employee
160
Thousands of 1982 dollars
140
120
100
80
60
GM
Ford
Chrysler
Toyota
Nissan
Mazda
Daitatsu
Isuzu
Fuji
Suzuki
Honda
40
20
0
64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96
Industry Costs
Emissions, fuel efficiency, safety, performance,
and technology
Vehicle updates lead to increased design,
production, testing, marketing, and
advertising costs
Input cost
Pension costs
Product liability lawsuits
Figure 1. Number of Employees
1,000,000
Chrysler
Daihatsu
100,000
Ford
Fuji (Subaru)
GM
Honda
Isuzu
Mazda
Nissan
10,000
Suzuki
Toyota
1,000
64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97
Figure 3a. Capital Stock per Worker (Japan)
200
Daihatsu
Fuji (Subaru)
Honda
150
Isuzu
Thousands of 1982 dollars
Mazda
Nissan
Suzuki
Toyota
100
50
0
64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97
Figure 3b. Capital Stock per Worker (US)
200
Chrysler
Thousands of 1982 dollars
150
Ford
GM
100
50
0
64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97
Figure 4. Cumulative Output of Vehicles
1,000,000,000
100,000,000
10,000,000
Chrysler
Daihatsu
Ford
Fuji (Subaru)
GM
1,000,000
Honda
Isuzu
Mazda
Nissan
Suzuki
Toyota
100,000
64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97
Figure 5. WIP/Sales Ratio
0.16
0.14
Chrysler
Daihatsu
Ford
0.12
Fuji (Subaru)
GM
Honda
0.1
Isuzu
Mazda
Nissan
0.08
Suzuki
Toyota
0.06
0.04
0.02
0
64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97
Figure 6. Average Vehicle Output per Plant
900000
Chrysler
Daihatsu
800000
Ford
Fuji (Subaru)
700000
GM
Honda
Isuzu
600000
Mazda
Nissan
Suzuki
500000
Toyota
400000
300000
200000
100000
0
64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97
Figure 7. Value-added/Sales (Vertical Integration)
0.6
0.5
0.4
0.3
0.2
0.1
Chrysler
Daihatsu
Ford
Fuji (Subaru)
GM
Honda
Isuzu
Mazda
Nissan
Suzuki
Toyota
0
64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97
Table 1A. Comparison of OLS and SFPF Estimates
Variable
OLS
SFPF
(Linear)
SFPF
(Quadratic)
0.0342
(12.09)
0.0254
(10.15)
0.1802
(3.15)
0.0587
(6.16)
0.3967
(8.36)
0.0842
(8.01)
0.0478
(8.39)
-0.0006
(-4.35)
0.3590
(7.59)
-2.144
(-7.61)
-0.1493
(-5.55)
-0.0584
(-2.82)
0.1845
(6.46)
2.512
(6.20)
0.2130
(6.28)
0.1050
(3.99)
-0.1501
(-4.12)
2S
-
0.0432
(7.83)

-
0.0454
(8.69)
0.5758
(3.46)
0.855
-
-
NA
65.91
75.15
Parameter
Stochastic Frontier
Time
0
Time^2
1
Capital to Labor Ratio

Employees

0.0723
(6.95)
Inefficiency Model
Constant
0
Sales Decline Dummy
1
WIP to Sales Ratio (lagged)
2
Volume per Plant
3
2.493
(5.74)
0.1971
(5.43)
0.0950
(3.68)
-0.1542
(-3.87)
Variance Parameters
R-bar square
Loglikelihood Function
0.5225
(3.29)
Observations from technical efficiency
scatter plot (Japanese producers):
 Technical efficiency increased 50% from the mid1960s to the mid-1980s. Little growth in
subsequent years, even a decline.
 Toyota has the highest technical efficiency
(A close second is Honda). Toyota’s lead in
technical efficiency is smaller than its lead in
labor productivity.
 A number of the Japanese producers have
historical performance that is well below the
efficiency frontier.
 Efficiency estimates fluctuate with business cycle.
Observations from technical efficiency
scatter plot (US producers):
 GM’s efficiency is slightly above the Japanese
level in the mid-1960s. By the 1990s, GM’s
efficiency falls below that of all Japanese
producers except Fuji and Mazda.
 Chrysler’s efficiency falls sharply in the late
1970s but recovers strongly in the 1980s. Ford
also shows strong improvement in the 1980s.
Both Chrysler and Ford have efficiency levels
comparable to the Japanese average in the late
1980s and 1990s.
Conclusion
 Get away from firm-size issue and focus on cutting
inventory (WIP) costs via flexible plants and JIT
inventory methods i.e. suppliers
 Increase speed of new product introduction to
market - benchmark Toyota
 Make cars that people in cities want not when you
go Pheasant hunting in South Dakota!