Transcript lecture2_2008old

Lecture 2: Control on Prices, Production &
Profits
Dr. Rajeev Dhawan
Director
Given to the
EMBA 8400 Class
South Class Room #600
January 5, 2008
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
Circular Flow Diagram
Revenue
Goods
and services
sold
MARKETS
FOR
GOODS AND SERVICES
•Firms sell
•Households buy
Spending
Goods and
services
bought
HOUSEHOLDS
•Buy and consume
goods and services
•Own and sell factors
of production
FIRMS
•Produce and sell
goods and services
•Hire and use factors
of production
Factors of
production
Wages, rent,
and profit
Labor, land,
capital
MARKETS
and
FOR
FACTORS OF PRODUCTION
•Households sell
•Firms buy
Income
= Flow of inputs
and outputs
= Flow of dollars
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)
Tavern’s Total-Cost Curve
Total Cost
Total-cost curve
$15.00
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
Quantity
of Output
(glasses of lemonade per hour)
8
9
10
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 282)
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
Cost & Profits
Airline Industry
0.00
US Airline Cost Index Report 2nd Quarter 2006
Other
TransRel
Ad &
Promotion
Utils & Office
Supplies
Communication
Insurance
Food &
Beverage
Maintenance
Material
Passenger
Commissions
Landing Fees
Professional
Services
Ownership
Fuel
Labor
UNIT COST BY CATEGORY
Cents per Available Seat Mile
3.50
3.00
2.50
2.00
1.50
1.00
0.50
LABOR COSTS
Wages + Benefits + Payroll Taxes per FTE
$80,000
$75,000
$70,000
$65,000
$60,000
$55,000
$50,000
US Airline Cost Index Report 2nd Quarter 2006
1Q06
1Q05
1Q04
1Q03
1Q02
1Q01
1Q00
1Q99
1Q98
1Q97
1Q96
1Q95
1Q94
1Q93
1Q92
1Q91
1Q90
$45,000
EMPLOYEE PRODUCTIVITY
ASMs (000) per FTE, 4 Quarter Moving Sum
2,500
2,400
2,300
2,200
2,100
2,000
1,900
1,800
1,700
1,600
US Airline Cost Index Report 2nd Quarter 2006
1Q06
1Q05
1Q04
1Q03
1Q02
1Q01
1Q00
1Q99
1Q98
1Q97
1Q96
1Q95
1Q94
1Q93
1Q92
1Q91
1Q90
1,500
Major Costs as Shares of Operating Expenses
%
50
40
30
20
10
0
1975
1980
Labor
Aircraft Ow nership
1985
1990
1995
Fuel
Non-Aircraft Ow nership
US Airline Cost Index Report 2nd Quarter 2006
2000
2005
Major Costs as Shares of Operating Expenses
%
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
-0.5
1975
1980
Landing Fee
Com m unication
1985
1990
Maintenance
1995
2000
Aircraft Insurance
US Airline Cost Index Report 2nd Quarter 2006
2005
Major Costs as Shares of Operating Expenses
%
12
10
8
6
4
2
0
1975
1980
1985
Passenger com m issions
Utilities and Office Supplies
1990
1995
2000
Advertising and prom otion
Food and Beverages
US Airline Cost Index Report 2nd Quarter 2006
2005
Airline Employment Down by 100,000+
ATA 2004 Economic Report
ATA 2004 Economic Report
ATA 2004 Economic Report
ATA 2004 Economic Report
ATA 2004 Economic Report
Leverage Burden
($ bil.)
70
(%)
12.0
60
10.0
50
40
8.0
30
20
6.0
10
0
1975
1980
Debt Outstanding
1985
1990
1995
2000
Avg. Book Interest Rate (Right)
US Airline Cost Index Report 2nd Quarter 2006
2005
4.0
Total Interest Cost
($ bil.)
4.0
3.0
2.0
1.0
0.0
1975
1980
1985
1990
1995
US Airline Cost Index Report 2nd Quarter 2006
2000
2005
LOAD FACTOR
Including Interest Expense -- 4 Quarter Moving Average
Breakeven
Actual
90%
85%
80%
75%
70%
65%
1Q06
1Q05
1Q04
1Q03
1Q02
1Q01
1Q00
1Q99
1Q98
1Q97
1Q96
1Q95
1Q94
1Q93
1Q92
1Q91
1Q90
60%
WSJ Article 2002
Article: One Airline’s Magic
Time Magazine by: Sally Donnelly
How does Southwest (SW) soar above its money losing
rivals?
 Productivity
Its employees work harder and are smarter, in return, they get
job security and a share of profits
– Pilots fly as many as 83 hours a month, compared with
about 53 hours in a busy month at United Airlines
– Flight attendants work almost twice as many hours as their
counterparts at other airlines
– Mechanics change airplane tires faster (like a NASCAR pit)
and thus get higher wages than their counterparts at other
airlines
 Flexibility
– SW pilots also pitch in to help ground crews move luggage
 In return, SW compensates it workers in ways other than the base pay
– It contributes 15% of its pre-tax income to a profit-sharing plan
– It has assured all its workers and unions that there would be no lay-offs
– SW doesn’t use the word “employee”, and gives them enough room to grow
and learn
– SW has enjoyed big savings by never having the type of defined-benefit
pension plans which has proved so costly for other airlines
 Other advantages of SW:
– Last year, SW selected 6,000 people out of 2 million resumes received on
the basis of attitudes and not necessarily skills
– SW flies point-to-point domestic routes, as opposed to the complex and
expensive hub-and-spoke international networks
– No meals served onboard, no bulky drink carts and no entertainment
– SW uses less expensive, less crowded secondary airports
– Flies only one type of aircraft – Boeing 737 to reduce maintenance costs
– Employees own more than 10% of SW outstanding shares, thus they work
more productively and more creatively to increase their own pay checks
– Lowest cost per seat mile: 7.5 cents
– Highest aircraft hours per day: 10.9 hrs/day
So What is the Solution?
Article: The Airline Industry’s Changing Business
Model
Do the legacy airlines have any comparative advantage that
they can use in competing with their low cost rivals for
domestic travelers?
– The honest answer is NO.
The time has come for some of the airlines to either merge
or liquidate so that excess capacity in the market can be
reduced to profitability manage the new demand frontier.
(permanent downward shift in demand curve esp. domestic
flying)
But will the mergers or liquidations save the big boys?
Maybe…
The only way out is a radical shift in thinking by the big
airlines: outsource to low-cost airlines and allow them to bring
passengers to your legacy hubs! Then fly these travelers to
international destinations on your planes at premium prices
where there is no competition from South-West and upstart
airlines.