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Lecture 3: Micro-econ. ~ last topic (Profits) & Basics of Macroeconomics - I Dr. Rajeev Dhawan Director Given to the EMBA 8400 Class South Class Room #600 April 2, 2010 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. How an Economist Views a Firm Profits 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 ATA 2004 Economic Report Article: The Painful Truth About Profits Business Week; by: Michael Mandel Without profits there’s no incentive for innovation or creating new companies. Today the biggest problem is that most companies are shooting for a return to the highest profit levels of the late 1990s. >> HIGH WAGES – Despite the recession and a year of slow growth, corporate labor costs are nearly $1 trillion higher now than in 1997. – Real wages and benefits continue to climb, growing at 2% rate during the past year >> SLOW GLOBAL GROWTH – Weak economies overseas have kept exports flat at best – Most major industrial countries are expected to grow more slowly than the US in the coming year >> OVERBUILT – There’s already an excess of US industrial capacity – This makes it almost impossible for corporations to raise prices 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 Total-cost curve $80 70 60 50 40 30 20 10 0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 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 2006 Tavern (Lemonade Example p.275) (change in total cost) TC MC (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 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 Costs and Revenue Profit Maximization The firm maximizes profit by producing the quantity at which marginal cost equals marginal revenue. MC MC2 ATC P = MR = MC P = AR = MR AVC 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 2004 Other Utils & Office Supplies Ad & Promotion Insurance Passenger Commissions Maintenance Material Food & Beverage Landing Fees Professional Services Ownership Fuel Labor UNIT COST BY CATEGORY Cents per ASM 4.00 3.50 3.00 2.50 2.00 1.50 1.00 0.50 LABOR COSTS Wages + Benefits + Payroll Taxes per FTE $85,000 $80,000 $75,000 $70,000 $65,000 $60,000 $55,000 $50,000 $45,000 US Airline Cost Index Report 2004 1Q04 1Q03 1Q02 1Q01 1Q00 1Q99 1Q98 1Q97 1Q96 1Q95 1Q94 1Q93 1Q92 1Q91 1Q90 $40,000 EMPLOYEE PRODUCTIVITY ASMs per FTE, 4 Qtr Moving Sum 2,200 2,100 2,000 1,900 1,800 1,700 US Airline Cost Index Report 2004 1Q04 1Q03 1Q02 1Q01 1Q00 1Q99 1Q98 1Q97 1Q96 1Q95 1Q94 1Q93 1Q92 1Q91 1Q90 1,600 Major Costs as Shares of Operating Expenses % 50 40 30 20 10 0 1973 1978 1983 Labor Aircraft Ow nership 1988 1993 Fuel Non-Aircraft Ow nership US Airline Cost Index Report 2003 1998 2003 Major Costs as Shares of Operating Expenses % 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 -0.5 1973 1978 1983 Landing Fee Com m unication 1988 1993 Maintenance US Airline Cost Index Report 2003 1998 Aircraft Insurance 2003 Major Costs as Shares of Operating Expenses % 12 10 8 6 4 2 0 1973 1978 1983 Passenger com m issions Utilities and Office Supplies 1988 1993 1998 2003 Advertising and prom otion Food and Beverages US Airline Cost Index Report 2003 Airline Employment Down by 100,000+ ATA 2004 Economic Report ATA 2004 Economic Report ATA 2004 Economic Report ATA 2004 Economic Report ATA 2004 Economic Report Leverage Burden ($ bil.) 60 (%) 12.0 50 10.0 40 30 8.0 20 6.0 10 0 1973 1978 1983 Debt Outstanding 1988 1993 1998 Avg. Book Interest Rate US Airline Cost Index Report 2003 2003 4.0 Total Interest Cost ($ bil.) 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 1973 1978 1983 1988 1993 1998 2003 LOAD FACTOR Including Interest Expense -- 4 Qtr Moving Average 100.0% Breakeven Actual 95.0% 90.0% 85.0% 80.0% 75.0% 70.0% 65.0% 60.0% 55.0% 1Q04 1Q03 1Q02 1Q01 1Q00 1Q99 1Q98 1Q97 1Q96 1Q95 1Q94 1Q93 1Q92 1Q91 1Q90 50.0% 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. Basics of Macroeconomics Chapter 23 The Economy’s Income & Expenditure For an economy as a whole, income must equal expenditure because: – Every transaction has a buyer and a seller. – Every dollar of spending by some buyer is a dollar of income for some seller. Gross domestic product (GDP) is a measure of the income and expenditures of an economy. It is the total market value of all final goods and services produced within a country in a given period of time. Simple Economy 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 Definition of GDP GDP is the market value of all final goods and services produced within a country in a given period of time. Definition of GDP “GDP is the Market Value . . .” – Output is valued at market prices. “. . . Of All Final . . .” – It records only the value of final goods, not intermediate goods (the value is counted only once). “. . . Goods and Services . . . “ – It includes both tangible goods (food, clothing, cars) and intangible services (haircuts, housecleaning, doctor visits). Definition of GDP “. . . Produced . . .” – It includes goods and services currently produced, not transactions involving goods produced in the past. “ . . . Within a Country . . .” – It measures the value of production within the geographic confines of a country. “. . . In a Given Period of Time.” – It measures the value of production that takes place within a specific interval of time, usually a year or a quarter (three months). Definition of GDP What Is Not Counted in GDP? – GDP excludes most items that are produced and consumed at home and that never enter the marketplace. – It excludes items produced and sold illicitly, such as illegal drugs. GDP and Economic Well-Being GDP per person tells us the income and expenditure of the average person in the economy. Higher GDP per person indicates a higher standard of living. However…GDP is not a perfect measure of the happiness or quality of life. Some things that contribute to well-being are not included in GDP. – The value of leisure. – The value of a clean environment. – The value of almost all activity that takes place outside of markets, such as the value of the time parents spend with their children and the value of volunteer work. GDP, Life Expectancy, and Literacy NIPA Definition of GDP Y=C+I+G+NX Y = GDP C = Consumption I = Investment G = Government Purchases NX = Net Exports = Exports-Imports NIPA Definition of GDP Consumption (C): – The spending by households on goods and services, with the exception of purchases of new housing. Investment (I): – The spending on capital equipment, inventories, and structures, including new housing. Government Purchases (G): – The spending on goods and services by local, state, and federal governments. – Does not include transfer payments because they are not made in exchange for currently produced goods or services. Net Exports (NX): – Exports minus imports. GDP Components Simple GDP Example This simple economy has 2 people: Baker and Miller. Baker buys flour for $350. He also uses a worker and pays $200 in wages. He also pays a rent of $25. He makes a profit as $25 on the bread he sells for $600. The miller pays his worker $300, a rent of $25, and his profit is $25 on a sale of $350. The GDP of this economy is $600! Why? 2 sides of a coin, Income=Expenditures Expenditures=Value of final Goods sold=600 Income=wages+Rent+profits=300+200+25+25+25+25=600 Real vs. Nominal GDP Nominal GDP values the production of goods and services at current prices. Real GDP values the production of goods and services at constant prices. Real GDP20XX Nominal GDP20XX 100 GDP deflator20XX •GDP Deflator deflates for Inflation! •Inflation is rate of change of prices. Macro Framework Households: Consume & Work Firms: Production & Investment Government: Money Supply, Taxes, Expenditures Foreign Sector: Exports, Imports & Exchange Rate Consumption Pattern (%) 72 70 68 66 64 62 60 1963 1968 1973 1978 1983 1988 1993 1998 2003 GDP and Consumption (Bil. $) 12000 10000 8000 6000 4000 2000 0 1973 1978 Consumption 1983 GDP 1988 1993 1998 2003 Investment Pattern (%) 20 18 16 14 12 1963 1968 1973 1978 1983 1988 1993 1998 2003 Exports Share (%) 12 10 8 6 4 1963 1968 1973 1978 1983 1988 1993 1998 2003 Imports Share (%) 16 14 12 10 8 6 4 2 1963 1968 1973 1978 1983 1988 1993 1998 2003 Net Exports (%) 2 0 -2 -4 -6 1963 1968 1973 1978 1983 1988 1993 1998 2003 Government Share (%) 24 23 22 21 20 19 18 17 1963 1968 1973 1978 1983 1988 1993 1998 2003 Federal Budget Deficit (%) 2 0 -2 -4 -6 1963 1968 1973 1978 1983 1988 1993 1998 2003 Federal Budget, Trade Deficits and US dollar trade-weighted exchange rate (Bil. $) 200 Index 2000 = 100 140 130 0 120 -200 110 -400 100 90 -600 80 -800 70 1976 1980 1984 Budget Deficit 1988 1992 Trade Deficit 1996 2000 2004 U.S. Dollar Exchange Rate GDP Components (2001) Government Purchases 18% Net Exports Investment -3 % 16% Consumption 69% Recessions A recession is a significant decline in activity lasting more than a few months and is visible in industrial production, employment, real income and wholesaleretail sales (NBER definition). NBER uses monthly data. Rule of thumb is 2 consecutive quarters of negative Real GDP growth or GDP decline.