Download Lecture 3 - Dr. Rajeev Dhawan

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.