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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.