The Long Run

I. Introduction

We are going to spend another week on the supply side: what you would produce if you were the President of a company. Recall that microeconomics is about supply and demand. When we are on the demand side, then we are discussing what you would buy as a consumer, and how much you would pay. When we are on the supply side, we are considering what you would produce in managing a company. Keep these concepts separate in your mind.

Recall that there are short run costs and long run costs associated with the supply of a good or service. Short-run costs include overtime labor to try to increase supply immediately. Variable inputs are the focus of short-run costs: they are the inputs (such as materials or labor) that are increased in order to produce more goods or services in the short run. Variable inputs are different from fixed inputs, which cannot be increased in the short run. An example of a fixed input is a manufacturing facility, which cannot be built quickly. A stadium is a fixed input in the sports world.

Essential to microeconomics are the two concepts of marginal ____ and average ____. For example, we have marginal cost and average cost. The marginal cost is how much it costs to make one more widget. The average cost is the overall average per-unit cost for all the widgets you make.

Similarly, the marginal product is the increase in supply due to one more unit of input (typically labor). If you hire one more laborer (e.g., employee or worker), how much will your output of widgets increase? Marginal product, or MP, gives you that answer. Your overall product output (Q) is the sum of all your marginal products (MP). You could then take the average of that, defining average product as your total output Q divided by your total labor (L). Expressed as an equation, this is AP = Q/L.

The average _____ always moves towards the marginal _____ as the relevant activity increases. Average cost approaches marginal cost, and average product approaches marginal product. Think about that, providing your own examples to convince yourself.

As President of your company, you do not want to be paying overtime wages to your employees for a long period of time. By law, overtime wages are 1.5 times regular wages. So when you pay overtime, you are paying 50% more than what you would pay if you could hire another worker. It is inefficient to be paying overtime. You only do it as a quick fix to an increase in demand.

In the long run, you maximize efficiency by making fundamental changes to your business. If you own a professional baseball team, a short-run change to increased demand for tickets by fans would be to build temporary bleachers. But the fans would prefer to pay more for permanent seats, and you would make more money with a larger stadium. So the long-run change is to build an entire new stadium. Many owners have done that.

Today we are going to focus on the long run. The homework will also address two examples of government intervention in the free markets that affect the long run: licensure of professional services and bailouts of big companies.

II. The Long Run

Jesus’ teachings were not always what the public wanted to hear. At one point it seemed like nearly everyone wanted to abandon Him. Jesus then turned to his apostles and said, “Will ye also go away?” Simon Peter responded, “Lord, to whom shall we go? thou hast the words of eternal life.” John 6:68 (KJV). Peter was committed for the long run. Over thirty years after Jesus’ crucifixion, Peter remained true to what he said and allowed himself to be crucified (upside down). Jesus picked apostles for the long run.

The long run is where the real impact is. Things that are here today and gone tomorrow are not going to amount to much. Moderate politicians are notoriously short-term in their activities and impact. They may win an election, but don’t expect them to last very long and make a difference. Remember Republican-turned-Independent James Jeffords? His long-term impact was nil.

The same is true in business. Quick fixes are typically short-lived and inefficient. When you are doing business with a supplier you want to be confident it will still be there a year or five years later. When you work on a cause you want it to have some lasting value.

Efficiency is maximized by focusing on the long run. As President of your widget company, you want to maximize the efficiency of your company. You want the lowest unit cost. You do not want idle workers or equipment. You do not want wasted inventory. Have you heard the expression “a penny saved is a penny earned?” It illustrates the real cost of waste. Actually, due to taxes, a penny saved is worth even more than a penny earned.

The changes you make to your company in the long run will be designed to maximize efficiency. You want to reduce overtime, and you want loyal workers at a relatively low wages. You want manufacturing facilities that are utilizing close to 100% of their capacity for production. If demand is increasing, then that means building new facilities. If demand is decreasing, then that means selling facilities that you already have.

There is a concept for the long run known as scale. It means the total amount of inputs (workers, facilities, equipment, etc.) that a company has. The large scale means large facilities and number of workers. The small scale means small facilities and number of workers.

We expect the output of a company to increase in proportion to the increase in scale. As President, you may think that doubling everything (facilities, workers, etc.) will double your output. Often that is true. When true, this is called constant returns to scale. When scale increases by a factor of x, then output also increases by the same factor of x.

An assembly line is perhaps the best example of this. Suppose one assembly line produces 1000 widgets a month. How much would two assembly lines, with double the workers, produce? Our first impression would be twice the output, or 2000 widgets a month.

But equally important are situations where there are increasing returns to scale (output goes up by a greater percentage than the increase in scale) and decreasing returns to scale (output goes up by a smaller percentage than the increase in scale). The popular term economies of scale refers to increasing returns to scale, which are what one often sees in a well-managed company.

The example of the assembly line may yield slightly increasing returns to scale. When we double the assembly line, we may not have to double the number of administrative workers like managers, clerks, phone operators, etc. We won’t need two presidents, for example. So we can double our output without doubling our workforce. Perhaps we can even squeeze the second assembly line into our existing manufacturing plant. We would still need twice the materials for the goods produced, but not twice the labor and facilities. In this case we have increasing returns to scale: output doubles when inputs increased by less than 100%.

When would a company have decreasing returns to scale? How could it be that we can double our workers and facilities and not produce at least twice the output? The reason is that inefficiencies creep in. Workers may spend more time talking with each other than doing productive work. Managers and other workers may fight each other for power rather than doing what is best for the company. People may call in sick more often, knowing that others are there to fill in for them. Waste could spiral out of control as more purchases are made. Each employee will feel less needed, and may become less motivated.

As President of your company, think before you make long-run changes to increase output: do you have increasing, constant, or decreasing returns to scale? Do not, however, confuse decreasing returns to scale with diminishing returns. Diminishing returns are something that occurs in the short run: it is the decline in marginal productivity as you keep increasing a variable input while all other inputs remain constant. For example, asking one employee to work more and more overtime is going to have diminishing returns. He is going to become so tired that he will not work as efficiently as when he is rested. And even if he did not tire, the added benefit of the worker to your company by himself is going to decline without adding other workers or facilities to support him. The entirely different concept of decreasing returns to scale refers to long term economic changes due to big modifications to your company. Diminishing returns are always expected; decreasing returns to scale are not.

A typical firm can initially expect average unit costs to decline as it increases inputs (workers, facilities, etc.) from zero. This is an increasing return to scale. But at some point, call it input = X, those increasing returns disappear and the company can only obtain constant returns to scale. It has attained its minimum efficient scale at that point. It can continue to increase its inputs, but its output only increases by the same amount as its input. Ultimately, the company will find that increasing inputs further does not even increase output much. It has too many workers or facilities at that point, and it begins experiencing decreasing returns to scale.

III.       Costs

Well-planned long-run changes should always be more efficient than short-run adjustments. For example, it should always be cheaper to hire a new employee at the basic wage than to pay time-and-a-half for existing employees to work overtime. It should always be more efficient to build a facility the way you need it than to pay someone else to rent a facility that is not exactly what you need. There may be reasons why you do not want to take a risk on a new facility, but efficiency is always on the side of long-run expenses.

That is true in life also. When you make decisions, you are better off thinking about the long-run consequences. Many mistakes are caused by short-term thinking. If drug addicts considered the long-run impact of their decision to take drugs, then they would save themselves from dying in a gutter some day or ending up homeless in Manhattan.

Exercise is not always the most pleasant activity in the short run. But its benefit is substantial for the long run.

Jesus was not focusing on the short run in picking his apostles. He was planning for the long run.

Economically, long-run unit costs are always less than or equal to short-run unit costs at all levels of output Q. If you graph unit cost on the y-axis and output Q on the x-axis, then the curve for the long run is a the shape of a big bowl (or U with a flattened bottom): downward sloping for small Q, flat for medium Q, and then upward sloping for large Q. That reflects the increasing returns to scale as production begins, constant returns to scale when production is medium, and then decreasing returns to scale as production becomes very large.

If plotted on the same graph, the short-run unit costs would be little bowls (or Us) are sitting on top of the bigger curve of long run costs. SHORT-RUN COSTS NEVER DIP BELOW LONG-RUN UNIT COSTS. That is because short-run unit costs are always equal or greater than long-run unit costs.

The key to increasing returns to scale, which is what ever company owner wants, is division of labor. Train employees to become specialists at certain functions so that they can be performed more efficiently. Henry Ford was a master at this, training his workforce in a way that each employee was an expert at a particularized aspect of the assembly line. The more specialized employees can become, the faster they can accomplish their task. After a while, they could almost do their job in their sleep. Which is a good thing, because doing the same task over and over puts one to sleep!

Charlie Chaplin mocked this division of labor in the mostly silent movie, Modern Times, made in 1936. In it, he portrays a factory working toiling in a dehumanizing position under the pressure of a mean boss. Charlie is just trying to earn a decent living and buy a house for his wife Paulette and himself, but bad luck keeps getting the way. The theme of class struggle occurs repeatedly in politics to this day. In 1988, Democratic presidential candidate Michael Dukakis emphasized the need for Americans to have good jobs, not just any job.

IV. Accounting

Keeping track of all the revenue, expenses and profits is the task of accountants. This is its own profession: like doctors, lawyers, ministers, teachers, and so on, there is the profession of accounting. You take courses in this in college, and can pass exams to become a certified public accountant (CPA). They provide services to businesses and earn a fine living. It involves numbers, but never becomes more complicated than ordinary arithmetic.

It is the job of accountants to calculate the profits of a business: Accounting profits equal total revenue minus explicit costs. The explicit costs are the expenses of the inputs, such as workers’ wages, cost of materials, and the cost of maintenance and depreciation on facilities like plants and equipment. (Depreciation is the predictable wear and tear on something that makes it gradually less valuable and useful.)

Economic profit is a broader concept than accounting profit. Economic profit includes all of the implicit costs, such as the opportunity cost of the time and effort spent by an owner (which can be enormous) and also the opportunity cost of investment in the firm. If a company turns a $1 accounting profit each year, then you can bet it has a huge economic loss once you factor in all the opportunity costs.

The highly publicized scandals of Enron and WorldCom suggest that there are tricks of accounting to overstate the profitability of a company. If you ever consider investing or even working for a company, you should be aware of the distortions that are possible in accounting. The rule caveat emptor (buyer beware) applies to investors just as much as consumers.

It is easy to overstate sales, particularly sales projections. It is easy to overstate the value of a company’s inventory. Something about money makes everyone want to exaggerate. That’s because nobody can ever obtain enough money to satisfy themselves. Take assertions about money with a grain of salt. Even if there is a lot of money somewhere, it is virtually never as meaningful as people claim.

Companies also find it easy to understate depreciation (wear and tear) and future liabilities. Some companies, like Ford Motor Company, may actually be completely broke once the true costs of its pensions for retired workers are taken into account.

Occasionally a major company will suddenly declare itself to be broke and will ask the government for a bailout to save its jobs. The car maker Chrysler did this about 25 years ago. The federal government, despite substantial criticism, provided cheap loans to Chrysler to keep it out of bankruptcy. So many jobs were at stake that there was political benefit to some officials for doing this. But don’t expect the government ever to save a company you work for from going bankrupt. Should the government bail out a company to keep it from going bankrupt?

V. Alfred Sloan

Born in 1875 in Brooklyn, Alfred P. Sloan, Jr., preferred studying over playing. After attending college, he went to work in ball-bearing factory in New Jersey. His employer was having financial difficulties, and Alfred persuaded his father to buy the troubled company at a discount. His father was an importer of coffee and knew nothing about the ball-bearing business. Alfred took it over.

In just six months Alfred was able to revive the company, and then ran it for 17 years before selling it in 1916 at a handsome profit to the founder of General Motors (GM) car company. Alfred then joined GM and spent five years studying its operation in detail as he worked there. He wrote and published The Organizational Study, which was the first treatise on management ever written. Its inspiration was the U.S. Constitution and its system of checks and balances. Sloan’s vision was to divide GM into many small divisions that could have their own revenue and cost targets, and check and balance other divisions in the company. The high performers could be easily identified and given greater resources; the poor performers could be replaced.

When Sloan was promoted to become Chairman of GM in 1923, GM had less than one-fifth of the car market. Ford Motor Company, founded by the legendary Henry Ford, enjoyed over half of all car sales. But within a mere eight years, by 1931, GM surpassed Ford based on Sloan’s organizational principles. GM became the largest corporation in the world. Sloan’s vision was for GM to make a car for every purse and purpose.

Sloan ultimately gave much of his wealth to found the Sloan-Kettering Cancer Center in New York, considered the finest in the world. What’s good for GM is good for America became a popular saying due to Sloan’s leadership of the company.

Times are different today, and GM may no longer deserve that motto. GM is now the largest private employer in Mexico. In its defense, it would say it has to move production to Mexico to lower its costs and compete with cars imported from Japan and Korea.

VI. Assignment

Read and, if necessary, reread the above lecture. Then skim (a detailed read is not necessary) the Wikipedia handout material: http://en.wikipedia.org/wiki/Accounting

Homework questions:

  1. Accounting profit is ________ minus _________.
  1. Suppose your company spends $10,000 on labor and $30,000 on equipment for an output of 5000 widgets. You increase your labor costs to $15,000 and your equipment costs to $45,000, and your output increases to 8000. Describe your return to scale.
  1. Presumably there is constant or increasing return to scale for the entire world itself. Suppose the population doubled and the other utilized economic inputs (air, water, capital, etc.) doubled as needed. What would happen to economic output, such as new inventions and food production?
  1. In comparing the short run to the long run, what might the insight of Coase yield? For example, suppose option A immediately gives your company an extra $10,000, but option B gives your company no money but a better long-term market position. Which option do you take?
  1. Suppose you hire an employee who just took this course, and he says you should invest everything you have in a new facility to reap long-run efficiencies. Why might you say no?
  1. Suppose Alexandra is going to hire people to write a book about homeschooling. It will cover all aspects of the topic. What will the returns to scale be on that project? At what point and why might there be decreasing returns to scale?
  1. When communists took over China, they destroyed their big steel mills and told every household to built its own little steel furnace to prove the superiority of communist will. What do you think happened to their economic output? Explain, using economic terms.
  1. Suppose Joseph knows more than real doctors do, and in emergencies has actually saved several lives. He wants to see and treat patients no one else will treat, but lacks a license to practice. Is this a short-run or long-run issue for him? Should the State require licenses?
  1. Tim’s company grew to 500,000 workers, but then faced bankruptcy and layoffs. Suppose he seeks legislation to grant him a special zero-interest government loan to make it through the tough times. Should he receive one?

 

 

Extra credit (4 points each for questions 10 and 11; 6 points for question 12):

 

  1. Suppose (ph)armer Phyllis invented fertilizer that is costly to make but has an ever-increasing marginal product. Suppose she owns an acre of farmland in South Jersey, and now must decide between buying more acres or making more fertilizer. Which does she do? Explain.

 

  1. A company’s stock price often rises when it announces taking a large one-time write-off (or loss) on its accounting books. Using one or more principles learned in this course, can you explain reasons for that effect on the stock price?

 

  1. The tremendous economic growth of the 1980s and 1990s resulted from the supply side economic policies of President Ronald Reagan, which boosted production by cutting taxes and encouraging investment. Why might the supply side be more important than the demand side?