ECON254. THEORY OF THE FIRM. TUTORIAL 4.

Q1.
The following diagram shows the cost curves of a firm under perfect competition.

(a) How much will the firm produce in order to maximise profits at a price
of £8 per unit? ......................................

(b) What will be its average cost of production at this output?.......................................................

(c) How much (supernormal) profit will it make?..........................................................................

(d) How much will the firm produce in order to maximise profits at a price
of £5 per unit? .......................................

(e) How much (supernormal) profit will it make?..........................................................................

(f) How much will the firm produce in order to maximise profits at a price
of £4 per unit? .......................................

(g) What will be its profit position now?........................................................................................

(h) Below what price would the firm shut down in the short run?..................................................

(i) Below what price would the firm shut down in the long run?...................................................
Q2.
A perfectly competitive firm has the following cost and revenue functions:

Total revenue: TR = 24Q

Total cost: TC = 200 + 4Q + 2Q2
Marginal revenue: MR = 24
Marginal cost: MC = 4 + 4Q

(don’t worry where the MR and MC expressions came from exactly, that is not the
point of the exercise – though they are first order differentials (calculus))

a) What is the profit maximising output? (hint: remember profit

maximisation happens where MC=MR)
b) What is the total profit made? (hint : Π = TR – TC)
c) What are the fixed costs and variable costs at the ‘profit maximising’
output (hint look at the cost function and determine what part is not
dependent on output)? What sort of costs would be examples of fixed
costs?
d) Depict the situation in a costs and revenue sketch (which should include
MC, AC, MR & AR) being sure to label all points of interest.
e) Comment on whether, according to neoclassical theory, the firm should
stay in the industry in the short-run and the long-run.
f) If this firm is fairly typical of the industry, use a diagram to show how
long-run equilibrium might be restored in this industry.

Q3.
Illustrate with demand and supply diagrams how equilibrium price and output will
change in each of the following market scenarios. Distinguish where appropriate
between the long-run response and the short-run response you have depicted.
a) Loans to buy houses have recently become plentiful and cheap. The stock
of housing is very inelastic in the short run.
b) Farmers have a bumper harvest of wheat. Wheat has an extremely low
price elasticity of demand. Interpret the price-quantity output changes
from your diagram to explain why this is good/ bad news for farmers.
c) Demand for DVD players has grown enormously in recent years yet prices
have been falling sharply. Show how this is possible.
Q4.
Read the article “Is General Motors Running Out of Gas?” (adapted from
Management@Wharton, May 2006) below and consider the following questions in
preparation for class discussion.

a) What problems had General Motors experienced with its costs?

a) How and why is size (scale) relevant to this cost crisis?
c) How should General Motors’ management respond to this crisis?

(© Dr B.Murakozy, University of Liverpool, 2020)

Is General Motors Running Out of Gas?
(adapted from Management@Wharton, May 2006)

General Motors may be down but it's not out. At least not yet.

True, it's been a tough year for the giant auto manufacturer: a $1.1 billion first-quarter
loss, junk-bond status for its debt, a largely lackluster lineup of models, and a
mountain of health-care and pension liabilities that builds an immediate cost
disadvantage into every vehicle that rolls off the line.

But experts at Wharton and elsewhere who follow the car and truck business say that
GM is not on the verge of filing for bankruptcy protection, that it has a talented
management team and that some new models on the horizon may rev up sales. In
addition, a much-publicized bid for GM shares by billionaire financier Kirk Kerkorian
is a sign of confidence in the company, according to Wall Street analysts. GM also
has an especially profitable gem in its consumer-financing subsidiary, General Motors
Acceptance Corporation (GMAC), and GM's assets are worth far more than the
company's relatively paltry market capitalization of $18 billion would indicate.

For GM to survive and thrive over the long term, however, the company needs more
than a few hot models, although desirable products are certainly pivotal; it requires a
major structural and cultural overhaul, these people say. GM must start thinking small
-- not an easy task for a company that has never done that -- and accept a diminished,
yet still significant, role in the global auto business. If GM had recognized years ago
that a steady erosion of its share of the U.S. vehicle market was inevitable, it might
have taken strategic steps to ratchet down its size on its own terms, according to
Wharton management professor John Paul MacDuffie. As things stand, however, GM
is going to continue to shrink, not by its own volition, but largely due to pressure from
competitors and macroeconomic conditions over which it has little control.

"GM will end up being smaller," says MacDuffie. "If they had accepted that idea
sooner, it would have helped them. The very slow adjustment to the market-share
trends is why they have continued some strategies that have turned out to be bad
choices." Whenever the company lost market share, he adds, the rallying cry always
was, "We're going to get it back. We're going to get back to 37% or 33% or 29%."
Today, GM's share of the U.S. market is 25.6%. By comparison, Ford Motor's share is
18.2%.

MacDuffie -- who is also co-director of the International Motor Vehicle Program

(IMVP), which has a network of researchers at universities worldwide and is funded
by major automakers and suppliers, including GM -- says it is understandable why
that rallying cry has been so constant. GM's entire way of thinking has long been built
on the benefits of economies of scale: Good things happen when the company's plants
are operating at full capacity and sales volume is rising. But that culture has been
showing signs of strain for a long time as competitors, mostly from Asia, have eaten
away GM's market share.
Slow in Learning

GM was slow to get its plants ready to build "flexibly," that is, to assemble multiple
models in each plant, says MacDuffie. But because it is more expensive to outfit a
plant with that capability, GM hesitated to go that route. GM's sales projections
showed the company selling a large volume of large vehicles, especially sports utility
vehicles. If the product sold well, everyone was happy. If it did not sell well, GM
found itself stuck in a money-losing situation.

"That belief in volume, and doing whatever it takes to keep volume, has driven a lot
of their decisions," MacDuffie points out. "GM's labor costs are fixed, meaning they
remain the same regardless of what the volume of sales is. GM wanted to keep
factories open as much as possible. There was some value in that strategy, but I think
they overdid it. That strategy delayed them in starting to engage the United Auto
Workers (UAW) on [health care and pension issues]."

John Moavenzadeh, executive director of IMVP, describes GM as "a formidable

company with substantial resources. They have managed turnarounds before in the
past." But Moavenzadeh labels the company's current situation "dire," adding: "It
seems to me like they can't get out of this trap with the company in its existing form,
or by making incremental improvements, or even by getting a few more hit products.
It seems like there has to be some sort of a restructuring that takes place."

Another researcher at IMVP, Matthias Holweg, a lecturer at the Judge Institute of

Management at the University of Cambridge in England, says "GM is too
conservative, not inventive enough." He adds: "In terms of product design and
engineering, the Big Three [GM, Ford and Chrysler] have fallen behind their Japanese
competitors. Recently, Chrysler has developed a much more attractive product
strategy. Neither Ford nor GM has been able to adapt to that."

Gerald Meyers, former chairman of American Motors, a now-defunct company that

once competed with GM, Ford and Chrysler in the days of the Big Four, also predicts
that GM's market share will continue to shrink. In 10 years or so, he says, "The U.S.
auto industry will be much like the European industry is right now -- in a word,
fragmented. Everybody will be fighting to get as much as 15% of the market. Nobody
will exceed that for very long, if they get it at all."

Meyers notes that GM also is buffeted by macroeconomic winds that are damaging
the company's bottom line and over which it has no control. Prices for steel, oil and
plastics all have risen in recent years. GM also is burdened with legacy costs over
which it has little control if it keeps its current promises to employees. "Health care is
the one you hear most about -- and it's big," Meyers says. "But pension costs are
enormous too."

Meyers also cites GM's culture as a key barrier to turning the company around. "GM's
got enormous momentum of the wrong kind. It has, in decades past, been hugely
successful. The culture has said, 'Whatever we've done in the past will repeat itself',
but that's not working in the current environment." Meyers admires GM's top
executives -- G. Richard Wagoner Jr., chairman and CEO; John M. Devine, vice
chairman and chief financial officer; and Robert A. Lutz, vice chairman of global
product development and well-known "car guy." "I know these people personally,"
says Meyers, noting that "they are doing their utmost to turn that organization around.
So far, they have not succeeded."

Labor-Management Talks

Meyers does not expect GM to receive any significant relief in the form of a
willingness by the United Auto Workers to reopen their current labor agreement,
which expires in 2007, and grant concessions to GM to save the company money.
"The UAW shows no inclination to back off and I don't think they can as a practical
matter," Meyers says. "The UAW's position is, 'We didn't create your problem and
were not going to solve it.'"

A New Strategy

In May, GM announced that it was launching a new marketing strategy in an attempt

to increase U.S. sales. Among other things, the company said it would use price cuts
to jump start sales rather than relying on 0% financing and rebates, which have hurt
its bottom line in the last few years; eliminate overlapping models and consolidate the
Pontiac and Buick nameplates; and strengthen its effort to sell more GM vehicles on
the East and West coasts, where foreign car sales are especially strong.

If it is clear that all is not doom and gloom for GM, it is also clear that the company is
at a crossroads.

Says MacDuffie: "There's a greater likelihood that the pendulum will swing back to
GM doing better than worse. But there does seem to be something about this
particular moment that feels like a tipping point of some kind, and I'm still trying to
figure out why it feels that way. Some of what I sense may be how the American
consumer looks at GM versus foreign competition. Some consumers always bought
American cars. Maybe, finally, after all these years of investing in American plants
and American jobs, Toyota and Honda have created a sense that consumers can feel
patriotic and still buy a Toyota and Honda. That could be part of what's going on. It's
not about GM, or Ford, in a performance vacuum, but a subtle shift in how loyal
people are to GM and Ford. That really is the tipping point: If people feel they can
embrace the cars of foreign competitors, that's a recipe for GM becoming a smaller
company much sooner."