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Chapter 7: Problem 5

A recent issue of Business Week reported the following: During the recent auto sales slump, GM, Ford, and Chrysler decided it was cheaper to sell cars to rental companies at a loss than to lay off workers. That's because closing and reopening plants is expensive, partly because the auto makers' current union contracts obligate them to pay many workers even if they're not working. When the article discusses selling cars "at a loss," is it referring to accounting profit or economic profit? How will the two differ in this case? Explain briefly.

Short Answer

Expert verified
The 'loss' that GM, Ford, and Chrysler are experiencing due to selling cars at a price below production costs refers to an accounting loss. While it may seem like they are operating at a deficit, the companies are actually trying to minimize their total costs when one considers the economic aspects. The costs of laying off workers and shutting down/reopening plants, which include both explicit and implicit costs, might outstrip the loss from selling their cars to rental companies below cost.

Step by step solution

01

Analyze the context

Begin by analyzing the situation. GM, Ford and Chrysler are selling cars to rental companies at a loss to avoid laying off workers. It's stated that shutting down and restarting production plants is costly due to union contracts obligating the payment of many workers, regardless of employment status.
02

Identify the type of 'loss'

Considering the context, the 'loss' they are referring to would be an accounting loss. This is because the auto manufacturers are selling the vehicles for less than the explicit costs associated with producing them, such as materials, labor, and overhead.
03

Consider the alternative (economic profit)

If we consider economic profit, which includes opportunity costs, the loss might look different. For instance, the opportunity cost of laying off workers and shutting down plants includes the cost of unemployment payments, possible damaging publicity, and the potential loss of skilled labor. Therefore, the decision may not represent an economic loss, as the alternative option could be more costly than selling at an accounting loss.

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Most popular questions from this chapter

You manage a plant that mass-produces engines by teams of workers using assembly machines. The technology is summarized by the production function \\[ q=5 K L \\] where \(q\) is the number of engines per week, \(K\) is the number of assembly machines, and \(L\) is the number of labor teams. Each assembly machine rents for \(r=\$ 10,000\) per week, and each team costs \(w=\$ 5000\) per week. Engine costs are given by the cost of labor teams and machines, plus \(\$ 2000\) per engine for raw materials. Your plant has a fixed installation of 5 assembly machines as part of its design. a. What is the cost function for your plant-namely, how much would it cost to produce \(q\) engines? What are average and marginal costs for producing \(q\) engines? How do average costs vary with output? b. How many teams are required to produce 250 engines? What is the average cost per engine? c. You are asked to make recommendations for the design of a new production facility. What capital/ labor \((K / L)\) ratio should the new plant accommodate if it wants to minimize the total cost of producing at any level of output \(q ?\)

Suppose a firm must pay an annual tax, which is a fixed sum, independent of whether it produces any output. a. How does this tax affect the firm's fixed, marginal, and average costs? b. Now suppose the firm is charged a tax that is proportional to the number of items it produces. Again, how does this tax affect the firm's fixed, marginal, and average costs?

Suppose the long-run total cost function for an industry is given by the cubic equation \(\mathrm{TC}=\mathrm{a}+\mathrm{bq}+\mathrm{cq}^{2}+\mathrm{d} q^{3}\) Show (using calculus) that this total cost function is consistent with a U-shaped average cost curve for at least some values of \(a, b, c,\) and \(d\).

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