An article in Business Week warned of the dangers of deflation as the collapse of numerous Asian economies was creating worries that Asia might try to “ export its way out of trouble” by oversupplying everything from automobiles to semiconductors. Evidence that deflation had become a genuine concern for managers was provided by a statement in the article by John Smith, chairman and CEO of General Motors Corporation: “Fundamentally, something has changed in the economy. In today’s age, you cannot get price increases. ” The article offers the following advice to managers: “Productivity growth lets companies boost profits even as prices fall.” Using short-run production and cost theory, comment on this advice.

The advice offered to managers in the article is that productivity growth can help companies increase their profits even in the face of falling prices, which is a characteristic of deflationary periods. To evaluate this advice using short-run production and cost theory, we need to consider the relationship between production, costs, and profits.

In the short run, a company's production is determined by its existing factors of production, such as machinery, labor, and capital. These factors are considered fixed in the short run, meaning they cannot be easily adjusted. In this context, productivity growth refers to increasing the efficiency and effectiveness of these fixed factors of production.

When a company experiences falling prices due to deflation, it means the revenue obtained from selling goods or services decreases. However, if the company can increase its productivity and produce more output with the same amount of fixed resources, it will be able to reduce its average costs per unit of output. This is because the fixed costs are spread over a larger quantity of output, resulting in lower average costs.

By reducing average costs, the company can maintain or even increase its profit margins despite the decline in prices. This is because the lower average costs offset the decrease in revenue resulting from falling prices. In other words, the company can achieve higher profits by becoming more productive and efficient in its production process.

However, it is important to note that this advice is applicable only in the short run. In the long run, companies have more flexibility to adjust their factors of production, and the relationship between productivity, costs, and profits becomes more complex. Nonetheless, in the short run, productivity growth can indeed help companies mitigate the impact of deflation and improve their profitability.