An article in BusinessWeek 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 given in the article to managers is that productivity growth allows companies to increase their profits even when prices are falling due to deflation. To analyze this advice using short-run production and cost theory, let's break it down step by step:
1. Short-run production theory: This theory states that in the short run, companies have fixed inputs (such as capital and technology) and variable inputs (such as labor and raw materials). In the short run, a firm can increase its output by increasing the variable inputs while keeping the fixed inputs constant.
2. Cost theory: Cost theory suggests that there are fixed costs (such as rent, depreciation, and insurance) and variable costs (such as labor and raw material costs). In the short run, fixed costs cannot be easily adjusted, while variable costs can be changed according to the level of output.
Based on these theories, we can analyze the given advice:
1. Productivity growth: Increasing productivity means producing more output with the same amount of inputs. If a company can increase its productivity, it can produce more units of output without incurring additional costs. This allows the firm to take advantage of economies of scale and reduce average costs per unit.
2. Falling prices: In a deflationary environment, prices across the economy are generally declining. If a company cannot increase its prices due to weak demand or intense competition, it may face declining revenues. However, if the company can maintain or increase its level of output through productivity growth, it can offset the negative impact of falling prices on its revenue.
3. Boosting profits: By increasing productivity and keeping costs under control, a company can maintain or increase its profit margins. This is achieved by minimizing the decline in revenues associated with falling prices while avoiding significant increases in variable costs.
In conclusion, the advice given in the article is supported by short-run production and cost theory. By focusing on productivity growth, companies can increase their output without incurring additional costs. This can help offset the negative impact of falling prices during deflationary periods and allow them to maintain or even boost their profits.
The advice offered in the article suggests that managers can mitigate the negative effects of deflation by focusing on productivity growth. To analyze this advice using short-run production and cost theory, we need to consider how changes in prices and productivity affect a firm's profits.
In the short run, a firm's production and costs are often assumed to be influenced by both fixed and variable factors. Fixed factors include things like capital and the size of the firm's facility, while variable factors include labor and raw materials. In the context of deflation, it is important to note that the prices of these variable factors may also be falling.
When prices fall due to deflation, it becomes more challenging for firms to increase their revenues through price increases. This is where productivity growth comes into play. By improving productivity, firms can produce more output with the same or even fewer inputs. This enables them to lower their per-unit production costs.
In the short run, assuming that fixed factors remain the same, a decrease in per-unit production costs will result in higher profits. This is because the firm can sell its output at lower prices while maintaining or increasing its profit margins.
Therefore, the advice offered in the article aligns with short-run production and cost theory. By focusing on productivity growth, firms can increase their profits even in the face of deflation. However, it is important to note that this strategy may have limitations in the long run, as firms will eventually reach the boundaries imposed by their fixed factors of production.