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Chapter 7 PRODUCTION ANALYSIS AND COMPENSATION POLICY QUESTIONS AND ANSWERS Q7.1 Q7.

1 Is use of least-cost input combinations a necessary condition for profit maximization? Is it a sufficient condition? Explain. ANSWER Employment of least-cost input combinations is a necessary but not sufficient condition for profit maximization. It is necessary because a failure to operate with a least-cost input combination means that costs could be lowered and profits increased at any given output level. It is not a sufficient condition because the cost-minimizing level does not incorporate any information concerning demand relations, and therefore provides no information about the optimal level at which to operate: that is, information concerning demand relations must be added to the analysis to determine how much to produce for profit maximization (an optimal level of output). In short, employment of a least-cost input combination will result in an optimal production of a target level of output. Conversely, employment of inputs such that MRPi = Pi for each input will result in an optimal production of an optimal level of output. Q7.2 Output per worker is expected to increase by 10 percent during the next year. Therefore, wages can also increase by 10 percent with no harmful effects on employment, output prices, or employer profits. Discuss this statement. ANSWER This statement is correct so long as the projected increase in output per worker is solely due to an improvement in labor productivity and provided that the demand for output is also expected to rise. Gains in labor productivity are sometimes derived from an improvement in worker skill due to education or experience, elimination of obsolete work rules, labor-saving technical change, and so on. When increases in output per worker can be directly attributed to such gains in labor productivity, a commensurate increase in wages can be justified with no resulting increase in output prices or decrease in employer profits. So long as output demand is growing as fast as the gain in labor productivity, no reduction in employment opportunities will result. However, should output demand be stagnant, an increase in labor productivity could reduce employment opportunities by reducing the number of workers required to produce a given level of output.

Q7.2

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Chapter 7 It is important to recognize that increases in output per worker are sometimes made possible by increased capital investment per worker, improvements in supplier efficiency, and so on. In such instances, increases in output per worker are not directly attributable to gains in labor productivity, and do not imply that a higher wage rate could be justified.

Q7.3

Commission-based and piece-rate-based compensation plans are commonly employed by businesses. Use the concepts developed in the chapter to explain these phenomena. ANSWER Commission-based and piece rate-based compensation plans ensure that the relevant labor cost per unit of output is the same for all units produced (or sold). More productive employees earn greater total compensation, although less productive employees earn the same compensation per unit of output. Using output-oriented labor compensation schemes, employers ensure that the MPL/PL ratio is equal for all employees and that optimal labor input proportions are employed.

Q7.3

Q7.4 Q7.4

Hourly wage rates are an anachronism. Efficiency requires incentive-based pay tied to performance. Discuss this statement. ANSWER Given that many successful firms use hourly wage rates, it seems rash to dismiss them as an inefficient method for employee compensation. When hourly wages are paid, employees are expected to provide a standard level of effort per hour. Because reprimand or dismissal for substandard performance, or goldbricking, is always possible, even hourly employees have strong incentives to provide a satisfactory level of performance. In addition, being there is often an important component of an employee's service to customers. Thus, hourly input is often synonymous with the hourly output of service.

Q7.5 Q7.5

Explain why the MP/P relation is deficient as the sole mechanism for determining the optimal level of resource employment. ANSWER The equality of the MP/P ratio across input factors in a production system is necessary to insure a least-cost input combination for production of any level of output. Satisfying this requirement does not, however, insure that the optimal activity level has been selected because it does not reflect the demand for output. An equality of MP/P ratios can be found at activity levels both above and below that activity (output) level at which profits are maximized.

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Clarify how profits are maximized and the optimal level of employment is achieved in a competitive labor market when the price of labor PL = MRPL. ANSWER The MRPL represents the value created by each additional worker, and represents net marginal revenue considering all costs except wages. In a competitive labor market, the price of labor represents the marginal cost of employment. When the market wage rate PL < MRPL, the firm has an incentive to increase employment to further expand profits. When the market wage rate PL > MRPL, wages paid at the margin exceed the amount of additional revenue generated. Therefore, when the market wage rate PL > MRPL, the firm has an incentive to cut back on employment. An optimal level of employment is achieved only when the market price of labor PL = MRPL. At the optimal level of employment, all profitable workers are employed but no unprofitable workers are employed.

Q7.6

Q7.7

Oregons minimum wage increased from $4.75 in 1996 to $5.50 in 1997, to $6 in 1998, and to $6.50 in 1999. According to a study by the Oregon Center for Public Policy, the minimum wage increases in Oregon did not harm welfare recipients opportunities to find work. In fact, a larger percentage of welfare recipients in Oregon found jobs after the minimum wage increased than before the increases. Discuss how these facts could be consistent with a downward-sloping demand curve for unskilled labor. ANSWER It is interesting to note that sharp increases in the Oregon state minimum wage during the late-1990s had little apparent effect on the ability of welfare recipients to find new higher-pay job opportunities. While perhaps surprising, these facts are entirely consistent with a downward sloping demand curve for unskilled labor. By itself, a simple increase in the state minimum wage has the effect of decreasing the quantity demanded of unskilled labor. This involves an upward movement along the labor demand curve. However, during the late-1990s, changes in the pace of economic activity were not stagnant. The late-1990s was a period of robust economic expansion and rising demand for labor. As sales rise, companies are able to spend more to attract workers, including minimum wage workers. Increasing demand for unskilled labor, reflected by a rightward shift in the labor demand curve, obviously overwhelmed the employment decreasing effect of rising minimum wages during this period.

Q7.7

Q7.8

Powerful unions like the AFL-CIO are staunch advocates for increasing the federal minimum wage despite the fact that highly-trained and experienced AFL-CIO workers

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Chapter 7 tend to earn far more than the minimum wage. Can you give an economic rationale for the AFL-CIOs position?

Q7.8

ANSWER Higher Federal minimum wages increase the number of workers willing to work, but decrease the number of workers employers are willing to hire. Raising wages by governmental edict creates a surplus of labor, or unemployment. Ample empirical evidence has led most economists to accept this conclusion. The magnitude of the unemployment effects of minimum wage increases can be questioned, but the existence of those effects is clear. An increase in the Federal minimum wage has the greatest impact on those with low skills whose normal wage would be less than or near the legally established minimum. However, as minimum wages are raised secondary effects can increase the wages of other workers. Most products can be produced in different ways. For example, crops can be harvested with stoop labor or by skilled workers using expensive machinery. As a result, unskilled labor often competes directly or indirectly with semiskilled and skilled labor. Some economists contend that this explains why the AFL-CIO staunchly supports increasing the minimum wage even though almost all AFL-CIO workers earn far more than the minimum. Increasing the minimum wage is sometimes seen as organized labor's attempt to eliminate price competition from low-price and low-skilled labor.

Q7.9 Q7.9

Cite some ways for increasing productivity growth in the United States. ANSWER During the 2000-05 period, the pace of annual increase in productivity in the United States averaged 3.1 percent, a big jump from the 1.4 percent annual rate common during the 1973-1995 period. This burst in U.S. productivity growth is greater than in many advanced industrial economies. Faster growth of inputs, both physical and human capital, is a major cause of faster productivity growth. In the United States, the capital-labor ratio has grown faster since the early-1990s, but not enough to account for all of the recent increase in productivity growth. The contribution from greater capital services, called capital deepening, is clearly evident. The rate of increase of human capital, as measured by the average education level and experience of workers, has accelerated since the 1950s and 1960s. Human capital growth is now responsible for roughly one-quarter of total productivity growth during the past 30 years. Therefore, policies to increase investment, education, and training, are an important contributor to the recent boost in U.S. productivity. A significant share of the recent boost in productivity growth is attributable to the more effective use of worker skills made possible through recent improvements in

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communications technology. Increasingly, companies have been eager to buy powerful computers and computer software at relatively low prices. Rapid advances in computer hardware and software technology, combined with the widespread adoption of the Internet, have led to an unprecedented boom in communications technology. Benefits from the recent boom in communications technology are evident in every home and workplace, and are broadly reflected in the 2000-05 burst in U.S. productivity growth. Q7.10 Explain why company productivity is important to managers, employees, and investors. Is superior worker productivity a necessary and sufficient condition for above-average compensation? ANSWER For managers and other employees, profits and revenues per employee give helpful insight concerning the income potential from employment. When profits and revenues per employee are high, the potential for high wages and growing incomes for exceptional employees can be significant. On the other hand, companies in industries that fail to generate attractive rates of return on investment rarely have the wherewithal to pay attractive and growing salaries. For example, Microsoft is well known for generous compensation policies that have allowed many Microsoft employees to earn stock-based rewards in excess of one million dollars each. At the same time, total compensation tends to be low for employees of regulated utilities and in other low-profit industries. Similarly, for investors, profits and revenues per employee give valuable insight on the investment potential of various companies and industries. For example, financial services like stock brokerage and specialized insurance are marvelous businesses that hold out the potential for exceptional rates of return for investors. Conversely, garbage collection (environmental and waste) is a tough business where it is extraordinarily difficult to make above-average rates of return. Finally, it is worth remembering that superior worker productivity is only a necessary and not sufficient condition for above-average compensation. When profits and revenues per employee are high, the potential for high wages and growing incomes for exceptional employees can be significant. However, wages and employee compensation reflect the relative productivity of the marginal employee. Only superior employees with hard-to-duplicate contributions can expect to earn above-average compensation. SELF-TEST PROBLEMS AND SOLUTIONS ST7.1 Optimal Input Usage. Medical Testing Labs, Inc., provides routine testing services for blood banks in the Los Angeles area. Tests are supervised by skilled technicians using equipment produced by two leading competitors in the medical equipment industry. Records for the current year show an average of 27 tests per hour being performed on the Testlogic-1 and 48 tests per hour on a new machine, the Accutest-3.

Q7.10

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Chapter 7 The Testlogic-1 is leased for $18,000 per month, and the Accutest-3 is leased at $32,000 per month. On average, each machine is operated 25 eight-hour days per month. A. B. C. D. Describe the logic of the rule used to determine an optimal mix of input usage. Does Medical Testing Lab usage reflect an optimal mix of testing equipment? Describe the logic of the rule used to determine an optimal level of input usage. If tests are conducted at a price of $6 each while labor and all other costs are fixed, should the company lease more machines?

ST7.1 A.

SOLUTION The rule for an optimal combination of Testlogic-1 (T) and Accutest-3 (A) equipment is MP T = MP A PT PA This rule means that an identical amount of additional output would be produced with an additional dollar expenditure on each input. Alternatively, an equal marginal cost of output is incurred irrespective of which input is used to expand output. Of course, marginal products and equipment prices must both reflect the same relevant time frame, either hours or months. On a per hour basis, the relevant question is 27 $18,000 /(25 8) 48 ? = $32,000 /(25 8)

B.

0.3 = 0.3 On a per month basis, the relevant question is 27 (25 8) $18,000 0.3 ? = 48 (25 8) $32,000

= 0.3

In both instances, the last dollar spent on each machine increased output by the same 0.3 units, indicating an optimal mix of testing machines. C. The rule for optimal input employment is

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MRP = MP MRQ = Input Price This means that the level of input employment is optimal when the marginal sales revenue derived from added input usage is equal to input price, or the marginal cost of employment. D. For each machine hour, the relevant question is Testlogic-1 MRPT = MPT MRQ ? PT = 27 $6 ? $18,000/(25 8) = $162 > $90. Accutest-3 MRPA = MPA MRQ ? PA = 48 $6 ? $32,000/(25 8) = $288 > $160. Or, in per month terms: Testlogic-1 MRPT = MPT MRQ ? PT = 27 (25 8) $6 ? $18,000 = $32,400 > $18,000. Accutest-3 MRPA = MPA MRQ ? PA = 48 (25 8) $6 ? $32,000 =

167 $57,600 > $32,000.

Chapter 7

In both cases, each machine returns more than its marginal cost (price) of employment, and expansion would be profitable. ST7.2 Production Function Estimation. Washington-Pacific, Inc., manufactures and sells lumber, plywood, veneer, particle board, medium-density fiberboard, and laminated beams. The company has estimated the following multiplicative production function for basic lumber products in the Pacific Northwest market using monthly production data over the past two and one-half years (30 observations): Q = b0 Lb1 K b2 E b3 where Q = output L = labor input in worker hours K = capital input in machine hours E = energy input in BTUs Each of the parameters of this model was estimated by regression analysis using monthly data over a recent three-year period. Coefficient estimation results were as follows: b0 = 0.9; b1 = 0.4; b 2 = 0.4; and b3 = 0.2 The standard error estimates for each coefficient are:

b0 = 0.6; b1 = 0.1; b2 = 0.2; b3 = 0.1


A. B. Estimate the effect on output of a 1 percent decline in worker hours (holding K and E constant). Estimate the effect on output of a 5 percent reduction in machine hours availability accompanied by a 5 percent decline in energy input (holding L constant). Estimate the returns to scale for this production system.

C. ST7.2

SOLUTION

Production Analysis and Compensation Policy A.

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For Cobb-Douglas production functions, calculations of the elasticity of output with respect to individual inputs can be made by simply referring to the exponents of the production relation. Here a 1 percent decline in L, holding all else equal, will lead to a 0.4 percent decline in output. Notice that:

Q/Q Q L = L/L L Q

(b0 b1 Lb1 - 1 K b 2 E b 3) L = Q

b0 b1 L b1 K b 2 E b 3 b 0 L b1 K b 2 E b 3

-1+1

= b1

And because (Q/Q)/( L/L) is the percent change in Q due to a 1 percent change in L, Q/Q L/L = b1

Q/Q = b1 L/L = 0.4(-0.01) = -0.004 or -0.4 percent B. From part A it is obvious that: Q/Q = b2(K/K) + b3(E/E) = 0.4(-0.05) + 0.2(-0.05)

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= -0.03 or -3 percent C. In the case of Cobb-Douglas production functions, returns to scale are determined by simply summing exponents because: Q = b0 L b1 K b 2 E b 3 hQ = b0 (kL ) b1 (kK ) b 2 (kE )b 3 = k b1 + b 2 + b 3 b0 L b1 K b 2 E b 3 = k b1 + b 2 + b 3 Q Here b1 + b2 + b3 = 0.4 + 0.4 + 0.2 = 1 indicating constant returns to scale. This means that a 1 percent increase in all inputs will lead to a 1 percent increase in output, and average costs will remain constant as output increases. PROBLEMS AND SOLUTIONS P7.1 Marginal Rate of Technical Substitution. The following production table gives estimates of the maximum amounts of output possible with different combinations of two input factors, X and Y. (Assume that these are just illustrative points on a spectrum of continuous input combinations.) Units of Y Used 5 4 3 2 1 210 188 162 130 94 1

Estimated Output per Day 305 272 234 188 130 2 360 324 282 234 162 3 421 376 324 272 188 4 470 421 360 305 210 5

Units of X used A. B. Do the two inputs exhibit the characteristics of constant, increasing, or decreasing marginal rates of technical substitution? How do you know? Assuming that output sells for $3 per unit, complete the following tables: X Fixed at 2 Units

Production Analysis and Compensation Policy Marginal Revenue Product of Y

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Units of Y Used 1 2 3 4 5

Total Product of Y

Marginal Product of Y

Average Product of Y

Y Fixed at 3 Units Total Product of X Marginal Product of X Average Product of X Marginal Revenue Product of X

Units of X Used 1 2 3 4 5 C. D.

Assume that the quantity of X is fixed at 2 units. If output sells for $3 and the cost of Y is $120 per day, how many units of Y will be employed? Assume that the company is currently producing 162 units of output per day using 1 unit of X and 3 units of Y. The daily cost per unit of X is $120 and that of Y is also $120. Would you recommend a change in the present input combination? Why or why not? What is the nature of the returns to scale for this production system if the optimal input combination requires that X = Y?

E. P7.1 A.

SOLUTION The inputs exhibit the characteristic of a decreasing marginal rate of technical substitution throughout. For decreasing MRTS, the slope of the production isoquants diminishes as one input is increasingly substituted for another. We can also see this point algebraically by holding X or Y constant in the input-output matrix and noting the decline in the relative marginal product of the other input as its usage level grows.

B.

171 X Fixed at 2 Units Units of Y Employed 1 2 3 4 5 Units of X Employed 1 2 3 4 5 C. TPY (1) 130 188 234 272 305 TPX (1) 162 234 282 324 360 MPY (2) 130 58 46 38 33 MPX (2) 162 72 48 42 36 APY (3) 130 94 78 68 61 APX (3) 162 117 94 81 72 MRPY (4) = $3 (2) $390 174 138 114 99 MRPX (4) = $3 (2) $486 216 144 126 108

Chapter 7

Y Fixed at 3 Units

Y = 3 will be employed. The marginal value of the first three units of Y is greater than their marginal cost. The marginal value of the fourth unit is only $114 or $6 less than its cost, and hence, the firm would employ no more than 3 units of Y. A change would be in order because the firm could produce 188 units at the same cost using 2 units of each output: that is, the marginal product to price ratios of the two inputs are not equal at the current input proportions. Relatively less Y, and more X, is needed to provide an optimal combination. The system exhibits constant returns to scale. This is true because a given increase in both inputs causes an increase in output of the same proportion. X 1 2 3 4 5 Y 1 2 3 4 5 Output 94 1 = 94 94 2 = 188 94 3 = 282 94 4 = 376 94 5 = 470

D.

E.

P7.2

Production Function Concepts. Indicate whether each of the following statements is true or false. Explain your answers.

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A. B. C. D. E. P7.2 A.

Decreasing returns to scale and increasing average costs are indicated when Q < 1. If the marginal product of capital falls as capital usage grows, the returns to capital are decreasing. L-shaped isoquants describe production systems in which inputs are perfect substitutes. Marginal revenue product measures the profit earned through expanding input usage. The marginal rate of technical substitution will be affected by a given percentage increase in the marginal productivity of all inputs.

SOLUTION True. When Q < 1, the percentage change in output is less than a given percentage change in all inputs. Thus, decreasing returns to scale and increasing average costs are indicated. True. Returns to the capital input factor are decreasing when the marginal product of capital falls as capital usage grows. False. L-shaped production isoquants reflect a perfect complementary relation among inputs. False. Marginal revenue product is the revenue generated by expanding input usage and represents the maximum that could be paid to expand usage. Because MRP is calculated before input costs (wages in the case of labor, for example), it does not measure the increase in profit earned through expansion. False. The marginal rate of technical substitution is measured by the relative marginal productivity of input factors. This relation is unaffected by a commensurate increase in the marginal productivity of all inputs. Compensation Policy. Pay for performance means that employee compensation closely reflects the amount of value derived from each employees effort. In economic terms, the value derived from employee effort is measured by net marginal revenue product. It is the amount of profit generated by the employee, before accounting for employment costs. Holding all else equal, indicate whether each of the following factors would be responsible for increasing or decreasing the amount of money available for employee merit-based pay.

B. C. D.

E.

P7.3

173 A. B. C. D. E. P7.3 A. Government mandates for employer-provided health insurance Rising productivity due to better worker training Rising employer sales due to falling imports Falling prices for industry output Rising prevalence of uniform employee stock options.

Chapter 7

SOLUTION Decreasing. Government mandates for employer-provided health insurance increase the costs of employment with no offsetting benefit in terms of increasing worker productivity and thereby decrease the funds available for merit-based pay. Increasing. Rising productivity due to better worker training increases the profits gained through expanding employment and increases the pool of funds available for merit-based pay. Increasing. As imports fall, domestic output and employer sales revenue rise, holding all else equal. Thus, output demand and MR Q would rise and increase the pool of available funds for merit-based pay. Decreasing. As output prices fall, so too does MRQ and the MRP of workers. This reduces the pool of funds available for merit-based pay. Decreasing. A rising prevalence of uniform employee stock options increases the costs of employment with no offsetting gain in worker productivity. This reduces the pool of funds available for merit-based pay. Returns to Scale. Determine whether the following production functions exhibit constant, increasing, or decreasing returns to scale. A. B. C. D. E. Q = 0.5X + 2Y + 40Z Q = 3L + 10K + 500 Q = 4A + 6B + 8AB Q = 7L2 + 5LK + 2K2 Q = 10L0.5K0.3

B.

C.

D. E.

P7.4

P7.4

SOLUTION

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A.

Initially, let X = Y = Z = 100, so output is: Q = 0.5(100) + 2(100) + 40(100) = 4,250 Increasing all inputs by an arbitrary percentage, say 2 percent, leads to: Q = 0.5(102) + 2(102) + 40(102) = 4,335 Because a 2 percent increase in all inputs results in a 2 percent increase in output (Q2/Q1 = 4,335/4,250 = 1.02), the output elasticity is 1 and the production system exhibits constant returns to scale.

B.

Initially, let L = K = 100, so output is: Q = 3(100) + 10(100) + 500 = 1,800 Increasing both inputs by an arbitrary percentage, say 3 percent, leads to: Q = 3(103) + 10(103) + 500 = 1,839 Because a 3 percent increase in both inputs results in a 2.2 percent increase in output (Q2/Q1 = 1,839/1,800 = 1.022), the output elasticity is less than 1 and the production system exhibits diminishing returns to scale.

C.

Initially, let A = B = 100, so output is: Q = 4(100) + 6(100) + 8(100)(100) = 81,000 Increasing both inputs by an arbitrary percentage, say, 1 percent, leads to: Q = 4(101) + 6(101) + 8(101)(101) = 82,618 Because a 1 percent increase in both inputs results in a 2 percent increase in output (Q2/Q1 = 82,618/81,000 = 1.02), the output elasticity is greater than 1 and the production system exhibits increasing returns to scale.

D.

Initially, let L = K = 100, so output is: Q = 7(1002) + 5(100)(100) + 2(1002) = 140,000 Increasing both inputs by an arbitrary percentage, say, 2 percent, leads to: Q = 7(1022) + 5(102)(102) + 2(1022) = 145,656

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Chapter 7 Because a 2 percent increase in both inputs results in a 4 percent increase in output (Q2/Q1 = 145,656/140,000 = 1.04), the output elasticity is greater than 1 and the production system exhibits increasing returns to scale.

E.

Initially, let L = K = 100, so output is: Q = 10(1000.5)(1000.3) = 398 Increasing both inputs by an arbitrary percentage, say, 4 percent, leads to: Q = 10(1040.5)(1040.3) = 411 Because a 4 percent increase in both inputs results in a 3.3 percent increase in output (Q2/Q1 = 411/398 = 1.033), the output elasticity is less than 1 and the production system exhibits decreasing returns to scale.

P7.5

Optimal Compensation Policy. Caf-Nervosa.com, based in Seattle, Washington, is a rapidly growing family business that offers a line of distinctive coffee products to local and regional coffee shops. Assume founder and president Frasier Crane is reviewing the company's sales force compensation plan. Currently, the company pays its three experienced sales staff members a salary based on years of service, past contributions to the company, and so on. Niles Crane, a new sales trainee and brother of Frasier Crane, is paid a more modest salary. Monthly sales and salary data for each employee are as follows: Average Monthly Sales $160,000 100,000 90,000 75,000 Monthly Salary $6,000 4,500 3,600 2,500

Sales Staff Roz Doyle Daphne Moon Martin Crane Niles Crane

Niles Crane has shown great promise during the past year, and Frasier Crane believes that a substantial raise is clearly justified. At the same time, some adjustment to the compensation paid to other sales personnel also seems appropriate. Frasier Crane is considering changing from the current compensation plan to one based on a 5 percent commission. He sees such a plan as being fairer to the parties involved and believes it would also provide strong incentives for needed market expansion. A. Calculate Caf-Nervosa.com's salary expense for each employee expressed as a percentage of the monthly sales generated by that individual.

Production Analysis and Compensation Policy B. C. P7.5 A. Average Monthly Sales (2) $160,000 100,000 90,000 75,000 Monthly Salary (3) $6,000 4,500 3,600 2,500

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Calculate monthly income for each employee under a 5 percent of monthly sales commission-based system. Will a commission-based plan result in efficient relative salaries, efficient salary levels, or both?

SOLUTION

Sales Staff (1) Roz Doyle Daphne Moon Martin Crane Niles Crane B.

Commission (4) = (3)/(2) 3.75 percent 4.50 percent 4.00 percent 3.33 percent

Average Sales Staff (1) Roz Doyle Daphne Moon Martin Crane Niles Crane C.

Monthly Sales (2) $160,000 100,000 90,000 75,000

Commission (3) = (2) 0.05 $8,000 5,000 4,500 3,750

The commission-based compensation plan will result in more efficient relative salaries for sales personnel. Under this plan, Caf-Nervosa.com sales compensation costs average 5 percent, irrespective of which member of the sales staff generates a given dollar of sales. Each employee is treated equally under this plan in the sense that all are paid the same rate for generating business. Although a commission-based plan will result in an efficient relative salary structure, a 5 percent commission may or may not result in an optimal level of compensation being paid to each employee. If 5 percent of sales represents the net marginal revenue (marginal revenue minus all costs except sales expenses) generated by the sales staff, then optimal levels of compensation would be generated under such a commission-based plan. However, if net marginal revenues are different than this rate, some adjustment to the commission rate would be appropriate.

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P7.6

Optimal Input Mix. The First National Bank received 3,000 inquiries following the latest advertisement describing its 30-month IRA accounts in the Boston World, a local newspaper. The most recent ad in a similar advertising campaign in Massachusetts Business, a regional business magazine, generated 1,000 inquiries. Each newspaper ad costs $500, whereas each magazine ad costs $125. A. B. Assuming that additional ads would generate similar response rates, is the bank running an optimal mix of newspaper and magazine ads? Why or why not? Holding all else equal, how many inquiries must a newspaper ad attract for the current advertising mix to be optimal?

P7.6 A.

SOLUTION No. The rule for an optimal combination of newspaper (N) and magazine (M) ads is: MP N = MP M PN PM Here, the question is 3,000 $500 1,000 ? = $125

6 8 In other words, the last dollar spent on newspaper ads attracted six inquiries, while the last dollar spent on magazine ads attracted eight inquiries. Therefore, the current ad combination is not optimal. More magazine ads and/or fewer newspaper ads should be run. B. Currently, magazine ads return 33 percent (eight versus six) more inquiries per advertising dollar than do newspaper ads. Therefore, in order for the current ad mix to be optimal, inquiries generated by newspaper ads would have to increase by 33 percent from 3,000 to 4,000. To check: MP N PN 4,000 $500 = MP M PM

? 1,000 = $125

8 = 8

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P7.7

Marginal Revenue Product of Labor. To better serve customers interested in buying cars over the Internet, Smart Motors, Inc., hired Nora Jones to respond to customer inquiries, offer price quotes, and write orders for leads generated by the companys web site. During last year, Jones averaged 1.5 vehicle sales per week. On average, these vehicles sold for a retail price of $25,000 and brought the dealership a profit contribution of $1,000 each. A. B. Estimate Jones= annual (50 workweek) marginal revenue product. Jones earns a base salary of $60,000 per year, and Smart Motors pays an additional 28% of this base salary in taxes and various fringe benefits. Is Jones a profitable employee?

P7.7 A.

SOLUTION In the long run, Jones= marginal revenue product is the maximum amount Smart Motors could pay in base salary plus all fringe benefits. It is the amount of added revenue after all other variable costs that Jones= effort brings to the firm. In this case, Jones= marginal revenue product is determined by the number of cars sold and the profit contribution earned on each sale. MRPL = MPL MRQ = (Car sales per year) (Profit contribution per unit) = (1.5 50) ($1,000) = $75,000 Because Jones is only engaged in the sales function, Jones does not produce cars. What Jones does produce are car sales, and the added value to the employer of Jones= sales effort is what determines the amount the employer is willing and able to pay.

B.

No. In addition to base salary, employers must pay additional taxes and fringe benefits. All of these costs must be justified by the amount of marginal revenue product generated to justify employment. In this case, employment costs for Jones are $76,800 (= $60,000 1.28). A comparison of marginal revenue product figures with these employment cost data suggests: MRPL = $75,000 < $76,800 = PL Therefore, Jones brings in $75,000 per year in additional profit contribution, but costs Smart Motors $76,800. This means that Jones brings in $1,800 per year less in net marginal revenues than the marginal cost of employment. At the margin, Joness

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Chapter 7 employment represents a marginal loss to Smart Motors. Jones is not a profitable employee.

P7.8

Optimal Input Level. Ticket Services, Inc., offers ticket promotion and handling services for concerts and sporting events. The Sherman Oaks, California, branch office makes heavy use of spot radio advertising on WHAM-AM, with each 30-second ad costing $100. During the past year, the following relation between advertising and ticket sales per event has been observed: Sales (units) = 5,000 + 100A - 0.5A2 Sales (units)/ Advertising = 100 - A Here, A represents a 30-second radio spot ad, and sales are measured in numbers of tickets. Rachel Green, manager for the Sherman Oaks office, has been asked to recommend an appropriate level of advertising. In thinking about this problem, Green noted its resemblance to the optimal resource employment problem studied in a managerial economics course. The advertising/sales relation could be thought of as a production function, with advertising as an input and sales as the output. The problem is to determine the profit-maximizing level of employment for the input, advertising, in this production system. Green recognized that a measure of output value was needed to solve the problem. After reflection, Green determined that the value of output is $2 per ticket, the net marginal revenue earned by Ticket Services (price minus all marginal costs except advertising). A. B. C. Continuing with Green's production analogy, what is the marginal product of advertising? What is the rule for determining the optimal amount of a resource to employ in a production system? Explain the logic underlying this rule. Using the rule for optimal resource employment, determine the profitmaximizing number of radio ads.

P7.8 A.

SOLUTION The marginal product of advertising is given by the expression: MPA = S/A = $100 - A

B.

The rule for determining the optimal amount of a resource to employ is: MRPA = PA

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The logic of this rule can be best understood by simply dissecting the above relations: MRPA = PA MPA MRQ = PA Q TR A Q TR A = TC A TC A

TR = TC Inflow = Outflow C. The optimal advertising level is found where: MRPA = PA MPA MRQ = PA (100 - A) $2 = $100 200 - 2A = 100 -2A = -100 A = 50 P7.9 Net Marginal Revenue. Crane, Poole & Schmidt, LLC is a successful Boston-based law firm. Worker productivity at the firm is measured in billable hours, which vary between partners and associates. Partner time is billed to clients at a rate of $250 per hour, whereas associate time is billed at a rate of $125 per hour. On average, each partner generates 25 billable hours per 40-hour workweek, with 15 hours spent on promotion, administrative, and supervisory responsibilities. Associates generate an average of 35 billable hours per 40-hour workweek and spend 5 hours per week in administrative and training meetings. Variable overhead costs average 50 percent of revenues generated by partners and 60 percent of revenues generated by associates. A. Calculate the annual (50 workweek) net marginal revenue product of partners and associates.

181 B.

Chapter 7 If partners earn $175,000 and associates earn $70,000 per year, does the company have an optimal combination of partners and associates? If not, why not? Make your answer explicit and support any recommendations for change.

P7.9 A.

SOLUTION The annual marginal revenue product calculation for partners (P) and associates (A) identifies the amount of net revenue generated per employee. MRPP = MPP MRQ = (Billable hours per year) (Net marginal revenue per hour) = (25 50) ($250 0.5) = $156,250 MRPA = MPA MRQ = (Billable hours per year) (Net marginal revenue per hour) = (35 50) ($125 0.4) = $87,500 Here it is important to note that each marginal hour of effort by partners brings to the firm $250 in revenue plus $125 of variable costs, for a net marginal revenue (value) for partner output of $125 per hour. Similarly, the net marginal revenue of associate output is $50 per hour. Both net marginal revenue figures reflect the marginal value of each service output.

B.

A comparison of marginal revenue product figures with salary data suggests: MRPP = $156,250 < $175,000 = PP MRPA = $87,500 > $70,000 = PA Therefore, partners bring in $18,750 per year less in net marginal revenues than their salary, whereas associates bring in a surplus of $17,500. At the margin, a $175,000 salary for each partner represents a marginal loss of $18,750 to the firm, whereas a $70,000 salary for associates represents a marginal profit of $17,500. Holding all else equal, the firm might seek to marginally reduce the number of partners. Alternatively, some small increase in the number of associates could be warranted. Either move would help shift the firm to a position where MRPL = PL, and profits would be maximized.

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As a first step, the firm might expand the number of associates until such a point as MRPA = $70,000 = PA. Then, a reevaluation of MRPP should be made to see if it has increased, as seems likely. If the new MRPP = $175,000 = PP, no further change in staffing would be necessary. On the other hand, some adjustment (reduction) in the number of partners may be required. P7.10 Production Function Estimation. Consider the following Cobb-Douglas production function for bus service in a typical metropolitan area: Q = b0 Lb1 k b2 Fb3 , where Q = output in millions of passenger miles, L = labor input in worker hours, K = capital input in bus transit hours, and F = fuel input in gallons. Each of the parameters of this model was estimated by regression analysis using monthly data over a recent three-year period. Results obtained were as follows: b0 = 1.2; b1 = 0.28; b 2 = 0.63; and b3 = 0.12 The standard error estimates for each coefficient are:

b0 = 0.4; b1 = 0.15; b2 = 0.12; b3 = 0.07


A. B. C. P7.10 A. Estimate the effect on output of a 4 percent decline in worker hours (holding K and F constant). Estimate the effect on output of a 3 percent reduction in fuel availability accompanied by a 4 percent decline in bus transit hours (holding L constant). Estimate the returns to scale for this production system.

SOLUTION For Cobb-Douglas production functions, calculations of the elasticity of output with respect to individual inputs can be made by simply referring to the exponents of the production relation. Here a 4 percent decline in L, holding all else equal, will lead to a 1.12 percent decline in output because:

183 Q/Q Q L = L/L L Q

Chapter 7

(b0 b1 L b1 - 1 k b 2 Fb 3) L Q

b0 b1 L b1 k b 2 Fb 3 b0 L b1 K b 2 Fb 3

-1 + 1

= b1 Because (Q/Q)/( L/L) is the percent change in Q due to a 1 percent change in L, Q/Q L/L = b1

Q/Q = b1 L/L = 0.28(-0.04) = -0.0112 or -1.12 percent B. From part A it is obvious that: Q/Q = b2( K/K) + b3( F/F) = 0.63(-0.04) + 0.12(-0.03) = -0.0288 or -2.88 percent C. In the case of Cobb-Douglas production functions, returns to scale are determined by simply summing exponents because: Q = b0 L b1 K b 2 Fb 3 hQ = b0 (kL ) b1 (kK ) b 2 (kF )b 3 = k b1 + b 2 + b 3 b0 L b1 K b 2 Fb 3 = k b1 + b 2 + b 3 Q

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Here b1 + b2 + b3 = 0.28 + 0.63 + 0.12 = 1.03 > 1.0 indicating slight increasing returns to scale. This means that a 1 percent increase in all inputs will lead to a 1.03 percent increase in output, and average costs will fall slightly as output increases.

185 CASE STUDY FOR CHAPTER 7 Worker Productivity Among Giant U.S. Corporations

Chapter 7

Traditional measures of firm productivity tend to focus on profit margins, the rate of return on stockholders equity, or related measures like total asset turnover, inventory turnover, or receivables turnover. Profit margin is net income divided by sales and is a useful measure of a companys ability to manufacture and distribute distinctive products. When profit margins are high, its a good sign that customer purchase decisions are being driven by unique product characteristics or product quality rather than by low prices. When profit margins are high, companies are also able to withstand periods of fluctuating costs or weak product demand without devastating consequences for net income. While high profit margins have the potential to attract new competitors, they also act as credible evidence that a firm offers a hard-to-imitate combination of attractive goods and services. Return on equity (ROE), defined as net income divided by the accounting book value of stockholders equity, is an attractive measure of firm performance because it reflects the effects of both operating and financial leverage. When ROE is high, the company is able to generate an attractive rate of return on the amount of money entrusted to the firm by shareholders in the form of common stock purchases and retained earnings. High profit margins give rise to high ROE, as do rapid turnover in inventory, receivables and total assets. Rapid inventory turnover reduces the risk of profit-sapping product closeouts where slow-moving goods are marked down for quick sale. Rapid receivables turnover eases any concern that investors might have in terms of the firms ability to collect money owed by customers. High total asset turnover, defied as sales divided by total assets, documents the firms ability to generate a significant amount of business from its fixed plant and equipment. Despite these obvious advantages, each of these traditional firm performance measures suffers certain shortcomings. Profit margins are strongly influenced by industry-related factors that might obscure superior firm productivity when firms from different industries are compared. For example, the automobile industry is huge and net profit margins for mediocre performers are commonly in the 2.5-3 percent range. Even standout performers, like Toyota, struggle to earn 6 percent on sales. Meanwhile, even mediocre banks commonly report profit margins in the 15-20 percent range. Similarly, and despite obvious advantages, ROE suffers as a performance measure because steep losses can greatly diminish retained earnings, decimate the book value of stockholders equity, and cause ROE to soar. When companies buy back their shares in the open market at prices that greatly exceed accounting book values, the book value of shareholders equity also falls, and can unfairly inflate the ROE measure. For these reasons, some analysts look to the growth in net income as a simple and less easily distorted measure of accounting profit performance. However, the biggest problem with corporate performance measures based upon profit rates tied to sales, stockholders equity or assets has nothing to do with measurement problems tied to irregular profit and loss patterns or corporate restructuring. The biggest problem with traditional corporate profit measures is that they fail to reflect the firms efficient use of human resources. In the services-based economy of the new millennium, the most telling indicator of a companys ability to compete is its ability to attract, train, and motivate a capable workforce. In economics, the term human capital is used to describe the investment made in workers and top

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management that make them more efficient and more profitable employees. Employee training and education are two of the most reliable tools that companies can use to keep an edge on the competition. However, determining an efficient amount of worker training and education is more tricky than it might seem at first. In a competitive labor market, employees can expect to command a wage rate equal to the amount they could compel in their next-best employment opportunity. At least in part, this opportunity cost reflects employee productivity created by better worker training and education. Because dissatisfied workers can be quick to jump ship, employers must be careful to maintain a productive work environment that makes happy employees want to stay and contribute to the firm that paid for their education and training. Employers need capable and well-trained employees, but no employer wants to be guilty of training workers that end up working for the competition! All successful firms are efficient in terms of constantly improving employee productivity, and then motivating satisfied and capable employees to perform. In light of the importance placed upon capable and well-motivated employees, an attractive alternative means for measuring corporate productivity is in terms of profits and revenues per employee. Table 7.5 gives interesting perspective on employee productivity by showing revenue per employee and profits per employee for the 30 giant corporations that together comprise the Dow Jones Industrial Average. A. What firm-specific and industry-specific factors might be used to explain differences among giant corporations in the amount of revenue per employee and profit per employee? A multiple regression analysis based upon the data contained in Table 7.6 reveals the following (t statistics in parentheses): Profit/Emp.= $1,269.016 + 0.220 Ind. Profit/Emp. + 0.084 Rev./Emp. + 0.004 Ass./Emp. (0.17) (2.33) (8.22) (1.20) R2 = 89.7 percent, F statistic = 75.48 Interpret these results. Is profit per employee more sensitive to industry-specific or firm-specific factors for this sample of giant corporations? CASE STUDY SOLUTION A. Firm-to-firm variation in the amount of profits per employee is sure to depend upon both firm-specific and industry-specific factors. For example, at the industry level of aggregation, the amount of capital employed per worker tends to be very high in financial services like banking and credit services. As a result, even the most mediocre banks in terms of relative efficiency report high profits and revenues per employee. However, the most efficient financial service companies will have better trained workers and motivate them most efficiently. Thus, it is important to control for industry effects when considering firm productivity as measured by profits and revenues generated on a per employee basis. Differences in employee productivity

B.

187

Chapter 7 will be affected by differences in total assets per employee, worker education and training, the effectiveness of incentive compensation plans, the amount of employee stock ownership, and so on.

B.

Based upon this sample of giant corporations taken from the DJIA, profit per employee appears to be sensitive to firm-specific factors and industry-specific factors. On an overall basis, the simple model estimated here explains a very large proportion (89.7 percent) of the variation in profits per employee for the 30 giant firms found within the DJIA. This is a statistically significant explanation (F = 75.49) of a meaningful share of the total amount of variation in profits per employee. Clearly, the firm-by-firm variation in profits per employee cannot be simply explained as a byproduct of industry effects. It is not surprising in this simple model that industry effects offer some marginal explanation of profits per employee (t = 2.34) when revenue per employee (t = 8.22) and total assets per employee (t = 1.19) are constrained. In this example, the marginal effects of industry profits per employee and firm revenues per employee overwhelm the marginal effects of total assets per employee. Of course, the strong influence of revenues per employee on profits per employee stems from the fact that both are commonly employed measures of employee productivity. At a minimum, results reported here suggest the importance of industry-related and firm-specific effects on employee productivity.

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