Dec 03 2008

American auto makers insult the intelligence of high school Econ students!

Automakers turnaround plans sent to Congress – Dec. 2, 2008

…and hopefully every other American with a functioning cerebral cortex. Ford Motor Company announced today its ambitious plan to cut costs and restore its profitability as it appeals once again to Washington for a $25 billion “low-interest bridge loan” (aka bailout).

The company announced that the salary of Ford CEO Alan Mulally would be cut to $1 a year if Ford actually borrowed money from the government. When Mulally appeared before the House Financial Services Committee last month, he did not agree to the suggestion of such a paycut…

Ford and GM also announced plans to get rid of corporate jets. Mulally, Wagoner and Nardelli were all roundly criticized at a House hearing last month when they admitted they had each flown their corporate jets to Washington to ask for help…

Mulally and Wagoner will be driving to Washington in hybrid vehicles made by their companies when they return to Capitol Hill later this week to make their case for loans. Nardelli is also not planning to fly to Washington but Chrysler has not disclosed any more specifics of his travel plans.

So the CEOs of the three largest auto companies are agreeing to be exploited for one year by accepting a salary of one dollar. The combined savings from the salary cuts of the three companies’ CEOs  equal roughly $6 million, or about 0.024% of the sum the companies are asking for from the government. Selling corporate jets during a recession when demand for such frivolous luxuries is at a record low will also do little to cut the costs of the incredibly inefficient US automakers.

As for any serious cost cutting plans, Ford had little to report:

…the Ford plan is perhaps most notable for what it did not include. The company did not mention that it would be dropping any brand or unprofitable models…

There was also no announcement of additional plants being closed or capacity being eliminated. Ford said it continues to work with its unions and dealers to achieve additional savings, but it did not set any cost savings targets for those discussions.

Ford highlighted many of the cuts it has already made, including closing 14 plants and reducing salaried personnel by 36% over the past three years. The company also touted labor cost savings that would bring the cost of factory workers’ pay and benefits close to those of the nonunion U.S. plants operated by Asian automakers

Real cost savings will only be achieved by the further closing of plants. With the economy in a deep recession and auto sales at their lowest in decades, the demand for new cars is just not there. Until Ford and its American competitors begin adjusting their plant capacities to the realities of market demand, the chances of achieving profitibility seem slim.

Allow me to make a connection between the situation faced by American auto makers and a basic economic concept we are currently studying in Microeconomics class. Firms, as any first year econ student knows, are profit maximizers. In fact, all companies are trying to make the same thing as all other companies, profits. When a firm experiences negative profits, or losses, as Amer auto makers are today, it can do one of two things to restore profitability: 1) Increase its revenues or 2) Lower its costs. Since demand for new cars is so low, the revenue increasing option is just not there, so American auto makers must reduce costs to restore profits.

There are two main types of costs we study in microeconomics. Short-run and long-run costs. In the short-run, which in the case of the auto industry we can consider the last few months since the financial crisis began, firms can do one thing to lower their costs: reduce the use of labor. Workers can be asked to take unpaid vacations, jobs can be eliminated, work hours can be cut back. In the short-run, plant size is fixed, meaning firms cannot add nor eliminate capital and land resources. The only variable resource is labor. By “reducing salaried personnel by 36% over the past three years” Ford has taken steps to lower its short-run costs of production.

Long-run costs must also be considered when firms are faced with negative profits. The long-run in the automobile industry is considered the period of time over which auto makers can either add new plant facilities or shut down existing facilities, lowering the costs of capital and land to firms. Long-run cost reductions have also been undertaken by Ford, including “closing 14 plants… over the past three years”.

Clearly, Ford has made an effort to reduce short-run labor costs and long-run capital costs by eliminating some of its work force and closing some of its factories in recent years. But today, as the US officially enters what is likely to be a deep, long recession, the announcement by Ford and its competitors that its new strategy for further cutting costs hinges on paying its CEOs one dollar and making them travel across the country in hybrid cars represents a laughable insult to the intelligence of high school Econ students.

Discussion Questions:

  1. What is the “variable resource” that firms can use less of in the short-run if cost reductions are needed?
  2. In Microeconomics, we sometimes refer to the long-run as the “variable plant period”. Explain the meaning of this concept.
  3. The law of diminishing marginal returns would indicate that if Ford were to close additional factories, it would almost certainly have to simultaneously lay off thousands of additional workers. What is the law of diminishing marginal returns and why does it require firms to lay off workers as plants are closed?

About the author:  Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course. Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this author

4 responses so far

4 Responses to “American auto makers insult the intelligence of high school Econ students!”

  1. Shahir Ahmedon 03 Dec 2008 at 12:57 pm

    Maximze profits. CEO's giving up salaries and corporate jets may seem funny at a level that can't earn it but the philosophy beyond loving and living in a capatilstic society is what still pays the big bills. As ironic as it is , all those american kids you teach in private schools are there because either their dad or mom was chasing the dollar. Some people just end up in a position chasing more. The real economic lesson should be, you don't have to do the same thing as your parents did to have a better life.

  2. Jason Welkeron 03 Dec 2008 at 4:38 pm

    Amen to that Shahir! Personal choices are so important and chosing to enter the rat race has its own risks. Then again, even those who chose a simpler path can find themselves in extreme hardship at times of recession today. Sadly, the Americans likely to be MOSt hurt by the recession are those whose incomes and access to health care were worst before the whole mess started. I won't be shedding any tears for the CEO who earns 1 dollar next year and has to say bye to his corporate jet… but the 10s of millions of Americans who will LOSE their health care, that's the real tragedy. Hopefully the Obama administration can make the right decisions, invest in healthcare and education, put people to work who will become unemployed from the downsizing of the auto and other industries. Then again, to save these firms despite their failures to remain competitive is clearly the wrong solution. Thanks for your comment!

  3. Zac Queryon 11 Dec 2008 at 4:26 am

    My stomach turned this evening as I watched a "debate" on FOXNews as to whether the auto companies should receive a bailout or not. One gentleman in favor of such a bailout supported his case by stating that The Big Three have made improvements over the last few years and they have some good vehicles in the marketplace. I won't waste any time debating that point but I'll get to the "meat" of what is really happening. It's irrelevant whether any one or all of The Big Three have good cars in the marketplace. What matters is how well they can run their businesses and are they able to stay financially healthy throughout all types of business cycles. The answer for The Big Three in this case is very obvious – NOT TOO GOOD. It seems that management and the unions deserve one another. Over the years, management has chosen to be reactive to their competitors and to the trends in the market. The unions have chosen to be self-serving, seeking only what they can get for themselves. Well, the consequences of their actions are coming home to roost. A bailout is only going to treat the symptoms and not cure the underlying illness.

  4. Saugata Mittraon 03 Dec 2010 at 10:35 pm

    1) Variable resource: labor is the only variable resource that can be changed in the fixed plant period.

    2) Variable plant period: a firm can change all of its variables of production to either increase output or decrease output. This is why the long-run is called the variable plant period, because firms even have the opportunity to vary their amount of "plants" or factories.

    3) The law of diminishing marginal returns states that the more of a variable resource you add to a fixed amount of capital or land, after a certain point, the productivity of the variable resource will drop, increasing costs for the firm. Especially if a plant is closed down, the workers of that plant should be laid off to prevent additional costs being accumulated by the firm.