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The Medical Device Tax and the Theory of the Firm
Lesson 3 Productivity: Not Such a Mystery

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Aggregate Supply (AS) – From Micro to Macro

Microeconomics generally aims its attention at a typical firm. The short-run is a time period short enough that the firm finds itself with some fixed inputs and fixed costs. They can vary their production in the short-run because they can change their usage of variable inputs. Often labor is used as an example of a variable input. Capital is often considered as fixed.

Economists believe that most mature firms face short-run diminishing marginal returns to production. That means that as more and more labor is applied to a given fixed amount of capital, you should expect output to rise, but the increases start to diminish. In this normal range of production firms can expect to be able to produce more – but the diminishing returns implies that each extra unit they produce costs a little more than the one before it (because each one has a little more labor in it). Thus we can go from talking about diminishing marginal returns to increasing marginal costs. This is a pretty realistic way to think about most firms. They can’t simply produce all they want right away without incurring rising costs per unit.

How could they increase more without incurring those rising costs per unit?  It might take a little time, but one important way is to improve their fixed input.

We know that while increasing marginal costs are to be expected in the short-run, we also know that firms are always trying to avoid this constraint in the longer term. If they are to be competitive, they must find ways to reduce cost per unit.

By doing more R&D internally or by buying newer and better capital they can improve the productivity of their variable inputs. When they increase productivity in this way, any given size labor force can now produce more output. Thus, the long-run offers a way for firms to lower cost per unit through higher productivity.  Productivity is not the only means to reduce their costs per unit in the long-run. For example,

  • They might try to gain buying economies in the purchases of materials.
  • They might also ask their workers to accept smaller pay increases.
  • They could find better lesscostly benefit packages.  
  • They could train their workers better.

The lesson from this brief review is that trying to produce more in the short-run raises the unit cost of goods and services. Thus, a larger amount of production often implies a higher price. But we learned that both productivity and costs impact the cost of producing a good.

Any time firms can improve the quality and lower the costs of its fixed input then it can expect to see cost per unit fall. Of course, any shocks that raise business costs relative to productivity would push the firm’s unit costs of production higher.

Economists believe it is reasonable to assume that firms attempt to maximize profits. They do so by equating marginal costs and marginal revenues. This is enough to help us think about how firms respond to change.

For example:

  • suppose the demand for a firm’s product increases and this causes marginal revenue to increase. Marginal revenue would be higher than marginal cost. If marginal revenue is greater than marginal costs it implies that the firm is not now maximizing profits – but that it can move to a profit maximum if it responds to the new situation. It needs to make a decision.
  • In the short-run the firm cannot change its fixed costs or its productivity. To meet this short-run change, it can alter the amount of variable input it uses. Will it use more or less?
    • The intuition suggests it would hire more labor so as to produce higher output to meet the higher demand.
    • As it tries to increase its output, this increases marginal cost, but the firm is willing to do that because it knows that marginal revenue is higher.
    • When it produces just enough to increase marginal cost up to the higher value for marginal revenue it knows it has reached a new profit maximum.

The above paragraph tells the production story for why an increase in demand leads to an increase in supply. We will use the microeconomics of production and cost to explain the macroeconomic AS sector.

The Short-run AS Sector

We apply these basic microeconomic principles to macro. Recall that in macroeconomics, we do not focus on specific consumers or firms. AD represents the combined national demand for goods and services. AS is its supply counterpart. The idea of how the nation’s output responds to changes is simply the “adding-up” of how all the firms would respond. If the typical firm responds in the ways described above, then we assume that all of the nation’s total output responds similarly. (It is unnecessary and over-simplistic to think that every single firm responds in exactly the same way – but it is okay to believe that many firms behave like the average firm and that the others trend to cancel out their aberrations from the norm.)

Let’s now discuss the behavior of AS. For this discussion, we forget AD and just isolate on the question of how key macroeconomic variables impact national output through the supply side.

Key AS variables

  • prices
  • wages
  • oil prices
  • productivity
  • a tax on labor
  • a tax on capital
  • a government credit for research and development.
  • Other supply stuff that impacts either costs or productivity

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We discuss how each of these would impact AS – the amount of output the firms of the nation would want to supply. In each explanation we act like good scientists – we change one item while believing all of the rest are constant (I know, I know – the world is never so still or well-behaved. In the real world all these things are changing. We can get to analyzing the real world and all things changing – but it helps a lot if we start the journey buy studying one thing at a time!)

First, consider a change in price.

  • By this we are asking, if all these other key variables are constant, how would the firm’s output decision change if the market set a higher price for its good or services?
    • The answer is they would produce more. Why?
      • The understanding comes from the microeconomics we reviewed above.
      • If price rises, then marginal revenue would be greater than marginal cost.
      • A profit-minded firm would see that an opportunity now exists to make higher profits. Its return on equity would increase.
      • A firm in the short-run would hire more labor and produce more output.
      • With everything else besides price held constant, producing more and selling it at the higher price will produce higher profits until the marginal cost of producing the extra output reaches the new higher marginal revenue.
      • A reduction in price would have the opposite impact – it would lead to a decline in production.

Second, what would a firm do if its wages or wage costs increased?

  • Imagine a situation where nothing else has changed. Workers are not more productive – they just cost more now.
  • The firm feels it cannot change its price but it can alter its output in response to the rise in wages. What would it do?
    • We follow the same profit analysis. The rise in wages would cause marginal cost to exceed marginal revenue.
    • Profits have decreased and are suboptimal.
    • Hiring less labor and producing less output would reduce marginal costs back to their lower level in equality with marginal revenue.
    • The firm has lower profits now but the profits are the maximum given the new situation with the higher wages.  

Third, oil prices increase.

  • Oil is just one of many inputs used by firms. Thus, this analysis could equally relate to costs of any primary resources or intermediate goods purchased by firms to produce. We use oil prices in this example because changes in oil prices have made the headlines many times since the 1970s.
    • In the 1970s there were two occasions when oil prices increased dramatically.
      • For example in 1973 oil prices increased from $3 to $12 per barrel. That four-fold increase did not last very long, but it nevertheless has some large impacts.
      • Oil prices increased again in 1979 but this spike was followed by a very long period of declining and low oil prices through most of the 1980s and 1990s.
      • In Desert Storm and then again in the War on Iraq oil prices were highly volatile.

A rise in oil prices, like an increase in wages, increases the cost of production and raises a firm’s marginal cost. This is because oil has many uses in production. For one thing, oil is an important source of energy. Most businesses use electricity to run their offices and factories. Oil is an important component to a firm’s transportation and travel expenses. Whether sending goods on highways or sales personnel on airlines, many companies’ transportation costs are affected by changes in oil prices. Finally, many products use oil as a raw material. We used to joke in the 1970s about polyester pants and suits and how much oil was used in their production. Oil is used in some garments but it is also used in plastics and other products as well. So when oil prices increase they can impact many firms in many different ways by raising their marginal costs. As in the example of rising wage costs, the optimal business response is to bring marginal costs back down by hiring less variable input and reducing output.

Fourth, productivity increases.

Increases in productivity imply that a given worker can produce more output in a given period of time. Increasing productivity can be gained in many ways.

  • Firms could buy newer and better capital.
  • Firms could rearrange a factory so workers are used more efficiently.
  • Firms would improve their logistics through better software.

A new trainer or training system might help the workers get more done in a day.

Regardless of the source, how would an increase in productivity impact a firm’s desire to produce?  We begin by noting that if wages and other factors are held constant – the ability to produce more in a given time period means that the costs per unit of output would decrease. This implies a reduction in marginal costs. This also implies higher profits and the need to move to a new profit maximum position. With marginal revenues unchanged in this example, the reduction in marginal costs suggests that a firm will make higher profits by hiring more variable input and producing more output.

Difference of Opinion: Productivity and Employment

At this point some might question the outcome that more labor input would result from an increase in productivity. We are all aware of many situations where individual companies buy better and more machines as a way to replace labor. Thus, many of us associate higher productivity with less employment. This micro result might be true for specific firms and workers, but it does not go far enough when considering the entire macroeconomic situation. Notice that the firms that displace the labor are not doing this to reduce output or profits. They adopt higher productivity so that they will be more competitive and sell more output. Some of the increase in output can be done without more labor. But as higher productivity facilitates lower prices and more competitiveness, the extra output does require more labor. In most countries we observe that this latter positive impact on employment swamps the displacement impact. In most countries the evidence is quite compelling. The late 1990s in the U.S. is one such period in which both productivity and national employment were rising at very strong rates.

But in the time period following the 2001 recession, employment did not snap back as quickly as many people had hoped. Productivity did continue to rise rapidly and there were many stories of companies that closed in the U.S., leaving unemployed workers as they found locations in other countries. This worry that higher productivity leads to less employment resurfaced after 2001 and was an issue in the presidential campaign.  This issue resurfaced again after 2007 and was a key part of the presidential election of 2012.

This leaves us to discuss how several government policies might impact national output decisions: a tax on labor, a tax on capital, and government credit for research and development. This discussion follows from thinking of business costs more broadly. What does a business pay to hire and use an input? Often we just say labor compensation but we know that these labor costs could include any or all of the following: recruiting expense, travel expense, training expense, wage or salary, value of benefits and perquisites, and any taxes paid. Of course, if the government subsidizes any part of these costs, then the subsidy would reduce the cost.  

Increasing taxes on labor or capital A business credit – whether for R&D or for purchases of any input
increases the labor costs of a firm. This would reduce employment and output reduces  business input costs. Thus a subsidy is a way to induce firms to increase employment and output.

The upshot of this discussion about supply shocks is that you can focus the discussion on one basic concept – unit costs.

Unit costs are defined as total costs embodied in each additional unit of output or more simply the cost per unit.

A $40 item might cost $30 to make. The rest is profit. There are essentially two parts of the $30 unit cost – (1) labor and other input costs and (2) productivity.

Example: assume that the cost of 2 workers is $100,000. Now assume that these workers can produce 300 bicycles per year. Cost per worker is $50,000. Output per worker is 150 bikes. The unit cost of a bicycle (assuming no other relevant costs of production) is $333. Now assume that both cost and productivity increase by 10%. That means business costs increased to $110,000. Cost per worker is now $55,000. Worker productivity increased to 330 bicycles or 165 per worker. The unit cost of a bicycle would be $333. In this example, since cost and productivity increased by the same percentage, unit costs were unchanged.  

A second example has total costs unchanged at $100,000 or $50,000 per worker. But now let only productivity increase by 10% to 165 bicycles per worker. Now cost per unit is $303. Cost per unit fell because productivity increased while total costs remained the same.

This discussion about unit costs leads to two key AS facts to remember:

Anything that raises costs more than productivity Anything that raises productivity relative to costs
leads to an increase in unit costs and leads to an outcome of lower AS leads to a decrease in unit costs and to an outcome of higher AS
Examples: a rise in wages, oil prices, labor taxes; a fall in productivity Examples: a rise in productivity, a decline in wages or energy costs, increasing an R&D subsidy