Friday, November 28, 2008

extra-credit test question on auto industry

Last Friday I gave a test in my intermediate microeconomics class with an extra credit question at the end. I thought it was a fairly easy question; a way to boost both scores and morales at the end of a hard test.

EXTRA CREDIT! Due to higher costs to support generous fringe benefits to current and retired employees, the average loss per car is $2000 per vehicle sold for the Detroit 3 (GM, Ford, Chrysler). The foreign nameplate companies also operating in the U.S. (Toyota, Nissan, Honda) have an average profit of $1200 per vehicle. Given this information and assuming a normal profit per vehicle produced in the U.S. is $1000, use economic theory to briefly explain what should happen in the long run to the U.S. auto industry in terms of the number and type of firms.

Except for the $1000 normal profit, the numbers above are real. The answer is that eventually the Detroit 3 would leave or contract in the U.S. (or go broke) while foreign nameplate companies would enter or expand in the U.S. All you need to answer is to know one simple concept concerning firms exiting and entering an industry: higher than normal profits attract and losses repel.

During last week's Congressional grilling of auto execs, Massachusetts Rep. Stephen Lynch asked GM's Rick Wagoner if "...GM was asking China for a bailout too. Mr. Wagoner mildly answered that GM's China operations are profitable. They actually help to underwrite the massive losses in the U.S." (Wall Street Journal, Nov. 26, 2008, p.A13).

POP QUIZ! Here is today's two-part EXTRA CREDIT question:
(A) Why can Ford and GM profitably make cars overseas but not in the U.S? (That is, why doesn't GM need a bailout from China?)
(B) Why do foreign nameplates (Toyota, Honda, Nissan) profitably produce cars in the U.S. but not GM or Ford or Chrysler?
[Hint: (A) and (B) both have the same answer.]

Answer: The $29/hr pay gap. The Detroit 3 have the UAW and the associated legacy costs (generous retirement and health benefits for retired and current workers) in the U.S. while other companies in the U.S., and all companies abroad, do not.

The above is the only answer. No partial credit for mentioning Detroit makes the wrong vehicles with low quality, or dumb CEO's, or lazy workers, or the need for better technology, or CAFE and other government regulations, etc. These are just distractions, side issues, needless complications,that do not explain why the Detroit 3 have higher costs of $3,200 per vehicle only in the U.S.

Any other explanation does not answer both parts (A) and (B).

How'd you do? One of last week's posts had the answer:
random random walk:
what's with the detroit auto bailout?

There'd be no need for pop quizzes if everyone did the reading.

Be blessed.

P.S. How do you think Congressman Lynch would have done on the quiz?

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