Read the following examples and resume why the first one failed and the second one succeeded with your own words.

What do you conclude about how a firm should choose the quantity it should produce? Explain.

GETTING IT RIGHT: THE FAILURE OF FRANKLIN NATIONAL BANK

In the mid 1970’s, Franklin National Bank – one of the largest banks in the United States – went bankrupt. The bank’s management had made several errors, but we will focus on the most serious one.

First, a little background. A bank is very much like any other business firm: It produces output (in this case a service, making loans) using a variety of inputs (including the funds it lends out). The price of the bank’s output is the interest rate it charges to borrowers. For example, with a 5 percent interest rate, the price of each dollar in loans is 4 cents per year.

Unfortunately for banks, they must also pay for the dollars they lend. The largest source of funds is customer deposits, for which the bank must pay interest. If a bank wants to lend out more than its customers have deposited, it can obtain funds from a second source, the federal funds market, where banks lend money to one another. To borrow money in this market, the bank will usually have to pay a higher interest rate than it pays to customer deposits.

In mid-1974, John Sadlik, Frankin’s financial officer, asked his staff to compute the average cost to the bank of dollar in loanable funds. At the time, Franklin’s funds came from three sources, each with its own associated interest cost:

What do these numbers tell us? First, each dollar deposited in a Franklin checking account cost the bank 2.25 cents per year, while each dollar in a savings account cost Franklin 4 cents. Also, Franklin, like other banks at the time, had to pay between 9 and 11 cents on each dollar borrowed in the federal funds market. When Franklin’s accountants were asked to figure out the average cost of a dollar in loans, they divided the total cost of funds by the number of dollars they had lent out. The number they came up with was 7 cents.

This average cost of 7 cents per dollar is an interesting number, but, as we know, it should have no relevance to a profit maximizing firm’s decision. And this is where Franklin went wrong. At the time, all banks, including Franklin, were charging interest rates of 9 to 9.5 percent to their best customers. But Sadlik decided that since money was costing an average of 7 cents per dollar, the bank could make a tidy profit by lending money at 8 percent – earning 8 cents per dollar. Accordingly, he ordered his loan officers to approve any loan that could be made to a reputable borrower at 8 percent interest. Needless to say, with other banks continuing to charge 9 percent or more, Franklin became a very popular place from which to borrow money.

But where did Franklin get the additional funds it was lending out? That was a problem for the managers in another department at Franklin, who were responsible for obtaining funds. It was not easy to attract additional checking and savings accounts deposits, since in the 1970’s the interest rate banks could pay was regulated by the government. That left only one alternative: the federal funds market. And this is exactly where Franklin went to obtain the funds pouring out of its lending department. Of course, these funds were borrowed not at 7 percent, the average cost of funds, but at 9 to 11 percent, the cost of borrowing in the federal funds market.

To understand Franklin’s error, let’s look again at the average cost figure it was using. This figure included an irrelevant cost: the cost of funds obtained from customer deposits. This cost was irrelevant to the bank’s lending decisions, since additional loans would not come from these deposits, but rather from the more expensive federal funds market. Further, this average figure was doomed to rise as Franklin expanded its loans. How do we know this? The marginal cost of an additional dollar of loans – 9 to 11 cents per dollar – was greater than the average cost – 7 cent. As you know, whenever the marginal cost is greater than the average, it pulls the average up. Thus, Franklin was basing its decisions on an average cost figure that not only included irrelevant sunk costs but was bound to increase as its lending expanded.

More directly, we can see Franklin’s error through the lens of the marginal approach. The marginal revenue of each dollar lent out at 8 percent was 8 cents, while the marginal cost of each additional dollar - since it came from the federal funds market – was 9 to 11 cents. MC was greater than MR, so Franklin was actually losing money each time its loan officers approved another loan!! Not surprisingly, these loans – which never should have been made – caused Franklin’s profit to decrease, and within a year the bunk had lost hundreds of millions of dollars. This, together with other management errors, caused the bank to fail.

GETTING IT RIGHT: THE SUCCESS OF CONTINENTAL AIRLINES

Continental Airlines was doing something that seemed like a horrible mistake. All other airlines at the time were following a simple rule: They would only offer a flight if, on average, 65 percent of the seats could be filled with paying passengers, since only then could the flight break even. Continental, however, was flying jets filled to just 50 percent of capacity and was actually expanding flights on many routes. When word of Continental's policy leaked out, its stockholders were angry, and managers at competing airlines smiled knowingly, waiting for Continental to fail. Yet Continental's profits-already higher than the industry average-continued to grow. What was going on?

There was, indeed, a serious mistake being made-but by the other airlines, not Continental. This mistake should by now be familiar to you: using average cost instead of marginal cost to make decisions. The "65 percent of capacity" rule used throughout the industry was derived more or less as follows: the total cost of the airline for the year (TC), was divided by the number of flights during the year (Q) to obtain the average cost of a flight (TC/Q = ATC). For the typical fight, this came to about $4,000. Since a jet had to be 65 percent full in order to earn ticket sales of $4,000, the industry regarded any flight that repeatedly took off with less than 65 percent as a money loser and canceled it.

As usual, there are two problems with using ATC in this way. First, an airline's average cost per flight includes many costs that are fixed and are therefore irrelevant to the decision to add or subtract a flight. These include the cost of running the reservations system, paying interest on the firm's debt. And fixed fees for landing rights at airports-non of which would change if the firm added or subtracted a flight. Also, average cost ordinarily changes as output changes, so it is wrong to assume it is constant in decisions about changing output.

Continental's management, led by its vice-president of operations, had decided to try the marginal approach to profit. Whenever a new flight was being considered, every department within the company was asked to determine the additional cost they would have to bear. Of course, the only additional costs were for additional variable inputs, such as additional flight attendants, ground crew personnel, in flight meals, and jet fuel. These additional costs came to only about $2,000 per flight. Thus, the marginal cost of an additional flight-$2,000-was significantly less than the marginal revenue of a flight filled to 65 percent of capacity-$4,000. The marginal approach to profits tells us that when MR>MC, output should be increased, which is just what Continental was doing. Indeed, Continental correctly drew the conclusion that the marginal revenue of a flight filled at even 50 percent of capacity-$3,000-was still greater than its marginal cost, and so offering the flight would increase profit. This is why Continental was expanding routes even when it could fill only 50 percent of its seats. In the early 1960s, Continental was able to outperform its competitors by using a secret-the marginal approach to profits. Today, of course, the secret is out, and all airlines use the marginal approach when deciding which flights to offer.

[Source: Principles and applications of microeconomics, M. Lieberman and R. Hall, Cengage]

Exercise 1:

1. Complete the following table:

2. Graph average total cost, average variable cost and marginal cost.

3. What is the relationship between average total cost and marginal cost?

4. If the market price in a competitive market structure were $40, how many units would the firm produce? What would be the profits? Would the firm produce or shut down in the short run? And in the long run?

5. If the market price in a competitive market structure were $80, how many units would the firm produce? What would be the profits? Would the firm produce or shut down in the short run? And in the long run?

Exercise 2:

Explain why the demand curve addressed to a firm in a competitive setting is horizontal.