Chapter 9 Production Costs and
Business Decisions
17
How can the so-called “crisis” be solved, at least partially? We don’t intend to
offer a detailed set of public policy solutions here. Other specialists in the field have
done that.
4
We only point out here that many of the supply and demand forces listed
above are beyond the control of individual businesses. There is simply not much most
individual businesses can do to affect the broad sweep of social attitudes and government
tax and expenditure policies. We only note, however, that the demand for healthcare
services can be lowered by reducing, at least marginally, government subsidies for the
healthcare of many Americans. This can be accomplished by lowering Medicare and
Medicaid expenditures and by eliminating all or a part of the tax deductibility of health
insurance. The cost of healthcare can also be lowered by reducing the rewards from
suing doctors or by giving patients the right (to a greater or lesser degree) to absolve
doctors of liability for problems that they may encounter while the patients are in the
doctors’ care.
Frankly, making those recommendations is much easier than getting them passed.
They are too politically painful for voters (although we suggest that voters should also
consider the gains to everyone from getting healthcare costs under control).
Barring changes in public policies, what can businesses themselves do to
ameliorate their own healthcare costs? Many businesses have done what has come
naturally: they have tried to select workers who are not likely to have medical problems
and, therefore, drive up the firms’ insurance costs. This is, we remind you, a solution that
can benefit both owners and many workers, given that healthier workers can mean lower
labor costs for firms and lower health insurance premiums. While people might object to
this solution on fairness grounds, we stress that it is the type of discriminatory hiring
policy that is likely to emerge when health insurance costs have been distorted by
political factors, such as the ones included in the list above.
Another private policy solution can emerge if employers and employees recognize
that low deductibles on health insurance policies are very expensive because they
encourage workers to spend someone else’s money, which motivates excessive demand
for healthcare and high insurance premiums. With a deductible of $5,000, the price of an
additional dollar of insurance coverage for a forty-year old male is measured as a tiny
fraction of a cent (actually, .06 of a cent). However, when the deductible is $500, the
price escalates to 55 cents. When the deductible is as low as $100, the price of an
additional dollar of coverage rises to $2.14, a poor bargain for owners and their
employees.
5
There is an obvious solution to the health insurance problem that has the potential
of not only introducing greater efficiency into the healthcare business but also improving
the fairness of the system, without any policy change in Washington. This solution seeks
to lower the private demand for healthcare by changing the incentives a firm’s workers
have to consume healthcare services.
4
See John C. Goodman and Gerald L. Musgrave, Patient Power: Solving America’s Health Care Crisis
(Washington, D.C. : Cato Institute, 1992).
5
As reported by Goodman and Musgrave (Ibid.).
Chapter 9 Production Costs and
Business Decisions
18
As we indicated above, most firms that offer their workers health insurance
provide “Cadillac policies,” ones with small deductibles and broad coverage for just
about everything that can go wrong with a person, regardless of whether the person is
responsible, through destructive behaviors, for the problems encountered. Each worker
has little incentive not to use healthcare services for the slightest problem. Each worker
has less incentive to incur the costs that might be required to eliminate or reduce their
destructive behaviors.
Each worker can reason that if he or she were to cut back on personal usage of
this or that healthcare service, the company’s health insurance costs would not be
materially affected. Certainly, the individual’s health insurance premiums would not fall
by the full value of the healthcare services not utilized. The savings from non-use by any
one individual, if the savings are detectable at all, will be spread over the entire group of
workers through slightly lower premiums for everyone. In short, the individual gains
precious little from personal restraint in consumption of healthcare services.
6
Hence, the
individual has little incentive to curb consumption.
Granted, if everyone in a firm were to cut back on healthcare usage, then
everyone could possibly gain in terms of reduced insurance premiums. The amount of
savings could be substantial, and everyone would share in the savings of everyone else.
However, as is so often true in business and, for that matter, all group settings, getting
everyone to do what is in their best collective interest comes up against the prisoners’
dilemma discussed earlier. If everyone else cuts back, there is still no necessary and
compelling reason for any one person to cut back. The one person’s reduction is, again,
inconsequential regardless of what all others do. And, we must add, as we have
throughout the book, the larger the group, the more difficult the problem in bringing
about collective cohesiveness of purpose.
7
The basic problem for the firm should be seen as one of finding a means of giving
all workers an incentive to cut their consumption. This can be done by raising the price
of healthcare usage. But how can the price of healthcare be raised by the firm?
Economist John Goodman, head of the National Center for Policy Analysis,
recommends what appears to us to be a ingenious and practical solution, one that firms
can, as some already have, institute on their own to the benefit of the workers and the
firm.
To see how Goodman’s proposal might work, let us start with a few observations
and assumptions. Many firms spend upwards of $4,500 annually per worker on health
insurance, partly because, with the small deductible, workers have an incentive to
consume a lot of healthcare. Let us assume that a basic catastrophic health insurance
policy, one with a very large deductible of about $3,000 (meaning the insurance covers
6
Of course, the extent to which the individual’s actions can be detected depends on the size of the
employment group. In small groups of workers, it would be easier to detect the impact of what one
individual does or does not do.
7
One of the more serious problems in having government provide health insurance is that the relevant
group is really large, extending to the boundaries of the country, which means people may have absolutely
no incentives to curb their consumption of healthcare services. The benefits of doing so are spread ever so
thinly over too many people.
Chapter 9 Production Costs and
Business Decisions
19
only major medical problems), can be purchased for each employee for a premium of
$1,200 per year (which is, we are told, in the ballpark of the actual cost for a group
policy).
Suppose also that the employer agrees to provide this catastrophic insurance
policy and, at the same time, agrees to place in a bank reserve account (what Goodman
prefers to call a “Medical Savings Account” or “MSA”) a sum of $3,000 each year per
employee. The employer tells the employees that they can draw on that account for any
medical “need” (with “need” being defined broadly). The workers can use the account,
for example, to pay for visits to doctors, to cover the cost of hospital stays not covered by
insurance, or to pay for a membership in a fitness center (given that exercise can prevent
the need for some medical care). Finally, suppose that the workers are also told that the
balance remaining in the account at the end of the year can be applied to their individual
retirement accounts, or even withdrawn at the end of the year for any purpose that the
workers choose.
8
This proposal has a chance of lowering the employees’ healthcare consumption
because it requires that people pay for most routine medical care with their own money.
Under common insurance arrangements, the additional cost of medical procedures (other
than the patients’ time) approximates zero (after the low deductible is met). Under the
MSA proposal, the cost to the employee of the first $3,000 of medical care is exactly
equal to the cost of the service. This is because the employee is made the residual
claimant on the balance at the end of the year. Hence, we should expect that workers will
more carefully evaluate their usage of medical services and cut back. After all, under the
old system, the workers were probably consuming “too much,” given the low cost (close
to zero) that they incurred.
We would expect that the gains from this new MSA system could be shared by
both the workers and their firm. We have already developed the example in a way that
obviously benefits the firm. The firm was paying $4,500 a year for the insurance of each
worker. Now, it must pay $1,200 for the insurance and $3,000 for the MSA, for a total of
$4,200. The firm saves $300 per worker.
The workers, however, can also gain. Under the old arrangement, the workers
were getting “paid” with insurance, not money. Under the MSA system, they are given a
pot of money, $3,000, that they can use, if they choose, to buy insurance that would cover
the first $3,000 of care. But many would not likely do that. They can self-insure just by
holding onto the money and paying the first $3,000 in medical bills. However, they can,
conceivably, also buy a variety of other things, from new televisions to education
programs to additional days of vacation.
9
Accordingly, the additional money should
enable workers to be better off by allocating the sum to higher valued uses.
8
The particulars of the Medical Savings Accounts are not important here. The important characteristic is
broad discretion on the part of the worker, which will likely mean that the worker has a sum of money that
is set aside to cover the large deductible under a catastrophic medical insurance policy and that can be used
by the employee when it is not spent for medical purposes.
9
Any actual MSA program might for political reasons have restrictions on the range of goods and services
that the workers can buy with any MSA balance remaining at the end of the year. For example, one MSA-
type proposal would require that the balance go into a worker’s retirement account.
Chapter 9 Production Costs and
Business Decisions
20
Both workers and their employers can also gain because the new insurance
arrangement can be expected to lower the worker’s demand for use of the health
insurance provided by their employers. Many workers will want to be careful not to use
up their $3,000 account, as they become more careful shoppers of medical care. Workers
will make use of the catastrophic insurance only in those situations when they have
serious problems and little choice but to make use of medical care, which explains why
the premiums for catastrophic insurance are so low.
By providing catastrophic health insurance coupled with a medical savings
account, a firm can attract better workers by providing them with a more valuable
compensation package at lower cost. Overall, we would expect the firms that adopt this
type of insurance system would be more productive and competitive.
However, we hasten to add that our simple example does not reflect the full
complexity of employment conditions most firms face. The problem managers will have
in developing acceptance of the MSA is the cross-subsidies that are embedded in current
insurance programs. Low-risk workers typically subsidize high-risk workers. Hence, we
doubt that the firm’s deposit into workers’ MSA accounts would equal the insurance
deductible, as we have assumed in our example. The reason is that many healthy
(typically younger) workers are fortunate in that they often don’t go to the doctor or
hospital in any given year, and other workers have only modest medical expenditures in
most years. They are subsidizing the unhealthy (typically older) workers who make
extensive use of medical care. If the MSA deposit equaled the deductible, this cross-
subsidy would be wiped out, and the insurance company would very likely be hit with
high bills from the high-risk workers without the payments from the low-risk workers.
To make the MSA system work, the deposit would have to be limited, with the workers
themselves sharing in some of the gains in the event they have limited expenses but also
sharing in some of the risks if their expenses exceed their MSA deposits. Therein lies the
rub, which will rule out many firms from instituting the deal. However, some firms will
still be able to find a reasonable compromise.
Managers must also be mindful of the possibility that MSAs can set up perverse
incentives for some workers for some types of healthcare. Knowing that they will have
to draw down their MSA account in order to cover annual physical examinations (and
other preventive healthcare measures), workers can reason that MSAs increase the
immediate cost of physical examinations. But that doesn’t mean that the “cost” of
physicals goes up for all workers. For some cost will rise; for others the cost will fall.
Some employees, no doubt, will be more inclined to get physicals, given that physicals
can be paying propositions (or will have a lower net cost to them). That is to say, the
employees can reason that the current outlay from their MSA for a physical can be more
than offset by the reduction in MSA outlays in the future, given that current physicals can
“nip” health problems when they are minor. Thus, current physicals can lower the
workers’ healthcare expenditures from their MSA account over the long run.
However, we suspect that it’s also a safe bet that some employees will not be
able, or will not be willing, to make the required careful calculations or can properly
assess the current and future benefits of physicals. Other workers may reason that most
of their later healthcare expenditures for “major” problems that go undetected will be
Chapter 9 Production Costs and
Business Decisions
21
covered as the catastrophic health insurance kicks in. To accommodate these potential
problems, employers can consider covering a portion of the current cost of physicals and
other preventive measures. The employers can cover the added cost of subsidizing the
physicals and preventive care with any reduction in their insurance premiums they get
from encouraging preventive care. If there are no insurance savings from the subsidy,
then it seems reasonable to conclude that either the problem of employees skipping
preventive care is not a problem or it is such a minor problem that the insurance
companies see no need to reduce the insurance premiums of firms that encourage
preventive care.
The main point is that managers must be tread carefully in trying to accommodate
problems with “preventive care.” The problem is that “preventive care” can include not
only physicals, but also an array of tests that have little useful medical value. If
“preventive care” is defined too broadly and the subsidies are high, managers can be back
in the prisoner’s dilemma trap that results in excessive healthcare and healthcare
insurance expenditures, the net effect of which is healthcare benefits that are not worth
the costs to the workers.
Has the MSA concept been tried and has it worked? Yes, on both counts,
although the trials to date do not correspond exactly with our example above. One of the
problems is that Medical Savings Accounts are not tax deductible, which means that a
part of the added cost that must be overridden with benefits is the greater tax payments
workers and firms must pay. Nevertheless, several firms have already tried the system
with beneficial effects:
• After Quaker Oats put $300 in each worker’s Medical Saving Account, the
company’s healthcare costs grew 6.3 percent a year. However, this was during a
period when the healthcare costs of the rest of the country were growing at
double-digit rates.
• Forbes magazine encourages its employees to curb medical care expenditures
with a variation of the MSA, by paying workers $2 for every $1 of medical costs
not incurred up to $1,000. This means that if a Forbes employee incurs medical
costs of only $300 in a given year, the employee is rewarded with a check of
$1,400 at the end of the year [2 x ($1,000 - $300)]. The magazine’s healthcare
costs fell 17 percent in 1992 and 12 percent in 1993, years during which other
firms’ insurance costs were rising.
• The utility holding company Dominion Resources gives each worker who chooses
a $3,000 deductible on the company’s health insurance policy a deposit of $1,650
a year. Since 1989, its insurance premiums have not risen, while the insurance
premiums of other companies have risen by an average of 13 percent a year.
• Golden Rule Insurance Company gives each worker a $2,000 deposit if they
select a deductible of $3,000. In 1993, its health insurance costs were 40 percent
lower than they would have otherwise been.
10
10
See “Answering the Critics of Medical Savings Accounts,” Brief Analysis (NCPA, September 16, 1994),
p. 1.
Chapter 9 Production Costs and
Business Decisions
22
We don’t propose to tell firms what to do in their own particular circumstances
for a very good reason: Frankly, we obviously don’t know the details of the individual
circumstances of what we hope will be a multitude of business readers of this book. We
can use our incentive-based approach to explore the types of business policies managers
should consider and then adjust to fit the particulars of their circumstances. Moreover,
our focus on health insurance is only illustrative of insights that are relevant across a
firm’s entire fringe benefit package.
The important point of this discussion is by now an old one for this book:
Incentives matter. One of the several important reasons many workers pay high health
insurance premiums is that they don’t have much of an incentive to carefully evaluate
their healthcare purchases. The best way of ensuring that workers get the most out of
their healthcare benefits is one that is as old as business itself: make the buyer pay a price
that reflects the true cost of their decision.
Medical Savings Accounts are simply a means (perhaps one of many that have
not yet been devised) of making workers potentially better off by making everyone pay a
price for what they consume. This solution may not work for all businesses. Some
worker groups may not want to be bothered with considering the costs of their behaviors.
However, it appears that many firms and their workers have not considered policies like
Medical Savings Accounts because they have not realized that they harbor the potential
of making everyone better off. These are the types of policies all managers should
examine. Such policies can raise their workers’ welfare, their firm’s stock prices, and the
compensation of managers. Again, we return to what is by now an old point of the book:
firms can make money not only by selling more of their product or service, but also by
creatively restructuring incentives in mutually beneficial ways.
Concluding Comments
Cost plays a pivotal role in a producer’s choices. Costs change with the quantity
produced. The pattern of those changes determines the limit of a producer’s activity—
from the production of salable goods and services to the employment of leisure time. The
individual will produce a good or service, or engage in an activity, until marginal cost
equals marginal benefit (marginal revenue). Graphically, this is the point where the
supply and demand curves for the individual’s behavior intersect. At this point, although
additional benefits might be obtained by producing additional units of the good, service,
or activity, the additional costs that would be incurred discourage further production.
Costs will not affect an individual’s behavior unless he or she perceives them as
costs. For this reason the economist looks for hidden, implicit costs in all choices. Such
costs, if uncovered, will affect choices that remain to be made. Implicit costs can also be
helpful in explaining those choices that have already been made.
Review Questions
1. Evaluate the adages “haste makes waste” and “a stitch in time saves nine” from an
economic point of view.
Chapter 9 Production Costs and
Business Decisions
23
2. If executives’ time is as valuable as they claim, why are they frequently found
reading the advertisements in airline magazines en route to a business meeting?
3. The price of a one-minute long distance call on a cell phone is several times the cost
of a call on any other phone. Does that mean that the introduction of cell phones has
increased the cost of long distance calling?
4. In discussing accident prevention, we assumed an increasing marginal cost. Suppose
instead that the marginal cost of preventing accidents remains constant. How will
that assumption affect the analysis?
5. Using the analysis of accident prevention, develop an analysis of pollution control.
Using demand and supply curves for clean air, determine the efficient level of
pollution control.
6. People take some measures to avoid becoming victims of crime. Can the probability
of becoming a victim be reduced to (virtually) zero? If so, why don’t people
eliminate that probability? What does the underlying logic of your answer suggest
about the cost of committing crimes and the crime rate?
7. If the money price of a good rises from $5 to $10, the economist can confidently
predict that less will be purchased. One cannot be equally confident that denying a
child a dessert will improve the child’s behavior, however. Explain why.
8. Consider the information in the production schedule that follows. (a) At what output
level do diminishing returns set in? (b) Assume that each worker receives $8. Fill in
the marginal product column, and develop a marginal cost schedule and a marginal
cost curve for the production process.
Number Total Product Marginal Product
of Workers of All Workers of Each Worker
1 0.10
2 0.30
3 0.60
4 1.00
5 1.45
6 2.00
7 2.50
8 2.80
9 3.00
10 3.19
11 3.37
12 3.54
13 3.70
14 3.85
15 4.00
16 3.90
17 3.70
Chapter 9 Production Costs and
Business Decisions
24
READING: Sunk Costs in the Railroad Industry
Clinton H. Whitehurst, Jr., Clemson University
Historically, a large part of a railroad’s investment has been in assets with fixed costs—cost that do not
vary with output in the short run. In the early 1900s, fixed costs were estimated to be as much as 75
percent of railroads’ total costs. More recently they have been estimated at 40 to 50 percent.
A significant part of a railroad’s fixed costs is the investment in its right of way—the 75- to 200-
foot-wide corridors in which its tracks are laid. Most railroads purchased that land and paid for its grading
many years ago, perhaps in the last century. Those costs are considered historical, or sunk.
To the degree that its costs are fixed, a railroad’s average total cost decreases as its volume
increases. The more tons it carries per mile, the lower the average total cost of moving a ton of freight.
The railroad’s fixed costs are simply spread out over more units of freight.
To use their hauling capacity fully and lower their average total cost, railroads have tended to set
their rates low for long hauls. In the early days they often generated only enough revenues to cover their
variable costs, not their total costs. But in many instances they compensated for low rates on long hauls by
charging high rates on short hauls. In 1887, customer complaints about differences in rates prompted
congress to place railroad rates and routes under the regulation of the Interstate Commerce Commission
(ICC). Throughout much of its history, the ICC considered rates that did not cover total costs to be unfair
or predatory—designed, that is, to drive out competition. It insisted that railroads set their rates high
enough to cover total costs.
After the Second World War, the rapidly growing trucking industry became the railroads’ chief
competitor. Fixed costs were much less significant in trucking than in railroads. As much a 90 percent of
the total cost of trucking varied with the number of tons carried per mile. From the point of view of the
trucking industry, then, the ICC’s requirement that rates cover total costs made sense. But from the
railroads’ perspective, the requirement was disastrous. By keeping railroad rates high, the ICC enabled the
trucking industry to compete for railroad business and expand its share of the transportation market.
In 1958, following an extensive lobbying effort by the railroads, Congress amended the Interstate
Commerce Act. The amendment instructed the ICC that “Rates of a carrier shall not be held up to a
particular level to protect the traffic of any other mode of transportation.” Earlier Interstate Commerce Act
provisions still barred “unfair or destructive competitive practice,” however. Given the ambiguity of the
legislation, the ICC continued to insist that rates cover total costs. In 1968 the Supreme Court upheld its
interpretation.
Recently railroads have been given considerable freedom to set their own rates under the railroad
Revitalization and Regulatory Reform Act (1976) and especially the Staggers Rail Act (1980). Rates that
cover only variable costs are no longer considered unfair and are not challenged by the Interstate
Commerce Commission.
Meanwhile, the interstate highways—the right of way for trucks—are becoming more congested.
Truck delivery, once much faster than railroad delivery, is slowing down. But railroad tracks remain
underutilized. As circumstances change, railroads are putting their century-old investment in their rights of
way to good use. By ignoring sunk costs and offering lower rates, they have recaptured much of the freight
business they lost to trucks after the Second World War. Today, one often sees highway trailers riding on
railroad flatcars, reflecting the new competitiveness of railroads. In fact, hauling trailers is now one of the
fastest-growing railroad services.
CHAPTER 10
Production Costs in the Short
Run and Long Run
In economics, the cost of an event is the highest-valued opportunity necessarily forsaken.
The usefulness of the concept of cost is a logical implication of choice among available
options. Only if no alternatives were possible or if amounts of all resources were
available beyond everyone’s desires, so that all goods were free, would the concepts of
cost and of choice be irrelevant.
Armen Alchian
he individual firm plays a critical role both in theory and in the real world. It
straddles two basic economic institutions: the markets for resources (labor, capital,
and land) and the markets for goods and services (everything from trucks to
truffles). The firm must be able to identify what people want to buy, at what price, and to
organize the great variety of available resources into an efficient production process. It
must sell its product at a price that covers the cost of its resources, yet allows it to
compete with other firms. Moreover, it must accomplish those objectives while
competing firms are seeking to meet the same goals.
How does the firm do all this? Clearly firms do not all operate in exactly the
same way. They differ in organizational structure and in management style, in the
resources they use and in the products they sell. This chapter cannot possibly cover the
great diversity of business management techniques. Rather, our purpose is to develop the
broad principles that guide the production decisions of most firms.
Like individuals, firms are beset by the necessity of choice, which as Armen
Alchian reminds us, implies a cost. Costs are obstacles to choice; they restrict us in what
we do. Thus a firm’s cost structure (the way cost varies with production) determines the
profitability of its production decisions, both in the short run and in the long run. Of
course, there is one very good reason MBA students should know something about a
firm’s cost structure. “Firms” don’t do anything on their own. It’s really managers who
activate firms and make decisions that will ultimately determine whether a firm is
profitable or not.
Out analysis of a firm’s “cost structure” is nothing like the imagined costs on
accounting statements. Accounting statements indicate the costs that were incurred when
the firm produced the output that it did. Here, in this chapter, we want to devise a way of
structuring costs for many different output levels. The reason is simple: We want to use
this structure to help us think through the question of which among many output levels
will enable the firm to maximize profits.
T
Chapter 10 Production Costs in the
Short Run and Long Run
2
You will also notice that our cost structure is very abstract, meaning that it is
independent of the experience of any given real-world firm in any given real-world
industry. We develop the cost structure in abstract terms for another good reason: MBA
students plan to work in a variety of industries and in a variety of firms within those
different industries. We want to devise a cost structure that is potentially useful in many
different business contexts. To do this, we need to construct costs in several different
ways for different time periods, because production costs depend critically on the amount
of time for production.
Fixed, Variable, and Total Costs in the Short Run
Time is required to produce any good or service. Therefore, any output level must be
founded on some recognized period of time. Even more important, the costs a firm
incurs vary over time. In thinking about costs, then, we must identify clearly the period
of time over which they apply. For reasons that will become apparent as we progress,
economists speak of costs in terms of the extent to which they can be varied, rather than
the number of months or years required to pay them off. Although in the long run all
costs can be varied, in the short run firms have less control over costs.
The short run is the period during which one or more resources (and thus one or
more costs of production) cannot be changed—either increased or decreased. Short-run
costs can be either fixed or variable. A fixed cost is any cost that (in total) does not vary
with the level of output. Fixed costs include overhead expenditures that extend over a
period of months or years: insurance premiums, leasing and rental payments, land and
equipment purchases, and interest on loans. Total fixed costs (TFC) remain the same
whether the firm’s factories are standing idle or producing at capacity. As long as the
firm faces even one fixed cost, it is operating in the short run.
A variable cost is any cost that changes with the level of output. Variable costs
include wages (workers can be hired or laid off on relatively short notice), material,
utilities, and office supplies. Total variable costs (TVC) increase with the level of output.
Together, total fixed and total variable costs equal total cost. Total cost (TC) is
the sum of fixed costs and variable costs at each output level.
TC = TFC + TVC
Columns 1 through 4 of Table 10.1 show fixed, variable, and total costs at various
production levels. Total fixed costs are constant at $100 for all output levels (see column
2). Total variable costs increase gradually, from $30 to $395, as output expands from 1
to 12 widgets. Total cost, the sum of all fixed and variable costs at each output level
(obtained by adding columns 2 and 3 horizontally), increases gradually as well.
Graphically, total fixed cost can be represented by a horizontal line, as in Figure
10.1. The total cost curve starts at the same point as the total fixed cost curve (because
total cost must at least equal fixed cost) and rises from that point. The vertical distance
between the total cost and the total fixed cost curves shows the total variable cost at each
level of production.
. was paying $4,500 a year for the insurance of each
worker. Now, it must pay $1,200 for the insurance and $3,000 for the MSA, for a total of
$4,200. The. problems), can be purchased for each employee for a premium of
$1,200 per year (which is, we are told, in the ballpark of the actual cost for a group
policy).