Markets, Profits and Prices of Boeing - Case Study Example

Markets, Profits and Prices In order to understand how Boeing estimated the offer made to its machinists, a number of economics concepts should be examined. They include profit-maximization assumption, fixed and variable costs, marginal costs, opportunity costs and market types. Because Boeing is considered to operate under profit-maximization assumption, it is necessary to first discuss conditions necessary for profit-maximization. There are two basic rules for profit maximization as described by Barron, Lynch & Blanchard (2003): Rule 1: A business should operate only if it does better by operating than by not operating. Rule 2: A firm should increase production as long as the added revenue from selling the increase in output exceeds the added cost of producing it. (p.241) The first rule applies the concepts of fixed and variable costs. In an essence, it stipulates that it is more profitable in the short run for a company to stay in business, even if the firm is operating at a loss, as long as revenues are high enough to cover variable costs. If revenue is less than total variable costs, a firm should stop operating, even in the short run (Barron, Lynch & Blanchard, 2003, p.241). The second rule applies the concept of marginal cost. The profit must rise if producing another unit of output adds more to revenues that to costs. Similarly, the profit must fall if producing another unit increases costs by more than it increases revenues. The analysis of fixed, variable and marginal costs combined with identification of the market in which Boeing operates and the concept of opportunity costs can assist in understanding how Boeing estimated the offer made to its workers in a commercial aircrafts division. Fixed, Variable, Average and Marginal Costs of Boeing In the context of production, fixed costs are costs that do not change with the level of output they produce. Whether the firm produces 1 million units of output or zero units of output, those costs must be paid (Barron, Lynch & Blanchard, 2003, p.241). For Boeing, the plant, machinery and equipment should constitute the majority of its fixed costs in the commercial aircraft division. The production of commercial aircrafts involves advanced technological process and highly automated sophisticated machinery, which should be very expensive. Other fixed cost components might include wages to executives, administrative and selling expenses, leases, etc. Overall, Boeing is expected to have a very high level of fixed costs. "On the other hand, any costs that do vary with output, like materials and labor, are referred to as variable costs" (Barron, Lynch & Blanchard, 2003, p.241). The major variable costs for Boeing are materials used for aircraft production (i.e. steel), utilities and labor. It is stated in the article that there are more than 18,500 members of the International Association of Machinists and Aerospace Workers covered by the Boeing contracts. This number indicates that Boeing hires a large amount of workers. Therefore, labor costs might account for the majority of variable costs of Boeing in producing commercial aircrafts. The total cost of producing a given amount of output is simply the sum of costs associated with the hiring of all the inputs, both fixed and variable. The average cost for Boeing is the total cost divided by the number of aircrafts that Boeing produces. Even though average cost figure provides some useful information to the company, it does not seem to play a significant role in economics decision-making. "The marginal cost of production is the increase in total costs resulting when output is increased by one unit" (Barron, Lynch & Blanchard, 2003, p.79). Commercial aircrafts are very large products. So the marginal cost of production of Boeing should be very high in money terms, but commensurate with the prices Boeing charges for its aircrafts. Out of fixed and variable cost, only variable cost plays a role in decision-making. "Because the fixed costs do not vary with the level of output, they are irrelevant in making decision making and often are referred to as sunk costs in economics" (Barron, Lynch & Blanchard, 2003, p. 241). When making a decision about its operations, Boeing first of all takes into consideration its variable costs, particularly its labor costs. If the total revenue exceeds total variable costs, the company should continue to operate at a loss in the short run. But if revenue is less than total variable costs, it should shut down even in the short run (Barron, Lynch & Blanchard, 2003, p. 242). Effect of a Strike on Costs and Revenue of Boeing In case of a strike Boeing will not be able to continue producing commercial aircrafts in its sites in Portland, Ore., Seattle and Wichita, Kan for an undefined period of time. The fixed costs of Boeing will not change. All the plant sites are already constructed, equipment acquired and manufacturing processes implemented. Fixed costs remain the same whether the production is undertaken on the plant or not. The variable cost will be influenced by the strike. While material costs will stay the same, labor costs will decrease. It can even decrease to zero at the time of strike if all of the workers stop working on the plant. Even if not all of the workers participate in the strike, they will not be able to do any meaningful work on the plant because of absence of other workers responsible for other parts of a manufacturing process. The utilities costs should also drastically decrease, as equipment and machinery will not be run without workers. Therefore, the overall variable costs should significantly decrease providing the strike starts. The average cost should also decrease due to the reduction in variable costs. It is difficult to estimate the new marginal cost. If the whole production process is halted on the Boeing's plants, no additional aircrafts will be produced. So there will be no marginal cost of production incurred at that time. But there will be also no revenues. The biggest risk for the company associated with the strike is the risk of losing some orders or inability to maintain the schedule of production and delivery terms. As a result, some aircrafts might be finished later than agreed with the customer, possibly having negative effect on the revenues. Effect on Costs of Boeing if the Offer is Accepted According to the Boeing's offer, the wage will increase by 5.5 percent, pension payment will amount to $66 a month for each year of a retired employee's service, plus as much as $15,400 in lump sum payments and bonuses. There was a different package proposed for Boeing's employees in Wichita, Kan. The new offer will have direct effect on the variable costs. Because wage increases by 5.5%, labor cost increases by the same amount. As a result, variable cost will also increase by a significant amount. Pension payments are assumed to be a part of the fixed cost because they are not directly related to the level of output, even though they are related to the number of employees Boeing hires. So the fixed cost should also increase as a result of the proposed offer. Accordingly, both average costs and marginal cost of production will increase. Effect on Revenue of Boeing if the Offer is Accepted Because Boeing operates under profit-maximizing condition, it should increase the price of its commercial airlines in order to match prices with growing marginal cost of production, following Rule 2 of profit maximization. This should affect the market supply of Boeing, as is described by Barron, Lynch & Blanchard (2003): One factor affecting market supply that arises specifically when supply derives from production is a change in the price of an input. When producers are making supply decision, they do so based on a given set of process paid for their inputsIf, for example, the cost of labor increases, the production costs rise. It leads to increase in marginal cost of production and reduction in the market supply. (p.87) If Boeing manages to increase its prices, the revenues might increase. Profit level might remain at the previous level as increase in revenues will be offset by an increase in costs. However, most probably, Boeing will not be able to increase prices of its commercial aircrafts for two reasons. First, Boeing produces commercial aircrafts for its customers under certain terms and conditions. In most cases agreements include all details about the price of the aircrafts to the customers and time frame of delivery. So even if the production costs grow, Boeing might not be able to increase prices of its aircrafts. The second reason is the market type in which Boeing operates. There are only several major producers of aircrafts in the world and entrance into the market is relatively restricted. So it corresponds to the definition of the oligopoly, as explained by Barron, Lynch & Blanchard (2003): Oligopoly is a market structure in which there are a relatively small number of competing sellers and entry by new firms is impededA unique feature of oligopoly is that there are few enough competitors that an oligopolist must be concerned with how competitors will react to various actions, such as setting of its price. (p.239) The major competitor of Boeing is Airbus. In the light of their rivalry, Boeing might not be able to increase prices of its aircrafts in order not to lose its current and prospective customers. Therefore, the new offer most probably will not have any effect on Boeing's revenues, but it will decrease its profits due to costs growth. Opportunity Cost in Case of a Strike Opportunity cost of a strike will be "the value of the best alternative forgone" (Barron, Lynch & Blanchard, 2003, p. 7). For machinists, it will be the salary that they do not receive during the strike. For consumers, it will be possible inconveniences associated with the delay of their aircrafts delivery. For example, the airline that ordered the aircraft planned to start flights on it on the 1st of October. But because of the strike, it will be able to have the aircraft delivered a month later. So it potentially loses all the profits it could realize from a one-month operation of the aircraft. For Boeing, the opportunity cost of a strike is the contracts that it might lose as a result of the late aircrafts' delivery or related penalties. It can be assumed that the opportunity cost faced by the machinists is the highest as most of them do not have any other source of revenue except for the wages. Boeing company operates a number of businesses, being "the world's leading aerospace company and the largest combined manufacturer of commercial jetliners and military aircraft, with additional capabilities in rotorcraft, electronic and defense systems, missiles, satellites, launch vehicles and advanced information and communication systems" (Overview of Boeing). Therefore, it may overcome its opportunity cost more easily than machinists. Opportunity Cost in Case Boeing's Offer is Accepted The opportunity cost for machinists will be higher wages, better security, health care plan and pension payments than currently offered. For customers, there will be no opportunity cost provided Boeing doesn't raise prices (the most probably scenario). For Boeing, the opportunity cost will be other uses of the money promised as an increase to wages and pension payments to machinists. Those funds could be invested into other Boeing's divisions or can be distributed in the form of dividends among shareholders. Conclusion It is viable to assume that the increase in wages and pension funds as stipulated in the offer was approaching the limit of variable costs that can be covered by the revenues of Boeing in the short run, following Rule 1 of profit maximization. If the variable cost surpasses the revenues from the selling aircrafts, it will not be economically feasible to continue production. Knowing that the opportunity cost of machinists is more significant then Boeing's possible opportunity cost, Boeing adhered to its profit maximizing strategy and didn't accept the demands of the mechanists. Even though the strike does jeopardize Boeing's revenue stream and customer's satisfaction, the decision of Boeing is economically justified and correspondent to the profit-maximization rules. A separate offer for Wichita employees shall not be sustainable within a competitive market. The workers at Wichita site that are offered worse conditions than the rest of the Boeing's machinists can try to reallocate themselves to other sites with better conditions, being rational economic agents. References Barron, J.M., Lynch G.J. & Blanchard K.H. (2003). Economics: A Survey. Euclid: Lakeshore Publishers, Div. Lakeshore Communications. Overview of Boeing. Retrieved November 11, 2005 from Boeing official site http://www.boeing.com/companyoffices/aboutus/brief.html Reuters (2005, September 1). Boeing Braces for Walkout by Machinists. The New York Times. Retrieved November 11, 2005 from http://classwork.busadm.mu.edu/Economics%20Newspaper%20Articles/Microeconomics/Labor,%20Unions,%20Costs,%20Production/2005/2005%2009%2001%20Boeing%20braces%20for%20walkout%20by%20machinists.pdf Read More