Question

Chevy Volt Production Temporarily Shut Down GM will temporarily lay off 1,300 employees as the company stops production of the electric car, Chevy Volt, for five weeks. GM had hoped to sell 10,000 Volts last year, but ended up selling just \(7,671 .\) It plans to maintain inventory levels by adjusting production to match demand. Source: Politico, March 2, 2012 a. Explain how the shutdown decision will affect GM Chevy Volt's TFC, \(T V C\), and \(T C\). b. Under what conditions would this shutdown decision maximize Chevy Volt's economic profit (or minimize its loss)? Explain your answer. c. Under what conditions will GM start producing the Chevy Volt again? Explain your answer.

Short answer

TFC stays constant; TVC and TC decrease. Shutdown maximizes profit or minimizes loss if revenue is less than variable costs. Production resumes when revenue exceeds variable costs.

Step-by-step solution

Title - Understand Key Terms

Identify and understand the key terms: Total Fixed Cost (TFC), Total Variable Cost (TVC), and Total Cost (TC). TFC are costs that do not change with production levels, like rent or salaries. TVC are costs that vary with production levels, such as raw materials or direct labor. TC is the sum of TFC and TVC.

Title - Impact of Shutdown on TFC, TVC, and TC

Determine how the shutdown affects each cost component. During the shutdown, TFC remains constant because these costs do not change with the level of production. TVC will decrease significantly because no variable inputs are used when production stops. Consequently, TC, which is the sum of TFC and TVC, will also decrease.

Title - Conditions for Maximizing Economic Profit or Minimizing Loss

Economic profit is maximized, or losses are minimized when the marginal cost (MC) of production equals the marginal revenue (MR). The shutdown decision will maximize economic profit or minimize loss if the revenue from producing and selling the Chevy Volt is less than the variable costs of production. This means that operating would result in a greater loss than shutting down temporarily.

Title - Conditions for Restarting Production

GM will restart production when the projected revenue from selling the Chevy Volt exceeds its variable costs and contributes to covering fixed costs. Additionally, increased demand or a higher sales price that results in marginal revenue being greater than marginal cost (MR > MC) would justify restarting production.

Key concepts

Total Fixed Cost (TFC)

Total Fixed Costs (TFC) are expenses that remain unchanged regardless of the level of production. These costs are unavoidable in the short term and must be paid even if production is halted. Examples of TFC include rent for the factory space, salaries of permanent employees, insurance, and loan payments. Understanding TFC is essential since businesses must cover these costs irrespective of production activities. During a shutdown like GM's temporary halt in Chevy Volt production, TFC remains constant because these costs are not linked to manufacturing activities. Even though production stops, expenses such as rent and managerial salaries must still be paid.

Total Variable Cost (TVC)

Total Variable Costs (TVC) change directly with the level of production. If production increases, TVC will rise, and if production decreases, TVC will fall. These costs include expenses like raw materials, direct labor, and utility costs specific to the manufacturing process. In the case of a production shutdown, TVC will drop significantly because the production activities cease. This means no raw materials are purchased, and no direct labor is needed. Therefore, halting production saves the company from incurring these variable costs, making the shutdown a strategic decision to avoid financial losses when demand is low.

Total Cost (TC)

Total Cost (TC) is the sum of Total Fixed Costs (TFC) and Total Variable Costs (TVC). The formula for calculating TC is:
\[ TC = TFC + TVC \]
Understanding TC is crucial for assessing the overall expenditure associated with production. When GM decides to shut down Chevy Volt production, although TFC remains unchanged, TVC decreases. Consequently, TC also decreases since it is a combination of both fixed and variable costs. This reduction in total cost, during a period of low demand, helps to minimize losses by reducing the outflow of variable expenses.

Marginal Cost (MC)

Marginal Cost (MC) is the additional cost incurred in producing one more unit of a good or service. The concept of MC is critical for making production decisions. It is calculated as:
\[ MC = \frac{ \Delta TC } { \Delta Q } \]
where \( \Delta TC \) is the change in total cost, and \( \Delta Q \) is the change in quantity produced. By comparing MC to Marginal Revenue (MR), companies determine the profitability of increasing production. During a shutdown, MC is particularly important since if the cost of producing an extra unit exceeds the revenue generated from its sale, continuing production would result in losses. Therefore, a shutdown decision is made to stop incurring those additional costs.

Marginal Revenue (MR)

Marginal Revenue (MR) is the additional income earned from selling one more unit of a product. It is calculated by:
\[ MR = \frac { \Delta TR } { \Delta Q } \]
where \( \Delta TR \) is the change in total revenue, and \( \Delta Q \) is the change in quantity sold. For a firm to maximize its economic profit or minimize losses, MR should be greater than or equal to MC. In cases where MR falls below MC, companies lose money on each additional unit produced. During the decision to shut down GM's Chevy Volt production, the understanding was that MR was less than MC, making it more economical to halt production until conditions improve. The company will resume production when MR exceeds MC, ensuring profitable operations.