Automobile Accounting

Stories have been circulating this week about the production costs of the Chevy Volt hybrid automobiles. The numbers are astounding! According to a Reuters article in the National Post story, it costs US$89,000 to produce a car that sells for US$39,995. GM is losing US$40,000 per car. Yet GM continues to produce and market these vehicles. There is something seriously wrong with the management at GM, or there is something wrong with these numbers.

Basic economic theory suggests that a firm will be willing to sell its product for any price greater than the marginal cost of production, provided that the price is higher than the minimum average variable cost. The same economic theory tells us that “sunk costs” are irrelevant for decision making. A sunk cost is a fixed cost that has been incurred that can never be recouped. An example would be research and development costs. These costs certainly effect profits, but not the profit making decisions.

The article referenced above suggests that the $1.2 billion spent by GM should be divided up among the number of Volts that have been sold. While an accountant might agree with this, an economist certainly would not. The R&D money is a sunk cost. It can never be recovered. It reduced profit by $1.2 billion dollars. That money is an investment in a technology that is still developing, and will be used in other models in the future. The patents are intellectual property of GM and could, in theory, be sold to other automobile manufacturers.

The costs that are relevant to the production of the Volt, are the materials, labour and equipment used to produce each vehicle – the marginal costs of production. We haven’t asked GM for their cost figures, and we suspect that the batteries add significant costs over internal combustion engines, but to suggest the marginal cost of producing a Volt is US$89,000 is ridiculous.

Another issue surrounding the Volt, as reported by CBS news, is the lackluster sales of the Volt. GM has recently reduced the price of the volt (increasing the loss per vehicle reported by the industry analysis in the Financial Post article) in an attempt to increase sales. Demand curves are downwards sloping, so a reduction in price should increase the number of vehicles sold. The biggest problem that electric vehicles face is that oil prices, and therefore gasoline prices have fallen. Electric cars are a substitute for gasoline fueled cars, and a drop in the cost of operating a gasoline vehicle reduces the demand for electric cars. On our road trip through the western states this summer, we were able to purchase gasoline for about the equivalent of C$0.90 per litre. At this price, electric cars don’t make economic sense.

At some point in the future, oil prices will be high enough and the technology used in electric cars will be efficient enough that we will see more electric cars on the road. Until then, we’re investing in the oilsands.

The Story of Isaac and Joe

On the morning of August 21^st of this year, I stumbled out of bed at the Marriott Key Largo Resort and went out on the balcony to drink my morning coffee. (Tough life, I know) I called back in to my niece, who accompanied me on this particular adventure, and told her that a storm must be coming. The wind in the Keys usually blows from the west, but on that particular morning, it was blowing from the south. Later that day we learned that the National Hurricane Center was predicting that Tropical Storm Isaac would strengthen to hurricane force as it crossed the Straits of Florida and would then hit somewhere in the Keys in 5 days. Fortunately, we flew home from Miami on the 23^rd and didn’t have to cross “hurricane” off the bucket list.

The euphoria was short lived as the economic impact was felt back home. Not the minor damage in the Keys, or the more substantial damage in Plaquemines Parish LA, but the devastating damage to the Louisiana crabbing fleet. Crab is one of my favourite foods, and I have been known to drive the 275 miles (440 kms) just to get a steamer pot from the closest Joe’s Crab Shack. In Louisiana, they catch mainly Blue crab, and my particular favourite is Dungeness so why, might you ask, will the hurricane have any effect on me.

The supply of Blue crab is down as a result of the hurricane. Boats, docks, coolers and traps have been lost and flooded roads make it impossible to get to those that were not destroyed or damaged. According to a New Orleans Times-Picayune, the current daily catch is 6,000, down from 18,000. This reduction in supply is sure to raise the price of Blue crab. (Sounds like something straight out of Forrest Gump – but that was shrimp, not crab – and I digress.)

Dungeness crab, which is found in the North-Eastern Pacific Ocean off the coast from Northern California to Alaska, is a substitute for Blue crab. As the price of Blue rises, the demand for Dungeness increases. As the demand for Dungeness increases, so does its price. When the price of Dungeness increases, the marginal cost of producing steampots at Joe’s will increase. Joe’s supply curve is dependent on their marginal costs. As Joe’s supply curve shifts left, they may be forced to increase their prices.

That’s where I get hurt. An increase in prices at Joe’s will not stop me from eating at Joe’s, but it will reduce the consumers’ surplus I receive – the difference between the value that I receive and the price that I pay. Consumers’ surplus is what generates my happiness. Higher prices means lower consumers’ surplus which means less happiness. Blame it on Isaac.