Solved problem – HubbardOBrienEconomics.com Blog

Supports: Microeconomics, Chapter 11, Section 11.5; Economics, Chapter 11, Section 11.5; and Essentials of Economics, Chapter 8, Section 8.5

Photo from the Wall Street Journal.

Imani owns a firm that sells payroll services to companies in the Atlanta area. Her largest cost is for labor. She employs workers who use software to prepare payroll reports and to handle texts and calls from client firms. She decides to begin using a generative AI program, like ChatGPT, which is capable of quickly composing thorough answers to many questions and write computer code. She will use the program to write the additional computer code needed to adapt the payroll software to individual client’s needs and to respond to clients seeking advice on payroll questions. Once the AI program is in place, she will need only half as many workers. The number of additional workers she needs to hire for every 20 additional firms that buy her service will fall from 5 to 1. She will have to pay a flat monthly licensing fee for the AI program; the fee will not change with the number of firms she sells her services to. Imani determines that making these changes will reduce her total cost of providing services to her current 2,000 clients from $2,000,000 per month to $1,600,000 per month

In answering the following questions, assume that, apart from the number of workers, none of the other inputs—such as the size of her firm’s office, the number of computers, or other software—change as a result of her leasing the AI program.

a. Briefly explain whether each of the following statements about the cost situation at Imani’s firm after she begins using the AI program is correct or incorrect.

Her firm’s average total cost, average variable cost, and average fixed cost curves will shift down, while her firm’s marginal cost curve will shift up.
Her firm’s average total cost, average variable cost, average fixed cost and marginal cost curves will all shift up.
Her firm’s average total cost, average variable cost, and marginal cost curves will shift down, while her average fixed cost curve will shift up.
Her firm’s average total cost, average variable cost, average fixed cost, and marginal cost curves will all shift down.
Her firm’s average fixed cost curve will shift up, but her other cost curves will be unchanged.

b. Draw a graph illustrating your answer to part a. Be sure to show the original average total cost, average variable cost, average fixed cost, and marginal cost curves. Also show the shifts—if any—in the curves after Imani begins using the AI program.

Solving the Problem

Step 1: Review the chapter material. This problem requires you to understand definitions of costs, so you may want to review the sections “The Difference between Fixed Costs and Variable Costs,” “Marginal Costs,” and “Graphing Cost Curves”

Step 2: Answer part (a) by explaining whether each of the five listed statements is correct or incorrect. The cost of the AI program is fixed because it doesn’t change with the quantity of her services that Imani sells. Her firm will have greater fixed costs after licensing the AI program but she will have lower variable costs because she is able to produce the same level of output with fewer workers. Her marginal cost will also decline because she needs to hire fewer workers as the quantity of services she sells increases. We know that the average total cost per month of providing her service to 2,000 clients has decreased because we are given the information that it changed from ($2,000,000/2,000) = $1,000 to ($1,600,000/2,000) = $800.

This statement is incorrect because her average fixed cost curve will shift up as a result of her total fixed cost having increased by the amount of the AI program license and because her marginal cost curve will shift down, not up.
This statement is incorrect because all of her cost curves, except for average fixed cost, will shift down, not up.
This statement is correct because it describes the actual shifts in her cost curves.
This statement is incorrect because her average fixed cost curve will shift up, not down.
This statement is incorrect because her rather than being unaffected, her average total cost, average variable cost, and marginal cost curves will shift down.

Step 3: Answer part (b) by drawing the cost curves for Imani’s firm before and after she begins using the AI program. Your graph should look like the following, where the curves representing the firm’s costs before Imani begins leasing the AI program are in blue and the costs after leasing the program are in red.

Supports: Macroeconomics, Chapter 18, and Economics, Chapter 28.

Photo from the *Wall Street Journal* of the Tianjin Port in China.

In an article on axios.com, economic journalist Neil Irwin discussed the Bureau of Economic Analysis’s latest data on gross domestic product. He noted: (1) “In the arithmetic around U.S. economic output, trade acted as a more severe drag [in 2021] than it has in a generation.” and (2) “The flip side of higher trade deficits is higher debt. In the third quarter [of 2021], net U.S. borrowing from abroad was $127 billion as the current account deficit widened 8.3%.”

What does Irwin mean that during 2021 international trade acted as a “severe drag” on real GDP? What’s a severe drag? What must have been true of the relationship between U.S. imports and exports during 2021 for international trade to have been a severe drag on U.S. real GDP?
Why is the flip side of high trade deficits higher debt? What is the link between U.S. borrowing from abroad and the current account deficit?

Solving the Problem

Step 1: Review the chapter material. This problem is about the effect of a trade deficit on real GDP and on U.S. borrowing abroad, so you may want to review Macroeconomics, Chapter 8, Section 8.1, “Gross Domestic Product Measures Total Production,” and Chapter 18, Section 18.4, “The International Sector and National Saving and Investment.”

Step 2: Answer part 1. by explaining what the phrase “severe drag” means and indicate what must have been true of the relationship between imports and exports in order for international trade to have been a severe drag on U.S. real GDP. By severe drag, Irwin means that real GDP would have significantly higher if not for the effects of international trade. We know that increases in U.S. real exports—holding all other factors constant—increase U.S. real GDP and increases in U.S. real imports reduce U.S. real GDP. If international trade was a severe drag on U.S. real GDP in 2021, then imports must have been significantly larger than exports—that is, net exports must have a large negative number. In fact, net exports were −$1.28 trillion, which was the largest gap ever between real exports and real imports.

Step 3: Answer part 2. by explaining why a trade deficit leads to larger U.S. borrowing from abroad. A trade deficit occurs when the U.S. imports more goods and services than it exports. The current account balance is determined mainly by the trade balance, so if the United States is running a trade deficit it will typically also run a current account deficit. The financial account balance roughly equals net capital flows, which equal net foreign investment with the opposite sign.

Therefore, as we show in Macroeconomics, Section 18.4:

Current account balance + Financial account balance = 0

or:

Current account balance = −Financial account balance

or:

Net exports = Net foreign investment

When net exports are negative, so is net foreign investment. In other words, a trade deficit results in the United States borrowing from abroad. So, Irwin is correct to write that the “flip side of higher trade deficits is higher debt.”

Source: Neil Irwin, “Covid Created an Epic U.S. Trade Gap,” axios.com, January 27, 2022.

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