Industry Structure Simulation
Fred C. White
Agricultural and Applied Economics
The Universtity of Georgia
fwhite@agecon.uga.edu
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Directions for Instructors
Economic Simulation
The operation and expansion of hypothetical firms are modeled in the classroom through economic simulation. The simulations involve role playing in which the students perform as resource owners and managers in simulated markets. Students are asked to make decisions on firm size and production. Students are able to experience the consequences of their decisions in terms of simulated profits and losses.
Each firm faces a series of average cost (AC) and marginal cost (MC) curves as identified in Fig. 1. Average and marginal costs for the four firm sizes are: AC1 and MC1 for 100 acres, AC2 and MC2 for 200 acres, AC3 and MC3 for 300 acres, and AC4 and MC4 for 400 acres. These land resources underlie the cost curves but are not explicit in the figure. Instead, the figure shows the cost of producing some commodity such as apples. The structure of the cost curves presented in Fig. 1 exhibit lower costs for larger firms, which is called economies of scale. Such economies of scale may result from specialization of inputs such as machinery, other capital, and labor and from greater efficiencies in management.
The basic simulation model is simple enough so that students in any level of undergraduate economics can follow the process. However, the model is flexible enough to include such concepts as production, growth, leverage, and uncertainty. These concepts can be introduced to the students at whatever level the instructor deems appropriate.
A set of rules is developed to capture the more salient aspects of the economic situation. Rules may vary depending on course objectives and student backgrounds. A typical set of rules will be described to illustrate the simulation. Each firm is given an initial resource base of 200 acres. Product price is first fixed and then allowed to vary over selected ranges.
Initial Production Period
Product price is set at $110 per unit in the initial period. Students calculate potential profits at various firm sizes. The existence of significant economies of scale provide incentives for firm expansion. Although total resources for the class are fixed at 200 acres per firm times the number of firms, these resources can be moved from one firm to another by renting. A firm may choose to rent out 100 acres of its land if the combined net income from production at a smaller scale and rental income is greater than it would earn from operating 200 acres. Another firm may choose to rent in 100 or 200 acres if the addition to net income is greater than rental expenses.
Production decisions have to be made in 100 acre units. Rental arrangements are determined through negotiations between any two firms. Possible rental rates between two firms can be determined from sharing profits for the ending firm sizes. Actual rental rates would be determined through negotiations.
The goal in the early periods of the simulation is for the firm to maximize profits.After determining firm size decisions by completing rental negotiations, students set production levels Marginal cost curves in Fig. 1 are important in determining the appropriate production level. Without taking marginal costs into consideration, students would tend to minimize costs rather than maximize profits.
At the end of each production period, students report production decisions, rental arrangements and profits in an income statement. The instructor reviews each team's decisions and evaluates their performance, reporting back to the class. With a goal of maximizing profit, it is easy to evaluate performance and help students make corrections.
Multiple Production Periods
The farm structure simulation is repeated several periods, adding new information and more complexities to the model. In the second period, the product price is raised to $120 per unit. The impact of higher prices on rental rates, farm structure decisions, and quantity supplied are considered.
Land valuation is introduced in the second production period and carried through subsequent periods. Land values can be determined by discounting the net income (or rental rate) stream over the planning horizon. In addition to rental arrangements, firms can now transfer land resources to other firms through negotiated purchases. Each firm must maintain an up-to-date balance sheet as well as an income statement.
Uncertain Product Prices
In the third production period, uncertain product prices are introduced. The product price can range between $110 and $130, with an expected price of $120. A simple approach for implementing price uncertainty is to flip a coin at the end of the production period in order to determine whether the low or high price applies. Uncertainty adds more realism and challenges to the decision-making process. Each firm takes on its own unique characteristics related to risk and uncertainty.
Students must decide whether their firm is risk averse, risk neutral or risk loving. After characterizing the firm, students choose a strategy to deal with risk
The primary goal switches from maximizing profit to maximizing utility where utility is based on expected profits and variability of profits. Operationally, students may choose a desired level of profit and minimize the risk.
Firms may reduce risk through diversification by renting out land or selling land. Such a strategy would combine certain income from land rental or land sales with uncertain income of production. Firms which are characterized as risk neutral or risk loving may rent in land or purchase land in order to increase income resulting from economies of scale.
Comparing results between the second and third periods shows how risk affects production and farm structure decisions. Expected product price is the same in both periods. However, rental rates and land values can change as firms attempt to maximize utility rather than profits.
Effects of changing the variability of prices can be considered in the fourth period. The product price is allowed to range from $100 to $140, while the expected price remains at $120. Higher risk may result in changes in production and farm structure decisions, as well as rental rates and land values.
Other Considerations
Public policies can be introduced in subsequent production periods to analyze their impacts on production and farm structure decisions. These policies may affect the expected level or variability of product prices. Income distribution policies may also be considered that favor land owners over renters or favor small farms over large farms. Changing interest rates in the model can be used to demonstrate the impact of credit policies on farm structure decisions and land values.
Students are required to explain the impact of changes in the expected level and variability of product prices on their firm's decisions, income statement and balance sheet. Likewise, they are to explain the impact of public policies on their firm. Both oral and written reports are given by the students. The instructor may use the information from all of the firms to explain how the changes affect aggregate production, average rental rates and land values, and farm structure.
Implementation
The farm structure simulation has been implemented in two courses: (1) microeconomic principles and (2) economic analysis of public policies. The first course is a lower division course, and the second is an upper division course. The lower division course introduced economic principles, while the upper division course applied the principles in policy analysis. The economic concepts were explained in detail before the students participated in the simulations only in the lower division course. Since the upper division course required the microeconomic principles course as a prerequisite, these economic principles were only lightly reviewed in the upper division course prior to the simulation.
Measuring student performance is solely dependent on profits from production and rental income when prices are known with certainty. Measuring performance is more complicated when uncertain product prices are introduced, because actions need to be consistent with the students' attitude towards risk. Students are graded on their performance and on their oral and written reports.
Simulation of a production period may take 15-20 minutes. For a given level of complexity, students are able to complete the production periods quicker as they become more familiar with the process. Time is allowed to update income statements and balance sheets. Students use a cash basis income statement and a market basis balance sheet. The market values are averages for all firms. Students make their calculations on a calculator.
The simulation exercise is a role playing game that is not computerized. After students complete a production period in the simulation exercise, I use a computer program to summarize results for the whole class. It usually takes 30-45 minutes outside of class for each production period to go over the students' work, run the computer program, and analyze the results in preparation for the next period. The computer output reports average rental rates and average profits and ranks the teams by the level of profits. This evaluation could be done within the same day of the simulation.However, I prefer to report the results to the class immediately preceding the next simulated production period. Reviewing the previous results helps students correct for past mistakes and prepares them for the current production period.
The simulation exercise does not require any special resources. I do not use any teaching assistants. While students are working on the exercise, I am available to answer questions and clarify instructions. I have never experienced any difficulty in administering the simulation exercise
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Link to average and marginal cost curves to be distibuted to students.
Cost Curves
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Record of Management Decisions
Farm Structure
Round __
___________________________________________________
1. Team Number __
Each farm has 300 acres (size 3).
2. Do you wish to rent 100 acres to the
government at the average rental rate for
all farms in the class? __yes __no
Each farm must rent in or rent out 100 acres
to another farm in the class.
3. Did you rent in or rent out 100 acres?
__rented in 100 acres
__rented out 100 acres
4. What was the rental rate? ____
5. What was the team you negotiated with? ___
6. How many acres did you operate? ___
7. What quantity did you produce? ___
___________________________________________________
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Directions for instructors ||
Cost curves
Record of management decisions||
Computer program
Fred White's home page
Computer Program
* This program is written for the software:
* Regression Analysis of Time Series (RATS)
* Instructions on data are in blue letters.
* Data to be entered by the user is highlighted in bold red letters.
* Revised 5/26/97
OPEN OUTPUT A:O
* DISK I92
* FILE A:STRUC4
* FOUR SIZES
* YEAR
IEVAL IYEAR=1997
* IRND IS ROUND NUMBER
IEVAL IRND = 1
* NT IS NYMBER OF TEAMS
IEVAL NT = 6
DECLARE RECT DATUM(NT,7)
DECLARE RECT COEF(4,4)
DECLARE VECT GOVT(NT)
DECLARE VECT PROFIT(NT)
DECLARE VECT TC(NT)
DECLARE VECT TREV(NT)
DECLARE VECT PILESSR(NT)
DECLARE VECT FPROFIT(NT)
DECLARE VECT WI(NT)
INPUT COEF
-.4353741 120.1361 -5.013605 .3129252
4.1496e-12 270.0000 -30.0000 1.2500
-.3092282E-10 720.0000 -80.0000 2.500000
.1978151E-10 1070.000 -100.0000 2.500000
* RECORD OF TEAM DECISIONS
* 1) TEAM NUMBER
* 2) RENT TO GOVERNMENT (1=YES, 2=NO)
* 3) RENT IN (1) OR RENT OUT (2)
* 4) RENTAL RATE
* 5) NUMBER OF THE OTHER TEAM
* 6) ACRES OPERATED (100, 200, 300, OR 400)
* 7) QUANTITY PRODUCED
* INPUT DATA FOR MANAGEMENT DECISIONS
INPUT DATUM
1 1 2 200 2 100 10
2 2 1 200 1 400 21
3 1 2 180 4 100 11
4 2 1 180 3 400 22
5 1 2 220 6 100 10
6 2 1 220 5 400 20
WRITE DATUM
* AVERAGE PRICE
EVAL PRICE = 110.
EVAL TTLRENT = 0
* AVERAGE RENT
DO I = 1 , NT
EVAL TTLRENT = TTLRENT + DATUM(I,4)
END DO I
EVAL AVERENT = TTLRENT / NT
* FINDS PROFIT
DO I = 1 , NT
* IS = SCALE (1, 2, 3, OR 4)
DO J = 1 , 5
IF J < .01 * DATUM(I,6) + .5
IEVAL IS = J
END DO J
EVAL TC(I) = COEF(IS,1) + COEF(IS,2)*DATUM(I,7) $
+ COEF(IS,3) * DATUM(I,7)**2 + COEF(IS,4) * DATUM(I,7)**3
EVAL TREV(I) = PRICE * DATUM(I,7)
EVAL PILESSR(I) = TREV(I) - TC(I)
DISPLAY I TREV(I) TC(I) PILESSR(I)
* RENTAL TO GOVERNMENT
EVAL GOVT(I) = 0.
IF DATUM(I,2) == 1.
{
EVAL TREV(I) = TREV(I) + AVERENT
EVAL GOVT(I) = AVERENT
}
* RENTAL RATE
IF DATUM(I,3) == 2.
EVAL TREV(I) = TREV(I) + DATUM(I,4)
IF DATUM(I,3) == 1.
EVAL TC(I) = TC(I) + DATUM(I,4)
EVAL PROFIT(I) = TREV(I) - TC(I)
DISPLAY I #####.## PROFIT(I)
END DO I
* AVERAGE PROFIT
EVAL PROFAV = 0.
EVAL QTTL = 0.
DO I = 1 , NT
EVAL PROFAV = PROFAV + PROFIT(I)
EVAL QTTL = QTTL + DATUM(I,7)
END DO I
EVAL PROFAV = PROFAV / NT
EVAL VARPI = 0.
DO I = 1 , NT
EVAL VARPI = VARPI + (PROFIT(I) - PROFAV)**2
END DO I
EVAL VARPI = VARPI / (NT-1.)
EVAL STDEV = SQRT(VARPI)
EVAL CVAR = 100. * STDEV / PROFAV
* AVERAGE QUANTITY
EVAL QAV = QTTL / NT
* RANKING OF TEAMS
{
DISPLAY
DISPLAY
DISPLAY ' FARM STRUCTURE MODEL '
DISPLAY
DISPLAY ' ROUND ' IRND
DISPLAY ' AVERAGE PROFIT ' PROFAV
DISPLAY ' COEFFICIENT OF VARIATION ' CVAR
DISPLAY ' AVERAGE RENT ' AVERENT
DISPLAY ' AVERAGE QUANTITY PRODUCED ' QAV
DISPLAY ' AVERAGE PRICE ' PRICE
DISPLAY
DISPLAY ' TEAMS RANKED BY PROFITS'
DISPLAY
DISPLAY ' NO. PROFIT RENT GOVT QUANTITY PROFIT'
DISPLAY ' w/o RENT'
EVAL ZPROFIT = -10000
DO J = 1 , NT
IEVAL K = 0
EVAL RPROFIT = -10000
DO I = 1 , NT
IF PROFIT(I) > RPROFIT
{
IEVAL K = I
EVAL RPROFIT = PROFIT(I)
}
END DO I
DISPLAY ##### K #####.## PROFIT(K) #####.## DATUM(K,4) $
#####.## GOVT(K) $
#####.## DATUM(K,6) #######.## PILESSR(K)
EVAL PROFIT(K) = ZPROFIT
END DO J
DISPLAY
DISPLAY
DISPLAY
DISPLAY
}
END
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