Here is an application of the shut-down analysis.
According to the New York Times, Monday, Feb. 28, 2000, (p. A8:"Amtrak to Expand
Service, Copying Strategy of Airlines") Amtrak, the American passenger rail
service, was planning to reorganize and expand their services. The New York Times
wrote "Cutting trains that did not earn back their direct costs and their share
of overhead costs ... reduced the number of passengers fed into the system.... Now
the railroad wants to add trains that can earn back direct costs, and make some contribution,
even a small one, to the overhead."
We need to synchronize our jargon, here. "Overhead costs" are pretty much
the same thing as "fixed costs" in economics, and "direct costs"
are the equivalent of variable costs. Thus, the times write-up is saying that in
the past, Amtrak had closed down trains if the didn't pay back their variable costs
plus some minimum share of the fixed costs. That sounds like common sense -- I'm
sure it sounded like common sense to the Amtrak management -- but we have learned
that it is not the way to maximize profits (or minimize losses). The shut-down rule
for a train is the same as that for a "firm:" shut down only when the train
cannot cover its variable costs. As long as it can cover the variable costs, it is
more profitable to run the train, even when it contributes proportionately less toward
overheads than other trains do. Any contribution toward overheads, even a very small
one, is better than nothing, and nothing is what you get if you shut it down.
The New York Times quoted George Warrington, Amtrak President, as saying that "The airlines figured this out a long time ago," and reported that, along with other changes, it would improve Amtrak's net revenues by $65 million.
Of course, Amtrak, as a semi-governmental agency, may not be as sensitive to strategies
to increase its profits as the private-sector airlines are. On the other hand, in
the 1970's the IBM corporation made the same mistake (Fortune Magazine, Sept. 1977,
pp. 106-120: "Gene Amdahl takes aim at IBM.") Common sense is powerful
-- but a careful analysis of the rules for maximizing profits
can do better than common sense, whether in Amtrak, airlines or IBM.
