F I G U R E 4 . 5 T O T A L V A R I A B L E C O S T ( T V C ) A N D T O T A L C O S T ( T C )

A firm’s total costs are found by adding up its total fixed and total variable costs. Graphically this gives rise to a figure similar to Figure 4.5 panel A, the only difference being it does not start at zero cost when output is zero since fixed costs (FC) must be paid. This is shown in Figure 4.5 panel B, which differs from panel A only with respect to fixed costs that have been added on at each point on the total cost curve.

4.3.5MARGINAL AND AVERAGE COSTS

The marginal and average cost curves that correspond to the total cost curve is shown in Figure 4.6.

Average cost (AC) is total cost per unit of output. AC is computed as total costs divided by output (TC/Q ).

Average total cost (ATC) is made up of average variable cost (AVC) plus average fixed cost (AFC): ATC = AVC + AFC.

Marginal cost (MC): the change in total costs as output changes ( TC/ Q ).

Firms’ average cost (AC) curves tend to follow a general U-shaped pattern. The AC curve for a firm with relatively low costs would lie below the AC curve for a higher-cost firm.

The minimum point on a firm’s AC curve corresponds to the level of output the firm should produce in order to produce at its minimum average cost. However, an individual firm cannot always sell this amount of output – there may not be a market for it. Producing at minimum average cost would be a welcome outcome from the perspective of making efficient use of economic resources but firms do

Cost

MC

C

AC

A

B

Q1 Q2 Q3 Output

F I G U R E 4 . 6 M A R G I N A L C O S T ( M C ) A N D A V E R A G E C O S T ( A C )

Notes: If TVC = ¤2500 when 250 units are sold, AVC = ¤2500/250 = ¤10.

If TVC rise to ¤3000 when 275 units are sold, the MVC of the additional 25 units of output is ¤500 in total or ¤12 per unit.

not always produce this amount of output as it does not always coincide either with demand for their products or with the output level that allows firms to maximize their profits. This is explored further below.

From Figure 4.6 we see that:

•When the marginal cost curve lies below the average cost curve, producing one extra unit of output leads to a fall in the average cost.

•When the marginal cost curve lies above the average cost curve, producing one extra unit of output leads to an increase in the average cost.

•The marginal cost curve intersects the average cost curve from below at the lowest point on the average cost curve.

Explaining U-shaped cost curves

The reasons for U-shaped cost curves differ in the short run and long run. In the short run the firm has some fixed (usually capital) and some variable (usually labour) factors of production.

A short-run cost curve is drawn for one specific size or scale of plant.

Because capital is fixed in the short run and the scale of the plant is limited, a firm finds that beyond a certain amount of production the fixed factor leads

to diminishing returns to other factors of production meaning that average costs rise – as we see in Figure 4.6 beyond point B when output is greater than Q2. This also helps to explain the shape of the short-run supply curve.

When selling ice cream, when one van operates and with both the driver and another employee selling cones, beyond a certain amount of sales trying to expand output by employing an extra worker would only lead to the workers getting in each other’s way, given space and machine constraints, and would not necessarily expand output at all although the worker would have to be paid and so costs would rise.

In the long run, all factors are variable and each firm can decide on what scale of production it wants, such as how many ice-cream vans to operate and what technology to use. The implications of these decisions will be evident in a firm’s costs and will depend on its size or scale of production. The U-shape of the average cost curve arises because of the ways efficiencies may initially be generated within firms over a certain range of output and how inefficiencies may eventually result beyond a certain scale of output.

Efficiencies and inefficiencies arise that are associated with a firm’s scale of output which can vary over the long run. They are known as economies and diseconomies of scale.

Economies of scale are enjoyed when average costs of output decline as output increases.

Diseconomies of scale are experienced when average costs of output rise as output increases.

For a given set of input prices, if all a firm’s inputs were increased by 20% and

a)its output increased by more than 20% it enjoys economies of scale and its average unit costs would fall as output rises. See Figure 4.6 up to point B.

OR

b)its output increased by less than 20% it experiences diseconomies of scale and its average unit costs would rise as output rises. See Figure 4.6 from point B on.

OR

c)its output increased by 20%, it would experience constant costs (more on this below).

There are a number of potential reasons as to why falling average costs might be observed in the long run:

1.specialization;

2.indivisibilities in production;

3.returns to large-scale production.

Specialization: It was Adam Smith who first explained with his example of a pin factory that splitting up a manufacturing process into separate tasks (18 for pins) made for greater productivity from a given set of inputs. The focus of some workers on specific limited tasks allowed them to specialize and develop the skills most suited to those tasks as opposed to trying to carry out all of the various tasks in the production process. This logic underlies assembly lines that still characterize many manufacturing processes including those for vehicles.

Indivisibilities in production: Fixed costs by their nature are a source of economies because the greater the output, the more units over which fixed costs can be apportioned. Such costs are also known as indivisibilities in production because they are independent of output.

Returns to large-scale production: There are physical or engineering reasons that explain why, in some circumstances, large-scale firms can achieve lower average costs than smaller firms. The engineer’s rule of two thirds explains how the volume of cylinders expand by 100% if the surface area rises by only 66% (based on the mathematical formula for the area of a cylinder). Similarly for some machines and factories, where their cost represents only two thirds of the value of the additional output they can produce. Large-scale firms might also be able to benefit by being in a position to buy machinery and equipment appropriate for large-scale production only. A large furniture manufacturer might be able to buy sophisticated technology that is both appropriate and cost-effective for its high output level allowing it to have relatively low average costs compared to a smaller-scale operation producing lower output and for which the same equipment would not be cost effective because its associated fixed costs would be simply too high and inappropriate for the scale of output.

Any output greater than Q2 in Figure 4.6 leads to a rise in average costs or diseconomies of scale. This is usually due to the fact that, as the scale of the firm’s

F I G U R E 4 . 7 L O N G - R U N A V E R A G E C O S T ( L R A C ) A N D C O N S T A N T R E T U R N S T O S C A L E

operations becomes so complex and bureaucratic, management finds it increasingly difficult to coordinate the operations and average costs rise with scale.

At point B on the average cost curve, average costs are neither rising nor falling but constant. This corresponds to a size of plant where there are constant returns to scale. For some firms constant returns to scale are possible not just at one point on their average cost curve but over an entire portion of it – as shown in Figure 4.7 between points D and E when output is between 5000 and 7500 units.

The firm that might have such a cost curve needs to produce a lot of output before its costs decline to their minimum level but once a large scale of output is produced (5000 units in this case), minimum average costs apply until output expands beyond 7500 units. This cost curve could describe the situation for a large-scale car producer. Once at least 5000 cars can be produced, it makes sense for the firm to buy sophisticated and expensive robotic equipment that can be used to produce such a large quantity of output efficiently, so technology can give rise to economies of scale. Point D is referred to as the minimum efficient scale (MES) of production.

The minimum efficient scale (MES) of production is the size/scale of plant required if a firm wishes to produce sufficient output to allow it to produce at its lowest long-run average cost.

If the car firm in Figure 4.7 has markets for its output it would continue expanding its production to achieve economies of scale implying it could efficiently produce up to 7500 cars.

C H A L L E N G E S F O R C A R P R O D U C E R S

The car industry in developed countries is often described as ‘mature’ because growth in the market is relatively modest compared to the growth observed in markets for newer products – such as for MP3s. In the mature car market, firms face a challenge since most people who wish to have a car have already purchased. Demand still exists because consumers replace their vehicles over time but no substantial jump in sales is expected as the penetration of cars is considered to have levelled off.

Large-scale producers in the market have adopted similar technologies of production and have similar average cost curves. Large-scale production is required to minimize costs and diseconomies of scale set in beyond a certain scale of organization.

One approach to competing in such saturated markets is to attempt to take market share from other competitors by offering more valued attributes. Alternatively, companies can acquire or buy out competitors and increase scale, which may be profitable once increased coordination costs do not outweigh scale benefits. For some companies it might be possible to develop new technology that effectively creates a new market for them – such as Ryanair and easyJet in the air travel market.

For car manufacturers the tendency over recent years has been towards consolidation across companies via mergers and acquisitions: Daimler acquired Chrysler while Nissan and Renault have merged. Analysts of the industry predict that over the next decade three main international players will dominate the market.

It is possible to link long-run and short-run average cost curves since each short-run average cost curve (SRAC) corresponds to one scale or size of plant; in other words, one fixed level of capital. In the short run, with a fixed level of capital, a range of output can be produced depending on how many workers are employed, and each quantity of output within that range has an associated cost. In Figure 4.7, two examples are shown for outputs of 1500 and 8000. These SRAC curves indicate the costs associated with producing output when plant size is limited to either a small or a large scale. Neither of these plant sizes allows the firm to produce at its minimum average cost because in the first case economies of scale cannot be fully exploited because of the small size of the plant while in the second case, the plant size is too big to be optimally efficient and diseconomies of scale have kicked in.

Finally, you will see that the LRAC in Figure 4.7 does not pass through the minimum points on SRAC1 or SRAC2.

The long-run average cost curve is not a map of minimum SRACs

•The LRAC displays all the minimum average cost methods of producing output when all factors of production can be varied.

•The SRAC displays the average cost of production of a range of output for one plant.

4 . 4 M A X I M I Z I N G P R O F I T S I N T H E L O N G R U N

If firms are to make the most efficient use of their resources, they should produce as much output as possible from the factors of production they use. To decide how much output each firm should produce firms need to consider their profits. Initially here, the case of the long-run output decision is considered. Using analysis as in previous sections, we can examine the marginal revenue and marginal cost position of a sample firm to work out what the best or optimal output should be to maximize its profits. These are shown in Figure 4.8.

The firm faces the downward sloping demand curve shown in Figure 4.8. The corresponding MR curve for this demand curve is also shown. The costs facing the

F I G U R E 4 . 8 P R O F I T - M A X I M I Z I N G O U T P U T : R E V E N U E , C O S T A N D D E M A N D

firm are graphed by the marginal cost curve (the corresponding average cost curve is not included to keep the diagram clear initially).

To maximize its profits the firm wants to produce output up to the point where the additional revenue earned on its last unit of output covers the costs of that unit. This occurs at output of Q and is found by examining the point where the MR and MC curves intersect and checking the level of output that corresponds to this point. It makes sense to produce output up to Q because up to this output level the marginal revenue curve lies above the marginal cost curve – increasing output adds more to revenues than to costs. Beyond Q , this is no longer the case as the marginal cost curve lies above the marginal revenue curve and the marginal costs of further units of output are greater than the marginal revenue earned by the firm.

The profit-maximizing output level is found by identifying the quantity that coincides with MC = MR.

Once the decision regarding output has been made, this also suggests the profitmaximizing price that the firm should charge, as shown in Figure 4.9. If the firm wishes to produce Q , this quantity corresponds to one price only on the demand curve and that price is shown as P . If price were other than P , a quantity other than Q would be demanded.

To maximize profits in the long run a firm should:

•Establish the quantity that coincides with the point where its marginal costs and its marginal revenues intersect.

•Based on this quantity, set the price of its product from its demand curve.

•Ensure that the price it charges customers is sufficient to cover its average production costs.

F I G U R E 4 . 9 P R O F I T - M A X I M I Z I N G P R I C E : R E V E N U E , C O S T A N D D E M A N D