Why Is the Learning Curve of Short Term Most Valuable to the Firm - Math Problem Example

Long-run average cost curves are referred to as an envelope for the short-run average cost curves’ Discuss with reference to relevant examples from an industry of your choice with the aid of diagram Perhaps the most important pillar of modern economics is the interplay between demand and supply with price acting as an important component in the whole play (Perloff, 2001). Price is the key offense mechanism for the firms competing in a perfect market scenario (Kreps, 1990). Even in this real world of “not so perfect” competition prevailing in the market many companies trying to maintain their competitive advantage depend on the price factor for that edge. They try to meet the wants in the economy while competing with other players trying to target the same unfulfilled want and at the same time strive to increase the wealth of the shareholders (the supreme objective of the modern day organization). The interplay between maximizing wealth and competing in the market on the basis of price, in turn largely depends on the firm’s ability to tame the cost of production or the cost at which it makes its product/service available to the customer. With the rise of the Chinese led Eastern hemisphere’s efficiency and low cost advantage the importance of cost control is being well appreciated by all. Though the cost advantage is a factor that is only achieved with time, the movement along the learning curve in the short period is very important. This short term play or the short tem average cost is the key phenomenon that helps at arriving at the low levels of cost in the long term as well. In other words the innovations and learning of short term is the thing that determines the long term cost structure of a firm. Thus, it is not wrong to say that the Long run average cost curve is an envelope of the short term average cost curves. The above mentioned factors (namely short term decision making that gives a lower average cost) which has direct impact on the long term cost is very well captured in the following words of the famous economist, Armen Alchian. In economics, the cost of an event is the highest-valued opportunity necessarily forsaken. The usefulness of the concept of cost is a logical implication of choice among available options. Only if no alternatives were possible or if amounts of all resources were available beyond everyone’s desires, so that all goods were free, would the concepts of cost and of choice be irrelevant. -Armen Alchian (Lee & McKenzie, ch 10, p 1) Further getting into the core topic and understanding short term costs we observe that during a short run few factors of production bear a fixed cost or we can say that those factors are more or less indispensible for continued production, for e.g. we cannot change the cost of land in use in a short term but considering a longer period of time a firm can create options for itself to move to another piece of land to carry on the production activities or can negotiate with the owner of the land for better rent rates. Thus the factor of production which in the short term had a fixed cost or was indispensible for continuous production becomes a variable cost over the long period. So, what we do over various short terms is what gets reflected in the long term (Pindyck & Rubinfeld, 2001). On the other hand there is also a variable cost in the short run. The variable cost is that cost that varies with the level of production, for e.g. wages for labor (who can be hired or fired with the level of production), raw material required for production is also variable and so is the usage of office supplies and utilities. The variable cost remains variable over the short term and hence remains variable in the long run as well. So, in a short term, the fixed cost (FC) and the variable cost (VC) together constitute the total cost (TC) that a firm incurs in carrying out the production activity. TC = FC + VC To appreciate the topic further, let’s put things into perspective of the automobile industry. The total cost for an auto firm comprises of the cost of setting up a production line, setting up the supply chain network and the R&D costs (FC) that goes into engineering and designing of the viable automobile that can perform to the standards and expectation of the government, customers and society at large. There is also the cost of material, cost of labor working on the manufacturing lines and its selling and advertising expenses to push the vehicles in market (VC). An auto company does not incur additional fixed costs in the short term because in short run the firm is solely focused on creating returns on the investments it had incurred on developing the technology and business set up to manufacture and sell the vehicles. It tries to minimize its average cost of production (by increasing is total output that can share the fixed cost of the firm thereby reducing the overall average cost of production) after the commercial launch of a new model while meeting the market demand. Hence it has certain fixed cost in total cost structure which does not change irrespective of the units of vehicles produced. It means that even if a firm does not produce any vehicle it has to bear a cost that has already been incurred and since the automobile firm has huge fixed costs it needs to manufacture thousands of cars before it benefits from economies of scale (the phase during which the firm sees a decline in its average cost with every increase in the output level). At the same time variable cost component is also present in the form of the fluctuation in the prices of steel, besides the traditional concept of variable cost (which includes the quantum of such steel required will depend upon the level of production). This whole phenomenon is reflected in the graph below, where- X Axis denotes the Units produced (in ‘0000s) Y Axis denotes the components of cost of production (‘000 Euros) The graph shows that at production level of 25,000 (approx) the firm is able to reach the lowest cost of production. The firm does not reach this lowest point all of a sudden since it increases its output from 1 unit to 25000 during which phase its average fixed cost sees a steep decline resulting into a sharp decline in the average total cost. This is the level that the firm would like to produce at, forever! Obviously this is not possible in a real world because the business environment is not static, it is very dynamic. So the firm has to adjust as per the changed circumstances (rising level of demand, new model launch, change in cost structure, innovation in technology and the list can go on) and has to move to a new cost curve which may or may not give the same optimal level of production at lowest cost. This is reflected (in the graph) in the average total cost of the firm that sees an upward trend beyond the 25000 level of production. In other words the firm starts facing diseconomies of scale. Thus, the cost competitiveness that a firm looks for requires constant adjustments on part of the firm. This is where the firm realigns its processes and comes up with a new cost structure that can help it emerge from diseconomies of scale and move towards creating newer economies of scale with a new lowest cost of production at new output level. The above point is very much reflected in the below graph (Lee & McKenzie, ch 10, pg 7). Let’s say the demand has increased in the market, the firm cannot ignore the increasing demand, it has to produce extra (beyond the optimal level) till it finds alternative (at q1) that can result in further reduction of cost (this is where the firm transitions to a new cost curve). This cycle of innovation continues and at q2, firm further realizes that it can produce extra units at a lower cost by adjusting to make transition to new cost curve. When we see all these continuous transitions to build and maintain the cost advantage in totality, we find that there is no such thing as long term average cost curve, but it is just a representation of the movement along the short term average cost curves. Hence it is not wrong to say that the Long-run average cost curve could be referred to as an envelope of the short-run average cost curves. The same point is brought home in the graph (Lee & Mckenzie ch 10, pg 8) below. The graph tries to bring forth, the transition path of the auto firm where the firm adjusts to new market challenges and opportunity. In due course, the firm reached ATC4 which was the level to produce q1 units of output at a minimum cost per unit. But to achieve the lower cost level the company shifts to ATC5 and produces more vehicles at a lower cost than what it would have been able to produce while being at ATC4. To sum up this essay, the transition over time and production levels of a firm defines its success in reaching and/or managing cost competitiveness. The learning curve of short term is what is most valuable to the firm and all put together define the path followed by the firm to reach that stage. Reference List: Kreps, D, 1990, A Course in Microeconomic Theory, Princeton, London. Lee. D and Mckenzie R., Microeconomics for MBAs, Cambridge University Press, Delhi. Perloff, J., 2009, Microeconomics, Pearson, Delhi. Pindyck R & Rubinfeld D, 2001, Microeconomics, Prentice-Hall, London. Read More