Economics
Constant Cost Industry
Constant Cost Industry refers to a market in which the average total cost of production remains unchanged as the industry expands or contracts. This occurs when input prices and technology remain constant. In such industries, firms can increase or decrease production without affecting the average cost per unit.
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7 Key excerpts on "Constant Cost Industry"
eBook - PDF- Rhona C. Free(Author)
- 2010(Publication Date)
- SAGE Publications, Inc(Publisher)
Cost Curves Economists have had a difficult time obtaining accurate cost data. In the first place, accounting data never include the implicit costs that are so important in economic decision mak-ing. Second, firm and industry data, when they are available, are collected on a fiscal year basis. Rarely does this coincide with either the short- or long-run time periods of economic analysis. Third, inputs are often used in different ways to pro-duce different products. This makes it difficult to assign costs specifically to the production of any one good or service. Nevertheless, costs, like production functions, have been studied widely. The results (Mansfield, 1997), while even more widely dispersed than production function estimates, are very interesting. Studies of long-run average cost, across a wide range of industries, over a long period of time, show little evidence of decreasing returns to scale. Rather than sug-gesting that decreasing returns rarely occur, it is more likely that when they become evident, entrepreneurs act quickly to eliminate them by reducing the scale of operations and per-haps creating separate companies. Several studies, across a wide range of industries, indi-cate that long-run average costs may be L-shaped but with the horizontal portion of the L extended out to the right. That is, the industry first experiences increasing returns to scale, and then as it grows enjoys constant long-run average costs (and constant returns to scale) over a wide range of output. A fewer number of studies suggest that increasing returns to scale are evident. This implies that the long-run average cost curve is negatively sloped. If an industry is experiencing increasing returns to scale, there is a strong incentive (as long as there is sufficient demand for the product) to increase the scale of operations because rev-enues are increasing and average costs are falling.
eBook - PDF- Steven A. Greenlaw, Timothy Taylor(Authors)
- 2015(Publication Date)
- Openstax(Publisher)
that is, because they are in the past and cannot be altered, they should play no role in economic decisions about future production or pricing. Variable costs typically show diminishing marginal returns, so that the marginal cost of producing higher levels of output rises. Marginal cost is calculated by taking the change in total cost (or the change in variable cost, which will be the same thing) and dividing it by the change in output, for each possible change in output. Marginal costs are typically rising. A firm can compare marginal cost to the additional revenue it gains from selling another unit to find out whether its marginal unit is adding to profit. Average total cost is calculated by taking total cost and dividing by total output at each different level of output. Average costs are typically U-shaped on a graph. If a firm’s average cost of production is lower than the market price, a firm will be earning profits. Average variable cost is calculated by taking variable cost and dividing by the total output at each level of output. Average variable costs are typically U-shaped. If a firm’s average variable cost of production is lower than the market price, then the firm would be earning profits if fixed costs are left out of the picture. 7.3 The Structure of Costs in the Long Run A production technology refers to a specific combination of labor, physical capital, and technology that makes up a particular method of production. In the long run, firms can choose their production technology, and so all costs become variable costs. In making this choice, firms will try to substitute relatively inexpensive inputs for relatively expensive inputs where possible, so as to produce at the lowest possible long-run average cost. Economies of scale refers to a situation where as the level of output increases, the average cost decreases. Constant returns to scale refers to a situation where average cost does not change as output increases.
eBook - ePub- Richard Jones(Author)
- 2021(Publication Date)
- Routledge(Publisher)
Constantly increasing returns would imply that the firm need never stop growing; the result would be monopoly. The desire to retain the perfectly competitive model has dictated in economics a need to retain the U-shaped cost curve. The L-shaped curve would, therefore, seem at first sight to have serious implications. It supports the hypothesis that scale economies produce a decline in long-run average costs as the rate of output expands – provided that it is accepted that the empirical studies concerned represent adequate tests of the theory of costs which produces the concept of a U-shaped curve. Likewise, the evidence seems to reject the possibility of the upward branch of the typical U-shaped curve. It is this dimension of the evidence that appears to have potentially damaging consequences for the received theory of supply. The centre of this theory is the upward-sloping industry supply curve. It is demonstrated in Chapter 4 that there is no unique supply curve. The long-run supply curve of the firm depends upon the long-run marginal cost curve above the minimum point of the long-run average cost curve (see Chapter 4, p. 67). The marginal and average cost curves are related, as has been seen above. Therefore the L-shaped cost curve must have implications for the shape of the marginal cost curve, and ultimately for the supply curve. Constant long-run average cost along the horizontal arm of the L-shaped curve as the rate of output rises, implies constant marginal cost. By the same reasoning the supply curve would forfeit its typical upward-sloping configuration. These points may be restated by reference to the diagrams used in this chapter. The long-run total cost curve depicted in Figure 3.1 gives rise to average and marginal curves of the typical U-shape. A straight-line total cost curve would produce equal average and marginal costs, which would be constant for all rates of output
eBook - PDF- Steven A. Greenlaw, Timothy Taylor, David Shapiro(Authors)
- 2017(Publication Date)
- Openstax(Publisher)
In this portion of the long-run average cost curve, larger scale leads to lower average costs. We illustrated this pattern earlier in Figure 7.9. In the middle portion of the long-run average cost curve, the flat portion of the curve around Q 3 , economies of scale have been exhausted. In this situation, allowing all inputs to expand does not much change the average cost of production. We call this constant returns to scale. In this LRAC curve range, the average cost of production does not change much as scale rises or falls. The following Clear It Up feature explains where diminishing marginal returns fit into this analysis. 174 Chapter 7 | Production, Costs, and Industry Structure This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 How do economies of scale compare to diminishing marginal returns? The concept of economies of scale, where average costs decline as production expands, might seem to conflict with the idea of diminishing marginal returns, where marginal costs rise as production expands. However, diminishing marginal returns refers only to the short-run average cost curve, where one variable input (like labor) is increasing, but other inputs (like capital) are fixed. Economies of scale refers to the long-run average cost curve where all inputs are allowed to increase together. Thus, it is quite possible and common to have an industry that has both diminishing marginal returns when only one input is allowed to change, and at the same time has economies of scale when all inputs change together to produce a larger-scale operation. Finally, the right-hand portion of the long-run average cost curve, running from output level Q 4 to Q 5 , shows a situation where, as the level of output and the scale rises, average costs rise as well.
eBook - PDF- Steven A. Greenlaw, Timothy Taylor, David Shapiro(Authors)
- 2017(Publication Date)
- Openstax(Publisher)
At SRAC 4 , the level of fixed costs is too high for producing q 3 at lowest possible cost, and again average costs would be very high as a result. The shape of the long-run cost curve, in Figure 7.10, is fairly common for many industries. The left-hand portion of the long-run average cost curve, where it is downward- sloping from output levels Q 1 to Q 2 to Q 3 , illustrates the case of economies of scale. In this portion of the long-run average cost curve, larger scale leads to lower average costs. We illustrated this pattern earlier in Figure 7.9. In the middle portion of the long-run average cost curve, the flat portion of the curve around Q 3 , economies of scale have been exhausted. In this situation, allowing all inputs to expand does not much change the average cost of production. We call this constant returns to scale. In this LRAC curve range, the average cost of production does not change much as scale rises or falls. The following Clear It Up feature explains where diminishing marginal returns fit into this analysis. 176 Chapter 7 | Production, Costs, and Industry Structure This OpenStax book is available for free at http://cnx.org/content/col12122/1.4 How do economies of scale compare to diminishing marginal returns? The concept of economies of scale, where average costs decline as production expands, might seem to conflict with the idea of diminishing marginal returns, where marginal costs rise as production expands. However, diminishing marginal returns refers only to the short-run average cost curve, where one variable input (like labor) is increasing, but other inputs (like capital) are fixed. Economies of scale refers to the long-run average cost curve where all inputs are allowed to increase together.
- Roberto Serrano, Allan M. Feldman(Authors)
- 2018(Publication Date)
- Cambridge University Press(Publisher)
Somewhat more precisely, when returns are increasing, costs are falling, and vice versa. As we will see below, this is what we find for constant, increasing, and decreasing returns to scale. 9.3 Cost Minimization in the Long Run 161 1 MC = AC = C (1) C ( y ) $ y (output) C (1) Figure 9.5 Total cost C ( y ) (in blue) with constant returns to scale. Suppose a firm’s production function satisfies constant returns to scale . Let ( x ∗ 1 , x ∗ 2 ) be the cost-minimizing input combination that results in one unit of output. Then C ( 1 ) = w 1 x ∗ 1 + w 2 x ∗ 2 . Now, if the firm wants to produce an arbitrary y units of output, by constant returns to scale, it can do so by multiplying by y both the input quantities that gave one unit of output. Moreover, as we saw above, scaling up both the inputs in this fashion will leave MP 1 , MP 2 , and TRS unchanged. Therefore, since ( x ∗ 1 , x ∗ 2 ) was a point of tangency between an isoquant and an isocost line, ( yx ∗ 1 , yx ∗ 2 ) will also be a tangency point. Therefore, C ( y ) = yC ( 1 ) is the least-cost way to produce y units of output. That is, for constant returns to scale, the long-run cost function is a very simple linear function that makes C ( y ) directly proportional to output y . We show this kind of linear cost function in Figure 9.5 . Remember that average cost is total cost divided by quantity, or AC ( y ) = C ( y )/ y . For our constant returns to scale case, average cost is constant. This is because AC ( y ) = C ( y )/ y = yC ( 1 )/ y = C ( 1 ) . Also recall that marginal cost is the derivative of the cost function, or, intuitively, the extra cost per additional unit of output. That is, MC ( y ) = dC ( y )/ dy . In the constant returns to scale case, MC ( y ) = d ( C ( 1 ) y )/ dy = C ( 1 ) = AC ( y ) . In short, with constant returns to scale, total cost is a linear function of y , and both average and marginal cost are constant, equal to each other, and equal to the cost of producing just 1 unit of output.
eBook - PDF- David Stager(Author)
- 2013(Publication Date)
- Butterworth-Heinemann(Publisher)
Normal profit, the minimum profit required to retain a firm in a particular industry, is also a cost of production. 2. The short run is the period within which the quantity produced can be varied even though some factors, such as plant size, remain cons-tant. The long run is the period within which all factors of produc-tion can be changed. Variable factors are factors that can be varied in the short run; fixed factors are those that can be varied only in the long run. 3. Total product is the total quantity produced in a given time period; average product is the quantity produced by one unit of a variable factor; marginal product is the change in total product associated with an additional unit of the variable factor. The quantity of the variable factor employed when the total product reaches a max-imum is the point of diminishing total productivity. 4. The law of diminishing returns states that as increasing quantities of a variable factor are combined with a fixed factor, the total product will eventually decline. 5. Fixed costs are those that must be incurred regardless of the level of output; variable costs vary directly with changes in the level of output. Total costs include both fixed and variable costs. 6. The average fixed cost decreases as long as output is increasing; the average variable cost usually declines initially, then increases at the output level where average product begins to decline. The aver-age total cost curve is also U-shaped; a firm's capacity is defined as the output level at which average total cost is at a minimum. Mar-ginal cost, the change in total cost associated with producing an additional unit, begins to increase at the output level where mar-ginal product reaches a maximum. When AVC and ATC are at a minimum, they are also equal to the marginal cost. The long-run average total cost curve shows the lowest average total cost at which each quantity can be produced. 7. Returns to scale may be increasing, constant, or decreasing.
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