From cost structure to supply curve

Marginal cost and supply

    Suppose one accepts the general proposition that costs per unit initially decline

and after a certain point start to rise. Two implications follow. First, an optimal

firm size becomes possible to determine analytically. It is located at the level of

output where MC # MR and AC # price. Second, a link can be directly established

between the firm’s supply and the industry supply.

    The link between the individual firm’s supply curve and the industry supply

curve can be illustrated by imagining the reaction of the firm to changes in price.

Returning to Figure 5.5, at a price of £12, six units are produced. A higher price of

£14 leads to seven units; at £16, eight units are produced, and so on. Thus, the

MC curve can be interpreted as the supply curve of the firm.

    To derive the market supply curve, the supply curves of the individual firms are

laterally summated .This is depicted in just the same way as individualdemand curves were laterally summated in order to derive the market demand curve. The resultant upward-sloping market supply curve reflects two main influences. First, a rise in price elicits more supply from each firm in the industry in accordance with the profit-maximisation rule. Second, a rise in price, by raising the profitability of the industry, attracts new entrants. These two effects – more output from firms in the industry and still more from new entrants – are incorporated in the industry supply curve. They illustrate how a shift in market demand can, through the price mechanism, attract more supply from the industry. As the industry gets larger, various influences begin to impinge on the firm’s MC curve. First, the price of inputs into the industry might be bid up. If this happens, the supply curve will shift upwards. Second, scale economies will also have to be taken into account. They could involve downward shifts in the supply curve over time.

External economies of scale

    As an industry grows, an additional class of scale economies often emerges,

namely external economies and diseconomies of scale. Although internal to the

industry, they are external to the individual firm. External or agglomeration

economies are relevant to understanding the pattern of location of industries, the

tendency of some industries to form clusters, and the reinforcing of competitive

advantage through clusters of activities related to a specific industry.

    Expansion of a particular sector in a location means that skilled personnel are

attracted to that location and a specialised R&D capacity may develop.

Subcontractors find it worthwhile to locate nearby. The development of a centre of

excellence reduces costs for all firms in the industry, but the cost reductions happen

only because of the expansion of the industry as a whole in the region. Growth

feeds on growth, in a virtuous circle of cumulative and circular causation. Instances

of the practical significance of external economies of scale are easy to list:

- The cases of the flower industry in the Netherlands, ceramic tiles in Italy, the

Swiss watch industry and the German printing press industry are much cited

examples of industries that have drawn competitive strength from external

scale economies. Their experience has been documented in Michael Porter’s

classic study, The Competitive Advantage of Nations._16

-The regions of north-central Italy are another much studied

instance of external economies in action._17 For example, the growth of the

Emilia-Romagna region, based on small, heavily localised firms with a high

proportion of owner-managers, owes much to regional support mechanisms

which generate substantial external economies of scale. Trade associations

provide marketing, technical information and training facilities. Financial

cooperatives are a vehicle for guaranteeing loans to individual artisans.

External economies of scale enable small firms to compete and to attain very been found to play a vital role in overcoming the disadvantages of small firm

size.External scale economies can be incorporated into the supply curve by imagining outward shifts in the curve occurring as output expands. The key feature of external scale economies is that they impact favourably on all firms in the industry

and, therefore, do no violence to the assumption of a competitive market.

They can be treated more or less the same as technology improvements. Such

improvements lead to a downward shift in the cost curves of all firms in the

industry. high levels of productivity.

- The concentrated location of the entertainment industry in Hollywood, high

tech in Silicon Valley and international banking centres in London,

Luxembourg and Dublin is heavily influenced by external economies of scale.

- Similar effects have been observed in the Languedoc-Roussillon region of

France and in the Jutland region of Denmark, where inter-firm cooperation has

been found to play a vital role in overcoming the disadvantages of small firm

size.

    External scale economies can be incorporated into the supply curve by imagining

outward shifts in the curve occurring as output expands. The key feature of

external scale economies is that they impact favourably on all firms in the industry

and, therefore, do no violence to the assumption of a competitive market.

They can be treated more or less the same as technology improvements. Such

improvements lead to a downward shift in the cost curves of all firms in the

industry.