Cost III: Learning curve

The learning curve (not to be confused with experience curve) is a graphical representation of the phenomenon explained by Theodore P. Wright in his “Factors Affecting the Cost of Airplanes”, 1936. It refers to the effect that learning had on labour productivity in the aircraft industry, which translates into a relation between the cumulative number of units produced (X) and the average time (or labour cost) per unit (Y), which resulted in a convex downward slope, as seen in the adjacent diagram.

There is a simple rationalisation behind all this: the more units produced by a given worker, the less time this same worker will need to produce the following units, because he will learn how to do it faster and better. Therefore, when a firm has higher cumulative volume of production, its time (or labour cost) per unit will be lower. Wright’s learning curve model is defined by the following function:

where:    Y = average time (or labour cost) per unit

a = time (or labour cost) per unit

X = cumulative volume of production

b = learning rate (%)

Some important implications arise from this curve. If the time (or labour cost) per unit decreases as the cumulative output increases, this will mean that firms that have been producing more and for a longer period, will have lower average time per unit and thus dominate the market.

We must consider what happens when two firms compete with the same product. Since the learning curve considers only time per unit, and we consider that they spend the same amount of time per unit for a given unit when each firm’s cumulative volume of production is at the same level, both firms will have the same learning curve (green curve, LC). In the diagram on the left, we have a starting situation where two firms compete. Firm B has been in that market for a longer time (or has produced more volume during the same period of time), therefore its average time (or labour cost) per unit is lower than A’s. If price equals the average cost of A, firm B will have profits while firm A will just survive. It must be noted that B could decrease its price, which will force firm A to lower its price, thus incurring in losses. Firm A will ultimately leave this market.

However, if A and B maintain a price level at which firm A can endure, time per unit for A will decrease at a higher rate than B, because of the steeper slope for lower cumulative volumes of production. Therefore, the longer A stays in the market, the lower the profits for B, as it is drawn in the diagram on the right, where the difference between average times (from Y’_A to Y’_B) is smaller. Game theory and the analysis of oligopolies tell us that, since B is able to anticipate all these scenarios, firm B will try to banish firm A from the market.

The obvious critique to all this is that, if learning curves were so obvious and could be anticipated as easily, we would live in a world consumed by monopolies. Older firms would keep banishing potential competitors from markets until entry barriers became so great that no other firm would try to enter this market.

Even though the term learning curve is usually merged in economics and business management literature with the term experience curve, there are a few differences between the two. These differences are summarized in the following grid: