Description

This video explains what the experience curve is. We start by learning how to build an experience curve, then we compare two companies competing with the same learning curve, and finally we analyse two particular scenarios.

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The experience curve (not to be confused with learning curve) is a graphical representation of the phenomenon explained in the mid-1960s by Bruce D. Henderson, founder of the Boston Consulting Group. It refers to the effect that firms learn from doing, which means that the higher the cumulative volume of production (X), the lower the direct cost per new unit produced (C). Therefore, the experience curve will be convex and have a downward slope.

There is a simple rationalisation behind all this: there is a reduction in the average cost of production of a particular product, as a consequence of an increase in the firm’s experience. The time and cost of producing a unit of output will be reduced, as learning economies, economies of scale, economies of scope, etc. appear due to the cumulative output increase and other process related growth. The difference between learning curves and experience curves is that learning curves only consider time of production (only in terms of labour costs), while experience curve is a broader phenomenon related to the total output of any function such as manufacturing, marketing, or distribution.

Some important implications arise from this curve. If direct costs decrease as the cumulative output increases, this will mean that firms that have been producing more and for a longer period, will have lower direct costs per unit and thus dominate the market.

Learn more by reading the dictionary entry.

Related videos:

• Economies of scale
• Learning curve
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• Economies of learning
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Description

This video explains what the learning curve is. We start by learning how to build a learning curve, and then we compare two companies competing with the same learning curve.

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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.

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.

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.

Learn more by reading the dictionary entry.

Related videos:

• Economies of scale
• Experience curve
• Production

Related articles:

• Economies of learning
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• Economies of scope

Description

This video explains what economies of scope are. We analyse how different production possibility frontiers show different types of economies (or diseconomies) of scope.

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The concept of economy of scope is very similar to that of economies of scale. When we talk about economies of scope, we mean that average costs are reduced by introducing another product into our portfolio that can share some of the infrastructure or know how, thus reducing overall average cost per product. It is essentially the same concept as economies of scale, but based on producing more than one product instead of producing more of the same one.

This can happen for various reasons. Firstly, because fixed costs do not increase proportionally with production but rather in stages, we can introduce a second production line that benefits from the common infrastructure whilst reducing average cost per unit.

We can also see a reduction in average variable costs. Employees can benefit from shared know how or from a certain skill set that can be transferred to a much wider range of products, raising productivity across the board. In this way, labour need not increase proportionally with production output, as it is the case for economies of scale. What we can also see here are skills being transferred from one production range to another, resulting in synergies that are unique to economies of scope instead of economies of scale.

Learn more by reading the dictionary entry.

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Description

This video explains what subadditivity is. We start with economies of scale for one firm, and then analyse what happens when a second firm enters the market.

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Subadditivity is an important concept because it is often used to justify imperfect competition, the classic nemesis of neo-classicists. The only real way to justify less than perfect competition is the kind of sector that lends itself to natural monopolies. Natural monopolies are those where barriers to entry are so high that it is worth making the investment only once, and where one producer will operate more efficiently than two. Traditionally, natural monopolies are state-run, generally in energy or communication sectors, although current trends are leaning towards privatisation.

When a large investment is required in order to begin production, these costs must naturally be passed on to the consumer. What differentiates natural monopolies is that generally, once the investment is made, marginal costs are infinitely small. In these cases, if there is only one company in the market, prices for consumers may actually be lower than if there are rivals, because of the way average costs drop with additional users.

So what exactly is the difference between subadditivity and economies of scale? Subadditivity is a more generic concept which encompasses economies of scale. We say subadditivity exists when the costs function (including initial investment) for the sum of all units at a given level of production is actually smaller than the sum of the various cost functions (given multiple companies) at the same given level.

This is why subadditivity is considered a necessary but insufficient condition for a natural monopoly to be considered optimal, whereas if economies of scale exist, this is a sufficient but not necessary condition for a natural monopoly to be sustainable.

Learn more by reading the dictionary entry.

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Description

This video explains how economies of scale affect production. We start by explaining how the average cost curve defines when economies of scale appear, and then analyse the difference between economies and diseconomies of scale.

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This economic phenomenon occurs when increasing output is translated into a decline of the firm’s average cost of production. Alfred Marshall was the first economist to distinguish economies of scale depending on their origin:

Internal economies of scale occur when something inside the firm makes the average cost of production lower:

• Purchasing: buying raw materials in large quantities or big bulks brings better prices and discounts which allow average cost to be reduced.
• Specialisation: covering all areas of management and work can be very difficult, however when operating on a large scale, workers can specialize in the activities in which they are best and more productive.
• Flexibility: a more efficient production process can be achieved by managers when scale means that different arrangement of the inputs can be made. Better capital can be purchased by firms that have more money, increasing the quality of their products and/or reducing cost of production.

External economies of scale occur when something outside the business, but inside its industry, makes average cost of production lower. As the industry of the firm grows, more support may come from the suppliers’ side: more variety, more quality, more quantity, etc. Government may give extra aid if it considers that the industry has some special interest.

Learn more by reading the dictionary entry.

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• Returns to scale
• Fixed and variable costs
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Description

In the long run, no cost is fixed. This video explains how to analyse cost curves in the long run. We’ll see how they form derived from multiple short run cost curves.

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We can determine our production level and adjust plant sizes, investment in capital and labour accordingly. This gives us unlimited options. Depending on the scale we choose to implement, each level of production will be associated to new, short run cost curves. When we exhaust the infrastructure these provide us, we can upgrade to a new production level and so forth. The actual long run cost curve is made up of all of these individual scenarios, built up year after year.

Marginal costs only really make sense in the long run for each individual level of production. At optimal levels of production for each level, they intersect the long run average cost curve where this meets the short run average cost curve. This is what determines our optimal level of production.

The other important lesson to take away from this is the fact that, when we reach the optimal point where efficiency is at its best, average and marginal costs are the same, as happened in the short run.

Learn more by reading the dictionary entry.

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• Short run cost analysis
• Economies of scale
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Description

This video explains how costs behave in the short run, and analyses when a company should start producing.

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In the short run, fixed costs include capital, K, whereas labour, L, is considered variable. Fixed costs are usually represented as a horizontal line and do not vary whatever level of production we achieve.

The video shows two phases. In the first phase (I), variable costs (and therefore total costs, seeing as fixed costs are a constant) grow slower than growth at first, before reaching a point of inflection (II) and beginning to grow much faster than the output they are capable of generating.

This is related with returns to scale. In phase I, where the elasticity of scale is greater than 1, there are increasing returns to scale, while phase II corresponds to decreasing returns to scale. In point II, the elasticity of scale equals 1, which represents constant returns to scale.

If we translate this into average and marginal costs, an optimal level is reached along the stretch between which marginal costs are equal to average variable and fixed costs respectively.

Learn more by reading the dictionary entry.

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• Long run cost analysis
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Description

This video explains how average and marginal costs are calculated. Starting from fixed and variable costs, we analyse how average and marginal costs behave.

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Average costs are those associated to one unit of production. Costs per unit grow quicker as production increases, so we find the arithmetic average as the sum of costs divided by the sum of production.

Marginal costs are also a very important concept in Economics because they show costs at a very specific point in time: they show the cost associated with producing one additional unit at any given production level.

Learn more by reading the dictionary entry.

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• Fixed and variable costs
• Returns to scale
• Cost analysis

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Description

This video explains how different types of costs affect the production process. We start by explaining the main characteristics of fixed and variable costs, and how these form total cost. Finally, we explain its relationship with returns to scale.

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When analysing costs, the first thing to know is that there are fixed and variable costs:

Fixed costs: fixed costs cannot be altered in short run. They mainly include things like rent, repayments on technology, etc., which require time to change, and are often associated with indirect production costs (all that which is not a direct input). They do not depend on the level of production and cannot be adjusted accordingly.

Variable costs: variable costs depend on the level of production, and can include things such as direct inputs (raw materials) and contracted labour hours (not fixed salaries).

The way in which fixed and variable costs affect production is related with returns to scale. The video shows three phases. In phase I, where the elasticity of scale is greater than 1, there are increasing returns to scale, while phase III corresponds to decreasing returns to scale. In point II, the elasticity of scale equals 1, which represents constant returns to scale.

Learn more by reading the dictionary entry.

Related videos:

• Returns to scale
• Cost analysis
• Average and marginal costs

Related articles:

• Short run cost analysis
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