SummaryIn this LP we learn about cost efficiency, how to reduce costs while maintaining volume and quality. After understanding how cost efficiency can be achieved, we turn to the main critiques of neoclassical cost analysis. Up to now, everything sounded just as what they’ve been teaching us at school and college. However, a few theories stood up against all this, mainly form Industrial Organization theory.
Achieving cost efficiency:
- Economies of scale
- Economies of scope
- Economies of learning
- Learning curve
- Experience curve
Critiques to neoclassical theories:
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, as shown in the adjacent diagram.
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. The experience curve is defined by the following function:
Cn = C1X-a
C1 = direct cost of first unit of production
Cn = direct cost of nth unit of production
X = cumulative volume of production
a = experience rate (%)
The experience rate corresponds to the elasticity of cost with regard to output. In other words, the rate at which direct costs decrease (in percentage points) when output increases (also in percentage points).
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.
We must consider what happens when two firms compete with the same product and the same experience curve (blue curve, EC). 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 direct costs are lower than A’s. If price equals the direct costs 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, direct costs 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 direct costs (from C’A to C’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.
As mentioned before, experience curves is a wider phenomenon than learning curves because they consider not only labour productivity, but also technology, distribution, etc. This difference allows for different experience curves to coexist. Let’s consider two more scenarios, considering open economies.
In the first scenario shown in the adjacent diagram, firm A enters firm B’s market with a different, steeper experience curve. This may happen when firm A is able to learn and get more experience out of the same increase in volume. A few examples include firm A’s workforce being able to learn quicker because it’s highly qualified, or because firm A’s factory allows for quicker modifications. Under these circumstances, even if firm A enters the market with higher direct costs than B (CA > CB), it will ultimately catch up with firm B. Actually, after a certain volume, firm A would get more experience and will have lower direct costs than firm B (C’A < C’B), even with lower cumulative volume.
In the second scenario, shown in the next diagram, firm C enters firm B’s market with an exclusive technology, which translates into a lower experience curve (let’s assume for the sake of simplicity that this innovative technology cannot be copied or transferred). Then, because of its lower experience curve, firm C will be able to get the same level of direct costs than B with lower cumulative volume. Initially, firm C will have higher direct costs than firm B (CC > CB). However, after a while, C will have reached a volume at which it has the same level of direct costs as B. After this point of inflection, firm C will produce each unit with lower direct costs than firm B (C’C < C’B).
These two scenarios are usually considered as good examples of the infant industry argument, since trade protectionismin these situations is welcomed. The rationale behind this is quite obvious: if we consider that all these firms (A, B and C) compete in an infant industry, which in these scenarios would be that existing in the home country of B, it is reasonable to limit the extent at which firms such as A and C can act in B’s country. If firm B isn’t kept alone for the time required to gain some experience, national industry in B’s country would not exist, and it would all be controlled by foreign and more powerful firms (A and C). This is usually the case in third world countries, in which infant industries must be protected, in order to help their economic growth.
Even though the term experience curve is usually merged in economics and business management literature with the term learning curve, there are a few differences between the two. These differences are summarized in the following grid:
|Learning curve||Experience curve|
|Origins:||Theodore P. Wright, 1936||Bruce D. Henderson, mid-1960s|
|Variable considered:||average time (labour cost) per unit||direct costs: production, labour, distribution, etc.(includes learning curve effects)|
|Measures:||labour productivity||total efficiency|