Cost III: Stigler’s cost analysis theory

As a contribution to industrial organization, George Stigler developed his “own” theory on cost analysis in his article “Production and Distribution in the Short Run”, 1939, which moved slightly away from neoclassical cost analysis.

This theory arises as many economist started to criticize the traditional U-shaped representation of a firm’s average costs. George Stigler used empirical data to question the traditional theory. His cost theory can be divided into the analysis of both the short-term and long-term average costs:

Average Costs in the short-term

According to classical economics, each plant ensured only a specific level of output could be produced in the short-run because of production inflexibility. However, Stigler introduced the notion that firms could adapt to changes in demand and be flexible even in the short-run. His main argument in favour of this idea is that whenever a firms built a plant they would have what is known as a reserve capacity.

The existence of this reserve capacity is justified by economic and technical reasons. From the former we include possible changes in the good’s demand due to cyclical reasons, favourable changes in consumers’ tastes or as a preventive method to avoid a production stop in case there is a breakdown or a repair. The latter can arise as there are some basic installations that are indivisible or as managers and workers are hired in excess to allow future expansions.

-before X₁  : marginal costs < decreasing average costs (increasing returns to scale)

-X₁ to  X₂: marginal costs = average costs (constant returns to scale, maximum efficiency)

-after X₂  :  marginal costs > average costs (both increase, therefore decreasing returns to scale)

It must be noted that this theory allows for maximum efficiency to exist for a while, which completely differs from the neoclassical view, which viewed maximum efficiency as a point of inflection, rather than a straight line.

Average Cost in the long-term

Taking into account production costs and managerial costs, Stigler argued that in the long-run average costs will decrease until a point where they cannot longer do so and from which they will become constant.

Production costs will decrease due to economies of scale until the optimum size is reached and then remain constant. Further average production cost reduction could come along with technological or skills increase. As for managerial cost, he considers, they will start to increase after a certain size is reached. However, managerial diseconomies of scale would be compensated by technical economies of scale, with a zero sum net effect and therefore would remain constant as a result.