Help me understand basic economics here. According to the supply curve it costs companies more dollars per product to supply larger quantity of products. But with economy of scale isn't it supposed to be the opposite? The more products a company produces the cheaper should be the production cost of each product. What don't I understand here? Thanks.
Suplly curve shows how many goods producers are wiiliing to sell at certain price. Clearly, at a low price only highly competitive manufacturers with low cost per unit would be able to sell products. And vice versa, when prices are high, the more manufacturers would come to market, which, in effect, will bring prices down to the equilibrium level.
P.S. The supply-demand analysis assumes that all factors except price are constant so I am not sure whether it is right to apply economy of scale effect to supply curve.
This may be useful for you:
The Limits of Supply and Demand by Frank Shostak
I'll give a concrete example.
Let's say a bakery sells daily 100 bread loafs for 5$ each bread. The daily production cost of each load of bread is 1$. It follows that the daily revenues of the bakery are 500$, and the profit is 500-100=400$. Now the government sets a price ceiling for a loaf of bread of 3$. At this price the demand for bread increases twofold. However at the next day the revenues of the bakery are only 300$, and the profit is 300-100=200$. The baker is not satisfied with the small profit so he decides to expand production to satisfy the rising demand and to increase profits. He invests in another bakery and starts selling twice as more bread. Since the demand for bread has increased twofold, all the bread is sold. Now the two bakeries sell 200 bread loafs at 3$, and since the production cost for each bread is the same, that is 1$, the new revenues are 600$, and the profit is 600-200=400$. So in this example price ceilings did not cause shortage. What am I missing here?
Price ceilings did cause a shortage in your example. The baker had to construct another bakery, which takes time. During that time, supply was below demand but the baker was not allowed to increase price to reduce demand. Also, unless bakeries cost $0 to build your profit figures are wrong.
There is nothing magical about price controls that will cause a shortage. The government could set a price ceiling of $1 million per loaf and you would see no effect. The government could set a price ceiling of 1 cent for a product nobody wants at that price and you would see no effect.
To create a temporary shortage, the price ceiling needs to be below the current equilibrium price but high enough that expanded production is still profitable. After production is expanded the shortage of bread would go away, but the time and resources required to expand bakeries are now unavailable to be used by other businesses, causing an increase in price in these other affected industries.
To create a permanent shortage, the price ceiling needs to be below the current equilibrium price and also below the price where expanding production would still be profitable. This latter price need not be below the cost of production for bread ($1). It simply needs to be below the profit margin the baker could earn by doing anything else (maybe he decides to make salad dressing, which isn't controlled at all).
Thank you for the answer, it was very useful. I still have one piece of the puzzle missing. The supply curve is always depicted as upward, that is suppliers would provide larger quantity of goods only with increasing prices. Is that because of the investment needed to expand production? Isn't this only a short term problem? In the long term the capital needed to expand production is insignificant if the goods can be sold at a profit. So I assume the textbook supply curve is a short term curve. Right?
Eugene:The baker is not satisfied with the small profit so he decides to expand production to satisfy the rising demand and to increase profits. He invests in another bakery and starts selling twice as more bread. Since the demand for bread has increased twofold, all the bread is sold. Now the two bakeries sell 200 bread loafs at 3$, and since the production cost for each bread is the same, that is 1$, the new revenues are 600$, and the profit is 600-200=400$. So in this example price ceilings did not cause shortage. What am I missing here?
So in this example price ceilings did not cause shortage. What am I missing here?
The highlighted statement is inconsistent with human rationality. Given the reduced profitability of baking, the baker will be able to put his money to better use doing almost anything besides baking... perhaps he uses his money to buy bonds or switch trades and go into butchering where he can earn profit at the natural rate. There's an economic theorem to this effect that basically capital seeks the highest return so it tends to leave industries where profitability is small and enter industries where profitability is high. Price controls cause capital to flee production of the price-controlled good, not the other way around. If you cap rent, no new housing will be built while demand will skyrocket.
Clayton -
Economy of scale within the context of your baker example, as i understand it, he would have to purchase machinery that would allow for him to reduce the costs of bread per unit, which would increase profit or buy his ingredients at cheaper rate due to buying in bulk.
So if he was producing 100 loaves within 12 hours at an operating cost of $1 a loaf, then he purchases machinery that allows him to produce 200 loaves within 12 hours at a cost of $0.5 per loaf.
So the problem with your example is that it is not reducing the cost per unit, the baker is only doubling the production at the same cost per unit, so i do not think that represents economy of scale.
No, increases in production capacity are semi-permanent. If you hire and train 20 new bakery staff, they remain trained in baking and can continue their duties for years. If you buy a new dough-making machine, your dough-making capacity is permanently increased (until the machine breaks down, of course). That new capacity will be utilized as far as it is profitable and the profitability is determined by the price of bread. If you make capital investments into training new bread-makers and buying dough-making machines and then the price of bread falls, you will suffer losses as you are unable to recoup your investments on expanding production capacity.
You're confusing cash-flow analysis with supply-demand curves. The break-even point of an investment is dependent on the amount invested and the profitability of the investments. If the profitability is negative, the break-even point will never be reached. If the profitability is positive, the break-even point will eventually be reached but the length of time until it is reached depends on the relative size of the capital investment and the profit per unit. A large investment with very low profit per unit may require too long to reach break-even. A small investment with high profit per unit will quickly pay for itself (and such opportunities are, therefore, rare in the market).
Eugene:The supply curve is always depicted as upward, that is suppliers would provide larger quantity of goods only with increasing prices.
That's not what it means. You should really read the link I gave above, especially the "Graphs vs Reality" section.
Eugene:In the long term the capital needed to expand production is insignificant if the goods can be sold at a profit.
As Clayton said, in the real world capital needed isn't insignificant because you can be doing something better with it instead. Yeah, maybe you can make an extra 1% profit with 50 years of investment in bakeries, but you can go make 10% profit by investing in a different industry right now.
Jack Roberts: Economy of scale within the context of your baker example, as i understand it would have to purchase machinery that would allow for him to reduce the costs of bread per unit, which would increase profit. So if he was producing 100 loafs within 12 hours at a operating cost of $1 a loaf then he purchases machinery that allows him to produce 200 loafs within 12 hours at a cost of $0.5 per loaf. So the problem with your example is that it is not reducing the cost of per unit, the baker is only doubling the production at the same cost per unit, so i do not think that represents economy of scale. Economy of scale results in an increased profit margin, not just increased profits as a linear function of units produced. Sometimes, it's said that economy of scale results in reduced profits but this is a confusion of competition which forces producers to operate on lower and lower profit margins. The economy of scale is what reduces the input costs per unit of producing a good. If I hire 10 people to produce a widget, each one must produce all stages of the widget but if I hire 100 people, I can make 10 groups of 10 specialists each of whom produces 1 of the 10 stages of a widget. This increases throughput and decreases the input costs (labor) by reducing the total number of person-hours spent on each widget. There are as many variations on this idea as there are businesses in existence. Clayton - http://voluntaryistreader.wordpress.com | Post Points: 20
Economy of scale within the context of your baker example, as i understand it would have to purchase machinery that would allow for him to reduce the costs of bread per unit, which would increase profit.
So if he was producing 100 loafs within 12 hours at a operating cost of $1 a loaf then he purchases machinery that allows him to produce 200 loafs within 12 hours at a cost of $0.5 per loaf.
So the problem with your example is that it is not reducing the cost of per unit, the baker is only doubling the production at the same cost per unit, so i do not think that represents economy of scale.
Okay, I need to return to the basics. The supply curve as depicted here: http://en.wikipedia.org/wiki/Supply_and_demand, goes upwards, but when I think about real life it seems that it should go downwards. For example when there are only 400 models of some car, each car would usually cost a lot of money, but when demand kicks in and the cars start to be mass produced the price drops. I'd appreciate if you could explain to me what do I not understand about the supply curve, but please don't use too many economic definitions, I'm not very familiar with them.
Thank you!
Eugene,
Can you explain to me what you don't understand in this article? It contains the answers to your questions.
Yeah I read the article, but I'm not familiar with the mainstream view of things, so its kind of pointless to listen to the criticism of something I don't even completely understand.
Anyway I think I get your point. It might be profitable to expand production, but it might be even more profitable to expand production elsewhere where there are no price limits.
Exactly. As long as even one penny per unit is being earned, it is "profitable" to continue production of the given good. But the real question is not whether any profits can be made but where can the most profits be made?