Steve Bain

Decreasing Cost Industry Types

By Steve Bain

A decreasing cost industry is one that is distinguished by its long run supply curve being downward sloping. In this case, when an increase in market demand spurs extra output to meet that demand, product prices will tend to fall because of falling costs of production.

The obvious question relates to what circumstances might cause industry costs to fall as production levels increase. The answer is usually because of the economies of scale that firms benefit from when an under-developed industry expands output levels.

Such industries often emerge from technological advances that create new products and services. For example, when the automobile industry first appeared on the market, car prices were very high. The expense made them a luxury item that few could afford, but over time new mass production techniques like the assembly line where introduced that made it possible to produce greater quantities of cars at lower costs, and that allowed prices to be reduced as output increased.

Input costs for firms in automobile production would fall because component part suppliers could also gain from the cost savings of mass production. Manufacturing costs have fallen further with the introduction of advanced robotics, and 'just-in-time lean manufacturing' techniques.

Decreasing Cost Industry Graph

Decreasing Cost Industry Graph

In the decreasing cost industry graph above, we start with a typical firm within an industry which produces at a price and output combination of p and q. This is an equilibrium market-clearing price and output combination given an existing level of demand.

Sticking with the early years of the automobile manufacturing industry, for example purposes, we see that an increased level of demand for automobiles from D to D' (as illustrated on the right side of the graph) will affect costs and lead to a new price and output combination.

You may ask what might have caused the increase in demand, and whilst the answer to that is not given we can simply assume that some people may have been reluctant to purchase an automobile when they were first introduced, but were encouraged to do so once friends and neighbors bought them and gave favorable accounts of them. New infrastructure investment in roads would also make them more useful, and over time demand would have increased as the utility of owning one increased.

With a higher industry demand at D', each existing manufacturing firm would expand production. However, in the short run this would only be possible via firms increasing the output of existing production facilities, and that will increase costs.

This sort of output expansion would mean paying overtime rates, night-shift rates, weekend rates and so on. Firms might also hire extra employees to work in those existing facilities and while all this extra work would certainly raise output, it would only come with a significant increase in costs per unit of output. This in turn would require higher prices, and this is illustrated by the increase in price from p to p'.

The Long-Run supply curve, economic profits & costs

In the long run things are different. Decreasing-cost industries encourage existing firms and new entrants to invest in extra manufacturing facilities, and with a temporarily higher price at p', the extra economic profits that firms are earning provides a strong incentive to do so. In a situation like this, it will not take a long time before the number of extra firms (and extra production facilities per firm) increases the industry supply, so the supply curve shifts from S to S'.

The right side of the decreasing cost industry graph illustrated above shows how this process works itself out. The initial equilibrium starts at point A, but growing industry demand takes us to point B where a small increase in output has been achieved by existing firms, but only with an increased price. Then, as long run supply increases due to new plant and equipment investment, a new supply curve pushes out to the right and intersects the increased demand curve at point C with a lower price of p'' and output significantly higher at Q'.

Points A and C are both long-run industry supply equilibrium points, and by drawing a line through them we can get an idea of the long run supply curve (SL). As can be seen, this is a downward sloping curve, indicating that this is a decreasing cost industry.

Examples of Industries with Decreasing Long Run Costs

Most real world examples of decreasing cost industry structures fall into one of two camps:

  • Those that emerge from technological advances, and haven't had time to mature. The early years of the automobile industry described above is a good example of this. Technological advances in computer and information technology is another good example, with falling prices for computers, plasma screen televisions, smart phones and so on can all explained by the downward sloping long run supply curves for these products.
  • Industries for which there are are ongoing economies of scale even at large output rates are often decreasing cost industries. Obvious examples here include the energy suppliers and other utility companies. The long run downward sloping supply curve of a nuclear power plant occurs because, however large the investment required to build such a plant, their enormous capacity to generate power grows more than proportionately with the cost of that investment.

The second of these types of industry structure are usually called 'natural monopolies' because the long run cost advantages of having only a very small number of big suppliers tends to result in smaller firms being bought out by larger firms, or being driven out of business altogether.

There are of course plenty of valid reasons to discourage monopolized industries, and perfect competition is nearly always a preferable target to aim for, but the most acceptable form of monopoly from a societal benefit point of view are the ones that benefit from a downward sloping long-run supply curve i.e. a decreasing-cost industry structure.

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