X-Innefficiency

   While we are constructing average-total-cost curve, we assume that firms have the most efficient technology. In other words, the firm owns the technology that permits to achieve the lowest average-total-cost at whatever the quantity output is. X-Innefficiency is the failure of firm to produce any specific output at lowest possible average total cost.
Why does X-inefficiency occurs if it reduces firm’s revenue? The answer is that some entrepreneurs may have such goals as easier work time, corporate growth, avoidance of business risks or giving some jobs to their relatives that aren’t competent in performing them, so these causes may be in conflict with cost minimization. X-inefficiency also may arise when firm’s workers are poor motivated or under-supervised, also it happens when a firm is inert when it comes to making decisions about future business actions.
Question is where more likely X-inefficiency is prevailing: monopolistic or competitive industry? Firms in competitive industry are under pressure from rivals, so that they are forced to be efficient at production if they want to survive and get profit, but monopolists are protected from such competition and pressure by entry barriers, so that lack of this pressure may lead to X-inefficiency.
There is one general evidence that probability of X-inefficiency increases as competition decreases. Also, it is estimated that X-Inefficiency may be 10% or more of costs for monopolies and just 4% on average for oligopolies where four biggest firms produce more than 60% of total output.  There were a saying :” X-inefficiency exists and it’s more possible to be reduced when there is competitive pressure on firm rather than it is isolated”.

In the figure shown above, both costs are higher than minimum ATC, this implies that in this firm(industry) X-inefficiency exists, since the firm(industry) is operating at greater than lowest cost of a specific level of output. For Q1 ATC should be 1, but for Q2 ATC should be 2.

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Profit-Maximization in Long-Run (Pure competitive Market)

 In Short-Run only a specific number of firms is present in an industry, each of them having fixed and unchanged plant. They can shut down in sense that they may produce zero output, but these firms don’t have enough time to sell their assets and go out of business. In Long-Run, however, firms can expand or contract their output capacity. The number of firms in an industry can increase or decrease, because they can enter or leave this industry.

 Some assumptions related to Long-Run in this article

• Entry and exit only- Firms are able or enter industries only under long-run adjustment
• Identical Costs- Let’s assume that all firms in this industry have identical costs curve, so it’s easier to talk about a firm, knowing that all other firms are affected by any long-run adjustments
• Constant-cost Industry- We assume that leaving or entry of industry by a firm doesn’t affect the price, consequently the position of average-total –cost curve.

   Important Idea

  The main conclusion we should get here is that: After all long-Run adjustments are completed; product price will be equal to each firm’s minimum average cost.

  This conclusion can be proven by the following facts: each firm tries to get profit and to avoid losses and in a pure competition market firms a free to enter and to leave the industry. If the market price of a good will be higher than average total cost of it, then new firms will enter the industry, this industry expansion will create a higher supply, so that the price will fall and will get equal to initial average total cost of this good. Conversely, if price if the price initial is less than average total cost then firms of this industry will support losses. These losses will push some firms to leave the industry, so as they leave, total supply will decrease, which will make the price equal to average total cost.

Long-Run Equilibrium

 Let’s suppose that each firm produces cell phones. Average total cost for producing them is 100$. Marginal Revenue will initially be 100$. But what happens if the demand for these cell phones will increase?

The answer is quite simple, initially there will be an increase in price to (let’s suppose) 120$, because of that increase in demand, then more firms will enter the industry since there is possible to get economic profit (20$). More firms enter the industry then the supple will increase, prices decreases until the point where marginal revenue equal average-total-cost (take care amount of produced goods isn’t the same with initial one).

What happens if the demand of our cell phone decreases?

If the demand decreases then for a period of time marginal revenue will be less that average total cost, so that our firms will get some loss. Some firms will leave the market, so the supply will decrease. Then this supply will make the average total cost equal to marginal revenue. So again this point of intersection shows that no economic profit is made just normal one. Equilibrium price is the same, but equilibrium quantity is different (less).

Long Run Supply for a constant-Cost Industry

In our example we took a constant-cost industry (industry in which entry or exit of new firms doesn’t shift long-run ATC curve of individual firms. In this case industry’s demand for resources is small in comparison to the total demand for resources.  So that industry can expand or contract without affecting resource price and resource costs. How does the demand curve look like in a constant cost industry? Since we saw that demand change doesn’t affect the price, since it always comes back to the original value, then we may say that demand curve is perfectly elastic in constant-cost industry.

 Long-Run Supply for Increasing Cost Industry

  Most of the industries are Increasing Cost Industries, in which average total cost (ATC) moves up as the industry expands and moves downward as it contracts. In Increase cost Industries entry of new firms increases resource prices. Higher resource prices result in higher value of average total cost in long rung for our firms.

If there occurs an increase in demand for the goods of this kind of industry, then new firms will be attracted to it in order to eliminate the economic profit, as we said before more firms-higher ATC value.  For example

50000 units will be sold for 80$, 70000 for 100$ and 90000 for 120$. So if firms leave this increase cost industry then the demand declines, so does the price for goods.

Long-Run Supply for Decreasing Cost Industry

In a decreasing cost industry firm experiences a lower costs as the industry expands. An example can be industry that produces PCs. An increased demand for personal computers made new PC manufactures to enter the marker and greater increased the demand for components used to build them. An increase demand for PC’s components made producers to supply more of them and to expand factories, so that they achieved economies of scale. Supply for PCs increased more than demand, so that the price declined.

 

Long-Run Production Costs

 Economies and Diseconomies of scale
     In the Long Run like in Short Run average total cost (ATC) is U shaped, but why? We can’t explain this by law of diminishing returns, because only in short run plant’s capacity is fixed. In long run all resources are variable. Since prices of the resources are constant we can explain the form of the ATC in terms of economies and diseconomies of scale:
 
   Economies of Scale or economies of production explain the down-sloping part of ATC curve. The following factors may lower ATC of production:
 Management Specialization
     Large-scale production also means the better us and specialization of management. A manager that can supervise 50 people will be used inefficiently when the firm will employ only 20. Small plants won’t use managers to their best advantage, because they will have to divide time among more functions. Greater production means that manager will do his job full time so a higher efficiency will be achieved. This may result in lower product price.
Labor Specialization
     Increased specialization of labor becomes more achievable when factor’s size is increased. Hiring more workers means that tasks can be divided and subdivided, so that each worker has its own function. In this case a worker will perform only one job instead of five. In a small firm some skilled machine operators won’t be used efficient since they will perform unskilled task, leading to higher production costs.
   Workers by performing fewer tasks will become more proficient at them. Also greater labor specialization eliminates the time loss needed for them to switch their job.
Efficient Capital
       Small businesses may not afford to buy the most efficient machineries.  Some of these machineries are available only for mass-production, so a high efficiency is achieved only when there is used a big amount or resources. So a small firm is in dilemma between choosing to produce at inefficient equipment or at efficient one but with small amount of resources, but in both cases output is inefficient and too costly.
Other Factors
   An example of factor that creates economies of scale is advertising. These costs for advertising are decreased as more units are sold. So if there is an increase in quantity of resources ex: 30% followed by a greater increase in quantity of output ex: 50% then this event  declines ATC and may be a factor of economies of scale.

Diseconomies of Scale
   While a firm is expanding, their ATC may increase, so the curve of it becomes up-sloping. The main factor of diseconomies of scale is the difficulty of controlling and operating a bigger firm. In small ones a single manager may make all decisions for plant’s operations.
   But as the firm grows there is need for more managers. One person can’t digest and understand all the information needed for decision making. Expansion of management hierarchy leads to problems of communication and cooperation. So decision making may be slowed down so that they fail to respond immediately to change in consumer’s demand.
   In massive production workers may feel free from their employers so that they care less about working efficiently. So if there is an increase in quantity of resources ex: 30% followed by a smaller increase in quantity of output ex: 20% then this event increases ATC and may be a factor of diseconomies of scale.

Constant Return Scale
     In some industries a wider range of output may exist between the output at which economies of scale end and output at which diseconomies of scale begin. This range is called constant return scale and may exist over a wide part of long-run curve in which average total cost (ATC) doesn’t change. So if there is quantity Q input there will be also quantity Q output.