Knowledge of the cost functions is very important for optimal decision-making by the firm and the government.
Knowledge of the short-run costs is crucial for pricing and output decisions while the long-run costs provide useful information for planning the growth and investment policies of the firm.
The implications of the L-shaped cost curves for the theory of the firm and for economic theory as a whole have been discussed by various writers. Oliver Williamson and Rowley have examined in detail the effects of economies of scale on the problem of mergers and monopoly. The following examples are chosen as an illustration of the importance of the shape of costs in the theory of the firm.
1. Costs and price-output decisions:
Costs are one of the main determinants of price in all market structures, and in all models pertaining to the explanation of the behaviour of the firm. The pure competition model breaks down unless the costs are U-shaped, since otherwise the size of the firm (its optimal output) is indeterminate. In monopolistic competition the shape of the cost curves is of no particular importance; so long as the slope of the marginal cost is smaller than the slope of the marginal revenue curve the size of the firm is determinate. However, costs are one of the determinants of price and output both in the short run and in the long run, since the profit maximizing position of the firm is determined by the marginalistic rule MC = MR.
Similar considerations hold for the equilibrium of the monopolist, who sets his price at the level defined by the intersection of his MC and MR curves. Thus, the cost curves are entering into the monopolist’s price-output decisions explicitly. In oligopolistic markets that operate with collusion, the level of costs is one of the main determinants of the bargaining power of the firms which enter collusive agreements.
In cartels the costs of individual firms determine the supply of the industry and the price which will be set in the market, as well as the quota of each firm member, either by marginalistic calculations or by bargaining procedures. In the traditional theory of price leadership the leader will be the firm with the lowest costs. Even if the leader is a large firm, its costs must be low if it is to enforce its leadership on the smaller firms.
The average-cost pricing practices are based on detailed knowledge of the costs of the firm. Managerial and behavioural models imply some form of collusion, which, as we said, is based on the cost structure of the firms.
2. Costs and barriers to entry:
Costs, either in the form of an absolute cost advantage or in the form of minimum optimal scale of output, have been found the most important determinants of the height of barriers to entry in many industries. Preference barriers may in general be overcome if new firms are prepared to spend an adequate amount of money on research and development as well as on advertising and other selling activities.
Such actions, of course, will raise the costs of the new firms and thus put them at a relative cost disadvantage. The lower the costs (at all levels of output) and the larger the minimum optimal scale (that is, the greater the economies of scale) the greater the entry barriers and hence the higher the price that firms in an industry can charge without attracting entry.
3. Costs and market structure:
Costs determine, to a large extent, the market structure. Given the size of the market, the greater the economies of scale, the smaller the number of firms in the industry. Thus, when the economies of large-scale production are important one should expect an oligopolistic market structure to emerge in the long run. If the economies of scale are not important one should in general expect a large number of firms in the industry.
4. Costs and growth policy of the firm:
Given the market size, the direction of growth of a firm is determined basically by cost considerations. If the long-run costs are U-shaped and the firm has exhausted the available economies of scale, further expansion in the same market will most probably take place by building up a new plant. If the firm is faced with a U-shaped scale curve and the market is stagnant, the firm will look for investment in other markets (diversification).
Mergers and take-over’s are based (among other things) on cost considerations. Similarly if cost advantages are expected from a vertical integration of the various stages of production, the firm will sooner or later adopt such a policy. Integrated production may also be attractive as a means for preventing entry, since a new firm must enter with a similar integrated production organisation, which requires substantial initial capital outlays.
5. Costs and the regulation of industry:
A detailed knowledge of costs is also essential for the regulation of industry by the government. Regulatory authorities, such as the Monopoly Commission, require detailed information on the costs of the various firms before they decide to split up large firms, to encourage or prohibit mergers, to create a monopoly or dissolve an existing one in order to enhance competition.
If there are too many, small firms in an industry in which economies of scale are substantial, the government can justify a policy aiming at the increase in the size of firms. On the other hand, if economies of scale are unimportant and the industry is highly concentrated, the government may decide to adopt policies aiming at the reduction of the size of the firm (for example, by forbidding mergers or breaking up the existing large firms). The above are some illustrative examples of the importance of cost functions in optimal decision-making.