Economies of Scale and the Law of Supply

Don Boudreaux has this nice post on the law of supply. Here is a quote:

Teaching the law of supply is a tad bit trickier because of the widespread knowledge of economies of scale. Each semester, several thoughtful students always ask "Doesn’t producing more of something reduce the cost per unit and, hence, enable producers to sell it at a lower price? So don’t lower prices, rather than higher prices, correspond to higher quantities supplied? I don’t understand why price must rise in order to inspire a firm to offer greater quantities for sale." Good point.

I respond first by asking the students to wait a few lectures until we explore the law of diminishing returns; they’ll see then that no firm can expand output indefinitely without eventually seeing its costs of production per-unit rise.

Another thing at play is that the supply curve, technically, refers to a competitive market (although many of its principles are widely applicable to other market structures as well). In a competitive market, each firm is such a miniscule portion of overall market supply, that diminishing returns set in relatively early on for each firm. In other market structures, such as monopoly, firms have economies of scale, and firms can keep competition out because the economies of scale give them a pricing advantage, and thus, market power - at least in the short run.

Don links to an excellent article on oil drilling in urban neighborhoods in Texas. With oil at over $50 a barrel, drillers are going after oil in urban areas.

"This is one of the oddities of $50 oil," Ms. Sage said. "This type of thing doesn't happen with $20 oil."

Some cities, of course, have long coexisted with oil drilling in their midst - the La Brea Tar Pits in Los Angeles, for instance. But most of those fields were explored decades ago and some long forgotten. The emergence of urban oil exploration in Houston illustrates the lengths to which some companies are going in their search for oil in areas long written off.

The low-hanging fruit principle states that rational firms produce the cheapest units first. I explain to my students that, according to the law of supply (and the low-hanging fruit principle), the reason that businesses stop supplying additional units at the market price is because one more unit costs more that it generates in revenue. This principle is alive and well today in the oil industry.

Will we run out of oil? Not if market forces are allowed to work.