Returns to Scale and Scope
At this new exchange rate, Japan’s labor costs per unit of output (converted into dollars) become 500/125 $4 and 1,250/125 $10 for the respective goods. With the appreciation of the dollar, Japanese goods become less costly (after converting into dollars). The U.S. cost advantage in pharmaceuticals has narrowed significantly ($3.75 versus $4.00), whereas the Japanese cost advantage in watches has widened. Accordingly, U.S. pharmaceutical exports should decline; these exports simply are not as attractive to Japanese consumers as before. In turn, a more expensive dollar (a cheaper yen) makes Japanese watch exports more attractive to U.S. consumers. To sum up, relative productivities, relative wages, and the prevailing exchange rate combine to determine the pattern of cost advantage and trade. With respect to the exchange rate, depreciation of a country’s currency increases its exports and decreases its imports. A currency appreciation has exactly the opposite effect.
RETURNS TO SCALE AND SCOPE Returns to Scale Returns to scale are important because they directly determine the shape of long-run average cost. They also are crucial for answering such questions as Are large firms more efficient producers than small firms? Would a 50 percent increase in size reduce average cost per unit? Although the exact nature of returns to scale varies widely across industries, a representative description is useful. Figure 6.4 depicts a long-run average cost curve that is U-shaped. This reflects increasing returns to scale (and falling LAC) for low output levels and decreasing returns (increasing LAC) for high levels. In the figure, the minimum level of long-run average cost is achieved at output level Qmin. As in Figure 6.3, SAC curves for three plants are shown. Thus, output Qmin is produced using the medium-sized plant. If the costs of all possible plants were depicted, the lower “envelope” of the many SAC curves would trace out the figure’s LAC curve. To sum up, if the firm is free to use any size plant, its average production cost is exactly LAC. As noted in Chapter 5, a number of factors influence returns to scale and, therefore, the shape of long-run average cost. First, constant average cost (due to constant returns to scale) occurs when a firm’s production process can be replicated easily. For instance, the electronics repair firm may find it can double its rate of finished repair jobs simply by replicating its current plant and labor force—that is, by building an identical repair facility beside the existing one and proportionally increasing its labor force. By duplication, the firm could supply twice the level of service at an unchanged average cost per job. Second, declining average cost stems from a number of factors, including capital-intensive mass production techniques, automation, labor specialization,
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