by Don Boudreaux on June 4, 2011

in Complexity & Emergence, Economics

A few commenters on this post wonder why I assume that, if BMW invents a method for reducing its costs of producing automobiles, it will therefore lower the prices it charges for its cars.  Won’t BMW simply enjoy lower costs on the automobiles it produces – lower costs that increase BMW’s profits – rather than dissipate these higher profits by cutting the prices of its automobiles?

No.  If BMW doesn’t expand its output, it would earn fewer profits than it would earn by lowering its prices.

More specifically, the economist’s answer (and, remember, the original question on the pop quiz is from an exam I gave to students in my Principles of Microeconomics class) is that each period each firm expands the quantity of its output up to the point at which that firm’s marginal revenue becomes equal to that firm’s marginal cost.  Only in this way do firms maximize their profits.

Marginal cost – the cost of producing an additional unit of output – rises as quantity produced rises.  (Marginal revenue – the change in the firm’s total revenue that results from selling one additional unit of output – falls as the firm sells more and more output if selling these additional units of output requires the firm to lower the prices it charges for its outputs.)

The efficiency-enhancing machine lowers BMW’s schedule of marginal costs; that is, use of the machine lowers BMW’s marginal cost at each possible quantity of output.  With a now-lower schedule of marginal costs, the (upward sloping) marginal-cost curve intersects the (generally downward sloping) marginal-revenue curve at a higher quantity of output than previously.  So it pays BMW to produce and sell more automobiles even though BMW can sell these additional automobiles only by lowering its prices.

If BMW does not lower its prices in this situation it leaves money on table (or, as economists say, it doesn’t maximize its profits).  If BMW doesn’t lower its prices in this situation it would continue to sell the same quantity of automobiles that it sold before its costs fell.  So it would produce and sell some automobiles profitably (automobiles whose production and sale add more to BMW’s revenues than they add to BMW’s costs) but not the full quantity of automobiles whose production and sale add more to BMW’s revenues than they add to its costs.

In short, because the machine lowers BMW’s costs of production, the number of automobiles that it is now profitable for BMW to produce and sell is greater than it was before BMW started using the machine.  But to sell this higher quantity of cars requires BMW to lower it prices.  And so BMW lowers the prices it charges for its cars.


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