Essays

The key to understanding competition in the marketplace is to understand that the total revenue curve is controlled entirely by consumer behavior. Businesses can only control costs. Clearly, given any consumer marketplace, the maximum amount of profits that businesses can achieve depends on two factors: how low are their fixed costs, and how high is the point on the revenue curve where their variable costs dictate their point of maximum profits ($max).

Notice, however, that only higher/lower variable costs will actually affect the volume level of $max since variable cost changes represent a slope change in the total cost curve. Increases in the fixed cost component may very well wipe out profits but it does not alter the point at which those profits will maximize. The point of $max is determined by the slope of the variable cost curve, not the fixed cost curve. However, the two may be interrelated.

The relationship between fixed and variable costs is crucial to understanding capitalism in general, and market competition in particular. It is possible for fixed and variable costs to be totally unrelated: for example, if you rent a place to sell books, the room rental is a fixed cost and will not be affected by the cost of the books, and vice versa. However, in a production environment, the cost per unit of production (the variable cost) may be very heavily affected by the efficient use of machines and labor. The cost of the machines will be a fixed cost, but the efficiency of those machines in producing output from inputs can be crucial in determining variable costs.

For example, one machine can be a gas guzzler that produces a lot of waste from the input ingredients and takes up a lot of floor space. Another machine might be much smaller, run very efficiently on electric power, while reducing the waste of input ingredients. An inefficient machine will result in a high degree of slope in the variable cost curve; in other words, the cost per item of production will be high if inefficient machines are used. The inefficient machine, however, may be old and have low fixed costs (red lines). The business may decide to purchase more efficient machines that result in a substantially lower slope to the variable cost curve, but to buy the machines produces a higher fixed cost (blue lines).

Notice that the higher fixed cost will push up the total cost curve and thus reduce total profits, but the variable cost reduction will reduce the slope of the total cost curve and therefore both increase total profits and make the point of (blue) $max appear at a point of higher revenues and higher volume than before (red $max). The critical question is not simply whether the reduction in variable costs overcomes the increase in fixed costs: there may also be greater total profits available at the new $max.

The critical question is whether the new total cost at the new $max increases less than the increase in total revenues at the new $max, thus increasing total profits. Since total revenues necessarily must be higher at the new $max, even if total costs increase (because the variable cost reduction is not enough to overcome the fixed cost increase) there could still be an increase in total profits if the increase in total costs is less than the increase in total revenues.

The new variable cost curve will start at a higher level on the left axis but rise at a lower rate as volumes increase compared with the old total cost curve. Consequently the old total cost curve will actually rise above the new total cost curve at some volume level. It is actually possible for the total costs at the new $max (from the lower variable cost slope) to be lower than the total costs at the old $max while the level of total revenues will always be higher at the new $max, which means new technology investments can result in spectacular profit increases under some circumstances.

But it is also crucial to remember that the consumer demand curve has not changed: consumers are simply getting more products at a lower price and are therefore willingly spending more money, but the total amount of money that consumers had available to spend has not changed. As the efficiency of production increases, consumers reap more goods at lower prices while sellers reap higher total profits, but the amount of savings is reduced. This is simply a mathematical necessity.

However, notice also that the volume difference between $max and Rmax becomes less as the slope of the variable cost curve decreases. This means that it is very difficult for the $max to approach the Rmax because near Rmax the slopes of the curves are near zero, which in turn means the increase in revenue from moving to the new $max is near zero. Spectacular profit increases occur primarily when new technology impacts very inefficient production with a high slope on the variable cost curve parallel to an almost vertical total revenue curve slope.

This also means that investors have a greater chance of seeing spectacular profit increases by investing in new technology in industries that are the most inefficient. As a consequence, the search for higher profits will tend to drive technological change into less efficient markets. Those same inefficient markets are where consumers are charged the highest prices (because the slope of the inefficient variable cost curve is higher and this results in a $max at a higher price) and they therefore produce the most savings (because $max is farther away from Rmax).

Similarly, since an inefficient production process necessarily reaches a $max at a lower volume (and lower revenue) than a more efficient process, the introduction of new technology not only boosts efficiency and reduces variable costs, it also requires a larger market to absorb the higher production level necessary to reach the new $max. Further, the charts also demonstrate that higher production levels necessarily correspond to lower price levels. There is no way to break this link. The introduction of new technology will necessarily increase profits, reduce prices, and expand production (partly as a consequence of the lower prices). This is true even if the item bought by the consumer shows no significant alteration because the new technology results solely in production efficiency.

Up to this point though, we haven't really addressed how competition between firms operates in the marketplace. The key to understanding how competition functions, however, derives from understanding this relationship between changes in variable costs and the shift in $max to a point of higher volume and higher revenues. The key is simply that different firms will have different profit levels, volume levels, and $max levels depending on how they implement technology even in the same market for the same item with the same consumers.

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