If firms experience falls in long run average costs, do consumers benefit?

 A firm’s costs are made up of fixed and variable costs. Fixed costs do not change with output, and therefore fall when averaged. Variable costs do change with output, and will eventually always increase because of rising marginal costs, which in turn cause returns to diminish with each extra item of output before becoming negative.  The lowest point of each short-run average cost curve forms a point on the long-run average cost curve (the short run being the period when at least one factor of production is fixed and the long run being that when all factors can be varied.)

It follows that there will be a point on the Long-run average cost curve when a firm reaches its lowest LRAC, and that the LRAC will have been falling as each successive SRAC falls ‘downwards’ along it.  The explanation for why this process occurs is not linked to any one cause, and could involve falls in wage, raw material, regulatory, or business costs.  They could also be the result of economies of scale resulting from the enlargement of the business.

At the level of an industry, which is made up of firms, such falls in costs are more likely to be the result of innovation transferring from one firm to others because of a lack of legal or information barriers, an increase in the number of firms in the market, or falling wage, legal, or resource costs. Any of these factors could also increase productivity, which is a figure arrived at by dividing the value of factor output by the cost of factor input in a given time.

If for instance wage costs fell because the government changed the taxes employers have to pay to employ people, such as national insurance in the UK, or because there were more workers looking for jobs who were prepared to accept a lower wage, the cost of labour would fall, but the output would almost certainly remain the same, leading to higher productivity. Equally, if workers or capital became more productive and output rose across an industry, average costs would fall, caeteris paribus since average costs are calculated according to output.

Costs help define profits. Profit is the difference between revenue and cost, whether in total, on average or at the margin. An industry in which firms found that marginal costs fell, for instance, but marginal revenue remained the same—a free market in the short run—would produce where MC=MR, but make money where AR was greater than AC. A difference would be an abnormal profit. In the short run, this would be good for firms, but not necessarily for consumers since they would be paying a price higher than marginal cost, transferring their consumer surplus to companies, and living in an economy which was not allocating resources efficiently in terms of welfare or production.

This situation could resolve itself, however. A free market has no barriers to information or knowledge, and many firms in it. If costs fell, eventually some firms would be first movers and lower price, and consumers would then flock to them, other suppliers would copy them, and all supply would increase. Consumers would benefit and so would the whole economy, assuming no externalities, because everyone would be getting more goods, more cheaply.

Markets are usually not perfect, however. If an oligopoly or monopoly (and even more a natural monopoly) experienced falling costs across an industry, the firms involved might be just as likely to keep the difference between costs and revenue in terms of profit. Their shareholders might in fact force them their directors to do that, as owners seeking a dividend. In that event, consumers would not necessarily benefit.

Situations in which large companies make such large profits rarely last, however. In the very long run, large profits might be partially turned into a profit-satisficing level of cost in which firms diverted some of the money gained into things which are either fixed costs—like research and development, advertising, marketing, or mergers and acquisitions—or variable ones, like wages and worker compensation. This could result in more productivity, the reduction of externalities, a greater market in which global competition and development becomes possible, or the development of products, services, and supply chains which are secure and robust and benefit consumers in ways other than simple low prices.

Very large falls in industry costs leading to high profits might also encourage windfall taxes and government intervention which pays down national debt or lowers taxes elsewhere, leading to higher growth, more redistribution of income, or more public goods. These things could in theory encourage the growth of national welfare and allocative efficiency in a sophisticated society, and reduce dependency ratios.

It is therefore the case that falls in long-run average costs are possible, could benefit consumers (though they will not necessarily do so automatically) and depend on market structure, barriers to entry, and government policy. Such falls could, but will not automatically, benefit the whole economy provided that they do not simply turn into abnormal profits to be spirited away to tax havens, wasteful superyachts, Mars rockets, or dubious metaverse projects.