When Ryan says that profit will rise with more volumes that is, higher sales he feels that with rise in revenue profit will increase. But he is considering only the fixed cost which does not change in the short run. So as sales rise the average fixed cost falls. But he is not taking the variable costs into consideration. As production increases so does variable cost. The average cost will fall up to a certain point. If sales rise beyond that point the average total cost will rise. Thus with a price fixed at a low level the firm will incur losses.
In the long run when the firm grows it has to invest in capital expansion. With the establishment of new plants and machineries the firm faces fall in average cost as production rises, due to economies of scale but after a certain scale of operation is reached diseconomies set in and the average cost starts rising. So the firm can limit is output to the optimum scale when the average cost is lowest and keep the price of its product low. If it allows production to rise it must increase the price also to remain profitable.
For example, in the electricity sector we can see the existence of scale economies. If the supplier increases its operation area initially the average cost will fall. If it faces threat to competition it will keep the electricity prices low. So that a new entrant will be deterred due to such low prices as the new entrant’s initial costs will be high. If the power supplier increases its operation beyond the optimum scale, the average cost will rise leading to a fall in the profit. In such a case the firm will have to raise prices and consumers will lose. In a competitive situation the firm will not be able to raise the price and face fall in profit.
Works Cited
Pindyck, Robert and Daniel Rubinfield. Microeconomics. 7th. Prentice Hall, 2009. English.
