These are strategic concepts which many of us learned about in a college microeconomics 101 course. They may be a bit theoretical, but nevertheless often provide helpful insights into how an industry functions.
The industry cost curve concept is a classic framework helpful to understand pricing. It fundamentally states that producers of commodity products are willing to supply products as long as the price is higher than their cost of production. The graph of an industry’s cost curve charts capacity on the horizontal axis and unit costs on the vertical axis, incrementally listing various competitors in order of increasing costs. The theory states that the competitive market price is determined by overall market demand and the unit costs of the next available supplier.
In reality, a number of questions make this a lot more complicated than it seems at first blush. Key questions would include: Are the products really interchangeable and do various user segments attach a different perceived value to different suppliers’ products? Are there significant entry and exit barriers? Do the locations of suppliers vs. users matter? What about non-commodity products? Some of these questions can be included in a more complex analysis, using linear programming. But in the end, a qualitative element will always remain part of the analysis. Nevertheless, the industry cost curve provides an interesting starting point for many pricing related questions.
Related to the cost curve is the experience curve. The terms of experience curve and learning curves are used mostly interchangeably (although the former more often refers to organizations becoming better at doing things, while the latter generally applies more to individuals). The fundamental rule states that the more you do something, the less time it will take next time around. Or in other terms: if the quantity of an item produced doubles, the cost decreases at a predictable rate (as little as a few percentage points, or as high as more than 30%). Experience curves have been observed empirically in a variety of industries, and you can find formulas to express the relationship (Wikipedia has good sections on both cost curves and experience curves).
What drives the experience curve effects? A variety of factors play a role:
–Labor efficiency
–Standardization and specialization
–Technology and automation
–Better use of equipment
–Changes in the resource mix
–Product redesign
The link back to the cost curve is that you would typically expect the largest producers to have the lowest unit costs (i.e. they appear to the left of the cost curve). Strategically, it can be a significant advantage for a significant competitor to fully take advantage of experience curve effects, generating above average profits or achieving higher market shares, or a combination of both. Of course, we all know that cost leadership is not the only way to achieve a strong sustainable position.
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