Thursday, March 28, 2013

Economies of Scale and the Solar Power Industry

An economic topic that occurs frequently in courses that I teach is economies of scale.  Simply put, economies of scale occur when the per unit total cost of production fall as the amount of output produced rises.  Thus in economic terms I refer to economies of scale occurring when average total costs fall (implicitly assuming an increase in output).  Over the last few years we have seem an increase in capacity in the solar panel industry (and the political implications of industrial policy) and subsequent bankruptcy of solar panel producing firms.  The New York Times reports that a subsidiary of Suntech Power (a Chinese solar panel production firm) is following this market trend of filing for bankruptcy.

So why is there so much overcapacity in the solar panel production market?   You guessed it, economies of scale.  If you read the very end of the article linked in the previous paragraph, you see it mentioned there as, "[t]he industry’s problem is that most of the cost of a solar panel lies in building the factory, not in operating the equipment".  In other words, the building costs are fixed costs and the operating costs are variable costs.  Given most of the overall production costs are fixed costs, a small increase in production lowers those fixed costs and since they are a large portion of the total costs, then average total costs fall as output increases.  Of course, the problem is that as output increases, market prices fall and the industry spirals out of control in increasing capacity to reduce average total costs resulting in lower prices and smaller average profits or larger average losses.

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