Automation, minimum efficient scale and a price-matching rival
Atlantic Precision is a small Irish-owned manufacturer of components for medical devices. It produces 30,000 units a year using a labour-intensive process: fixed costs are €90,000 and variable cost is €4 per unit. The selling price is €9. A new automated line would raise fixed costs to €300,000 but cut variable cost to €2 per unit and raise capacity to 120,000 units. The firm has one prospective customer offering a five-year contract for 70,000 units a year at €9, but the contract is not guaranteed. Its bank will lend the €300,000 only if projected profits cover the loan. A larger UK competitor produces 200,000 units with a similar automated process and has announced it will match any price cut. The owner must decide whether to invest, stay small, or seek a merger. The firm currently has no debt.
1. Calculate accounting profit at 30,000 units under the current process and at 30,000 and 70,000 units under the automated process. At what output do the two processes have the same average cost?
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Current process at Q = 30,000: Revenue = 30,000 × €9 = €270,000. Variable cost = 30,000 × €4 = €120,000. Fixed cost = €90,000. Profit = €270,000 − €120,000 − €90,000 = €60,000. Average cost = (90,000 + 4Q) / Q = €7.00.
Automated process at Q = 30,000: Revenue = €270,000; variable cost = 30,000 × €2 = €60,000; fixed cost = €300,000. Profit = €270,000 − €60,000 − €300,000 = −€90,000 (loss). Average cost = (300,000 + 2Q) / Q = €12.00.
Automated process at Q = 70,000: Revenue = 70,000 × €9 = €630,000; variable cost = €140,000; fixed cost = €300,000. Profit = €630,000 − €140,000 − €300,000 = €190,000.
Equal average cost: (90,000 + 4Q)/Q = (300,000 + 2Q)/Q. 90,000 + 4Q = 300,000 + 2Q, so 2Q = 210,000 and Q = 105,000 units. At 105,000 units both processes have average cost of about €4.86. Below 105,000 the labour-intensive process has lower average cost; above it, automation does.
2. Advise the owner whether to invest if the contract is for 70,000 units. Consider the competitor's price-matching threat and economies of scale.
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At 70,000 units the automated process earns €190,000 profit, but the current process would earn revenue €630,000 − variable cost €280,000 − fixed cost €90,000 = €260,000. The automated line is therefore worse at 70,000 units because output is below the break-even quantity of 105,000. The €300,000 investment also has to be repaid, and the bank requires projected profits to cover the loan. On the 70,000 contract alone, the owner should not invest unless the contract is near-certain and brings other strategic benefits.
The competitor at 200,000 units is likely to have lower average cost and has announced price matching. If Atlantic invests and then cuts price to win volume, the competitor can match, leaving both with lower margins. The investment creates sunk costs and increases risk. However, if Atlantic can secure 120,000 units, automation earns €540,000 versus €510,000 for the current process, a modest advantage. A merger or contract manufacturing agreement could raise output toward minimum efficient scale without the full capital risk. The decision depends on credible demand above 105,000, not just the offer of 70,000.
3. Explain how economies of scale and contestability affect the decision. Distinguish internal from external economies of scale.
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Internal economies of scale arise within the firm as output rises: the automated line spreads €300,000 of fixed cost over more units, reduces variable cost through specialisation and may improve purchasing. These explain why average cost falls from €12 at 30,000 units to €4.50 at 120,000 units. The minimum efficient scale is around 105,000 units, where the two technologies have equal average cost. Producing below that leaves Atlantic with a cost disadvantage.
External economies of scale arise from the industry or location: a cluster of medical-device firms can share specialised suppliers, skilled labour and transport infrastructure. These lower costs for all firms, including the UK competitor, and do not depend on Atlantic's own output.
Contestability refers to how easily rivals can enter or discipline the market. The UK competitor's price-matching threat makes the market less contestable from Atlantic's perspective: any price cut can be met immediately. High sunk costs in automation also make the investment risky because the firm cannot easily recover the €300,000 if demand falls. A merger could increase scale and bargaining power but may reduce competitive pressure. The owner should weigh the cost advantage above 105,000 units against the risk of a price war and the irreversibility of the investment.