Essay Question T4W2

8/3/2019 Essay Question T4W2

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Syllabus requirements

1. Objectives profit maximisation (MC=MR) and

ALTERNATIVES2. COSTS short/long fixed/variable EOS3. Range of competition ± market structures

± Compare Efficiency Equity Innovation Consumer choice

4. Barriers to entry

5. Behaviour of firms ± Price discrimination ± Price and non-price competition ± Collusion and competition ± Interdependence (oligopoly)



Essay QuestionLarge firms enjoy lower costs thus

they can charge lower prices.

a) Explain why large firms mayenjoy lower costs. [12]

b) Discuss the view that large

firms are beneficial in view of the cost-savings they enjoy [13]



a) Definition - context

³I am going to offer some definitions and then use the

idea of economies of scale to explain why some firms

can enjoy lower costs´

Introduction ± firm ± unit of production. INPUT ± PROCESS - OUTPUT

Production important to understand supply.

Supply important because its part of the market. Market is important because it is theMECHANISM for allocating scarce resources.



SUBSTANCE OF ANSWER

b) Explain why large firms may enjoy lower costs.

COSTS ± PAYMENTS TO FACTORS OF

PRODUCTION

Firms consider costs in the SHORT and LONGrun and FIXED and VARIABLE COSTS

Define

Short Run ± rising MARGINAL COSTS.

Long run ± ECONOMIES OF SCALE

Relate to specific industries e.g.

± Airlines ± high fixed costs (planes) ± Mobile phones ± MASS PRODUCTION/standardisedproduct

± Oil refining ± INDIVISIBLE PRODUCTION



Economies of (large) Scale

The advantages of large scale productionthat result in lower unit (average) costs(cost per unit)

Economies of scale ± the DECISION of the firm about SIZE.

Advantage in some markets

Singtel ± establishing cell phoneinfrastructure expensive (fixed costs) ± MCof additional user at or near zero (variablecosts)



Understanding Long Run Cost Curves

Successful firms GROW

ONLY if the market can be extended Growth by product ± new factories/offices/shops We can say firms DECIDE on different or larger

sets of factors of production.

P rofit maximising firms will choose the lowest cost set.

This increase in SIZE is known in economics as aSCALE change.

It is useful to TRACK the possible changes inSCALE; this is the LONG RUN AVERAGE COSTCURVE

In the long run ALL costs are VARIABLE



$

Q [units]0

The entrepreneur in the long run can choose the scale.The COST of SETS OF FACTORS TO PRODUCE

OUTPUT Q ± which would you choose?

Q

A

B

C

The LONG RUN is aboutSIZE and about howbest to combine thedifferent factors.

Should the firm be;

LABOUR INTENSIVE

or

CAPITAL INTENSIVE

or

LAND INTENSIVE



Sets of FactorsScale 1

Scale 2



One of these scales willbe the MINIMUM

EFFICIENT SCALE

Scale 3

Scale 4



LRAC

$

Q [units]0

The entrepreneur in the long run can choose the scale.

However once the choice is made the firm will

move along the SRAC.

The DECISION MAKING period of time.

1.Potential demand2.Capital costs

3.Confidence inter alia

There are an INFINITE number of possible scales.



LRAC

$

Q [units]0

The entrepreneur in the long run can choose the scale.As the firm GROWS scale changes

The LRAC shows ALL possible decisions.

If the firm is a profit maximiser it willDECIDE to employ the lowest cost set of factors of production.

12 3

4



$

Q [units]0

The entrepreneur in the long run can choose the scale.Minimum Efficient Scale ± one combination of factors

will be at the lowest point of the long-run cost curve.

MES

1

2 3 4 5

6



LRAC

$

Q [units]0

The entrepreneur in the long run can choose the scale.The OPERATING period of time.

ATC



LRACH

$

Q [units]0

The entrepreneur in the long run can choose the scale.FIRMS/INDUSTRIES ARE DIFFERENT.

LRACOR

LRACPUB

The most productively efficient output depends on the

industry we talking about.



Internal Economies of Scale

Advantages that result from the growth of the firm

Internal economies take place inside thefirm

± Technical

± Commercial

± Financial

± Managerial

± Risk Bearing

Collateral ± value of assets Banks

Bulk buying Supermarkets

Cubic Capacity Area x 2 Volume x 8; OIL TANKERS

Sales in different countries; Apple

Division of labour; Singtel ± accountants, marketing, HR



External Economies of Scale

The reduction of costs if the INDUSTRYgrows.

Support services ± The Port in Singapore

Transport

Insurance

Finance Training ± university courses

FIRMS may benefit ± question focus



Firms that continue to grow MAY

experience rising costs Diseconomies of scale ± Rising costs of management and control

± Employment of staff who supervise, measure

and monitor ± but do not contribute directly tooutput

If the large firm makes SUPERNORMALPROFIT there is a risk of X-inefficiency.

The economies of scale can be shown ona model.



A Typical Long-Run Average Total Cost Curve

Q

Costs perunit ($)

10

50

55

20

60

15 40

LRAC

13-18

0

Economies

of Scale

ConstantReturns

to Scale

Diseconomies

of Scale

Minimum Efficient Scale ± the lowest

point of the LRAC

Decreasing

returns to scale

Increasing

returns toscale



Conclusion³The reasons I have given above explain how

large firms can may enjoy lower costs.´ BUT

Industries are different Different consumers (MARKET SIZE)

± Standardised product ± big firms ± Non-standardised product ± smaller firms

Large firms can also charge lower prices tosome customers because they canDISCRIMINATE. (based on price elasticity of demand)

Lower prices may also be due to LIMIT or PREDATORY pricing ± where large firms use their MARKET POWER to reduce competition.



Discuss the view that large firms are beneficial inview of the cost-savings they enjoy [13]

As shown in part A economies of scaleCAN reduce LRAC.

A number of issues can be discussed ± Benefits to who? VALUE JUDGEMENT/ NORMATIVE

Competition and market share

EOS as a barrier to market entry

± Not ALL industries can become µlarge¶. Large market

Standardised product ± CONSUMER CHOICE

DISCUSS

Thesis Antithesis

For Against

Strengths Weaknesses

Advantages Disadvantages

Positive Negative

Look for the discussion territory ± before writi ng your answer ± make some notes.

Look out for VALUE JUDGEMENTS

/NORMATIVE ECONOMICS



Benefits

Producer

± Price higher output lower than in a competitivesituation.

± SNP ± (possible wider benefits) Society

± If the most efficient size involves big firms this maysave scarce resources (prevent wasteful duplication)

± The Public Utilities Board (PUB) for example and theprovision of piped water is a NATURAL MONOPOLYthat may prevent wasteful duplication.



Stakeholders

Consumers

Producers

Government

Workers Managers

Suppliers

S

ociety Alternative (real world) objective ±stakeholder satisficing)



Consumer Benefits

If cost savings are passed on to theconsumer.

Large firms can SHARE high fixed costsover many outputs.

e.g. Exxon-Mobil oil refining ± litre of fuelless than $2



Exxon-Mobil ± Singapore¶s largest manufacturing

capital investment ± costs $5-6 billion

How can Exxon-Mobil sell a litre of petrol for $2 (c)?



Economies of Scale: Effect on average fixedcosts for Exxon-Mobil ± a potential BENEFIT

to consumersy

x0

Average andTotal Fixed

Costs

(S$)

Quantity (units)

Total Fixed Costs

Average

Fixed

Costs

(AFC)

AFC = FC/Q



Workers

Jobs ± employment

Large firms may less FLEXIBLE to

changes in consumer demand (IBM?) Unclear whether large firms BENEFIT

workers.



The case against

Consumers buy goods and services for a varietyof reasons ± COST (PRICE) are not the onlyinfluences on demand.

Although price may influence our choice of food

it is NOT the main reason we buy. Some markets by definition are small

There is little scope for economies of scale.

The manufacture of jewellery for example iswhere many people want a more personalisedproduct (and service).



The importance of CONSUMER CHOICE

Large firms may dominate markets andreduce consumer choice.

Buying a NEW car in Singapore for example there are only a small number of dealers ± some of whom have aMONOPOLY.

There is the potential for consumer exploitation and INEQUITY.



Benefits?

Competition ± allocative efficiency/ productiveefficiency as shown in perfect competition.

Markets may be dominated by a small number of largefirms. ± Restricting consumer choice

Large firms may use PERSUASIVE advertising toencourage sales. ± Some people argue that some advertising is a waste of resources

± Advertising can distort CHOICE.

Large firms may use their MARKET POWER to eliminate

smaller more efficient producers ± predatory pricing. ± Microsoft ± gave away IE ± killed other browsers

Large firms may use economies of scale as barrier tomarket entry.



The Inefficiency and Inequity of Monopoly

Quantity0

DemandMarginal

revenue

Marginal cost

Monopolyprice

Deadweightloss

Efficientquantity

Monopolyquantity

Price

The MC curveCAN be seen asthe INDUSTRY

SUPPLY curve inperfect

competition.

Price in

competitivemarket



It¶s the market model

Quantity0

Demand

Supply

Monopolyprice

Deadweightloss

Efficientquantity

Monopolyquantity

Price

Price



Examples where large scale isµbeneficial¶

Large firms MAY earn SNP and have theCAPACITY to INNOVATE

This is most likely in the oligopolistic

market structure where non-pricecompetition is important.

Cars

Pharmaceuticals ± Also use of SNP ± innovation/product

development BENEFITS SOCIETY



Where is the competitive SUPPLY curve likely to be?

Quantity0

DemandMarginal

revenue

MCm

Monopolyprice

Monopolyquantity

Price($)

Would the sum of MCs be HERE inperfect

competition?

Price in

competitivemarket

MC= S

in PC

Efficientquantity



In some industries lower costs (standardisedproducts) are not a consumer benefit.

Clothing (?) ± limited scope

Hairdressing

Airlines ± safety Surgery (?)

Can cost cutting lead to lower quality?

Large firms X-inefficiency (Leibenstein)



Conclusion

The idea of µbenefits¶ is complex. There is evidence in some industries - chemicals, oilrefining that economies of scale reduce costs ANDbenefit consumers.

Where a non-standardised product is preferred there are

fewer benefits from the economies of scale. Producers are aware of these issues. The Apple I-phone is standardised (2 colours) However many people buy cases to protect and

personalise their phone.

In some industries consumers may receive greater benefits through competition. The hawker centres are unable to benefit from

economies of scale and competition between vendorsmay help to keep prices lower.



Review

There is no single way to write essays Plan (MAKE NOTES ± you can leave them for

the examiner to read if you wish)

State answer strategy

Read question from time to time

Stick to the question focus

Hit the µHOT BUTTONS¶ in the syllabus

Be thoughtful Relate your answer to the real world whenever

you can.

QUESTIONS



Output (Q)

C o s t s ( $ )

AFC

AVC

MC

x

AC

z

y

Average and marginal costs in the S/R Average and marginal costs in the S/R

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Essay Question T4W2