Chapter 7-economies-of-scale-and-the-size-of-a-firm
Upcoming SlideShare
Loading in...5
×
 

Chapter 7-economies-of-scale-and-the-size-of-a-firm

on

  • 328 views

 

Statistics

Views

Total Views
328
Views on SlideShare
328
Embed Views
0

Actions

Likes
0
Downloads
9
Comments
0

0 Embeds 0

No embeds

Accessibility

Upload Details

Uploaded via as Adobe PDF

Usage Rights

© All Rights Reserved

Report content

Flagged as inappropriate Flag as inappropriate
Flag as inappropriate

Select your reason for flagging this presentation as inappropriate.

Cancel
  • Full Name Full Name Comment goes here.
    Are you sure you want to
    Your message goes here
    Processing…
Post Comment
Edit your comment

Chapter 7-economies-of-scale-and-the-size-of-a-firm Chapter 7-economies-of-scale-and-the-size-of-a-firm Document Transcript

  • Written by: Edmund Quek CHAPTER 7 ECONOMIES OF SCALE AND THE SIZE OF A FIRM LECTURE OUTLINE 1 INTRODUCTION 2 INTERNAL ECONOMIES AND DISECONOMIES OF SCALE 2.1 2.2 Internal economies of scale Internal diseconomies of scale 3 EXTERNAL ECONOMIES AND DISECONOMIES OF SCALE 3.1 3.2 External economies of scale External diseconomies of scale 4 ECONOMIES OF SCOPE 5 SIZE OF A FIRM 5.1 5.2 Minimum efficient scale (MES) Alternative measures 6 GROWTH OF A FIRM 6.1 6.2 Internal growth External growth References John Sloman, Economics William A. McEachern, Economics Richard G. Lipsey and K. Alec Chrystal, Positive Economics G. F. Stanlake and Susan Grant, Introductory Economics Michael Parkin, Economics David Begg, Stanley Fischer and Rudiger Dornbusch, Economics © 2011 Economics Cafe All rights reserved. Page 1
  • Written by: Edmund Quek 1 INTRODUCTION When the scale of production expands, average cost will usually fall. The forces that lead to a fall in average cost due to an expansion of the scale of production are known as economies of scale (EOS). However, when the scale of production reaches a certain size, any further expansion will lead to a rise in average cost. The forces that lead to a rise in average cost due to an expansion of the scale of production are known as diseconomies of scale (DOS). EOS and DOS give rise to the U-shaped LRAC curve. Otherwise stated, the term EOS refers to internal EOS, which are forces that lead to a fall in average cost due to an expansion of the scale of production. EOS are shown by a downward movement along the LRAC curve. However, average cost may fall due to external EOS, which are forces that lead to a fall in average cost due to an expansion of the industry rather than an expansion of the scale of production. Although internal EOS are shown by a downward movement along the LRAC curve, external EOS are shown by a downward shift in the LRAC curve. The difference between internal DOS and external DOS is the same as the difference between internal EOS and external EOS. This chapter gives an exposition of EOS and DOS. 2 INTERNAL ECONOMIES AND DISECONOMIES OF SCALE 2.1 Internal economies of scale Technical economies of scale Division of labour is the process whereby each job is broken up into its component tasks and each worker is assigned one or a few component tasks of the job. An expansion of the scale of production often leads to a greater division of labour and hence greater specialisation resulting in higher productivity and hence lower average cost. Further, an expansion of the scale of production often leads to the use of larger machines that are more productive than smaller machines and this leads to lower average cost. Managerial economies of scale Larger firms are able to afford more specialised departments where people perform specific administrative operations such as human resource, purchasing, finance and marketing. Greater specialisation in these areas of expertise often leads to higher productivity and hence lower average cost. Organisational economies of scale Larger firms are able to spread overheads such as marketing cost and training cost over a larger amount of output. Spreading overheads leads to lower overheads per unit of output and hence lower average cost. For instance, since the cost of an advertisement is independent of the amount of output produced, larger firms that produce a larger amount of output have a lower marketing cost per unit of output. © 2011 Economics Cafe All rights reserved. Page 2
  • Written by: Edmund Quek Purchasing economies of scale Larger firms are able to obtain more trade discounts for the larger quantities of raw materials and other supplies that they purchase and this leads to lower average cost. Financial economies of scale Larger firms are able to obtain loans at lower interest rates due to their big sizes that are often associated with low default risk and this leads to lower average cost. The container principle of scale (not needed for the exam) Any capital equipment that contains things tends to cost less per unit of output the larger its size. The reason has to do with the relationship between the volume of a container and its surface area. The cost of a container depends directly on the materials used to build it and hence its surface area. Its output depends on its volume. Larger containers have a bigger volume relative to surface area and hence larger firms that use larger containers have a lower cost of container per unit of output and hence lower average cost. 2.2 Internal diseconomies of scale Managerial diseconomies of scale When the scale of production expands, more specialised departments may be created which may give rise to more problems with coordination. If this happens, productivity will drop which will lead to higher average cost. Technical diseconomies of scale Problems with motivation may also become more severe when division of labour increases because doing the same thing all the time can lead to boredom and hence a fall in productivity resulting in a rise in average cost. 3 EXTERNAL ECONOMIES AND DISECONOMIES OF SCALE Internal economies/diseconomies determine the shape of the LRAC curve. However, the position of the LRAC curve is influenced by external economies/diseconomies of scale. External EOS will result in a downward shift in a firm's LRAC curve while external DOS will result in an upward shift in a firm's LRAC curve. 3.1 External economies of scale External EOS are forces that lead to a fall in average cost due to an expansion of the industry rather than an expansion of the scale of production. An expansion of the industry will lead to an increase in the demand for factor inputs required by the firms in the industry which will allow the firms which supply the factor inputs to the industry to expand their scale of production, and if they reap more economies © 2011 Economics Cafe All rights reserved. Page 3
  • Written by: Edmund Quek of scale due to the expansion of their scale of production, the firms in the output industry may be charged lower prices for the factor inputs they purchase which will lead to fall in their average costs. If the industry expands, training schools may find it profitable to design and conduct training courses which cater for the industry and this will help the firms reduce their training costs. 3.2 External diseconomies of scale External DOS are forces that lead to a rise in average cost due to an expansion of the industry. The rise in average cost could be due to an increase in the demand for factor inputs which lead to a rise in their prices. 4 ECONOMIES OF SCOPE When the number of types of good produced increases, average cost will usually fall. The forces that lead to a fall in average cost due to an increase in the size of the firm associated with an increase in the number of types of good produced rather than an increase in the scale of producing any one good are known as economies of scope. Economies of scope are due to several reasons. For instance, an increase in the number of types of good produced will lead to a fall in the research and development cost per unit of output if the technologies that are used to produce the goods are related. An increase in the number of types of good produced will also lead to a fall in the marketing cost per unit of output if the goods use the same branding. 5 SIZE OF A FIRM 5.1 Minimum efficient scale (MES) The minimum efficient scale (MES) is the lowest output level at which economies of scale are fully reaped. At this output level, the LRAC curve stops falling. The size of a firm is often measured by its long-run output level which depends on the MES. © 2011 Economics Cafe All rights reserved. Page 4
  • Written by: Edmund Quek If the MES is low, the firm will tend to be small. Conversely, if the MES is high, the firm will tend to be large. However, the long-run output level of a firm does not depend entirely on its MES. A firm with a large MES in a small market may have a long-run output level lower than that of a firm with a small MES in a large market. In other words, the long-run output level of a firm also depends on the size of the market in which the firm operates. 5.2 Alternative measures There is no standard measure of the size of a firm. As a result, it is difficult to make inter-market comparisons. Nevertheless, there are a few criteria which are commonly used for comparison purpose, although each criterion is not without its limitations. The value of the capital assets Limitations - Overestimation of the size of a capital-intensive firm relatively to a labour-intensive firm. The size of the workforce Limitations: - Overestimation of the size of a labour-intensive firm relatively to a capital-intensive firm. © 2011 Economics Cafe All rights reserved. Page 5
  • Written by: Edmund Quek Annual revenue Limitations: - Fluctuations in the price of the good will affect annual revenue even if the output level has not changed. - The value of output produced but not sold is not included. Annual profit Limitations: - A firm with a high output level but a small profit margin may make less profit than another firm with a low output level but a large profit margin. - A firm (especially a new entrant) may sacrifice profit margin in the short run to gain market share. Market share Limitations: - Difficult to be used to compare firms across markets of different sizes. 6 GROWTH OF A FIRM 6.1 Internal growth A firm can expand by ploughing back some of its profit into investment. It can also expand by issuing new shares, issuing bonds or getting bank loans. 6.2 External growth A firm can expand by joining with other firms and this is commonly known as a merger. A firm can also expand by acquiring or taking over other firms and this is commonly known as an acquisition or takeover. Merger and acquisition are the two types of integration. In practice, however, the term “merger” is loosely used to refer to both merger and acquisition. There are three types of merger: horizontal merger, vertical merger and conglomerate merger. Horizontal merger A horizontal merger is a merger between two firms that produce the same good. The reasons for a horizontal merger - To reap more economies of scale. - To reduce competition. © 2011 Economics Cafe All rights reserved. Page 6
  • Written by: Edmund Quek Vertical merger A vertical merger is a merger between two firms where one firm is a supplier or a customer of the other firm. When a firm merges with a supplier, the act is known as a backward merger. When a firm merges with a customer, the act is known as a forward merger. A vertical merger is usually initiated by the customer. The reasons for a vertical merger - To achieve greater control and stability in the supply of inputs through a backward merger. - To eliminate transaction costs which include the costs of negotiating, monitoring and enforcing a contract, through a backward merger. - To restrict the supply of inputs to competitors through a backward merger. - To prevent leakage of vital information pertaining to the firm’s product through a backward merger. Conglomerate merger A conglomerate merger is a merger between two firms that produce different and unrelated goods. In the case where the two firms produce different but related goods, the act is known as a lateral merger. The reasons for a conglomerate merger - To reap more economies of scope. - To spread risk. - To create an internal capital market. © 2011 Economics Cafe All rights reserved. Page 7