Economies of scale Flashcards
Economies of scale
A reduction in the long run average costs as output increases , because we begin to repay the fixed costs over time
Total cost=
Fixed cost(costs that don’t change with output)+ variable output(costs that change with output)
Internal economies of scale
Within a businesses’ control, businesses can exploit them
Average cost for economies of scale
Total cost/quantity(if quantity increases faster than total cost, average cost will go down, producing more units at a lower cost meaning average unit costs drop, until average costs reach their lowest points)
Types of internal economies of scale
Risk Bearing(how much risk the business will take on)
Financial - how much money the business will spend(as a business is larger, they can negotiate lower rates of interest)
Management of businesses - as a firm gets larger, specialist managers and workers are brought in to improve productivity,meaning quantity will rise faster than total cost
Technical - specialist machinery/technology skills can improve productivity
Marketing e.g. bulk buying advertising(purchasing a large number of advertising at once) can negotiate better unit rates of advertising and spread advertising costs over a wider range of output
Purchasing - buying raw materials, can negotiate unit discounts(quantity rises in company faster than costs)
Diseconomies of scale
An increase in the long run average costs as output increases
How unit costs become cheaper in internal economies of scale
Can spread fixed costs over a wide range of output - unit costs become cheaper
External economies of scale
Better transport infrastructure
Component suppliers move close
Research and Development Firms move closer
Average cost(external economies of scale)
Reducing total cost while output remains the same - this brings down average cost
Profit=
Total revenue - total cost
Diseconomies of scale
- Control
- Communication
- Coordination
- Motivation
All more difficult as organisations are bigger and there are lots of costly businesses around the country(price of unit starts to go up)
Average cost(diseconomies of scale)
Total cost increases more than quantity(average cost increases)
Market
A place where buyers and sellers meet to exchange goods for money
Four different types of market
- Perfectly competitive market
2.Monopoly
3.Monopolisticly Competitive Market
4.Oligopoly
Perfectly competitive market features
- Many buyers and sellers(infinite)
- Homogenous goods(sell an identical good/product): firms are price takers(no ability to set own prices)
- No barriers to entry/exit
- Perfect information
- Firms are all profit maximisers(will produce when marginal cost = marginal revenue)
What does it mean the more firms in each market?
The lower the profits for each player
Long run
When normal profit is being made. Firms in a perfectly competitive market can profit maximise in the short run(to make supernormal profits), but in the long run, firms can only gain normal profits.
What happens if, in a perfectly competitive market, there are supernormal profits to be earned?
New firms are attracted to markets, so these profits get competed away, therefore in the long run, everyone just earns normal profit. Here, the average cost curve will move up and touch the marginal cost curve(all supernormal profits are taken away and normal profit is left at the end). This is also because, as other firms enter the market, the supply curve will shift to the right and the price will fall.
Which market do consumers prefer?
Consumers prefer a competitive market,which has lower prices than a market without competition(e.g. monopoly- only one firm in the market).
Dynamic efficiency
If you’re reinvesting profits for growth
Productive efficiency
Using the exact right amounts of factors of production without wasting resources e.g. firm operating at lowest point of average cost curve
Allocative efficiency
Are we making the best use of available resources, where price = marginal cost
Monopoly
A firm dominating more than 25% of the market share
Pure monopoly
One seller/firm dominating 100% of the market
Examples of monopolies
Technically Tesco - 27% of market share
Barriers to entry/exit used by monopolies
Copyright, aysmmetric information, start up costs
In a monopoly, where are you making supernormal profits?
If average revenue is greater than average cost at the equilibrium quantity
Types of static efficiency
1) Allocative efficiency
2) Productive efficiency
3) X-Efficiency: By minimising wastage
These types of efficiency don’t change the size of the business
Dividends
Profits shareholders are expected to be given
Are monopolies dynamically efficient?
We don’t know - don’t know what they’re doing with their long run supernormal profits
Why is a perfectly competitive market structure more beneficial than a monopoly?
From the consumers’ point of view, in the long run,they’re only earning normal profits as prices are kept lower. Perfectly competitive markets also use resources more efficiently than monopolies, minimising wastage, which benefits consumers as a result of lower costs.
Consequences of monopolies
Result in welfare/deadweight loss - customers unhappy due to high prices and limited choices(resources are being wasted/misused)
Examples of external economies of scale
Silicon Valley- vast number of technology companies are headquartered there e.g. Apple, Alphabet’s Google, Cheuron, Meta and Visa
Market power
The ability of a business to set prices above a level that would exist in a highly competitive market
Dominant firm
A firm which accounts for a significant share of a given market and has a significantly larger market share than its next largest rival. Dominant firms are typically considered to have market shares of 40 per cent or more
Monopoly power
Refers to a situation where a single firm has control over a market for a particular product or service, allowing the firm to set prices and production levels without worrying about competition from other firms
Why does a monopoly have a downward sloping AR and MR curve?
A monopoly has price setting or price making power
Disadvantages of monopoly power
Prices are higher in a monopoly than under competition, which leads to a loss of allocative efficiency(P>MC).
High monopoly prices can have regressive effects on lower-income households, whose real incomes are diminished.
A monopoly might get too big, leading to diseconomies of scale in the long run and a loss of productive efficiency
Arguments in favour of monopoly power
Profits for a monopoly firms can be used to fund extra capital investment and research projects, which accelerates innovation.
Monopolistic firms can be regulated via an industry regulator acting as a proxy consumer to help keep prices down and standards of service high.
A natural monopoly benefits from huge economies of scale, which leads to lower average costs and lower prices. This is because a dominant firm can achieve significant internal economies of scale, meaning the average cost of supplying to the market is lower than if the market was fragmented with lots of smaller competing businesses
Policies to control monopoly power
Industry regulation e.g. OFGEM sets an energy price cap
Trade liberalisation - Free trade makes markets contestable e.g. trade deal with Australia and Japan
Windfall taxes e.g. Labour Party calling for a one-off windfall tax on the supernormal profits of energy firms
Price caps on a monopoly - Encourage cost efficiency and increases consumer surplus
Evaluation on monopoly power
Firms with market power are not always profit maximisers
Some barriers to entry are coming down, making markets less monopolistic and more contestable
Impact of a monopoly depends on how strong and effective is an industry regulator
Limits on market power of established firms in an industry
1) Threat of new entrants/substitutes including from overseas markets
2) Government intervention such as price caps and active use of competition policy such as blocking mergers and CMA investigations into collusive behaviour
3) Bargaining power of buyers limits to people’s real effective demand e.g. in a cost of living crisis
Benefits for consumers of the UK energy price cap
1) Has helped control the monopoly power of dominant energy suppliers - leading to lower prices and a higher level of consumer surplus
2) Before 2022, the EPC made energy bills more predictable for consumers helping them plan.Particularly important for larger families with big bills.
Limits for consumers of the UK energy price cap
1) The price cap has led to decreased contestability in the energy market, because smaller suppliers made heavy losses when wholesale prices soared in 2022 - many were bought up by larger firms.
2) The energy price cap doesn’t address the long term reasons why gas and electricity prices are high - including under investment in
renewables
Barriers to entry
Strategies/factors designed to block potential entrants from entering a market profitably: protect market power of existing firms, maintain supernormal profits and increase producer surplus
Examples of entry barriers in markets
Economies of scale: Established firms may have lower production costs due to their larger size, making it harder for smaller firms to compete.
Product differentiation: If a firm has a unique product or service, it can be hard for new firms to produce a comparable offering.
High fixed costs: Some industries require significant upfront investment, like research and development or specialised equipment, making it hard for new firms to enter.
Cost asymmetry
There is often an asymmetry in costs between an incumbent firm and potential entrants. If existing businesses have managed to exploit internal economies of scale and therefore developed a unit cost advantage, they can cut prices when new suppliers enter the market.
Limit pricing
Pricing by the incumbent firms to deter the entry or expansion of fringe/new firms. The limit price is below the short run profit maximising price, but above the competitive level.
Limit pricing means a short-run departure from profit maximisation.
Limit pricing as a barrier to entry
The monopoly sets its prices low enough to discourage new firms from entering, but not so low it sacrifices profits.
Predatory pricing
Where a monopoly intentionally sets prices so low(below cost) drives its competitors out of business. An anti-competitive move that’s illegal in most countries and can lead to hefty fines.
Significance of high entry barriers
The height of entry barriers affects the concentration of a market in the long run.
High entry barriers make a market less contestable.
Market power can lead to a loss of allocative efficiency(price> marginal cost).
Examples of barriers to entry in commercial banking
Regulatory barriers - new entrants need a banking licence by the central bank to become a licensed deposit taker
Natural or intrinsic barriers to entry - costs of entering the market include marketing costs,
building IT and payments infrastructure.
First mover advantages: strong brand loyalty for established banks, access to wholesale market funding
Examples of new technologies and lower entry barriers
Online platforms: Companies like Uber and Airbnb have disrupted traditional industries by using technology to connect people and facilitate transactions.
3D Printing: This technology has made it easier for smaller businesses to produce goods at lower costs, allowing them to enter markets previously dominated by larger firms.
Cloud computing: This technology has allowed small firms to access powerful computing resources at a low cost, levelling the playing field and lowering barriers to entry.
Increased availability of open-source software and sales platforms such as Amazon Web services
Growth of businesses prepared to use disruptive pricing models based on algorithms
First mover advantage
The idea that, by being the first to enter a new market , a business gains a commercial advantage over actual and potential rivals leading to higher revenues and profits over time
Four business objectives
Profit maximisation
Revenue maximisation
Profit satisficing
Maximising sales
Advantages of lower entry barriers
Market becomes more contestable in the long run: competition drives down prices(increased consumer surplus, real incomes, improved affordability), improves product quality(innovation), higher productivity, meaning a more efficient allocation of scarce resources, and the economy is more competitive in global markets
Disadvantages of lower entry barriers
Lower supernormal profits might reduce the finance to fund capital investment e.g. utilities, and therefore weaker tax revenues for the government.
Rapid entry of new firms might lead to over-supply which drags prices lower and makes an industry less sustainable(renewable power?)
Low barriers to entry is no guarantee of a contestable market - old established monopolies might soon be replaced by new ones(Uber?)
Barriers to exit
The costs associated with a decision by a business to leave a market/industry, because they’re making sub-normal profits
Examples of barriers to exit
Lost goodwill with consumers
Redundancy costs for the workforce
Reduced value of owned equipment sold at rock-bottom prices in a fire sale
Sunk cost fallacy
When firms are reluctant to realise the investment made in a business that is lost if the firm leaves the market
Barriers to entry for new businesses in the UK sports-wear market
- Economies of scale bring down a firm’s LRAC and give scaled businesses a unit cost advantage, which is reflected in lower prices.
- Brand loyalty: Strong brand loyalty reduces the cross-price elasticity of demand and raises the fixed costs of marketing needed for successful market entry.
- Distribution channels: Established brands might have strong relationships with retailers, which can make it difficult for new brands to get their products into stores.
