economies of scale ch6

Introduction to Costs and Revenue

Costs: Defined as money that must be paid for inputs used (the factors of production).
Revenue: Defined as money earned from selling goods and services produced.
Concept of Time Periods: - Short run: A period of time during which at least one factor of production is fixed in supply. - Long run: A period of time during which all the factors of production are variable in quantity. - Time periods vary by industry. - Example: A Deli - In the short run, a busy deli cannot expand its premises quickly due to time-consuming planning permissions; therefore, capital (buildings) is fixed. - The deli can, however, increase staff numbers, making labour a variable factor. - In the long run (which could be one year), both capital and labour become variable as the building can be increased alongside staff numbers.

Efficiency and Cost Classification

Efficiency: Defined as achieving maximum output while using the minimum amount of resources. - Highly efficient firms minimize production costs and generally achieve higher profits. - Inefficient firms face high production costs, leading to lower profits, losses, or closure.
Explicit Costs: Costs incurred when a firm pays an actual amount of money for something. - Example: A firm paying an electricity bill of $\text{ }500$ .
Implicit Costs: These do not involve cash outlays but are vital to economic analysis. They represent money not received, which is an opportunity cost or the cost of foregone alternatives. - Example: If a business owner invests $\text{ }200,000$ in their business without charging interest, but could have earned a $3\%$ return ( $\text{ }6,000$ ) in a bank deposit, the implicit cost of the investment is $\text{ }6,000$ .
Fixed, Variable, and Total Costs: - Fixed Costs (FC): Costs that do not change as output changes. These are incurred even when output is zero. Examples include rent of premises and commercial rates. - Variable Costs (VC): Costs that vary as output changes. As output increases, variable costs increase. Examples include wages, electricity, and raw materials. - Total Cost (TC): The sum of fixed and variable costs. $TC = FC + VC$ .

Short Run Shut Down Points

Survival in the short run depends on a firm's ability to cover its Average Variable Costs (AVC).
Deli 1 vs. Deli 2 Comparison: - Both delis have Fixed Costs of $\text{ }500$ and Variable Costs of $\text{ }1,000$ , resulting in a Total Cost of $\text{ }1,500$ . - Deli 1: Total Revenue is $\text{ }1,250$ . Even though it makes a loss, it should stay in business because it covers its variable costs (\text{ }1,250 > 1,000). - Deli 2: Total Revenue is $\text{ }900$ . It should close down because it fails to cover its variable costs (\text{ }900 < 1,000).
If a firm does not cover average variable costs, the loss incurred will increase over the long run as production increases.

The Law of Diminishing Marginal Returns

Definition: As more and more of a variable factor is added to a fixed factor, at some stage the increase in output caused by the last unit of the variable factor will begin to decline.
Deli Specialization Example: - One worker handles all tasks: ordering, producing, and cleaning. - A second worker joins: output increases immediately due to extra help. - A third worker joins: production continues to increase as employees begin to specialize in specific tasks. - Overcrowding: If 10 or 15 workers are employed in one deli, they get in each other's way. Marginal (extra) output per worker declines because the workplace is overcrowded (e.g., 3 or 4 employees trying to operate one machine).
Data Table Example: - 1 Worker: Total Output = $10$ ; Average Output = $10$ . - 2 Workers: Total Output = $25$ ; Marginal Output = $15$ ; Average Output = $12.5$ . - 3 Workers: Total Output = $42$ ; Marginal Output = $17$ ; Average Output = $14$ . - 4 Workers: Total Output = $60$ ; Marginal Output = $18$ ; Average Output = $15$ . - 5 Workers: Total Output = $70$ ; Marginal Output = $10$ . (Diminishing returns set in here). - 6 Workers: Total Output = $78$ ; Marginal Output = $8$ . - 7 Workers: Total Output = $85$ ; Marginal Output = $7$ .
Observations: - Total output increases with each extra worker. - Diminishing returns set in after the fourth worker, as the fifth worker's marginal output ( $10$ ) is lower than the fourth worker's ( $18$ ). - Average output per worker begins to fall once diminishing returns set in ( $14$ for the 5th worker vs $15$ for the 4th).

Average and Marginal Cost Analysis

Average Cost (AC or ATC): The cost of making one unit, calculated as $\frac{TC}{Q}$ .
Marginal Cost (MC): The extra cost of producing an extra unit of a good, calculated as the change in total costs ( $\Delta TC$ ).
Cost Relationships: - When $MC < AC$ , AC is falling. - When $MC = AC$ , AC is at its minimum point (the firm's most efficient point). - When $MC > AC$ , AC is rising.
Component Definitions: - Average Fixed Costs (AFC): Calculated as $\frac{FC}{Q}$ . AFC declines rapidly at first, then more slowly, as the fixed costs are spread over a greater number of units. - Average Variable Costs (AVC): Calculated as $\frac{VC}{Q}$ . These fall as workers specialize but begin to rise once the Law of Diminishing Marginal Returns sets in.

Short Run and Long Run Average Cost Curves

Short Run Average Cost (SAC) Curve: - Generally U-shaped. - Downward slope (A to B): Caused by specialization/division of labour (improved efficiency) and the greater spread of fixed costs over increasing units. - Upward slope (B to C): Caused by the Law of Diminishing Marginal Returns, where adding variable factors (labour) to fixed capital causes unit costs to rise.
Long Run Average Cost (LRAC) Curve: - All factors of production (Land, Labour, Capital, and Enterprise) are variable. - Generally saucer-shaped. - Downward slope: Driven by Economies of Scale (cost savings due to increased size). - Upward slope: Driven by Diseconomies of Scale (average costs increase as the firm grows too large). - Only the most efficient firms survive in the long run. These firms must cover their Average Total Costs to remain competitive and avoid wasting scarce resources.
Relationship between SAC and LRAC: - A firm plans expansion by constructing various SAC curves, each representing a different factory size with its own optimum production quantity. - A firm will choose the factory size (the specific SAC curve) that offers the lowest production cost for its intended quantity. - The LRAC is formed by joining the minimum points of the various SAC curves.

Internal Economies of Scale

Internal economies are forces within a firm that cause unit costs to decline as the firm grows:

Increased use of machinery: Growth allows for specialized, high-capacity equipment (e.g., an industrial printer for a newspaper publisher).
Specialization/Division of Labour: Breaking jobs into parts increases efficiency and reduces unit costs.
Purchasing economies: Large quantity orders allow for bulk discounts from suppliers.
Economies in distribution: Better delivery organization (e.g., a bakery delivering to all customers in a single area on a set day).
Financial economies: Large, established firms are seen as "safer" and can negotiate lower interest rates.
Management economies: Firms can hire specialists (HR, Marketing) by offering higher salaries and bonuses.

External Economies of Scale

External economies are forces outside the firm that benefit an entire industry as it grows:

Better infrastructure: Improvement in road and communication systems.
Specialist firms: Independent firms set up to provide services like payroll functions.
Subsidiary trades: Development of trades to support the industry (e.g., hotels/petrol stations near airports).
Training courses: Provision of courses by public bodies like SOLAS or Local Enterprise Offices.
Public body support: For example, Tourism Ireland or Teagasc (agricultural advice/education).
Separate R&D units: Shared research costs for individual firms.

Internal and External Diseconomies of Scale

Diseconomies are disadvantages that reduce efficiency and increase unit costs:

Internal Diseconomies: - Poor decision-making: Unclear lines of authority in large firms. - Fall in staff morale: Repetitive tasks/specialization causing boredom and high turnover. - Communication problems: Growing distance between management and workers. - Control problems: Difficulty controlling waste, stock breakages, and losses. - Administrative overheads: Increase in office staff ratio relative to production staff; higher legal and accounting costs.
External Diseconomies: - Shortages of factors of production: Increased demand for qualified labour leads to higher wages; hiring unexperienced staff increases training costs. - Raw material shortage: Pressure on supply leads to price increases. - Infrastructural problems: Demand for transport, housing, and telecommunication may exceed supply.

Market Concentration: Small vs. Large Firms

Large Firms: Dominate high-concentration markets (mobile phones, cars, game consoles). They achieve economies of scale and have resources for R&D.
Small Firms: Exist in low-concentration markets (coffee shops, restaurants, hairdressers).
Reasons Small Firms Survive: - More personalized customer service. - Consumer loyalty toward community-owned businesses. - Operating in markets that are too small to be viable for large firms.
Positive Implications of Large Firms: - Resources for innovation (e.g., slimmer phones). - Passing cost savings to consumers via lower prices. - Employee job security.
Disadvantages of Large Firms: - Moral Hazard: Being "too big to fail" removes the incentive to guard against risk (e.g., banks in financial crises). - Mergers/Takeovers: Reduces competition, choice, and innovation. - Political Influence: Power to resist regulation (e.g., tech firms resisting social media regulation). - Collusion: High concentration allows firms to exploit consumers via high prices.

Returns to Scale

Returns to scale refer to the effect on output when all factors are changed (e.g., doubled):

Increasing returns to scale: Inputs are doubled, but output more than doubles. This results in a downward-sloping LRAC curve.
Decreasing returns to scale: Inputs are doubled, but output less than doubles. This results in an upward-sloping LRAC curve.
Constant returns to scale: Output changes at exactly the same rate as inputs. This results in a horizontal LRAC curve.

Social Costs, Benefits, and Externalities

Social Cost: A cost to society (e.g., traffic congestion, global warming, pollution) resulting from production or consumption.
Social Benefit: An advantage for society (e.g., skilled employees from training, vaccine programs) not measured in the price paid.
Externalities: Unintended external costs or benefits imposed on society. - External diseconomies of production: e.g., a manufacturing plant causing uncompensated air pollution. - External economies of production: e.g., a company training employees who then work for other firms, raising the economy's skill level. - External diseconomies of consumption: e.g., the effect of smoking on third parties. - External economies of production (Action-based): e.g., a person volunteering at a local youth club.

Revenue Analysis

Total Revenue (TR): Calculated as $P \times Q$ .
Average Revenue (AR): Calculated as $\frac{TR}{Q}$ . This is equivalent to the price of the good and represents the demand curve.
Marginal Revenue (MR): Calculated as $\frac{\Delta TR}{\Delta Q}$ . The MR curve sits below the AR curve.
Price Taker Scenario (Perfect Competition): - When price is fixed ( $\text{ }10$ at every level), AR = MR. - The curve is horizontal and serves as the demand curve.

Profit Maximization

Normal Profit: The minimum profit required to stay in business ( $AR = AC$ ). It is considered an implicit cost because it accounts for income that could be earned elsewhere.
Profit Maximization Condition: A firm maximizes profit where $MC = MR$ .
Decision Rules: - If MR > MC, producing the extra unit increases total profit. - In the provided model, producing a 6th unit adds $\text{ }4$ to profit ( $MR = 15$ , $MC = 11$ ). - At the 7th unit, $MR = MC = 15$ . Profit stays the same; this is the maximizing position. - Beyond the 7th unit, MC > MR, and total profit falls.
Graphing MC and MR: The MC curve cuts the MR curve from below because MC eventually increases at a faster rate than a constant MR.

Alternative Objectives of the Firm

Firms may pursue goals other than simple profit maximization:

Maximize market share: Charging low prices or high advertising spend to become the largest firm.
Entry Deterrence: Settling for lower profits to avoid attracting new competitors into the market.
Takeover Target: Building a specific valuable asset to be bought out by another firm.
Social/Environmental problem solving: Social enterprises focusing on purpose over profit.
Satisficing (Sufficient Profit): Entrepreneurs may avoid further expansion to limit financial risk or maintain a healthy family life and work-life balance.