Econ Midterm 2 Review

Economies of Scale

One solution to the problem of high transaction costs is to bundle the funds of many investors together so that they can take advantage of economies of scale, the reduction in transaction costs per dollar of investment as the size (scale) of transactions increases. Bundling investors’ funds together reduces transaction costs for each individual investor. Economies of scale exist because the total cost of carrying out a transaction in financial markets increases only a little as the size of the transaction grows. For example, the cost of arranging a purchase of 10 000 shares of stock is not much greater than the cost of arranging a purchase of 50 shares of stock.

The presence of economies of scale in financial markets helps explain the development of financial intermediaries and why financial intermediaries have become such an important part of our financial structure. The clearest example of a financial intermediary that arose because of economies of scale is a mutual fund. A mutual fund is a financial intermediary that sells shares to individuals and then invests the proceeds in bonds or stocks. Because it buys large blocks of stocks or bonds, a mutual fund can take advantage of lower transaction costs. These cost savings are then passed on to individual investors after the mutual fund has taken its cut in the form of management fees for administering their accounts. An additional benefit for individual investors is that a mutual fund is large enough to purchase a widely diversified portfolio of securities. The increased diversification for individual investors reduces their risk, making them better off.

Economies of scale are also important in lowering the costs of resources that financial institutions need to accomplish their tasks, such as computer technology. Once a large mutual fund has invested a lot of money in setting up a telecommunications system, for example, the system can be used for a huge number of transactions at a low cost per transaction.

Expertise

Financial intermediaries are also better able to develop expertise that can be used to lower transaction costs. Their expertise in computer technology, for example, enables them to offer their customers convenient services such as cheque-writing privileges on their accounts and toll-free numbers that customers can call for information on how well their investments are doing.

Low transaction costs enable financial intermediaries to provide their customers with liquidity services, which are services that make it easier for customers to conduct transactions. Money market mutual funds, for example, not only pay shareholders relatively high interest rates but also allow them to write cheques for convenient bill paying.