Chapter 24: Theory of the firm long run costs (1.5)

Transcription

1 Chapter 24: Theory of the firm long run costs (1.5) HL extensions Long run economies of scale Diseconomies of scale Long run cost curves Production in the long run: returns to scale Costs of production in the long run Distinguish between increasing returns to scale, decreasing returns to scale and constant returns to scale Outline the relationship between short run average costs and long run average costs Explain, using a diagram, the reason for the shape of the long run average total cost curve Describe factors giving rise to economies of scale including specialization, efficiency, marketing and indivisibilities Describe factors giving rise to diseconomies of scale, including problems of coordination and communication LONG RUN An American firm was once approached by a Swedish firm proposing a business venture. The American firm politely wrote back asking for references as a guarantee that the Swedish firm had a solid and reputable historical standing and therefore a good credit rating. The Swedish CEO (chief executive officer)

2 promptly wrote back that their credit rating had been excellent during the entire time the firm had been a shareholding company which started some 40 years before Columbus set off on his voyage to India in One might say that this is somewhat beyond the boundaries of the short run. The long run is simply defined in economics; it is the time period where a firm can increase any and all factors of production, i.e. all factors are variable. Over time, firms will institute changes to factory size, machines, and any other type of fixed factor. Being able to adjust overall factor inputs in proportion to output needs, firms will be able to lower the unit costs as the scale of operations increases. Definition: Long run The long run (LR) is defined as the period within which all factors of production are variable. This lowers the average cost since firms will optimise the mixture of fixed and variable factors. ECONOMIES OF SCALE A firm which increases its use of fixed factors of production will naturally incur higher costs. However, as long as the additional costs are spread over increasing units of output, the unit costs will go down (as long as the proportional increase in unit costs are lower than the increase in output). Say that a firm is producing 50 thousand units and has total costs of $500 thousand; the average cost per unit is $10. Now, if the firm increases its use of capital, say a new machine in the production line, by a (fixed) cost of $10 thousand and thereby is able to increase output by 5 thousand units, then average cost per unit drops to $9,27 ($510 thousand / 55 thousand units = $9,27 per unit). This fall in long run costs (long run average costs; LRAC) is the result of economies of scale, or the benefits of scale. Note that scale in the case of firms operations means size and nothing else. Definition: Economies of scale Scale economies are said to exist when a firm increases output and increases both variable and fixed factors, whereby output increases at a proportionately higher rate than the increase in costs per unit. Thus average costs fall as firms achieves increased output per unit of input. This is also known as benefits of scale. As soon as one has grasped the central issue of how increasing costs are spread ever-thinner over increasing quantity of output, it s quite easy to think of real-life examples when scale economies would be apparent; industries which have large fixed costs and/or where there are obvious advantages to being large. Possible scale benefits are often grouped into internal and external economies of scale. Internal economies of scale Internal means that the benefits of being large arise within the firm itself. The increasing scale of operations allows the firm to reap benefits of its own growth regardless of the overall growth of the industry the firm is in. There are five major sources of internal economies of scale: 1. Technical economies of scale: These arise when a firm can take better advantage of its fixed capital. Using machines at 90% of capacity rather than 80% of capacity means that fixed costs per unit produced will fall, since the fixed costs are spread over increasing units. Therefore, buying additional machines and other capital goods serve to lower average costs when the new capital is used to its capacity. This is an example of how indivisibilities of production add to the merits of

3 economies of scale; the machine can not be divided in order for the firm to use it on only 4 out of five days (= 80%). The machine will cost the firm just as much in fixed costs on the fifth day, so by utilising the available machine time more fully, the firm will be able to lower costs per unit. In addition to production capabilities, increasing size give firms the ability to fully utilize transport availability. If goods are being shipped by truck, train or cargo ship, the firm will lower transport costs per unit by filling all available shipping space. Another example of decreasing costs of transportation is the container principle, which shows that an increase in the surface area of a tanker or other cylindrical container 1 will render a far greater increase in the volume of the container. The increase in available transport volume far exceeds the cost of the increased container size. 2. Managerial economies of scale: arise when firms can enhance productivity and output in all areas by increasing specialisation in all areas of production; increasing scale will allow the firm to break tasks down into smaller parts and increase productivity. There are also possible synergy ( synchronised plus energies ) effects; development of new production methods, new materials etc in one area of production can be used across the board in other areas for example a new plastic manufacturing method in the consumer electronics division could be re-applied to the automotive division. 3. Purchasing economies of scale: The larger the firm, the more likely it is to be able to negotiate good contracts for the bulk-buying of materials, components and such. Such purchasing economies of scale are most noticeable in manufacturing firms which use large amounts of basic commodities. Yet increasingly one finds purchasing economies of scale in firms which actually don t produce any goods themselves; Nike in sports goods and IKEA in furniture are good examples of firms which do not actually produce goods but instead design prototypes and subsequently have manufacturing firms submit lowest-cost tenders for the production of the goods. IKEA basically asks firms to submit bids for the production of a few hundred thousand bookshelves the lowest bid wins! You can just imagine that IKEA is able to play production companies against each other and get a far lower price per bookshelf than Mom & Pop s Furniture Store up the street. 4. Marketing economies of scale: Anyone who s seen TV commercials for large multinational companies in different countries soon notices that the advertisements are often the same no matter where you are. In fact, the commercials are often made without the actors speaking, as this makes it easier to do a voice-over in the background in the local language. Thus, Coke, Honda, Ericsson and Adidas can make one commercial and have it aired all over the world without making 170 different versions. This is an example of marketing economies of scale, and also includes such things as having wide-spread brand recognition, and creating barriers to other firms which do not have the advertising budget of incumbent (= already existing) firms and which are trying to enter the market. 5. Financial economies of scale: Getting funds for investment is one of the major issues for firms and the interest payments on loans are a sizable portion of a firm s total costs. Larger firms will often have much more in the way of assets to use as security for loans and therefore can negotiate better terms of interest and repayment than smaller firms. These financial economies of scale will give large firms a distinct cost advantage over small firms 2. In addition to the above, there are distinct possibilities of larger firms being able to spread risks by diversifying (= broadening) the range of output into other areas. Many Japanese and Korean firms are 1 The volume of a container is given by Π x r 2 x h. If the radius of a cylindrical container measuring 1 meter times 8 metres increases by 50%, the area of the container increases by 58% but the volume increases by 125%. 2 I often have some fun with the many inventive and often provocative T-shirts worn by my students. I pick someone wearing, say, a red T-shirt emblazoned with the image of Che Guevarra and the old Soviet flag and ask that we go down to the bank (separately) and negotiate a loan. The object is to see who gets the most favourable terms of finance; the Suit and Tie Man (me) or the Provocative T-shirt Person. The issue being dealt with is the perceived risk of the bank in lending money the lower the lender s perceived risk, the better the terms for the borrower. I believe that lax dress standards helped create the 2007/08 liquidity crisis you simply should not lend money to a guy wearing flip-flops and a grain store cap.

4 notable examples of this type of extension. These are often referred to as conglomerates; large firms which produce a vast array of goods sometimes with no discernable connection between them but often with a good many products which partially overlap in markets. For example, the Korean conglomerate Daewoo International Corporation produces steel, automobiles, media, electronics, textiles, commodities and energy. It has subsidiary companies in over 50 countries and branch offices in most of them. This breadth in terms of both markets and products enables the company to buffer its risks over time and ride out downfalls in regional business activity the business cycle and also changes in market demand for products. By having a wide product and sales base, the firm can afford short term losses in one sector by making it up in another. External economies of scale When there are benefits to scale arising outside the realm of the firm, one speaks of external benefits of scale. This is the overall growth in an industry which creates benefits by which all firms operating on the market will benefit. Increasing the size of an industry will result in more and better trained labour; more efficient sub-contractors providing parts and components; an infrastructure which benefits all firms in the industry; and a general rise in the knowledge and technology base needed to increase productivity. The Swiss watch industry is a good example, as this very important industry for the Swiss economy has benefited enormously from being concentrated to a limited geographical area, as this has led to a good many external benefits such as a long tradition of schools for watch-making, small parts manufacturing and high quality instruments. The lure of economies of scale Scale economies are most valuable in helping to explain a number of events in the global economy during the past 30 to 40 years. Perhaps the most obvious is the increasing concentration of firms, where industries have become increasingly oligopolistic, as firms force out rivals, merge or are bought up by rivals. In the beginning of the 1900s there were over 1,000 automobile manufacturers in the USA, whereas now there are basically three. Mergers and take-overs have been an increasingly strong presence during the 1980s and 90s, and the motives were growth; new markets; attaining new technology and know-how; risk-spreading; and of course to enjoy benefits of scale. This has been most pronounced, perhaps, in the pharmaceutical business, where soaring costs of producing ever-more complicated and research intensive medicines necessitated consolidation in the industry in order to achieve scale benefits. For example, the merging of Glaxo, SmithKline and Wellcome PLC became what is now the 16th largest company in the world, Glaxo- SmithKline 3. Going hand-in-glove with merger-mania (as somewhat hyperbolically inclined magazines put it) is the increasing integration of regional markets on a global scale. The rationale is that a small country will have a small market too small for a firm to get to the level where scale benefits are to be found. The answer is often found in looking to markets outside the country, i.e. exports. Many of the largest multinational companies (MNCs) can be found in very small countries; Holland s Phillips, Finland s Nokia, Switzerland s Nestlé, and Sweden s IKEA to name but a few. It is often argued in today s world of lower barriers to trade and an increasingly integrated global economy that large companies which can receive benefits of scale are the only way to remain competitive. DISECONOMIES OF SCALE Economic theory allows for the possibility of increasing costs in the long run, i.e. where costs per unit increase proportionately more than the increase in output. Such diseconomies of scale could result from a number of factors. For example, as organisations and firms become larger, the complexities of management might increase and together with an increasing span of control for middle-management, might result in more time involved in decision-making and implementation. This adds to total costs proportionately more 3 Business Week, July 14th, 2003; The Global 1000

5 than to output. There might also arise something called organisational slack, whereby the firm becomes so large that it seemingly lacks real competitors and complacency (= self-satisfaction) sets in, with lower productivity and higher costs as a result. Please note that I have been most careful to use adjectives such as might and could above. Few studies have shown conclusive evidence for the existence of diseconomies of scale, and I personally file diseconomies of scale under Mermaids or Giffen goods. In reality, firms that might outgrow themselves in terms of factor use versus productivity ultimately scale back on production or cut costs in other ways, thereby avoiding diseconomies of scale. Definition: Diseconomies of scale Diseconomies of scale occur when there is a rise in long run average costs due perhaps to communications problems and lack of control in an increasingly complex organisation. LONG-RUN COST CURVES The central theme in short run costs is productive efficiency, which is defined as how efficiently the firm is using all factors of production fixed and variable in producing a given amount of output. This is of course shown by average costs, which fall at first and then rise in accordance with diminishing returns. Optimum productive efficiency exists when the total cost per unit of output is at its lowest. Thus, whereas in the short run AC min would be the measure of efficiency, in the long run we can adjust all factors of production and increase output at a proportionately higher rate than costs. A firm will act in accordance with market demand and estimate whether to increase fixed factors in order to increase output. Figure below looks at the possibility for a firm to lower average costs by increasing fixed factors such as machinery or additional production area. If the firm is producing Q 0 then it would be productively efficient in the short run, since short run average costs (SRAC) are minimised at AC 0. If, however, the firm anticipates that it could indeed sell the quantity Q 1, then it would experience significant increases in average costs as diminishing returns set in, the constraint being the fixed production factors. Therefore the firm assesses options to expand output by increasing certain fixed factors. The estimated average cost of increasing fixed factors is shown by the new short run average cost curve, SRAC 1. It is clear that the increased use of fixed factors new machinery or factory area adds to average costs at the present level of output (Q 0 ), by 50%, i.e. from AC 0 to AC* 0. The firm must move to Q min in order to have the same initial cost per unit of AC 0 and can lower average costs by one third by producing at Q 1, which is the new optimal point of output along the new short-run average cost curve, SRAC 1.

6 Figure Increasing fixed factors the enveloping effect of average costs in LR Costs Costs AC* 0 SRAC 0 SRAC 1 SRAC 0 SRAC 1 AC 0 AC 1 LRAC Q 0 Q min Q 1 Q (SR) Q 0 Q 1 Q n Q (LR) The SRAC curve SRAC 0 shows how additional (fixed) factors lift the constraints of the short run, and assuming that any and all additional capital and other fixed factors are variable in the long run, we get an infinite array of SRAC curves, shown in the right diagram in figure The short run curves are enveloped by the long run curve, or rather, the long run average cost curve is made up of the tangential points of an infinite array of SRAC curves. Note that the assumption of endless SRAC curves means that fixed factors can be increased by minute incremental amounts. Also, any point on the LRAC curve will be equal to or lower than all tangential points on the SRAC curves; the SRAC curves never cross any part of the LRAC as this would mean two possible points on the SRAC curve being equal to the LRAC. The enveloping effect of the LRAC in figure will form an L-shaped or U-shaped LRAC curve. If increased use of fixed factors results in a lower SRAC curve, there are economies of scale or increasing benefits of scale. When additional expansion results in same-level SRAC then costs are optimised yielding constant benefits of scale. This is the LR optimum scale. If SRAC increase this would of mean that average costs are increasing due to the scale of the operation. The firm experiences diseconomies of scale. I always show the upward-sloping portion of the LRAC curve as a dotted line to convey the pronounced uncertainty as to the existence of diseconomies of scale. A rather large body of research points to LRAC curves being L-shaped (from Q 0 to Q 1 in the diagram on the left) rather than U-shaped (Q 1 to Q 2 ) since diseconomies of scale simply are not sufficiently proven.

7 Figure LRAC and economies of scale Costs An envelope for all relevant SRAC curves forms the LRAC curve. Costs The LRAC spans three possible output intervals with increasing, constant and falling benefits of scale. SRAC 0 SRAC n LRAC LRAC Economies of scale Optimum scale Diseconomies of scale Q 0 Q 1 Q 2 Q (LR) MES Q (LR) The L -shaped LRAC curve (Q 0 Q 1 ) is more realistic than the U shaped (Q 1 Q 2 ) On a final Outside the box note, figure shows the minimum efficient scale (MES) at the point where SRAC curves bottom out. Optimum efficiency in the short run is shown by SRAC min, while the long run cost curve has a potential range of constant benefits of scale, i.e. many possible points of long run optimum efficiency levels of output. The MES shows the minimum level of output that is possible in order to obtain long run lowest costs in production. We will return to this Outside the box concept in Chapter 85 when we deal with trade barriers in developing countries. POP QUIZ 2.3.3: LONG RUN AND THE FIRM 1. For what reasons might (internal) economies of scale exist? 2. How might the existence of economies of scale be linked to; a) the increasing size of firms; b) mergers; c) oligopolies; d) increasing trade and globalisation? 3. Using diagrams, explain carefully the difference between diminishing returns and diseconomies of scale. 4. Why is AC used as a measure of productive efficiency? Why not MC?!

8 Summary and revision 1. The long run is the time period for a firm during which all factors are variable. 2. When a firm increases both variable and fixed factors and output rises faster that total costs, average costs fall economies of scale exist. 3. When long run costs rise proportionately to output, there are constant benefits of scale. While unlikely, it is possible that average costs in the long run rise faster than output in which case the firms has hit diseconomies of scale. 4. Internal economies of scale arise due to lower production costs resulting from new technology, sharing of knowledge, spread of admin costs and bulk-buying of raw materials and components; marketing economies of scale such as brand recognition; and financial economies of scale when a firm gets easier and/or cheaper credit. 5. External economies of scale arise outside the firm and are created when a large industry is created and individual firms enjoy a larger pool of (specialised) labour, better communications and infrastructure and possibly related educational facilities for R&D. (Rory; what say you about space and value-added in including diags in the revision part? Is it worth it basically.)