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BUSINESS ECONOMICS

Sessions 7 & 8: COST ANALYSIS - II


2. 2.1 Post Work Learning Objectives to define optimal scale of operation (i) to understand how costs influence plant size decisions of business firms to understand how costs influence the location decisions of the business firms. to understand competitive implications of Economies of scope and Multiplant economies.

(ii)

(iii) 2.2

Summary The focus of this session has been to develop a framework for defining the optimal scale of operation for a business firm. In doing so, a brief review of the SRAC curve and the decision issues at the firm level has been taken up through the analysis of the caselet On the Global Highway. In the short run, the decision parameters of a business firm essentially is in identifying cost minimizing level of output. Cost

minimization can take through improvements in input productivities through improvements in product and process technologies. However, such productivity improvements are often discounted by the high/low transaction costs (i.e. transportation, inventory & other costs). These

issues impinge on the cost minimizing output level and also influence size and plant locations of the business firms.

2.2.1

LRAC and Optimal scale of Operation SRAC curves define the relationship between average costs and output for a specific scale of operation. The Long Run Average Cost (LRAC) defines the relationship between average costs and output under various scales of operation By assuming a number of possible plant sizes, where each plant is slightly larger than the preceding one, a continuous U shaped LRAC curve can be defined. The falling part of the LRAC curve implies that as plant size is increasing average cost of producing a given level of output is falling. This is referred to as Economies of scale. When average costs rise as plant size increases, Diseconomies of scale exist. The minimum point of LRAC is the optimal plant size and is referred to as Minimum Efficient Scale (MES). The optimal plant size (or MES) is defined with respect to the market size or demand. If the MES is small relative to the market size, this implies that a number of optimum size plants can operate thereby rendering the market structure to be Competitive. However, if the MES is large relative to the market size then only one optimum size plant can operate thereby rendering the market structure to be noncompetitive or Monopoly.

2.2.2

LRAC and Plant size decisions (SRAC) Conceptually, the LRAC is the envelope of SRAC curves. Each point on the LRAC curve defines the scale of operation for a given market demand. This, in turn, corresponds to a specific SRAC curve

wherein the firms decision is to identify the cost minimizing output level. Under expanding market demand conditions and when Economies of scale are present, a firm operates under excess capacity conditions in a bigger size plant. As against this, when diseconomies of scale present a firm installs a smaller plant and operates on the rising part of the AC curve.

2.2.3

LRAC and Plant location decisions A business firm can have one or more number of plants for its production activities. A bigger size plant far away from the market would involve transportation costs, inventory costs, higher transit time etc. As such per unit of transaction costs will rise with

output/distance. The implication of this would be lower MES (Q*B instead of Q*A). In general, when transaction costs are large relative to production costs as in the case of milk, bottled soft-drinks, cement small size plants (through inefficient) closer to the market are a better option than highly efficient and large plants that are far away from the market.

2.2.4

Economies of scope and Multiplant economies Economies of scope exist when the cost of jointly producing two or more products is less than producing each separately. Identifying economies of scope become important for a firm to consider both the direct and indirect benefits associated with individual line of business. Scope economies are also important for a firm to translate a superior skill into unique competitive advantage. For example, Pepsi Co has been a leader in soft drink market. Over time the company has broadened its product base to various types of soft drinks, fruit juices (by acquiring Tropicana), cookies and various snack foods. Today, Pepsi co is no longer a soft drink company but a diversified beverage and snack food company. Similarly, the

diversification of Reliance from polyester to petrochemicals and into telecom is also an example of exploiting economies of scope. Related to this is multiplant economies that operate from operating multiple facilities in the same line of business or industry, i.e. multiplant operations are cost efficient compared to a single plant operation. The sourcing of important inputs from different locations as also outsourcing some production activities to cheaper locations are some of the examples of multiplant economies. 2.3 Readings Text Book: Chapter 8

2.4 1.

Learning Activity (a) Why is the long run often referred to as the planning horizon while the short run is called the operation period? What is the relationship between the two concepts?

(b) 2.

Under what condition would the firm build a plant that does not minimize the cost of producing a specific level of output in the long run? What shape of the LAC curve has been found in many empirical studies? What does this mean for the survival of small firms in the industry?