Desirability give firms view, consumers view, and societys view. See remedial exercise 2.

Do SR notes on top

Def: LR: time period where all factors of production can be varied, except level of technology.

Long run average cost curve shows how average cost varies with output. (u shaped with axis: cost
and quantity. Label MES and do a doted divider and label iEOS and IDEOS). As output rises, at first
average costs fall because of large scale pdn advantages. The rising part of the lrac curve reflects
average costs increasing due to internal diseconomies of scale (happens when firm expands beyond
optimum size).

Minimum efficient scale: Achieved when long run average cost is minimum (lowest point on lrac). It
is the optimal plant size or output level beyond which no additional economies of scale can be
achieved.

Def: economies of scale are cost savings due to increase in pdn (either through firms expansion or
industry expansion).

Def: iEOS are the savings in cost that occur as a result of firms expansion, and have been created by
the firms own policies and actions.

Types of iEOS

Technical Economies

- Specialisation and division of labour

As the firm increases in size, it becomes possible to employ the principle of division of labour
to an increasing extent. Thus, the larger the scale of production is, the greater the scope of
specialization of both labour and machinery. By performing the same actions repeatedly, a
worker becomes very skilled and can perform with speed and dexterity. If production is
broken down into many different stages, machine can be designed specifically for each
stage.

Example: This process is clearly seen in a modern car assembly plant, where many of the
different stages in assembly are completed by computer-controlled machines. Hence, such
mass production techniques have helped to cut down unit costs of production.

Counter (for essays where you are asked the advantages of being a large firm. Even when
you just happen to mention these iEOS, you can mention the counter to give you
evaluation marks etc): Monotonous work. Might lead to mistakes on the part of worker and
lower productivity so AC increases.

- Indivisibility of Machinery (large scale machinery)

 Modern machinery is efficient and usually has high productive capabilities. They are suitable
for large firms whose output levels are high. Increased usage of such machinery in its
production process will have its AC of production decrease as output increases. This is
because the cost of the machinery, which is a sunk cost, is spread over a higher quantity of
output. It is, however, uneconomical for a small firm, whose output level is low, to employ
such modern machines. It would be a waste if the small firm cannot use the machines to full
capacity. Hence, only firms with large scale pdn can take advantage of such technical
benefits.

Example: Large office photocopiers more efficient than small copiers used at home.

Counter: Over dependent on machinery so have to face inconvenience when machinery fails.
Machinery very costly and have high maintenance costs. Furthermore, require specialise staff to
operate machinery.

Marketing economies

- Bulk buying

A large firm has greater bargaining power as it buys in bulk. Also lower overhead costs such
as transportation costs as they are done in bulk.

Counter: Poor quality control, storage costs

- Advertising
In selling a large volume of output, the firm may be able to use more expensive but more
cost-effective advertising. Advertising cost can be spread over a large volume of sales. A firm
with a nationwide market can afford to advertise in the papers and TV to bring its product to
the notice of potential buyers whereas a small firm may not have the capacity to advertise.
Though such firms may spend large sums on advertising, their advertising costs per unit sold
may be well below those of a small firm.

Counter: Gets consumer awareness but not consumer purchase so there is unnecessary
spending.

R&D

Greater ability to carry out R&D to make innovations, find cheaper and more productive pdn
processes and improve present products. It can enjoy such benefits as the cost can be spread out
among the greater output.

Counter: Rival firms can take the product produced and devise a method of producing a similar
product or even improve on it. Furthermore, even if a particular product in patented, replication is
possible. To obtain a patent, a firm must file detailed information about the invention which
becomes public information. This information can enable the rival frim to clone the product in a
way that does not infringe on the patent.
(Hence, if the rival firm can free-ride on the investments made by the first firm such as various
research projects to develop the new product, the second to introduce the new product can yield
higher payoffs than the first mover. This permits the second mover to produce at a lower cost than
the first firm. In addition, a second mover may gain an advantage as it can learn from the first
movers mistakes. In this case, the second mover may be able to produce a better product at a lower
cost than the firm that moves first. The abovementioned is a typical second mover advantage.
TRANSFER this to other sets of note and say link to the above counter. This can be used to say the
disadvantages of R&D and also why firms in oligopolies and monopolies may be less willing to
innovate due to late mover and second mover advantages.)

*When talking about a specific type of iEOS or eEOS such as technical economies always substantiate
with examples to enhance your point.
*Draw a LRAC curve and say that all the above sources of IEOS result in a downward movement
along the LRAC curve as shown above. Mark two quantities and their corresponding prices and say
average cost is lowered from C0 to C1 as output rises from Q0 to Q1 due to expansion of firms.

iDEOS happens from enlarged scale of production when a firm expands beyond its MES, whereby the
large firm faces a rise in costs as it expands its scale of production.

Complexity of Management

As firms grow in size, management of firm becomes more and more difficult, hence reducing
productivity levels within the firm and raising unit cost of production. For example, a long chain of
authority can lead to time lags for example in implementing decisions and responding to rivals
actions leading to losses.

Lack of personal element

Due to lack of personal element as firm expands, workers might have low morale leading to less
productivity. Moreover, bulk of responsibility on managers so workers might lose motivation and be
less productive.

Diseconomies of standardisation

Mass pdn, so lack of variety and cannot cater to individual preferences therefore firms can lose
some of its business.

Show that these sources if IDEOS lead to a movement up along the LRAC, raising the unit costs of
production for the firm, despite a rise in output levels.

*Firms do not need to grow in order to enjoy cost advantages as a firm can experience cost
advantages even if its output remains unchanged, this happens when the entire industry expands
(EEOS)

External Economies of Scale (EEOS), which is defined as a decrease in long run average cost to firms
in an industry as a result of the expansion of the industry or the concentration of firms in a certain
location. As a result, the LRAC curve for each and every firm will shift downwards and holding total
revenue constant, each of these firms will now enjoy greater profits.

*Whole LRAC curve shifts downwards, reducing average cost at each and every level of output. Firms
enjoy eEOS regardless of size

Economies of concentration

- Mutual benefits: 1) pool of skilled labour can be developed reducing the need for individual
firms to train its own workers. AC per unit falls. 2) Lower overhead costs per firm as they can
pool together to build and maintain infrastructure to cater for the industry.

Economies of disintegration

When industry becomes larger, it is possible for individual firms to specialize in specific processes in
the manufacture of a commodity or in the production of a particular variety of a commodity. Such
specialisation allows the subsidiary firms to produce at a larger scale and therefore enjoy greater
iEOS.

Firms can sell their by-products to specialized firms who can convert them to useful products which
helps to cover up some of the cost of production.

Economies of Information

R&D and advertisement can be done on an industry level displacing the need for individual firms to
do so. Moreover, if the industry is large enough, the government such facilities. This helps to cut
down costs of individual firms and so lower their LRAC.

Revenue Benefits (not eEOS as it does not reduce costs, but an additional advantage due to
expansion of industry)

When the industry expands, especially if there is concentration of similar firms in one area, it will
help to create a reputation for the industry. This will increase brand loyalty and also increase the
demand for the firms. This leads to an increase in revenue and profits of the firms, ceteris paribus.

eDEOS: Increase in long run average cost that occur to firms in an industry due to expansion of
industry or the concentration of firms in a certain location.

- Higher input costs. As industry goes larger, there might be shortages of certain inputs. Factor
input prices such as labour may rise due to increase in their demand. Bargaining power of
trade unions will increase, and will negotiate for even higher wages.
- Overconcentration of firms causes inefficiency. For example traffic jams results in loss of
man hours leading to increased costs of production. Increased pollution can translate to
higher health benefits payments to worker leading to further increased costs for firms.
Show how a firm can incur lowered costs from C0 to C1 despite not growing in size (so quantity of
both points would be the same but the cost of one point would be lower than another in the graph),
as seen from a downward shift of the LRAC.

*When given a particular industry in a question, make sure while talking about a particular eEOS you
give examples related to the industry required.

Distinguish between internal and external eos

Internal EOS External EOS

1) Benefits individual firm only
2) To enjoy such benefits the firm must
increase output in L.R. (i.e. increase scale of
production)
3) Graphically represented by downward
movement along LRAC
4) Follows a sequential order based on Law
of Returns to Scale
Internal EOS happens
first(then)Followed by Internal
Diseconomies of Scale
5) Sources of EOS explain two
-technical economies etc.
1) Benefits all firms in the industry
2) Such benefits occur when the industry
expands as a whole (more firms enter
industry)
3) Represented by downward shift of LRAC
4) No sequential order. Either Ext. EOS or
Ext. DEOS
Can happen first
5) Sources of EEOS
-economies of conc. Etc.
(when illustrating that firms need not expand to enjoy cost reduction, choose a quantity and see the
two point of intersection with the lrac and bring the dotted lines to the cost. In the essay, as shown a
firm that has an output level Q1 enjoys a reduction in costs from P1 to P2.)

Add in graph for IEOS.

Question 2

a) Explain how economies of scale determine the market structure in which a firm
operates in the real world. [10]
Introduction
Define economies of scale (EOS) & provide some examples
Relevant market structures in real world are monopolistic competition, oligopoly and
monopoly

Link to market structure

EOS exist in all industries, but the extent to which it is present in the real world varies
from industry to industry, from few to substantial
EOS forms a barrier to entry as new firms with relatively low output cannot fully
exploit EOS, hence its costs are higher than existing firms, and so it cannot
successfully compete with them on price
EOS also determines the minimum efficient scale (MES) of firms in the industry, the
lowest output at which LRAC is minimum
Hence industries with EOS likely to have fewer firms: more EOS -> higher barriers to
entry & larger MES relative to size of market -> fewer, larger-sized firms -> greater
market power (spectrum of monopoly > oligopoly > monopolistic competition)
In the extreme case where there are substantial EOS, the industry qualifies as a
natural monopoly (e.g. public utilities), such that it only makes economic sense for
there to be one firm in the industry as long-run average costs would be lower than if
the industry were shared between two competitors
On the other hand, industries with few EOS (e.g. services requiring personal
attention such as house renovation and hairdressing, where standardised production
allowing cost savings is difficult) would likely be in monopolistic competition

Conclusion
The exact market structure within which a firm operates would depend on the type of
good or service as well as the overall size of the market, with monopolies more likely
in small markets and industries with substantial EOS
Firms can choose to grow in size in 2 main ways i.e.

(i) Organic growth internal expansion OR moving into new markets

(ii) Mergers & Acquisitions

i) cost advantage: reduction in unit cost of production (AC) due to the ability to
reap internal economies of scale (IEOS) in the case of the expansion of a firm. In
question for why firms choose to grow or like advantages of large firms, when
you mention this always explain 2 types of IEOS if have time.

Anti-thesis to this would be iDEOS.

Further point to serve as evaluation. Firms also do not need to grow in order to
have cost savings. Cost savings can occur in a firm even if its output remains
unchanged, this happens when the entire industry expands (EEOS). (Elaborate on
two different eeos). Thus small firms can still enjoy cost reductions without
needing to undergo internal expansion.
Growth

Evaluation for large firms vs small firms: Though large firms experience cost savings due to
substantial economies of scale, firms often have to take loans to sustain the large-scale
production. For example, large firms require greater amount of capital (machinery) and do more
advertisement as compared to small firms. If the machinery fails or if advertisement only gets
consumer awareness as mentioned earlier, the firm would suffer huge losses. Moreover, can
suffer diseconomies

Another point to note is that firms may also not experience cost advantages with an enlargement of
their scale of production. This happens when costs remain constant as the firm expands its scale of
production, i.e. under constant returns to scale.

Enlarging scale of production may not lead to changes in AC (constant costs)

Theoretically, firms may also experience constant costs as they expand their scale of production. This
usually happens when firms are experiencing constant returns to scale, whereby output increases
proportionately to increases in its inputs. Under such circumstances, the growth of firms does not
necessarily bring about cost advantages since costs can remain unchanged.

Moreover in such situations where firms become concentrated in a location, small firms can enjoy
economies of scale from bulk purchases as well. This is so despite their small scale of production as
there are opportunities for them to band together to enjoy costs savings from bulk purchases.

*The amount by which price exceeds marginal cost depends on the number of firms in the industry
as well as the degree of product differentiation. (true for any mkt structure. Number of firms, and
degree of pdt differentiation determine steepness of demand curve which in turn determines price.
TRANSFER to other notes but also link to the growth/large firms).