Since large firms enjoy EOS, they are therefore more efficient and should be welcomed by society. Do you agree? [25]
Economies of scale (EOS) refers to the cost savings derived from large scale production of the firm. EOS can be generated internally or externally. If the average costs decrease due to the increase in the scale of production of the firm itself, we say that the firm experiences internal EOS. EOS allows efficiency to be achieved. To be economically efficient a firm has to achieve productive and allocative efficiency. Productive efficiency refers to the least cost method of production. Allocative efficiency on the other hand, occurs when the right amount of the right kind of goods are being produced. This occurs when the marginal social benefit is equal to the marginal social cost, society welfare is thus maximized. On top of that, Pareto efficiency also has to be achieved. Pareto efficiency is when it is no longer possible to change the allocation of resources such that it makes at least one individual better off without making any other individual worse off.
Large firms are firms usually classified as oligopolistic or monopolistic firms. An oligopolistic market occurs where the industry is dominated by a few large firms which control a large proportion of the industry’s output. These firms have a large share of market power. Similarly, in a monopolistic market, there is market dominance because a single firm controls the whole supply of a product which has no close substitutes. As a result of the large market share, profits gained from production will allow these large firms to achieve efficiency through EOS. As long as these EOS can be filtered down to consumers in terms of lower prices and higher output, I agree that because large firms enjoy EOS, they are therefore more efficient and should be welcomed by society.
A firm enjoys internal economies of scale if its average cost of production falls as its scale of production increases. This is represented by a movement along the downward sloping portion of the Long Run Average Cost (LRAC) curve. Average cost refers to cost per unit of output. This is illustrated in the figure below.
Insert Economics diagram - thinking question: what will this economics diagram look like?
A large firm can enjoy internal economies of scale through marketing economies. This occurs when a firm gets bigger and it buys inputs such as raw materials in bulk. Suppliers of these inputs, in their eagerness to secure the firm’s orders, will often offer a discount on its purchase. This lowers the firm’s unit cost of production. A firm can also enjoy marketing economies when it enjoys the ability to spread its advertising costs. Since a bigger firm produces more output, its total advertising cost is spread over a large output, thus unit cost is reduced. Such large firms can also enjoy EOS through financial economies whereby larger firms may be able to obtain financial loans at lower interest rates due to more credit worthiness. It can also raise funds in the capital market by issuing shares to member of the public. Moreover when a firm expands, it is also able to hire professionals to specialize in different areas of work. Different departments can be set up, each led by an expert in the field. With these expertises, a firm’s output can be increased, thus lowering its unit cost of production. This may not be worthwhile or economical for a smaller firm. This is known as managerial economies of scale. As such EOS allows for large firms to be more efficient as they get to reduce costs of production, achieve a minimum efficient scale (MES) and be more productively efficient. This will eventually result in costs savings passed on to consumers in the form of lower prices for the goods and services provided.
However, in the case of a natural monopoly, society has no choice but to welcome it into the market. A natural monopoly occurs when a tremendous amount of capital is required to produce a product or service. This leads to very large economies of scale and the firm’s MES occurs at a very high level of output, such that there will only be one firm in the market. This huge capital requirement means that total fixed costs make up a very large part of the total cost. Such examples of a natural monopoly would include producers for utilities such as gas, water and telecommunications. In the case of Singapore, the telecommunication lines are monopolized by Singtel. Although a natural monopoly is allocatively inefficient in P=MC pricing, where the cost of the good is equal to the marginal cost of producing a good, it is definitely more efficient than trying to duplicate the number of firm through liberalization. This is because the new entrant will eventually collapse to form a monopoly again because the duplicity of firms would cause the new entrant to incur large losses. As such, society would still accept such natural monopolists in the industry. This can be depicted by the existence of Singtel.
However, society should not welcome such large firms because there are disadvantages of EOS when it is being reaped beyond MES. These are internal diseconomies of scale (disEOS). Internal diseconomies of scale are the cost disadvantages a firm experiences as it increases its scale of production. When a firm becomes too large, its average cost of production rises as its scale of production increases. This is represented by a movement along the upward sloping portion of the LRAC curve. Internal disEOS are largely managerial inefficiencies. This can arise from the increase in complexity in management and greater difficulty in co-ordination in a large organization. A firm grows so large that it becomes more cumbersome to manage. It becomes more bureaucratic and decision-can also making process slows down. Work efficiency can be reduced by excessive paper work which results in low productivity and higher unit cost. Management problems of co-ordination may also appear as the organisation of the firm becomes too big. It becomes increasingly more difficult for top management to co-ordinate and monitor all operations, thus inefficiency may creep in. This increases unit cost.
Insert diagram - how will this economics diagram look like? Remember now that it is about disEOS rather than EOS.
Society should also not welcome such large firms because these firms tend to be monopolies. Monopolists experiences static inefficiency, or a lack of dynamic efficiency. Static efficiency is attained when there are both productive and allocative efficiency. The monopolist is productive efficient as long as it maximises profits. However, a profit maximising monopolist produces output up to the level where P>MC. Since consumers value the last unit of the good more than it costs to produce, the good is underproduced and increasing the output can increase the welfare of the consumers. The underproduction of the good has led to the loss in welfare for the society. This can be illustrated in the diagram below.
Insert economics diagram. Apply usual thinking!
As such, under similar cost conditions, the output produced by a single monopolist is lower and the price charged higher than the perfectly competitive industry. The perfectly competitive industry will produce where demand equals to supply, at output Qpc, and charge a price Ppc. However, the monopolist would produce at Qm, and charge a price equal to Pm.
Moreover, society should not accept large firms because there will be an unequal income distribution. This is because the monopolist can earn supernormal profits even in the long run due to barriers to entry. If a monopolist makes supernormal profits, these profits will go to shareholders who may be mainly upper income earners, This may worsen the income distribution in the economy. The existence of supernormal profit suggests that producers receive greater income than is needed to induce them to undertake their operations. The lack of competition enables them to receive higher profits than is economically justified. Thus income is more unequal than it needs to be.
In conclusion, large firms who enjoy EOS are accepted in the economy but too much of it will be non-beneficial for the industry. Hence, to ensure that society benefits equally, government intervention is needed where policies such as AC-pricing and taxation of profits are carried out.
JC ECONOMICS ESSAYS: Tutor's Comments: A very good attempt! Covers the majority of the points needed to tackle this exam question. This model Economics essay was written under "A" level Economics examination conditions. Economics tutor's suggested grade: 20/25. How would you improve this essay, and how would you approach the task of crafting a well argued, nuanced, balanced, and evaluative Economics answer? Perhaps the evaluation in the conclusion could be better, more argumentative, and more justified with relevant examples. Thanks for reading and cheers. Stay here for more Economics essays and materials.
