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Discuss whether economic analysis favours large firms over smaller ones.


This paper argues that economic analysis, on the one hand, favours large firms because they are able to reap economies of scale, with all its implications on costs, prices, and profitability, but on the other hand diseconomies of scale might pose an issue and other economic reasons might also favour small firms over larger ones.

First, it can be argued that traditionally economic analysis favours large firms. This is because of the fact that they can reap internal economies of scale. Internal economies of scale are cost savings that accrue directly to the firm from the expansion of the firm's output, independent of what is happening to other firms. As the firm increases its scale of production by producing more output, the LRAC falls accordingly. On an economics diagram, the falling portion of the firm’s LRAC reflects internal economies of scale. A large firm producing at a larger level of output will be able to benefit in the form of enjoying a lower average cost as compared to a small firm producing at a lower level of output with an average cost higher than the large firm. 

What economics diagram could/should be drawn here?

The lower average cost that a large firm enjoys can be derived from various sources. For instance, when a large firm is able to reap more internal economies of scale, consumers may benefit in the form of lower prices if firms pass on their cost savings. Many oligopolies pass on the benefits of lower costs onto their consumers. Firms may also use the cost savings to carry out research and development (R&D) to improve on their production processes, which can bring down the cost of production and eventually be passed on to consumers in the form of lower prices, or improve on the quality of the goods sold, improving the welfare of consumers.

Large firms are able to earn supernormal profits in the long run as compared to small firms like that of a monopolistically competitive firm. The large firms’ supernormal profits are protected by high barriers to entry, making it difficult for potential firms to enter the industry. This means that large firms will have a higher financial ability to carry out R&D that can benefit consumers as explained previously. This often results in dynamic efficiency, the willingness and ability to innovate and improve processes over time, and as Joseph Schumpeter once said results in "creative destruction", the creation of new, novel, and disruptive technologies and products, just like the iPhone came to dominate the market and displace many other cellphone models, like Nokia. And in contrast, small firms may not have the financial ability to do so since they can only earn normal profits in the long run, which means that they have neither willingness nor ability to conduct R&D. In business terms, these small firms may therefore be forced out of business. 

On the other hand, economic analysis does not always favour large firms, and in fact sometimes may favour small firms. One reason could be due to internal diseconomies of scale. This happens when a firm expands beyond its optimum size. In theory, a firm that expands beyond its MES (minimum efficient scale) will start to face diseconomies. There are many reasons for this. First, this could be due to managerial diseconomies. As the size of the firm increases, it becomes increasingly difficult to carry out the management functions of co-ordination, control, and the maintenance of morale. Large firms may then pass on this higher average cost in the form of higher prices, and this would not be advantageous to consumers. In some industries, diseconomies of scale set in early, meaning that the MES is low and internal economies of scale is exhausted quickly. As such, costs rise sharply as output increases. Any advantage to large-scale production is more than offset by the disadvantage. The optimum size of firms in such industries is small. Therefore it can be convincingly argued that there are many reasons for diseconomies of scale - but in this paper's opinion, the most important factors are managerial diseconomies, or the nature of the industry is such that small firms are favoured in a particular industry. 

Furthermore, economists should consider demand-side or revenue-side factors, not just cost-side factors. The demand for a particular firm's output may be low, thus leading to the situation where the firm has to be small by its nature. The total demand, both domestic and foreign, for the firm’s output may be small because the firm is selling a niche product. Such a market may be limited by price. This is true for distinctive products like luxury sports cars such as Lamborghini, exclusive clothing such as Gucci and Prada fashion, and high quality jewellery, where only a small group of customers are willing and able to pay for the element of uniqueness and prestige.

Furthermore, if the product has great bulk in relation to its value or requires special transport arrangement, the transport cost will be high relative to the unit price. Under such circumstances, the market for such products is likely to be local rather than national.  

Another reason for firms remaining small could be the need to cater to consumer’s specific or individual requests. In this case, due to the varying nature of such requests, the size of production unit tends to be small. Thus, firms providing services in the area of law or repair services tend to be small. For instance, as cars do not break down in exactly the same way, the ‘non-standardised’ services make mass production of repair services impossible.

In the final analysis, since large firms’ supernormal profits are protected by high barriers to entry, this lowers the firm’s incentive to engage in R&D and become dynamic efficient since there is little chance for new firms to enter the industry to erode away its supernormal profits earned. This will in turn have implications on consumers as there will be little improvements to the quality of goods. As such, large firms may not always be favoured. On the contrary, small firms like a monopolistically competitive firm may have the incentive to engage in R&D since firms making subnormal profits will be the first to leave the industry. Hence, in order to ensure long-term survival and the possibility to earn supernormal profits in the short run, they will have the incentive to innovate. Therefore, it can be argued that while the argument for internal economies of scale seems to favour large firms, small firms can and often do coexist with large firms.

JC Economics Essays - This economics essay is on the traditional economics debate on the size of firms - does size matter? Does analysis favour large firms over small firms, or does it really depend - and what does it depend on? On the one hand, what are the good points of having firms large? On the other, are there situations where it would be better to have small firms? Why is this the case? Do think through your approach after reading this suggested essay. Special thanks to B for his contribution to this economics blog. Thanks for reading and cheers. 

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