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. 

Since large firms enjoy EOS, they are therefore more efficient and should be welcomed by society. Do you agree? [25]

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.