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. 

Discuss, using examples from the United Kingdom, whether high levels of research and innovation are best achieved in competitive compared to monopolistic markets. (25 marks)

This Economics paper argues that high levels of research and innovation are best achieved in monopolistic markets, compared to competitive markets, because dynamic efficiency is best achieved when companies have the willingness and ability to conduct costly research and development (R & D).

First, what is dynamic efficiency? Dynamic efficiency means that companies can invest in education, research, innovation, and other creative processes that help them increase their efficiency over time, and in the long run will help them earn supernormal profits above opportunity costs and explicit costs. Competitive markets are markets with low barriers to entry, and can be idealised using the model of perfect competition.

What is perfect competition? Perfect competition is the market structure where there are many buyers and sellers of a single homogeneous product with perfect substitutes, low barriers to entry, suggesting that they earn normal profits in the long run, and where there is perfect information.

This is in contrast with monopoly, which in theory is a firm that sells a product with few close substitutes, with high barriers to entry, and which thus earns supernormal profits in the long run.

It can be argued that competition might not lead to research and development. Taking perfect competition to benchmark competitive firms in the UK, because they earn normal profits in the long run, they have neither the incentive nor the willingness to invest in research and innovation. For instance, small shops along the streets of London, especially monopolistic competitive firms, will not engage in research. 

However, having said that, if these firms are able to borrow from capital markets or get funding, or perhaps even due to external events causing temporary supernormal profits due to changes in demand and supply, they could have the willingness to invest in innovation so that they can because more “monopolistic”, when they produce a highly differentiated product.

It can be argued that monopolistic markets have firms that earn supernormal profit, because of their high barriers to entry. They therefore have both the ability and willingness to innovate to keep their monopolistic position. First, they have the ability because they earn supernormal profits, and can allocate massive funds to R&D. Second, they have the willingness because if they are in monopolistic markets that could potentially be contested by more efficient firms that could displace them to take over their market, they need to innovate to maintain their long term dynamic efficiency. 

For instance, Rolls Royce which manufacturers engines and aeroplane systems is a dynamic company probably because it has incentive and ability to innovate. BAE Systems plc is also another such company, and in fact both Rolls Royce and BAE are multinational companies, companies that span international borders with their unique product chains that require high levels of research and development. In fact, it can be said that some monopolies are monopolies because they have developed a product that is unique, differentiated, and wanted by consumers.

However, having said that, on the other hand contestable markets are usually perfectly competitive or competitive in nature, and as such competitive markets could help dynamic efficiency better in that respect. Thus competition might also lead to research and innovation, but the level could be lower than that of monopolies that have incentive and ability to do research and innovation.

Also, there are problems with monopolies. It can be argued that monopolies sometimes have x-inefficiency, where they do not act energetically to curb costs, and they could therefore become slothful and inefficient firms. This is because they may preserve their position through the use of patents, laws, legislation, and other legal means that have nothing to do with their level of technology or the sophistication of their product.

In the final analysis, this paper argued that high levels of research and innovation are best achieved in monopolistic markets, compared to competitive markets, because dynamic efficiency is best achieved when companies have the willingness and ability to conduct costly research and development, even though there are indeed some limitations to monopolies such as x-inefficiency. Competitive markets may have the incentive to conduct some research, but their levels are lower, and most of the time they neither have willingness nor ability due to the lack of barriers to entry which ensure supernormal profit. 

JC Economics Essays (H2, H3 A levels): Economics Tutor's Comments - This Economics paper on research and development and comparison of monopolistic and competitive firms was crafted under model examination conditions and has a few good points that one can learn from, but also some problematic areas, such as simplistic analysis and lack of many other relevant examples from UK manufacturing or service industries. Do think: if you were an Economics tutor, what advice would you give this student to help him make the Economics essay better? Perhaps you could focus on an area of improvement, such as the structure or organisation of this essay. Think of how this Economics paper could be made better. Thanks for reading and cheers!

Compare and contrast the various types of economic efficiencies. [10]

Compare and contrast the various types of economic efficiencies. [10]

The fundamental economic problem is a problem of scarcity, necessitating choice. This is because human wants are potentially unlimited, but resources are limited, and hence choices have to be made, “efficiently”, between competing uses for the same resources. The scarce resources, or factors of production, are land, labour, capital, and entrepreneurship. Land refers to resources, gifts of nature, and other natural factors. Labour refers to human effort and work. Capital refers to any good that can be used to produced another good. Entrepreneurship refers to risk-taking, organisation, and business acumen, among other things. It can be said that efficiency is concerned with the optimal production and distribution of society’s scarce resources. This economics essay compares and contrasts the various main types of economic efficiencies – productive efficiency, allocative efficiency, dynamic and static efficiency, X-inefficiency, social efficiency, and Pareto efficiency.

Productive Efficiency

First, productive efficiency occurs when the maximum number of goods and services are produced with a given amount of inputs. This will occur on the production possibilities curve or production possibilities frontier (PPC or PPF), meaning that any point along the PPC will be productively efficient. On the PPC, it is impossible to produce more goods without producing fewer services. Productive efficiency will also occur at the lowest point on individual firms’ average cost curves (AC curves). This is because productive efficiency can be thought of as the method of least cost production, which means that production costs are minimised. Productive efficiency is not the same as the other types of efficiencies.

Think: how would you draw the PPC?

Allocative Efficiency

Second, allocative efficiency occurs when goods and services are distributed according to society’s preferences or when they are allocated in accordance with maximising society’s welfare. An economy could be productively efficient but produce goods that people that do not need, and this would be allocatively inefficient. In other words, allocative efficiency is a subset of productive efficiency, where productive efficiency is a necessary condition of allocative efficiency. (A necessary condition is a condition for some state of affairs that must be satisfied before the state of affairs can be obtained.) It should be noted that allocative efficiency occurs when the price of the good produced by a firm equals the marginal costs of production.

Dynamic Efficiency

Third, dynamic efficiency refers to efficiency over time, whereas static efficiency refers to efficiency at a particular point in time. The first concept has the element of time taken into consideration whereas the other does not consider time. Dynamic efficiency involves the introduction of new technology and working practices to reduce costs over time, whereas static means “at a fixed point in time”. Basically, this concept of dynamic means that there are changes over time whereas static means that time is held, as it were, frozen.

X-inefficiency

Fourth, X-inefficiency occurs when firms do not have incentives to cut costs. This is usually associated with monopolies, which usually pursue rent-seeking behaviour rather than think of how to lower costs. For instance, a monopoly which makes supernormal profits may have little incentive to get rid of surplus labour. Therefore, a monopolistic firm’s average costs may be higher than necessary.

Social Efficiency

Social efficiency occurs when externalities are taken into consideration and occurs at an output where the social cost of production (SMC) = the social benefit (SMB), or alternatively, the marginal social costs (MSC) = the marginal social benefits (MSB). This is closely related to both the concepts of allocative and Pareto efficiency, also known as Pareto optimality. Pareto efficiency or optimality is defined as a situation where it is not possible to make one party better off without making another party worse off. Hence, Pareto efficiency is socially efficient and also allocatively efficient, at society’s level.

Conclusion

In conclusion, there are many efficiency concepts in Economics and it is important to understand economic efficiency. Many of the concepts are related and can be understood in relation to each other.

JC Economics Essays – Tutor’s Commentary: This is a good introduction to the various “efficiencies” that Economics has to offer, not just at ‘A’ levels, but also at O, AS levels and introductory undergraduate Economics as well. ‘A’ level Economics can be quite esoteric, it is true, and this Economics material might seem difficult. Think positively instead: how could you make this Economics essay comprehensible and easily understood by you? Let’s do some counterfactual experiments here. Put yourself in the role of the Economic tutor, the examiner, or the lecturer, and you were marking this essay paper. If you were an Economics tutor, how would you judge this essay? What were its strengths and weaknesses, and why do you think – as a professional Economics tutor – those parts of the Economics essay were strengths or weaknesses? Thanks for reading, all the best and good luck!