How Do Economies of Scale Come About - Assignment Example

1. How do economies of scale come about? How might economies of scale offer a competitive advantage to a business? Scale economies refer to the decreases in the long run average cost of production for each produced unit resulting from an increase in the scale of production enjoyed by firms. In the diagram above, as the firm raises its scale of production reflected in a rise in the output from Q1 to Q2, the associated long run average cost per unit falls to C2 from C1. It is pertinent to note that these are significantly different from increasing returns, which are in essence reflected in falling short run average costs due to expanding production within existing capacity. This is thus a short run phenomenon while scale economies are a long run phenomenon as they involve increasing existing capacities. A firm irrespective of its size can enjoy scale economies by simply expanding its scale of production. The act of expansion entails certain factors which cause the decline in long run costs. The common sources of scale economies are – bulk purchasing, managerial efficiencies, financial efficiencies, and marketing advantages. When a firm is involved in bulk buying of raw materials through long term contracts, the inputs are likely to be obtained at lower costs as vendors are likely to provide certain discounts and rebates on bulk purchases and these shall lower the long term costs for the firm per unit of output. Similarly when a firm borrows large from banks or other financial institutions and on longer terms it is likely to be given certain benefits which shall lead to comparatively lower overall interest burden and thus lower long run costs. Again when a firm expands its operation and divides the entier process under the perview of an increased number of managers hired for the purpose that shall give rise to managerial efficiencies which shall lead to reduced long run costs through efficiency reflected in right ward shifts of the short run average total cost curve (SRATC). Expanding shall entail certain marketing benefits as well for a firm. For example if a firm increases the number of goods produced or increases the variety of the product, fewer advertisements can serve to inform the consumers about each product instead of having to involve in advertising for each product separately. As a result long run average costs fall. However these are referred to as internal economies as they are derived from the firm itself expanding. Sometimes a firm benefits in terms of lowered costs resulting from expansion of the industry as a whole. Such scale economies are reffered to as external scale economies. Often expansion of industries leads to cheaper availability of resources like labour for ever member firm of the industry.This would be an instance of external scale economies. For a firm thus enjoying scale economies degree of competitiveness is greatly enhanced. The presence of internal scale economies allows a firm to reduce prices and still enjoy high profits as it faces lower costs compared to its rivals. This raised profitability is one source of competitive advantage. Again this improved profitablity allows firms to invest larger funds for research and development activities which can again lead to better and more efficient products thus creating another source for competitive advantage. So the presence of such scale economies make firms potentially more competitive both in terms of prices as well as quality, the two most important parameters for gaining competitive advantage. 2. How are changes in the equilibrium price and quantity in an industry influenced by the elasticities of demand and supply? How might shortages and surpluses occur in the short run and the long run? Elasticities and Equilibrium The equilibrium price and quantities in an industry is determined through the intersection between the industry demand and industry supply curves. In the diagram P* and Q* represent the equilibrium price and quantity implying that when the industry asks for a price P* per unit of its product the amount it is willing to supply at that price is exactly the amount consumers are willing to purchase from the industry at that price and thus the market clears. The price elasticity, which measures the responsiveness of demand or supply to changes in price, plays a very important role in determining the new equilibrium if there are shifts in the demand or supply curve. Consider the following example. Suppose the industry demand shifts to D1. If, the supply curve is moderately elastic (Industry supply), then the equilibrium price moves to Q*1 and the corresponding equilibrium price becomes P*2. However if the supply curve were to be more elastic as S1, the equilibrium quantity would have been higher (Q1) and the price rise would have been smaller (P1) as the responsiveness of the supply to price changes was more, for a small hike in price the Producers would be willing to sell relatively more goods. Similarly for a less elastic supply, as they would be willing to increase their sales by a smaller amount for a larger price hike. Again for a supply shift, the elasticity of demand would play a crucial role in determining the magnitude of shifts in equilibrium price and quantity. As is evident from the diagram, if the demand curve is elastic (D2), implying customers are quite sensitive to price changes, then the hike in supply causing a relatively smaller fall in prices ( P* to P2) shall lead to a large increase in demand along the demand curve leading to Q2 becoming the equilibrium quantity. But if demand was less elastic, by similar reasoning one can see in spite of a greater fall in prices due to the supply shift, the increase in quantity demanded would be relatively smaller and thus the corresponding equilibrium quantity would be Q1. Market shortages and surpluses Shortages occur when the market price is below the equilibrium level leading to the demand being higher than the amount that suppliers are willing to provide at the prevailing price.This is the case of a short run supply shortage. In the diagram above, P1 is the market clearing price, but the prevailing price is P2 resulting in a shortage due to the quantity demanded being higher than the quantity supplied at the price P2. Government enforced price controls are the most common cause of shortages. When a price is held too low, causing a shortage, we call the price a "ceiling”. But if the prevailing price in the market is higher than the market-clearing price, the supply shall exceed the demand and resultingly we shall have a situation of surplus (Diagram above). However such cases are often the results of price supports and minimum wages. When a price is held too high, thus causing a surplus, we call the price a "floor." Such shortages or surpluses can persist in the long run if the causing variables remain active in the same manner. Persisting price controls or supports, minimum wage restrictions can thus cause long run as well as short run market disequilibria leading to shortage or surplus situations. However these are generally negated by shifts in the demand and supply curves which cause new equilibria adjusting to the regulatory controls. 3. Why is the demand curve faced by a perfectly competitive firm perfectly elastic? Why does the long-run profit in a perfectly competitive industry equal zero? Under Perfect Competition, each individual firm faces a horizontal demand curve reflecting the fact that it is only a price taker. Because it is structurally assumed that there are numerous sellers each with an insignificant share of the market each firm can sell any quantity desired at the market price, but cannot sell anything above the market price. If the firm decides to charge a higher price, consumers will buy from others. Again, it will not gain any more customers than it already has if it seeks to charge a lower price.This is also due to the fact that there are numerous buyers as well as a result of which it can sell an infinite amount at the prevailing market price and hence, the demand curve is perfectly inelastic and hence horizontal. In the short run, a perfectly competitive firm can enjoy super normal profits if the short run average cost of production for it lies below the market price per unit of output. However in the long run, new firms will be attracted by the presence of this supernormal profit and they shall enter the market. This will cause a rise in the industry supply (a downward shift in the industry supply curve) and thus the market price will be driven down thereby driving down the supernormal profit. So in the final long run equilibrium, all supernormal profits will be driven down to zero. Read More