Features of Minimum Efficient Scale in Economics - Coursework Example

Minimum Efficient Scale Submitted by: XXXXXXX Number: XXXXXXXX XXXXXXXX XXXXXXX XXXXXXX of XXXXXXXX Date of Submission: XX – XX – 2010 Number of Words: XXXX (Excluding References) Introduction: Economies of scale are an essential aspect of every business and various studies over the past show that most companies, specifically those in the manufacturing industry show high levels of economies of scale. Researches by C F Pratten in 1980s and also the group of advisors of the European Commission in 1997 have both found a number of evidences that confirm the same. This paper aims at understanding a major concept that relates to the economies of scale and brings out the extent of economies of scale within a firm. This concept is referred to as minimum efficient scale (MES). The paper will firstly provide an overview of Minimum Efficient Scale and this will be followed by the various factors that determine the MES. Also, the relationship between Minimum Efficient Scale has also been discussed to find out the extent to which the level of competition is dictated by minimum efficient scale. Minimum Efficient Scale and Its Determinants: The minimum economies of scale have been explained to be the smallest level beyond which no significant or additional economies of scale can be achieved. As explained by the Investor words, “The smallest amount of production a company can achieve while still taking full advantage of economies of scale with regards to supplies and costs. In classical economics, the minimum efficient scale is defined as the lowest production point at which long-run total average costs (LRATC) are minimized” (Investor Words 2010). This can be simply explained as the position from where the long – run average cost curve (LRAC) curve starts to flatten off. The minimum efficient scale curve can be expressed in terms of both or either the individual factory as well as the whole firm. When the MES curve is based on an individual factory, the curve is referred to as the minimum efficient plant size. The minimum efficient curve can be expressed in both percentage of the total size of the market as well as the total domestic production (Pass, Lowes and Davies 2005). When the minimum efficient scale is small when compared to the total market size there is scope for more companies to exist in the same space, for instance in the case of computer software (Investor Words 2010). However, in the case of other industries like telecom, the level of minimum efficiency scale is much higher and this is mainly due to the high ratio of the fixed costs to the variable costs (Investor Words 2010). Hence in these cases, there can only be a few large players in the market who tend to be the market leaders and dominate the markets. The first point on the LRAC is referred to as the minimum efficient scale. The graph below provides a clear view of the minimum efficient scale and the main idea here is to illustrate that the long run average curve is normally a ‘flat bottomed’ curve which simply refers to the fact there is a range in terms of the size of the firms where there is maximum efficiency (Jim and Geoff 2010). Minimum Efficient Scale (Blacksacademy 2010) Theoretically, the long run average curve is depicted to be a ‘U-Shaped’ curve. These tend to depict the economies of scale and show the reduction in the average cost with an increase in the output (Hazlitt 1988). However, in the case of diseconomies of scale, the average cost sees a rise with a rise in the output as well. Considering the statistical studies, it is clear that in the real world, the actual long run average cost curves tend to be ‘L-shaped’, like the image below Minimum Efficient Scale (Pass, Lowes and Davies 2005) As has been clearly noted, the smalled firm where the maximum efficieicny has been obtained is referred to as the minimum efficient scale. This has a major impact on the struture of the industry and can determine the competition in the markets to a great extent as well. For example a simple illustration as, If the output of the industy is 1000 units for a product and the minimum efficient scale is at 200 units, then the industry will be an oligopoly with a total of (1000/200) = 5 firms (Sowell, Applied Economics: Thinking Beyond Stage One 2008). Where there are five firms in the markets, the competitive level will be very high and thus the long run average cost curve will be ‘flat bottomed’. The profits in this case will increase with an increse in the output (Sowell, Basic Economics 3rd Ed: A Common Sense Guide to the Economy 2007). However considering another example where the output is a total of 100 units and the minimum efficient scale is just 1 unit, here there will be 100 different firms which will product the units and thus will lead to a perfect competition market (Sowell, Basic Economics 3rd Ed: A Common Sense Guide to the Economy 2007). Hence it is clear that the minimum eficient scale has a major impact on the structure of the markets and the it is clear that where the minimum efficient scale is large, the industry tends to be more towards the monopoly (Samuelson and Nordhaus 2009). Further explanation of the same has been discussed in the following section. There are a number of determinants that affect the minimum efficient scale and have a major impact on the struture of the markets. There are a number of doubts and also confusions which pertain to the diseconomies of scale (Pass, Lowes and Davies 2005). Various economomists have worked together and have been able to come to a conclusion that the level of management and the skills and techniques used by the management along with excellent incentives can have a major impact on the reduction of the risks and also can lead to rising long run average costs likewise (Hazlitt 1988). The main reasons that the diseconomies have been doubted and the persistence has been unconviencing includes the following factors like the human resource management is a way used to keep a tab on the risks and to ensure the costs of diseconomies of scale are avoided (Samuelson and Nordhaus 2009). It is also essential to note that there are three kinds of returns to scale and these include the technical return to scale, specialisation returns and also purchasing. Considering the technical returns to scale, it is clear that these occur mainly due to the availability of the use of mass production technique. Elements like indivisibilities where a productive technique can only be used where the output is large, for instance, in the case of bottleing machines which have smallest size caps, these can only be useful and worthwhile where the output required is higher than the minimum level that has been set down for the particular technique (Samuelson and Nordhaus 2009). Also it is important to note that capital can alo be indivisible in other means like a single manager. In the case where there is an increase in the size, there can also be an increase in the individibility as well. As explained by Blacksacademy (2010), “For example, the capacity of a container increases more than proportionately to the quantity of material used in its construction” (Blacksacademy 2010). Also as further explained by Blacks academy, in the case of constant and reducing or diminishing returns arise where as the large machine although seem very efficient, may not be so as there us a appoint up until where these machines prove to be effective. Also the large management structure also proves to be less efficient in an overall sense (Sowell, Applied Economics: Thinking Beyond Stage One 2008). In terms of specialization it is possible for a firm only when there is an expansion of the firm; this also helps in development of more efficiency and overall reduction in the costs. Similarly, when firms order and purchase more, there is also a better level of terms and discounts that they receive and these also tend to reduce with an increase in the supplies that the company receives (Sowell, Basic Economics 3rd Ed: A Common Sense Guide to the Economy 2007). Competition and Minimum Efficient Scale: The minimum efficient scale tends to be dependent of the nature of the cost of production in particular industries. There are a number of aspects that need to be kept in mind while learning about the determinants of minimum efficient scale (Sowell, Applied Economics: Thinking Beyond Stage One 2008). Firstly, where the ratio of the fixed and variable costs is high, here there is a clear scope for the costs to be reduced with an increase in the scale of output. This tends to lead to make the results more concentrated and leads to the development of oligopoly and even monopoly markets (Hazlitt 1988). The economies of scale clearly do act as a barrier to entry of new firms into the markets as there is also an achievement of cost advantage within the markets and the existing firms here can become the price markers. Hence if the new firms do enter into these markets, there is high chance that they will lack any position in the market and will be beat down by the competition very easily (Samuelson and Nordhaus 2009). Secondly on a contrasting note, it is possible that the MES might turn out to be only a small percentage of the market’s demand as there might be limited opportunities for economies of scale. In such a case, the position in the markets will be very different and the markets will be very competitive with a high availability of suppliers who will be able to achieve the minimum efficient scale more effectively (Sowell 2007). Lastly in the case where there is a natural monopoly, there is a fall in the cost curve where there is a huge range of output and this may also lead to enough space only for one or two suppliers in the industry, and these will be able to fully exploit the economies of scale that are available. Here the cost structure is different (Samuelson and Nordhaus 2009). Take for instance, in the case of companies where there is a need for huge networks and also national channels for distribution, the costs of overheads in such cases is very high and thereby leads the running costs to also be very high. In such cases there is a higher chance for the economies of scale to be exploited (Hazlitt 1988). This will lead the minimum efficient scale to be a major part of the total market demand and then it is possible that the space is only enough for one business to fully exploit the economies of scale. The min assumption here is that the long – run average cost curve (LRAC) will see a continuous fall only at levels where the output is very large. This can clearly be noted in the figure below: Minimum Efficient Scale (Jim and Geoff 2010) In the long run there is a higher chance for the economies of scale to be exploited based on the different industries. Some industries reach the minimum efficient scale at a very low level of output (Hazlitt 1988). In this case there is more room for the companies to achieve the minimum efficient scale. Conclusions: In conclusion it is clear that the minimum efficient scale is a level beyond which there are no chances of receiving higher or additional economies of scale. The minimum efficient scale is the area where the LRAC tends to flatten out. As has been discussed, it is clear that the minimum efficient scale is one which can have a major impact on the structure of the markets. Hence it is clear that minimum efficient scale plays a major role in the markets and is an essential part of the economic markets as a whole (Samuelson and Nordhaus 2009). References Blacksacademy. Market Structures. 2010. http://www.blacksacademy.biz/ba/civ/XG9hg1anx/3a6ddnoFAG.pdf (accessed August 1, 2010). Hazlitt, Henry. Economics in One Lesson: The Shortest and Surest Way to Understand Basic Economics . Three Rivers Press, 1988. Investor Words. Minimum Efficient Scale. 2010. http://www.investopedia.com/terms/m/minimum_efficiency_scale.asp (accessed August 1, 2010). Jim, and Geoff. Minimum Efficient Scale (MES). 2010. http://tutor2u.net/economics/content/topics/buseconomics/mes.htm (accessed July 31, 2010). Pass, C., B. Lowes, and L. Davies. Minimum Efficient Scale. 2005. http://www.credoreference.com/entry/collinsecon/minimum_efficient_scale (accessed August 1, 2010). Samuelson, Paul, and William Nordhaus. Economics. 19th edition: McGraw-Hill/Irwin, 2009. Sowell, Thomas. Applied Economics: Thinking Beyond Stage One. Basic Books, 2008. —. Basic Economics 3rd Ed: A Common Sense Guide to the Economy . Basic Books, 2007. Read More