What Are Economies of Scale and Their Main Source - Essay Example

Economics Q What are economies of scale? What is their main source? How might economies of scale offer a competitive advantage to a business? Economies of scale is said to be achieved if more goods and services can be produced on a larger scale through a relatively cheaper cost of production. In other words, the ability of a business organization to produce more goods and services from its existing fixed operational costs is one way of describing it. For example: a company that has a total number of 50 employees was able to produce as much as 100 bags/week from its usual production of 80 bags/week is said to have successfully reach economies of scale. Another way of looking at economies of scale is by maximizing the use of machineries and equipments. For example: a company that has an ice cream machine that usually produces 40 boxes of 1 pint of ice cream a day was able to produce as much as 80 boxes of 1 pint of ice cream a day by cutting on ‘down-time’ due to machine breakdown caused by lack of machine maintenance. It could also refer to the application of a special device in a machine in order to enhance its speed and therefore increase the volume of production. Another way is to maximize the use of manpower by establishing a short and clear chain of command within the business organization. Therefore, it is possible to avoid the incidence of employing too much unnecessary employee in the crowd. In order to achieve economies of scale, a good management is essential. Basically, it is the managers and supervisors who suggests and/or make critical decisions in order to maximize the daily fixed costs (such as labour costs and over-time pay and electricity costs) of the company. These are also the same group of people who are responsible in cutting down the number of ‘rejections’ in a production line. Minimizing the number of ‘rejections’ can indirectly increase the company’s profitability by ‘cutting down the unnecessary opportunity losses’ and ‘prevent avoidable expenses’ on the part of the company. Q.2 Explain how changes in the equilibrium price and quantity are influenced by the elasticity of demand and supply. Explain the difference between a shortage and a surplus and discuss why either might occur. Basically, the market equilibrium price and quantity is the point where the quantity supplied is equal to the quantity demanded. The said equilibrium point changes when there is an imbalance between the demand and supply. For example: if the demand for a certain goods is above the supply, the price of goods will automatically go up to a certain point where a new equilibrium point will be created. Likewise, if the supply for goods is below the demand level, the price of goods will go down. These changes will cause changes to the market equilibrium point. In economic point-of-view, shortage occurs when the amount of goods available is less than the expected amount of goods. It only means that a surplus occur when the amount of goods available is more than the expected amount of goods. Considering that supply is highly dependent on price, a shortage would therefore mean that the price is set lower than the level where the quantity supplied would be equal to the quantity demanded. The common cause of shortage is through government intervention. For example: the government control the price of gas. Even if the world market price of gas goes up and eventually create new market equilibrium; the gasoline sold within the said environment will not increase the local price of gasoline since the government mandated to sell the gasoline at a fixed price. (See figure I below) There will be a surplus if for example; customers who are tourists pay the services of a local band higher than the asking price. Thus, the income of the local band for the day is much higher than their expected income. Q.3 Why is the demand curve faced by a perfectly competitive firm perfectly elastic? What is the level of profit of a firm in a perfectly competitive industry in the short run and in the long run? Elasticity refers to the degree of responsiveness of one variable to another. The average revenue (or price) and marginal revenue of a perfectly competitive firm are equal and constant at a fixed (equilibrium) market price. The total revenue increases at a constant rate as the firm increases its output. Demand curve of a perfectly competitive firm is perfectly elastic because the price has to remain constant (horizontal) since increasing the price would decrease its competitiveness over a similar product that is produced by another manufacturer. On the other hand, the company won’t sell its product below the market price either since it would result to an opportunity loss on the part of the seller. Consumers could easily go from one supplier to another in a perfectly competitive firm. The level of profit in a short run can result to an abnormal profit in case the firm’s average cost falls way below the average revenue (AR) or price (P). The area between P and C represents the abnormal profit. (See Figure II below) On the other hand, it is possible for the average cost (AC) of a perfectly competitive firm in the long run to be above the average revenue (AR) or price (P). Thus, the abnormal profit is avoided. Basically, the presence of a new competitor in the market could make the demand curve (Horizontal) to shift downwards. Either new or existing competitors could bring down the price of its product. Eventually, other companies would also decrease their price. (See Figure III below) Q.4 How much profit is earned by a monopolist? How might a firm be able to create a monopoly and sustain it? Basically, a monopoly player in an industry means that the company has the exclusive right to sell a specific product and services within the certain jurisdiction. The fact that a monopolistic competition has no competitor that could grab the company’s market share; means that a monopolist earns as much as a 100% of the profit that comes from the sale of its product or services. In order to create and sustain a monopolistic right over a specific product or industry, the business owner should have the full support from the government in order to avoid encountering problems related to the preservation of the exclusive right to monopolize the market. Other ways to do it is by acquiring patent, copyrights and trademark. For example: Polaroid patented the ‘instant-picture cameras’ for a certain period of time in order to prevent other camera makers from having the right to manufacture a similar product. Q.5 What is an oligopoly? Explain the difference between natural and strategic entry barriers to entry in oligopoly. Why is the difference important? Oligopoly is a market situation whereby at least two to four largest companies are controlling or dominating more than 40% of the market share. A good example of oligopoly is the retailers of gas market since there are a limited number of small companies controlling a large majority of the market. A situation whereby the number of entrants to a certain industry is naturally ‘finite’ is called a natural oligopoly. It means that the entry to a specific industry is limited to a small number of companies (usually between 4 to 6) without any strategic decisions made. On the other hand, a strategic oligopoly occurs when the oligopolists or the players within the industry takes into account the responses of the market participants (other players and the consumers) when making important business decisions. The thing with a strategic oligopoly is the fact that there is a higher possibility that the existing market players may collude or make a secret agreement on making a strategic move in order to make the entry barriers to new players less feasible. Knowing the difference between the two is important on the part of any business person who wishes to enter an oligopolistic industry. Q.6 What are the main reasons for horizontal, vertical and diversified growth? How can a business use horizontal, vertical or diversified growth to gain an advantage over its rivals? The main reason why businesses enter into horizontal, vertical and diversified growth is for them to be able to cut down excessive operational and manufacturing costs of producing a product. This is necessary to cut down on these costs in order to make their product more competitive in the market. In the process, these companies are able to have advantages over its competitors. Businesses can achieve a horizontal growth by acquiring a business that delivers similar products and services through mergers and acquisitions. For example: a car manufacturer merged with a smaller car manufacturer in order to gain economies of scale and increase its current market share. Businesses can attain a vertical growth by investing on either a backward or a forward integration. A backward integration means that the company would itself manufacture other required raw materials for its main product. For example: a beverage manufacturer invests on manufacturing its own bottle in order to increase its profitability. A forward integration means that a company would invest in the development of its own distribution line for the same reason. Diversification growth is the practice of investing excess money in stocks, bonds, or money market instruments. Although there is a risk attached to these type of investment, there is still a possibility for the business to grow its excess money over time. Q.7 What is the difference between a principal and an agent? How does this difference create the ‘principal-agent problem’? A principal is a person who authorises an agent to enter into a legal agreement with a third party. In this case, the principal can be the employer or the business owner. On the other hand, the agent is a person who is agrees to perform a certain task and responsibility in exchange for the salary, wages, and/or commissions he/she will get from the employer. It is possible for a principal and the agent to encounter problems related to profit sharing, wages or commissions since both parties are looking after their own self-interest. It is more important for the agent to receive a certain sum of money in exchange with the services he/she needs to perform upon entering into an agreement more than the quality of work he/she is going to deliver to his/her employer. On the other hand, the principal / employer wants to get as much result from the money he/she is going to pay to the agent. Thus, a principal-agent problem occurs in the end. Q.7.1 How important are the assumptions made in alternative theories of the firm? Even though we already have a clear economic theories, gaps on many issues will always remain. For example, the theory on vertical integration explains only important issues that are directly related to it. It does not discuss issues related to disintegration, downsizing and refocusing which some business have chosen to implement. (Read: Laura Poppo and Todd Zenger, 1998) The assumptions made in alternative theories of the firm are important in the sense that it allows the managers to have a new theoretical and economic outlook or ideas that can be useful in making important business decisions. Q.8 If aggregate demand in an economy increases while aggregate supply stays constant, what is the likely outcome? How might the government influence any problems that arise? A significant increase in price will occur when the aggregate demand in an economy increases while the aggregate supply stays constant. (See Figure VI below) Once the economy has reached its full potential growth, a possible ‘bottleneck’ or an uncontrallable increase in the price of basic raw materials and commodities is likely to happen. To prevent the negative effect of a ‘bottleneck’, the government should increase the interest rates in order to slow down the economic growth and eventually allow the excess demand to decrease until it reaches back to a normal equilibrium point. Q.8.1 What is meant by the “business cycle”? How might it be explained and corrected? A business cycle or economic cycle shows the fluctuations present in the economic activities. This cycle represents a business or economic ‘peak’ (or maximum growth of output) and ‘trough’ (the lowest output level) over time. After the economy or business has reached the peak, eventually it would go through a contraction period until it reaches ‘trough’. Likewise, as soon as the economy or business has reached the ‘trough’, it would eventually enter into a ‘recovery’ and ‘prosperity’ (also known as the expansion stage) before it reaches the peak again. (See Figure V below) Since history repeats itself, managers and economists should know about the ‘business cycle’ since this cycle is an important tool when making important business and economic decisions. For example: when business managers have noticed that a product has reached its peak in the market, marketers should develop a new strategy to keep the demand for certain goods high. Failure to do so will result to a loss of sales until it reaches its lowest point. On the other hand, when economists notice that the Gross Domestic Product (GDP) is declining, it means that the government should help the local businesses to create more demand for goods by allowing new investors to invest in the country or by increasing the government. Q.9 What are the main reasons for Globalisation? Who benefits from it? The main reason for globalisation is to create and establish ‘a single global economy throughout the world’. In the process, developed countries will get the option and privilege of entering into a sub-contract with another country that offers a cheaper cost of competitive labour and energy resources. Likewise, it will also be easier for big companies to search for a good quality and cheaper raw materials from one country to another. In the process, big multinational companies such as Nestle, Uniliver, etc. could maximize their profit earnings by cutting down on the normal business’ operational costs. It is not only the big multinational companies and the developed countries that can benefit from globalisation. In return, developing countries could also gain some financial benefits because of the transfer of new businesses and job opportunities. Suggested Readings: Laura Poppo and Todd Zenger (1998) “Testing Alternative Theories of the Firm: Transaction Cost, Knowledge-based, and Measurement Explanations for Make-or-Buy Decisions in Information Services” Strategic Management Journal, 19: 853 – 877. Read More