Specialization And Economies Of Scale

According to theory, economic growth may be achieved when economies of scale is realized; this is usually attained through specialization. Adam Smith identified specialization and division of labor in 1763, in the beginning of his book entitled, “An inquiry into the Nature and Causes of the Wealth of Nations.” Adam Smith, considered the father of modern economic theory, identified the division of labor and specialization as the two key ways to achieve a larger return on production. Smith said that an increase in specialization in the use of labor becomes more achievable as a business increases in size because hiring more workers means that jobs can be divided and subdivided, which means each worker will have less tasks to perform. This enables the worker to concentrate on the task in which they have developed special skills. Hence, through such efficiency, time and money could be saved while production levels increase. The problem facing smaller businesses is many workers may spend a good portion of their time performing unskilled tasks or multiple tasks, leading to higher production costs due to inefficiency. However, with working fewer tasks, workers can become even more proficient and skilled at completing those tasks; concentrating on one task, causes the workers to become highly efficient at their task. In addition, greater labor specialization eliminates the loss of time that occurs whenever a worker shifts from one task to another.

Using specialization to achieve economies of scale, large scale producers often are able to supply consumers with a good at a substantially lower cost than a small business could produce it. Also, economies of scale increase the gains from trade that could not be achieved simply through self-sufficiency or small scale production. In addition to Labor Specialization, Managerial Specialization also improves efficiency, and occurs when a large company achieves economies of scale by enabling one person to supervise a larger number of employees for the same cost.

In addition to specialization and the division of labor, within any company there are various inputs that may result in economies of scale by larger firms when producing a good or service. These inputs include: lower input costs due to volume buying discounts, spreading of costly inputs (research. advertising, etc.), specialized inputs (machinery and labor), better techniques and organizational inputs (clear cut chain of command), and learning inputs (with time learning processes related to production, selling, and distribution can result in improved efficiency with more practice). In addition to internal economies of scale, external economies of scale can also be realized from the above-mentioned inputs as a result of the company’s geographic location. For example, a firm who is located in Idaho may pay less in transportation costs when buying potatoes than a firm located in Maine, since potatoes are grown in Idaho, but not grown in Maine. External economies of scale can also be reaped if the firm or industry lessens the burden of costly inputs by sharing technology or managerial expertise. This spillover effect can lead to the creation of standards within a firm or industry, which can save time and money. In conclusion, it is important to strive for economies of scale so that the firm is as efficient and profitable as possible; specialization is the key to that success because it leads to increased productivity and decreased costs.

Economies of Scale is a concept that indicates as firms get larger they become more efficient and their cost of production decreases. If this is the case, then why don’t firms continue to get infinitely larger? Provide at least 2 examples. In addition, distinguish between diminishing returns from diseconomies of scale.

In time the expansion of a firm could lead to diseconomies of scale, causing higher average total costs for the firm to endure. The main factor is the difficulty of efficiently controlling and coordinating a firm’s operations as it becomes a large scale producer. Since authority and decision making abilities must be delegated in a large scale firm, this expansion of management hierarchy can lead to communication problems, coordination problems, bureaucratic red tape, and the possibility that decisions will not be coordinated properly. Consequently these managerial decisions may take too long to keep up with changing markets, technology, and customer tastes. Also, a common problem with larger firms is sometimes employees feel alienated or unappreciated and therefor do not care to work as efficiently as they possibly could because they have no incentive.

Diseconomies of scale occurs when production is less than in proportion to inputs; meaning there are inefficiencies within the larger firm or industry that are resulting in rising average costs. Diseconomies of scale usually occurs due to inefficient managerial or labor policies, such as over-hiring or deteriorating transportation networks (external diseconomies of scale). This can often be location specific, in which case trade is used in order to gain access to the efficiencies.

It is important for a company to determine the net effect of its decisions affecting its efficiency, and not just focus on one particular source. In conclusion, while a decision to increase its scale of operations may result in decreasing the average cost of inputs (i.e. volume discounts), it could also give rise to diseconomies of scale if its subsequently widened distribution network is inefficient because there is not a powerful enough distribution network for their product, or consumer tastes have changed, and so on. When making a strategic decision to expand, companies must balance the effects of different sources of Economies of Scale and Diseconomies of Scale so that the average cost of all decisions made are lower, resulting in greater efficiency all around. If the firm can not accomplish economies of scale through growing larger, they need to reconsider their expansion until the appropriate time; one way to measure when the correct time to expand or contact is based on the level of economic profit the firm makes. When they are accomplishing positive economic profit, there is a good incentive to expand to capture more profits. If a firm is achieving zero economic profit, they are in equilibrium, and achieving a normal return on investment, meaning they should maintain current production scale. However, if a firm is earning negative economic profit, most likely they are in diseconomies of scale, and should decrease their size and scale of production, or face potentially inevitable bankruptcy.

Explain why it is profit-maximizing for a firm to produce output up until the point at which marginal revenue equals marginal cost.

Profit maximization is the process by which a firm determines the price and output level that returns the greatest profit. The profit maximizing rule for a perfectly competitive firm is to find the quantity of output where Marginal Revenue equals Marginal Costs; the same rule also applies to single-price monopolies. For a perfectly competitive firm, Marginal Revenue is also equal to price, so the intersection of Marginal Revenue and Marginal Cost yields the profit-maximizing output and price. The vertical distance between the demand (or average revenue) curve and the average total cost curve represents average revenue minus average total costs, which equals average economic profit, or economic profit per unit. A firm must determine a quantity of output where marginal revenue equals marginal costs because this is the level of output in which profit would be at its highest; the firm can do no better for itself. Any other output level will lead to lower profit, causing inefficiencies within the production process and diseconomies of scale.

In a competitive market all participants feel they are small (relative to the market), and therefore feel they have no control over what happens in the market, causing many participants to take price and the decisions of other people in the market as beyond their control. However, the competitive firm maximizes profit. The profit maximizing output occurs where market price equals the firm’s marginal cost (P = MC). Second, the firm has to check to see if it is covering its costs on average. So it compares the market price to its average costs (AC). If price is greater than average costs (P > AC) then the firm is earning an economic profit, showing a strong incentive to expand in order to capture more profits. If price is less than average costs (P < AC), then the firm is earning negative economic profits, which tells them they must either contract or shut down for a while in the short run, to prevent continued losses. Finally, if price equals average costs (P = AC) then the firm is earning zero economic profit which means that it is earning a normal rate of return on its investment, and is in equilibrium.

There are two different approaches a firm can use to calculate the level of output that returns the greatest profit, including the Total Revenue – Total Cost Method that relies on the fact that profit equals revenue minus cost, or the Marginal Revenue – Marginal Cost method which is usually easier to calculate and based on the economic fact that total profit in a perfectly competitive market reaches its maximum point where marginal revenue equals marginal cost. It is important for a firm to maximize profits so that it is producing at the most efficient level of output, accomplishing economies of scale, and earning the largest possible profit per unit of output.

Explain why the long run supply curve is flatter than the short run supply curve.

The long run supply curve measures the quantities of a good or service offered for sale by all sellers, potential and actual, who could sell in the market. It traces out the increase in output resulting from the shift in demand. The long run supply curve is more elastic than the short run supply curve, causing it to be flatter. Generally, it will always take time for the full supply response to a demand change to materialize, so long run elasticity’s are more elastic than in short run.

In the short run, the industry supply curve represents the sum of all the individual firms marginal cost curves. However, there is an important stipulation to this notion: If all firms increase their output up their marginal cost curves, they are all demanding more inputs to produce the extra output. This increased demand for inputs (shifting input demand curves to the right) will tend to increase the price (unit cost) of the inputs. This increase in the cost of inputs will shift the marginal cost curves upwards. Hence, in this case the Short Run Industry Supply Curve (SRS) will tend to be steeper (more inelastic) than the individual firms marginal cost curves. In the long run, increased demand for the industry products will tend to increase the price, thus increasing the profits earned by each firm in the industry. More firms will be attracted into the sector, shifting the Short Run Supply to the right, increasing industry output and reducing prices again, causing increased elasticity.

In conclusion, the long run supply curve is flatter than the short run supply curve because it is more elastic. The determinants of the elasticity of can have an effect on demand, causing changes in the production. Elasticity of Supply is a measure of how much quantity supplied (QS) reacts to a change in prices. Elasticity of Supply is equal to “percent change of QS” divided by “percent change in price”. This value can range from zero to infinity. When elasticity is less than one, supply is inelastic. If elasticity is greater than one, then supply is elastic. The main determinant of supply elasticity is length of time. The shorter the time period, the more inelastic the supply, because it is harder to get the additional inputs to increase production; although it can also depend on whether the firm is near its capacity. In conclusion, since supply is more inelastic in the short run, and more elastic in the long run, the long run supply curve is flatter than the short run supply curve.

Discuss the cost and benefits to society of a monopoly that is created because a patent is granted for the product the firm produces.

A patent granted for a product allows the patent owner to have sole production rights on that product for 17 years. This enables them to have a monopoly on this product, giving them the opportunity to gain monetarily to award their entrepreneurial and innovative ingenuity and allow them to recoup costs involved in the creation, testing, research, and production of their patented product. This benefits society because it encourages people to invent new products, bringing a better quality of life to the public, a chance for monetary success for the producer. Encouraging the creation of new products allows a society to further advance technologically, and economically, an instrumental part of growth.

Although monopolies can increase innovation and technological change, and achieve economies of scale and economies of scope, there can downsides to allowing a monopoly to exist as well; many times this depends on the firm and its ethical and moral judgments. Since patents allow a firm to have exclusive distribution rights on a product for a period of time, this can lead to the firm to gain a monopoly on the market. If this firm reapplies for new patents due to technological upgrades to their original patent, it can keep competition from having a chance at getting a piece of the market which subsequently allows the firm to have extreme market power without competition. Since a monopoly is a price setter, not a price taker like a perfectly competitive market is, this can have a negative cost on society because monopolies often maximize profits by raising prices to the highest possible price customers will pay while still achieving marginal benefit or utility from the product, and the firm achieving maximum profit. This can be considered as price fixing, and is an illegal practice. Prices should be determined naturally through free market forces, not set by the producing firm. The larger the firm grows, the more opportunity they have to corner a market, because they can achieve economies of scale through specialization, thus saving money on production, distribution, and other costs. This enables the firm to produce their product at a lower cost than a smaller business, meaning that even when their patent runs out, they already have such a head start, and a well-known name, and customer base, that smaller businesses have a hard time trying to compete.

Another argument against the monopoly created in a capitalist society through a patent is the concern that there is no incentive to improve their product to meet the demands of consumers because there is no competition; that Is until they must apply for a new patent anyway. Although antitrust laws by the government are used to prevent monopolies, there are exceptions which allow legal monopolies to flourish, such as ownership of a key resource (ex: rare minerals, diamonds), falling average cost (natural monopoly), public utilities (water, cable television), and exclusive rights given by the government (which is the case of a patent).

The best example is a patent for new pharmaceutical drug, which takes lots of time to test before coming to market. The patent gives the pharmaceutical company a chance to recoup its costs, and earn a profit for its efforts, while bringing better medicine to the people. Without this chance to recoup costs and gain monetarily, pharmaceutical companies have little reason to create new medications that increase quality of life and innovative ideas in medicine. In conclusion, although there can be negative effects of a monopoly, the creation of a monopoly by innovation of a unique product granted by patent are far more beneficial to society than detrimental.

Public utilities such as electricity are referred to as natural monopolies and are often subject to regulation by a state authority (the “Public Regulatory Commission”). Explain why a public utility such as electricity is referred to as a ‘natural monopoly’. Explain how and why an average cost pricing policy is applied to public utility. Discuss the effects of the policy of the price and the output the utility sells at and produces. In addition, discuss how the policy affects the utility’s profits and costs.

A type of monopoly that exists as a result of the high fixed or start-up costs of operating a business in a particular industry is defined as a Natural Monopoly. They exist legally because it is economically sensible to have certain natural monopolies, and governments often regulate those in operation, ensuring that consumers get a fair deal. The Utility industry (i.e. water, electric, gas) is an excellent example of a Natural Monopoly. The cost of establishing a means of producing and supplying a utility such as electricity to each household can be very large. This capital cost can be a large deterrent to possible competitors. A natural monopoly is often a more efficient way to run this type of industry because having multiple firms compete to work in the utility industry in the same designated area is economically inefficient, and often becomes too costly to operate at a profitable level. Because of economies of scale, one firm can supply the market at lower average total costs than multiple firms can, causing a natural monopoly to be the best economic way to supply certain utilities to consumers.

Natural Monopolies, such as public utility companies, often have an average cost pricing policy applied to their product. Average Cost Pricing was developed by Robert Hall and Charles Hitch through economic research, and holds that firms determine the selling prices of their products by adding a small mark-up or profit to their average manufacturing costs. This implies that businesses will set the unit price of a product relatively close to the average cost needed to produce it. Average cost is the production cost per unit of output, computed by dividing the total fixed costs and variable costs by the number of total units produced. This pricing policy is often imposed on natural (or legal) monopolies because these industries can benefit from monopolization, since large economies of scale can be achieved. The average cost pricing rule may be the most efficient pricing rule even though deadweight loss can occur.

However, allowing monopolies to be unregulated can produce economically harmful effects, such as price fixing. However, competition among utilities can be highly inefficient, so allowing a regulated natural monopoly to exist is the best possible solution because consumers still get the utility they need and at a fair price. Potentially high start up costs won’t hurt potential utility providers since regulators usually allow the natural monopoly to charge a small price increase amount above cost, average cost pricing looks to remedy this situation by allowing the monopoly to operate and earn a normal profit without a high risk of loss from fixed costs and competition.

Explain why the duopolist’s dilemma often leads to price-fixing schemes. Be sure to discuss a number of different price-fixing schemes and what may cause them to break down. Also discuss the enforcement mechanisms that the duopolist might undertake to ensure that a price-fixing scheme does not break down.

A duopoly is an oligopoly with only two members; it is the simplest type of oligopoly. Sometimes these duopolies may agree on a monopolistic outcome to control a market. Collusion is an agreement among firms in a market about quantities to produce or prices to charge. A Cartel is a group of firms acting in unison. The duopolist’s dilemma explains why it is difficult for firms to collude and achieve the maximum monopoly profit.

Although oligopolists would like to form Cartels or collusions and earn monopoly profits, often that is not possible because antitrust laws prohibit explicit agreements among oligopolists as a matter of public policy since they often result in price fixing schemes that can manipulate a market. Cooperation among oligopolies (or duopolies) are undesirable from the standpoint of society as a whole because it leads to production levels that are too low and prices that are too high; this is an example of price fixing. This price fixing is often done by limiting the supply, causing an increase in price due to the high demand and zero competition. However, maintaining cooperation is difficult in a duopoly due to the prisoner’s dilemma, which explains that usually two criminals who get arrested will often talk to get what they perceive as a better deal, because they are worried the other criminal will talk before them causing them to get more jail time and losing their chance to claim the previously offered deal; however if instead they would have collaborated and both stayed silent they would both get less or no jail time because the case is weaker without that testimony. The prisoner’s dilemma is an example of why misperceived self-interest, mistrust, greed, and initial gain often prevents this collaboration from happening even though both criminals would have been better off in reality if they had.

Since oligopolies are competing to sell the same product, they know that the firm that makes the most money will be determined through factors such as customer tastes, quality, or lowest price. Oligopolies have the same problem faced by the prisoner’s dilemma. They have to figure out if they want to compete aggressively for market share at both firm’s expense or cooperate and coexist without fighting for market share by trusting their competition not to cheat on their agreement. However, each firm has an incentive (just like the prisoners) to try and undercut their competitor and knows that the other has the same incentive. They know if they cooperate they can keep prices higher and make more profit as long as the other one does the same. But they have an incentive to lower their price to make even more profit through higher sales for a short time, at least until the other does the same thing and a price war starts, eventually leading to the lowest possible price both firms can afford to sell their product for.

The prisoners’ dilemma is based on having to make the decision only once. However, what happens in an oligopoly is that the firms have to make the decision over and over and always pay attention to what their rival(s) are doing and quickly responding to what they do. Often what happens is eventually the rivals understand what will happen and as a result they start to coordinate and cooperate by colluding with each other. However, because of the mistrust firms have for each other they worry that their rival will try to lower their price or increasing advertising to gain more of the market share, eventually one of them will end up betraying their agreement and doing so because they are concerned the other will first, and the dilemma comes back, repeating the cycle.

Obviously, this price war competition causes low to almost non-existent profits for the two competing firms. This is why the duopolists face a dilemma; should we continue to compete in a price war or should we collude to fix prices illegally so we can make a profit. This is how many price fixing schemes come about. However, as shown by the prisoner’s dilemma in game theory these price-fixing schemes can easily fall apart due to greed and mistrust. In order to ensure a price fixing scheme does not break down due to the prisoner’s dilemma, many times firms will collaborate to create a cooperative equilibrium where each firm complies with the collusive agreement and makes monopoly profits; for this to work properly firms must try to prevent temptation of cheating on their agreement, this requires firms to punish cheating. Methods of punishing cheating if it occurs can include using a Tit-for-tat strategy (taking the same action the other player took last period; the lightest punishment), or a Trigger strategy (which states you will cooperate until the other player cheats, then you can cheat forever; this is the most severe punishment to the cheater).

Price signaling is a form of implicit collusion, often there is one firm that is the price leader and all the other firms follow what that firm does, which is used in game theory (although this is not likely to be done with only two players as in the case of a duopoly). If there is one firm that dominates the industry then that firm sets the price that allows them to maximize their profits and the other firms just behave like a competitive firm and takes that price as the market price and that is what they charge. There is an advantage to being the dominant firm; this is known as the first-step advantage.

The Antitrust Procedures and Penalties Act of 1974 changed price fixing from a misdemeanor to a felony punishable by fines up to one million dollars for companies, five hundred thousand dollars for individuals, and a maximum prison sentence of 3 years. This just adds to the irony that the duopolists may end up in the criminal dilemma again, only this time literally, instead of economically through their firms. This is why they call it the duopolists dilemma, because both options, legal or illegal, are not very desirable.

In conclusion a duopoly is when there are only two businesses in a market. Their best outcome is to cooperate and restrict output to the monopoly quantity, where price is greater than marginal cost, and profit is maximized. A good example of a duopoly would be Coca-Cola and Pepsi Co. Usually, a duopoly trying to maximize profits will produce more than a monopolist but less than a competitive industry. Duopolies often collude to share output and set prices such as in a cartel. A cartel is a group of companies acting in unison, such as OPEC. If the competing companies cannot agree, then they may end up in the competitive position of a price war that leads to profits equal or near zero. Cartels are known to restrict output quantities in order to raise prices, and consequently prices. Many antitrust laws prevent agreements between duopolies, causing a dilemma to either break the law to make a profit, or operate legally with an almost nonexistent profit.

Explain whether a monopoly could increase its revenue and its profits by charging different prices to different groups of customers. You may wish to give a numerical examples to illustrate your point.

A monopoly can increase its revenue and its profits by charging different prices to different groups of customers through Price discrimination. Price discrimination can be profitable for a monopoly only if different consumer groups have different willingness to pay for their product. If such a difference exists, the price-discriminating monopolist treats the groups as different markets. The profit maximization rule for a price-discriminating monopoly is to find the quantity of output where marginal revenue in each market equals marginal cost. Then, in each market, charge the maximum price the consumer group is willing to pay for that output (on the demand curve). Different willingness to pay translates into different elasticities of demand between groups, yielding different prices in the two markets. This results in the monopoly achieving maximum profit through the technique of price discrimination.

Price discrimination is selling the same good to different customers/markets at different prices. Examples include movie tickets, airline tickets, and discount coupons. In order to practice price discrimination, it must be easy to separate customer into groups. These groups are determined based on their elasticities to demand. The company must also be able to prevent re-sales between groups, as well as arbitrage, which is buying where a good is cheap and selling where it is expensive. Price Discrimination can increase the profit of monopolies, since they can charge a higher price to those with less elastic demand, and a lower price to those with more elastic demand. In this manner, a business does not have to lower prices to all buyers in order to sell more goods.

Explain the circumstances under which a merger would likely to be granted and under which it would not. EXTRA CREDIT #1

Most mergers must be approved by either a board of directors, or a majority of shareholders, meaning it must be financially beneficial to the company and its investors to grant the merger for it to pass. Often the debate of mergers questions whether corporate mergers help consumers by lowering costs and thereby prices, or hurt consumers by reducing competition and thereby the incentives to keep prices low. However, the presumption is that most mergers are economically beneficially because in order to interfere with the market, one often has to prove that interference with the market is going to produce greater benefits than allowing the market to stay the way it is now; if not the merger likely will not be granted. However, the problems with some mergers is the firm becomes so large that is inefficient, and operates through diseconomies of scale rather than taking advantage of economies of scale in their production.

Mergers are likely to be denied if they are not beneficial to the market. For example, if the merger would give the company a monopoly on the market, it probably would not be approved (unless this merger resulted in a monopoly that saved one or both companies resulting in the prevention of an otherwise inevitable industrial collapse). However, if there are still plenty of competitors in their market, and the merger benefits consumers and the market economy, then it may be granted.

The Merger and Acquisition must complete the following steps to gain approval: (1) Market Valuation, Exit Planning, Structured Marketing Process, Letter of Intent, Buyer Due Diligence, and Definitive Purchase Agreement. Without such planning, mergers and acquisitions cannot be successfully executed. Often failure is the result of not doing enough preparation work to ensure a successful business transaction and future financial gains before attempting to negotiate terms and legal acceptance. Often lack of research is will result in considerable risk and uncertainty, however this can be alleviated with effective prior planning that helps to make the process easier, simpler, and safer.

Explain why predatory pricing is not a viable long-term strategy.

Predatory pricing involves a practice by which a firm temporarily charges prices below an appropriate measure of its costs in order to limit or eliminate competition, then subsequently raise prices to recoup losses and reap significant profits. The traditional view of predatory pricing is its application as a short term strategic investment in a firms future gains received through temporary losses caused by below cost pricing that results in elimination of competitors. In addition to the traditional view, a predatory campaign could be seen as a successful investment in reputation, which could pay dividends in other geographic or product markets by deterring entry, causing spillover effects that would cause additional monetary gains from the initial predatory episode. However, these gains are usually only achieved in the short term.

Predatory pricing is not a viable long term strategy for a variety of reasons, however the two main reasons are: (1) it is illegal and subject to the competition laws and policies of most Organization for Economic Co-operation and Development (OECD) member countries, and (2) the firm cannot sustain the price it is charging consumers which is below what is costs to make their product, over a long period of time. The first reason that predatory pricing is not a viable long term strategy is obvious since it is illegal; the longer you commit an illegal activity, the more likely you will be c