In our last module,

we learned that if economies of scale exist,

when the per unit output cost of all inputs decreases, its output increases.

But just as a firm can benefit from economies of scale,

so too can it be harmed by diseconomies of scale.

Such diseconomies are characterized by

higher unit cost as plant size increases beyond certain point.

In our figure, Q star.

The main problem causing diseconomies of scale lies with the managerial function.

It just becomes more and more difficult to efficiently control and

coordinate a firm's operations as it becomes a large scale producer.

To put this another way,

at some point a plant just gets too big for effective management.

In addition, in particularly large or massive production facilities,

workers may begin to feel alienated from their jobs and efficiency may suffer.

Now take a look at this key figure.

It shows four very different possible long run average total cost curves

for any given industry.

The first graph in the upper left shows the broad U-shaped curve we observed earlier.

And now in the second graph at the upper right,

note that the U-shape is much more pronounced.

Note also the flat segment in the third graph, bottom left.

And finally note the downward slope in the fourth graph, bottom right.

So how would you explain the shapes of each of these curves?

Let's start with the second graph.

Here, the narrow and steep U shape indicates that economies of scale are

exhausted quickly so that

minimum unit costs will be encountered in a relatively low output.

So what types of industries do you think might be

characterized by this narrow and steep U shaped curve?

Well, the typical profile of an industry characterized by

this kind of steep curve is numerous sellers in a healthy competition.

Examples include many retail trades and some types of farming as well as

certain types of light manufacturing such as baking, clothing and shoes.

In such industries,

a particular level of consumer demand will support a very large number

of relatively small producers.

Now what about this shape of the long run average total cost curve?

Here we see a smooth U-shape with

a long flat spot in the middle of the curve and over this long flat spot,

unit costs do not vary with size.

This is the case of constant returns to scale and it characterizes many industries.

For example, at times during its turbulent history often after financial crises,

the commercial banking industry has undergone a wave of

mergers whereby banks consolidate or acquire one another.

You would think that by getting bigger,

unit costs would fall dramatically.

After all in the wake of a merger,

the new combined bank often closes some of its branches in overlapping markets.

Plus, these new merged banks can combine support services such as computer processing,

advertising, auditing and legal work,

all of which should provide significant savings.

However, the research has typically not revealed any significant reduction in costs.

And one obvious possible explanation is that

the commercial banking industry is subject to constant returns to

scale over a broad spectrum of output.

Now take a look at the fourth possibility.

In fact, this is one of the most famous in economics because

it is the signature of what is called a natural monopoly.

You can see in the graph that unit costs steadily fall over the relevant range of output,

typically taken to be the size of the market,

the industry is serving.

So what we have then is increasing returns to scale over that relevant range of output,

and here is why this is so very interesting.

With increasing returns to scale,

any given producer can always gain

a competitive edge over a smaller producer by increasing scale.

In this case, bigger producers will

inevitably drive out smaller, less efficient producers.

Moreover, this process will continue until there

is only one big producer left controlling the whole market.

That's the infamous natural monopoly.

In the future lesson,

we will learn about why natural monopoly is often a bad thing.

The short answer is that in the presence of natural monopoly,

price will be set too high and the output too low for market efficiency.

That's what we call a market failure and such market failures are

precisely why the government sometimes has to come in and regulate a market.

And here's a question.

Can you think off hand what kinds of industries your government now

regulates where the natural monopoly argument might apply?

Well historically, the natural monopoly argument has

often been used to regulate industries like the railroads,

the cable-TV, as well as the distribution of electricity.

We will talk more about that soon.

For now, however, the case of natural monopoly

allows us to introduce yet another key concept in production theory.

That of a minimum efficient scale.

Minimum efficient scale is defined as the smallest level of

output at which a firm can minimize long run average costs.

This is a key concept because it provides insights into

just how many firms any given industry can

accommodate and just how competitive that industry might be.

For example, take a closer look at our constant returns to scale figure.

Here. The minimum efficient scale is reached at Q1.

However, beyond that point,

there is an extended range of constant returns to scale.

So in this case relatively large and relatively small firms

can coexist and be equally viable.

This in fact is the case in industries such as apparel,

food processing, furniture, wood products and small appliances.

In contrast, in the case of natural monopoly,

small firms cannot realize the minimum efficient scale or MES,

so there is only one seller.

Now, as our final point on this topic,

a large minimum efficient scale can also give rise to another type of industry structure

we've already briefly touched on in an earlier lesson, that of oligopoly.

Do you remember the definition of an oligopoly?

Do you remember what kinds of industries are characterized by oligopoly?

Why don't you pause the presentation now briefly and see if you can write

down the definition of oligopoly and provide a few examples.

Okay, as I'm sure you recall,

an oligopolistic industry is characterized by a small number of large sellers.

For example, oligopolistic industries include automobiles,

aluminum, steel and cigarettes.

Now here is the most important key point of this lesson.

The shape of any given industry's long run average cost curve

has an enormous influence on the structure of

that industry and because the structure of

an industry is in large part determined by its long run average cost curve,

both the conduct and performance of that industry is often determined as well.

Here, by conduct I mean,

how will the industry price its products?

Will it do so competitively or will firms try to collude with one another to set prices?

And by performance I mean,

will the industry operate most efficiently and deliver as many goods as possible at

the lowest possible price or will it

seek to use its market power to price gouge consumers?

To see what I mean, consider this.

An industry with constant returns to scale is likely

to have many smaller firms competing fiercely in

that structure and the result is likely to be

the lowest possible market prices and highest possible output.

That's conduct in performance and an efficient market.

On the other hand, a large minimum of

efficient scale or increasing returns to scale can structurally will give

rise to oligopolies and monopolies that will set prices too high and output too low.

I will talk a lot more about

the structured conduct performance paradigm in our next lesson.

For now let's move on to our next module,

which deals with a very intriguing difference between how economists

versus accountants actually measure profits.

So be ready, have at it.

Diseconomies of Scale; Minimum Efficient Scale; Natural Monopoly; The Structure-Conduct-Performance Paradigm

Strategic Business Management - Microeconomics

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