External economies also exist. These arise when there is a growth in the size of the industry that the firm operates within. Better road networks (bypasses, new motorways); poaching trained workers from other firms in the same industry, government assistance with export contracts are all examples of external economies of scale. These will ultimately shift the LRAC curve of a firm down and at any given level of output costs will be lower as the industry has grown as a whole. External diseconomies are another way of causing the firms average cost curve to rise. This happens in such a case where industry expansion increases costs.
The minimum efficient scale is defined as the minimum level of any activity at which all known economies of scale can be enjoyed. There are times where there is no finite level of output at which more cost savings are eradicated; this occurs when marginal cost is constant and fixed costs can be spread over an increasing output level. This can be defined as a level of output where further doubling would reduce average cost by less than 1%. Referring to Figure 1, the minimum efficient scale is at A*. To the left of A* then long run average costs will be higher and to the right they will either be the same (constant returns) or higher if diseconomies are in existence.
The second part of this essay will attempt to explain what affect the phenomena of economies of scale and minimum efficient scale has on market structure and power. The following example demonstrates what might happen should economies of scale be available in a perfectly competitive market.
Figure 2. A perfectly competitive market.
Figure 2 shows a perfectly competitive firm which initially produces at output Q1. Price is at £10 and profits are being made (shaded area). At point Q1, the firm hasn’t taken advantage of all the potential economies of scale that are available to it. By expanding to output Q2 it will reduce average cost level, and unless the price level falls, increased profits. At the same time, however, the existence of profits will attract new firms to the industry. The effect of new firms entering and expansion of existing firms causes the short run supply curve to shift to the right; S to S1. This is because with existing firms expanding, their individual short run marginal cost curves shift to the right and also with new firms entering there are now more firms and as such more marginal cost curves to add up. With more capital flowing into the industry, the industry supply curve shifts to the right and as such price falls (the law of demand and supply). Generally speaking, firms will continue to expand as long as there are economies of scale to take advantage of and new firms will continue to enter as long as profits are being made.
When economies of scale can be realized, firms have an incentive to expand. Firms will, therefore, be pushed by competition to produce at their optimal scales. Price will be driven down to the minimum point on the LRAC curve. The price falls to £5 when all available economies of scale have been used up. At this price level no economic profits are being earned and none can be earned by changing the output level. Competition drives firms to adopt not just the most efficient technology in the short run, but also the most efficient scale of operation in the long run. This example has highlighted the fact that no one company in perfect competition can abuse economies of scale; as such market power remains unchanged as there is no dominant firm. Market structure does in fact vary; when there are economic profits to be made new firms will enter the industry and when price falls below P* meaning economic losses firms will exit. Market structure will also change as existing firms will expand when there are economies of scale available to them.
An example where it would be hard to have an effect on market structure and power would be a natural monopoly. A typical natural monopoly would be pipelines, railway lines and electricity cables and pylons. The Channel Tunnel is another example of a natural monopoly. Being the only supplier in the market, these are most likely to be underutilised and if so then it is possible to lower costs by increasing throughput in the system. In these cases not even a single producer is able to fully exploit the potential economies of scale. It stands to reason that the dominant firm in the industry is always able to undercut potential competitors and force them out of the industry if it wishes to do so. Figure 3 shows the cost curves for a natural monopoly and what might happen should a Government impose regulation.
Figure 3. Natural Monopoly.
The monopolist would produce at MC=MR at output OB and earn abnormal profit by setting a price at OF. Trying to increase competition in the market wouldn’t be feasible. By splitting the industry into two companies with each firm producing half of what was produced before (now OA) cost of production would rise from OE to OG. Producing at the Pareto-Efficient level of output where price is equal to marginal cost (MC) would result in losses. This is because at output level OC, average revenue (AR) is less than average cost (AC). Before being split into two, market structure would remain the same as the monopoly could force any new firms out of the market and regarding market power the firm could potentially be even more powerful if they took full advantage of the available economies of scale. After being split in two via regulation, the power has shifted, the firm has become weaker and the structure has changed as it’s no longer a monopoly.
Summarising the essay, the concepts of economies of scale and minimum efficient scale have proved to an extent their relevance regarding market structure and power. The example of perfect competition highlighted the fact that the existence of economies of scale was enough to attract new firms into the industry, which in turn changed the market structure. Market power wouldn’t be relevant in this case as each firm in this industry is a price-taker and not a price-maker; no one company would be able to abuse the economies of scale as there is perfect information. The concepts again have a degree of relevance when discussing a Natural Monopoly. Due to the power of a monopoly and being a price maker means there is no effect on market structure or market power. This is partly down to the huge level of economies of scale potentially available to the firm that gives them their market power and enables market structure to stay the same. The only feasible way that this could change was if regulation was introduced thus splitting up the firm. The term minimum efficient scale is again relevant but only to a certain extent. The perfect competition example demonstrates that the equilibrium in a perfectly competitive industry that ultimately the equilibrium market price is the same point as the minimum efficient scale. Minimum efficient scale isn’t relevant to a Monopoly. This is because a monopolist makes abnormal profit, the minimum efficient scale is at a level where AR is less than AC; this would never happen in reality as a monopolist is a price taker and they wouldn’t sell at a price where they couldn’t cover costs.
Bibliography:
Economics 4th Edition 1996; Case, Fair, Gartner & Heather.
Principles of Economics 3rd Edition; Anderton
Microeconomics; Katz & Rosen
Oxford Dictionary of Economics; Black
