Sunday, 18 December 2011
Monday, 5 December 2011
Sunday, 4 December 2011
Sunday, 13 November 2011
Chapter 11: Firms in Perfectly Competitive Markets
Learning Objective 1 :
Define a perfectly competitive market, and explain why a perfect competitor faces a horizontal demand curve.
Firms in perfectly competitive markets are unable to control the prices of the goods they sell and cannot earn economic profits in the long run. A perfectly competitive market meets the conditions of (1) many buyers and sellers, (2) all firms selling identical products, and (3) no barriers to new firms entering the market.
A. A Perfectly Competitive Firm Cannot Affect the Market Price.
Prices in perfectly competitive markets are determined by the intersection of market demand and supply.
Consumers and firms must accept the market price if they want to buy and sell in a competitive market. A buyer or seller who is unable to affect the market price is a price taker. Each buyer and seller in a perfectly competitive market is too small to affect the market price.
B. The Demand Curve for the Output of a Perfectly Competitive Firm
Because the firm is a price taker, it can sell as much output as it wants at the market price. Although the market demand curve has the normal downward shape, the demand curve for a perfectly competitive firm is horizontal at the market price.
Define a perfectly competitive market, and explain why a perfect competitor faces a horizontal demand curve.
Firms in perfectly competitive markets are unable to control the prices of the goods they sell and cannot earn economic profits in the long run. A perfectly competitive market meets the conditions of (1) many buyers and sellers, (2) all firms selling identical products, and (3) no barriers to new firms entering the market.
A. A Perfectly Competitive Firm Cannot Affect the Market Price.
Prices in perfectly competitive markets are determined by the intersection of market demand and supply.
Consumers and firms must accept the market price if they want to buy and sell in a competitive market. A buyer or seller who is unable to affect the market price is a price taker. Each buyer and seller in a perfectly competitive market is too small to affect the market price.
B. The Demand Curve for the Output of a Perfectly Competitive Firm
Because the firm is a price taker, it can sell as much output as it wants at the market price. Although the market demand curve has the normal downward shape, the demand curve for a perfectly competitive firm is horizontal at the market price.
Saturday, 12 November 2011
Tuesday, 1 November 2011
ASSIGNMENT !
SEMUA PELAJAR DIKEHENDAKI MENJAWAB SEMUA SOALAN ASSIGNMENT DI BAWAH .
JAWAPAN HENDAKLAH DIHANTAR PADA 23 NOV 2011 (WAKTU KULIAH).
Tuesday, 18 October 2011
Tuesday, 11 October 2011
Lecture Note : Chapter 5 - Externalities, Environmental Policy, and Public Goods
Chapter Summary:
An externality is a benefit or cost that affects someone not directly involved in the production or consumption of a good or service. Negative externalities are costs imposed on individuals not directly involved in producing or consuming a good or service. Positive externalities are benefits received by individuals not directly involved in producing or consuming a good or service. When there is a negative externality as the result of production, the market supply curve understates the full economic cost, the social cost, of production. Economic efficiency would be increased if less of the good or service were
produced. When there is a positive externality, the market demand curve understates the full economic benefit, the social benefit, from consumption and too little of the good is produced.
produced. When there is a positive externality, the market demand curve understates the full economic benefit, the social benefit, from consumption and too little of the good is produced.
Negative and positive externalities lead to market failure. The absence of private property rights or the lack of sufficient enforcement of existing property rights is the underlying cause of externalities and other forms of market failure. Private solutions are possible and efficient if there are low transactions costs. When private solutions to externalities are not feasible, government intervention may be required. For example, if a negative externality is present, government can impose a tax equal to the additional external costs (the difference between the social cost and the private cost). When there are positive externalities,government can provide a subsidy to consumers equal to the external benefits.
To reduce pollution, governments have often used a command and control approach. With this approach, the government sets specific quantitative limits on each pollutant emitted, or the government may dictate the installation of specific pollution control devices.
Saturday, 8 October 2011
Wednesday, 5 October 2011
Tuesday, 4 October 2011
Economic Efficiency - Consumer Surplus & Producer Surplus.
Consumer Surplus and Producer Surplus
Learning Objective 1 :
Distinguish between the concepts of consumer surplus and producer surplus.
Consumer surplus measures the dollar benefit consumers receive from buying goods and services in a particular market. Producer surplus measures the dollar benefit firms receive from selling goods and services in a particular market. Economic surplus is the sum of consumer surplus plus producer surplus. When the government imposes a price ceiling or a price floor, the amount of economic surplus is reduced.
A. Consumer Surplus
Consumer surplus measures the difference between the highest price a consumer is willing to pay and the price the consumer actually pays. The demand curve can be used to measure the total consumer surplus in a market. Demand curves show the willingness of consumers to purchase a product at different prices. Consumers are willing to purchase a product up to the point where the marginal benefit of consuming a product is equal to its price. The marginal benefit is the additional benefit to a consumer from consuming one more unit of a good or service. The total amount of consumer surplus in a market is equal to the area below the demand curve and above the market price. This area represents the benefit to consumers in excess of the price they paid for a product.
B. Producer Surplus
Supply curves show the willingness of firms to supply a product at different prices. Firms will supply an additional unit of a product only if they receive a price equal to the additional cost of producing that unit. Marginal cost is the additional cost to a firm of producing one more unit of a good or service. Often, the marginal cost of producing a good increases as more of the good is produced during a given time period.
Producer surplus is the difference between the lowest price a firm would have been willing to accept and the price it actually receives. The total amount of producer surplus in a market is equal to the area above the market supply curve and below the market price.
Learning Objective 1 :
Distinguish between the concepts of consumer surplus and producer surplus.
Consumer surplus measures the dollar benefit consumers receive from buying goods and services in a particular market. Producer surplus measures the dollar benefit firms receive from selling goods and services in a particular market. Economic surplus is the sum of consumer surplus plus producer surplus. When the government imposes a price ceiling or a price floor, the amount of economic surplus is reduced.
A. Consumer Surplus
Consumer surplus measures the difference between the highest price a consumer is willing to pay and the price the consumer actually pays. The demand curve can be used to measure the total consumer surplus in a market. Demand curves show the willingness of consumers to purchase a product at different prices. Consumers are willing to purchase a product up to the point where the marginal benefit of consuming a product is equal to its price. The marginal benefit is the additional benefit to a consumer from consuming one more unit of a good or service. The total amount of consumer surplus in a market is equal to the area below the demand curve and above the market price. This area represents the benefit to consumers in excess of the price they paid for a product.
B. Producer Surplus
Supply curves show the willingness of firms to supply a product at different prices. Firms will supply an additional unit of a product only if they receive a price equal to the additional cost of producing that unit. Marginal cost is the additional cost to a firm of producing one more unit of a good or service. Often, the marginal cost of producing a good increases as more of the good is produced during a given time period.
Producer surplus is the difference between the lowest price a firm would have been willing to accept and the price it actually receives. The total amount of producer surplus in a market is equal to the area above the market supply curve and below the market price.
Tuesday, 27 September 2011
CONSUMER BEHAVIOR : CHAPTER 3
Consumer Behavior
Basics
- The Theory of Consumer Behavior, like the Law of Demand, can be explained by the Law of Diminishing Marginal Utility.
- Consumer Behavior is how consumers allocate their money incomes among goods and services.
- Rational behavior:
- The consumer is a rational person, who tries to use his or her money income to derive the greatest amount of satisfaction, or utility, from it. Consumers want to get "the most for their money" or, to maximize their total utility. Rational behavior also "requires" that a consumer not spend too much money irrationally by buying tons of items and stock piling them for the future, or starve themselves by buying no food at all. Consumers (we assume) all engage in rational behavior.
- Preferences:
- Each consumer has preferences for certain of the goods and services that are available in the market. Buyers also have a good idea of how much marginal utility they will get from successive units of the various products they might purchase. However, the amount of marginal & total utility that the people will get will be different for every individuals in the group because all individuals have different taste and preferenes.
- Budget Constraint:
- The consumer has a fixed, limited amount of money income. Because each consumer supplies a finite amount of human and property resources to society, he or she earns only limited income.
- Every consumer faces a budget constraint
- There is infinite demand, but limited income
- Prices:
- Goods are scarce because of the demand for them. Each consumers purchase is a part of the total demand in a market. However, since consumers have a limited income, they must choose the most satisfying combination of goods based partially on prices. For producers, a lower price is needed in order to induce a consumer to buy more of their product.
- To maximize satisfaction, a consumer should allocate his or her money so that the last dollar spent on each product, yields the same amount of marginal (extra) utility.
- When marginal utility are equivalent, consumer is in a equilibrium.
Marginal Utility per dollar:
- Rational consumers should compare extra utility from each product with its added price.
- Although spending all of one's income yields the greatest total utility, saving can be regarded as "commodity", that yields utility.
- MU/$ is found by taking the Marginal utility per good over the price of each good.
- This can be used to determine a buying pattern, and to help figure out what goods will be bought when.
-
- If marginal utility increases, then total utility increases
- If marginal utility decreases, then total utility decreases
Algebraic Restatement:
- MU of product A/Price of A = MU of product B/price of B (this is when the consumer is at equilibrium)
- MU of A = 6units/Price of A = $1 < MU of B = 18units/Price of B = $2, therefore, 6 < 9 (This concludes that the consumer can increase total utility by purchasing more of product B than product A.
- MUa = MUbPa Pb
Sunday, 25 September 2011
Tutorial Note No.2
After reading the whole note,the student is expected to able to :
- explain supply and demand analysis.
- Distinguish between a change in quantity DD & SS and a change in demand & supply.
- Calculate elasticities and explain the concept of elasticties.
- Understand how Government make Intervention in the Market.
- Applies of supply and demand analysis.
Wednesday, 21 September 2011
Tuesday, 20 September 2011
Lecture Note : Chapter 2 - The Basics Of Supply and Demand.
One of the best ways to appreciate the relevance of economics is to begin with the basics of supply and demand. Supply demand analysis is a fundamental and powerful tool that can be applied to a wide variety of interesting and important problems. To name a few:
- Understanding and predicting how changing world economic conditions affect market price and production.
- Evaluating the impact of goverment price controls, minimum wages, price supports and production incentives.
- Determining how taxes, subsidies, tariffs and import quotas affect consumers and producers.
Monday, 19 September 2011
TUTORIAL NOTES NO:1
This is the NO:1 of my Tutorial notes of a microeconomics course MES3023 students.The Notes is posted on the Internet, and access is entirely free.I am grateful for allowing it to be downloaded.
What is Microeconomics?
Economics is studied from two different perspectives, the macro view and the micro view. Macroeconomics is the study of the determination of economic aggregates such as national output, the level of employment, the price level and the rate of economic growth. Microeconomics studies resource allocation and income distribution as they are affected by the free working of the price system and specific government policies. How, for example, do firms and households make spending choices? What determines an individual's wages? How does the availability of public housing affect supply in the housing market?
Scarcity, Choice and Opportunity Cost
Scarcity of resources forces everyone to make choices. For example, faced with a fast approaching mid-term exam, a student could either study or go to a party. In this case, the cost of having a good time can be measured in terms of lost marks on the mid-term. Such a cost is called an opportunity cost.Opportunity cost, the measurement of the cost of something in terms of forgone alternatives, is fundamental to the study of economics. This concept can be illustrated by a production possibilities frontier, a graphical representation of the combinations of goods and services that are just attainable when all of society's resources are efficiently employed. .
TUTORIAL NOTE NO:1
What is Microeconomics?
Economics is studied from two different perspectives, the macro view and the micro view. Macroeconomics is the study of the determination of economic aggregates such as national output, the level of employment, the price level and the rate of economic growth. Microeconomics studies resource allocation and income distribution as they are affected by the free working of the price system and specific government policies. How, for example, do firms and households make spending choices? What determines an individual's wages? How does the availability of public housing affect supply in the housing market?
Scarcity, Choice and Opportunity Cost
Scarcity of resources forces everyone to make choices. For example, faced with a fast approaching mid-term exam, a student could either study or go to a party. In this case, the cost of having a good time can be measured in terms of lost marks on the mid-term. Such a cost is called an opportunity cost.Opportunity cost, the measurement of the cost of something in terms of forgone alternatives, is fundamental to the study of economics. This concept can be illustrated by a production possibilities frontier, a graphical representation of the combinations of goods and services that are just attainable when all of society's resources are efficiently employed. .
TUTORIAL NOTE NO:1
Tuesday, 13 September 2011
MES 3023: An Introduction to Microeconomics
The Scope of Microeconomic Theory.
The prefix micro- in microeconomics comes from the Greek word mikros, meaning small. It contrasts with macroeconomics, the other branch of economic theory. Macroeconomics deals primarily with aggregates, such as the total amount of goods and services produced by society and the absolute level of prices, while microeconomics analyzes the behavior of “small” units: consumers, workers, savers, business managers,
firms, individual industries and markets, and so on. Microeconomics, however, is not limited to “small” issues. Instead, it reflects the fact that many “big” issues can best be understood by recognizing that they are composed of numerous smaller parts. Just as much of our knowledge of chemistry and physics is built on the study of molecules, atoms, and subatomic particles, much of our knowledge of economics is based on the
study of individual behavior. Individuals are the fundamental decisionmakers in any society. Their decisions, in
the aggregate, define a society’s economic environment. Consumers decide how much of various goods to purchase, workers decide what jobs to take, and business owners decide how many workers to hire and how much output to produce. Microeconomics encompasses the factors that influence these choices and the way these innumerable small decisions merge to determine the workings of the entire economy. Because prices have important effects on these individual decisions, microeconomics is frequently called price theory.
firms, individual industries and markets, and so on. Microeconomics, however, is not limited to “small” issues. Instead, it reflects the fact that many “big” issues can best be understood by recognizing that they are composed of numerous smaller parts. Just as much of our knowledge of chemistry and physics is built on the study of molecules, atoms, and subatomic particles, much of our knowledge of economics is based on the
study of individual behavior. Individuals are the fundamental decisionmakers in any society. Their decisions, in
the aggregate, define a society’s economic environment. Consumers decide how much of various goods to purchase, workers decide what jobs to take, and business owners decide how many workers to hire and how much output to produce. Microeconomics encompasses the factors that influence these choices and the way these innumerable small decisions merge to determine the workings of the entire economy. Because prices have important effects on these individual decisions, microeconomics is frequently called price theory.
Microeconomics is based on the belief that most behavior can be explained by assuming consumers have stable, well-defined preferences and they make rational market choices consistent with these preferences. This provides the foundation for building economic models.
A model is used to simplify reality from which conclusions are logically deduced about some system. A system is a group of units interacting to form a whole - For example, consumers and producers interact to form a market system.
Consider a model of consumer behavior with the following assumptions:
1. Consumer is rational and attempts to maximize satisfaction (utility)
2. Consumer has a fixed level of income
3. Commodities (goods and services) vary continuously, and utility consumer derives from them is measurable
4. Consumer has a given set of preferences for these commodities
5. Commodity prices are constant
Monday, 12 September 2011
MES 3023 - MICROECONOMICS
COURSE DESCRIPTION
This course will cover the area of economics commonly defined as microeconomics which is concerned with the individual parts of the economy such as individual businesses or industries, individual consumers, and individual products. Our goal is to study whether the economy uses our limited resources to obtain the maximum satisfaction possible for society. We will concentrate on three issues or goals: ALLOCATIVE EFFICIENCY, PRODUCTIVE EFFICIENCY, and EQUITY (efficiency, efficiency, and equity).
This course will cover the area of economics commonly defined as microeconomics which is concerned with the individual parts of the economy such as individual businesses or industries, individual consumers, and individual products. Our goal is to study whether the economy uses our limited resources to obtain the maximum satisfaction possible for society. We will concentrate on three issues or goals: ALLOCATIVE EFFICIENCY, PRODUCTIVE EFFICIENCY, and EQUITY (efficiency, efficiency, and equity).
MES 3023 - MICROECONOMICS
FAKULTI PENGURUSAN PERNIAGAAN DAN PERAKAUNAN
Peringatan: Kandungan Maklumat Semasa Kursus ini tidak boleh diubah tanpa kelulusan jabatan / bahagian berkenaan.
| Academic year : | Semester 1 2009/2010 |
| Code : Course : Credit hours : | MES 3023 MICROECONOMICS 3 |
| Required Text Main references : | 1. Robert S.Pindyck dan Daniel L.Rubinfeld (2003), Microeconomics, 6th Edition, Prentice-Hall, New York 2. Dominick Salvatore (2003), Microeconomics Theory and Applications. 4th Edition. Oxford University Press, Inc. 3. Robert H.Frank (2003), Microeconomics and Behavior, 3rd edition, Mc Graw Hill. 4. Jack Hirshleifer dan David Hirshleifer (1998), Price Theory and Applications, 6th edition, Prentice-Hall, New York |
| Teaching Tools/ Equipments : | White board, LCD Projector |
| Teaching & Learning Methods : Blog Learning: | Lecture, Assignment, Tutorial, Quiz and Mid Semester Examination http://lecture67.blogspot.com/ |
| Lecturer : Tel / email : | TENGKU KHAIRI BIN TENGKU A.RAHMAN 0145433146 / lecture67@gmail.com |
| Day / Lecture time : Room : | Wednesday 8am-10am. GC22 |
| Grading | Aplia Exercises and Quizzes (15%) Test (15%) Midexam (20%) Final Exam (50%) |
Saturday, 2 April 2011
Oligopoly
Lecture Series No:12
An oligopoly is a market form in which a market or industry is dominated by a small number of sellers (oligopolists). The word is derived, by analogy with "monopoly", from the Greek ὀλίγοι (oligoi) "few" + πωλειν (polein) "to sell". Because there are few sellers, each oligopolist is likely to be aware of the actions of the others. The decisions of one firm influence, and are influenced by, the decisions of other firms. Strategic planning by oligopolists needs to take into account the likely responses of the other market participants.
Oligopolistic competition can give rise to a wide range of different outcomes. In some situations, the firms may employ restrictive trade practices (collusion, market sharing etc.) to raise prices and restrict production in much the same way as a monopoly. Where there is a formal agreement for such collusion, this is known as a cartel. A primary example of such a cartel is OPEC which has a profound influence on the international price of oil.
Monopolistic competition
Lecture Series No:11
Monopolistic competition is a form of imperfect competition where many competing producers sell products that are differentiated from one another (that is, the products are substitutes but, with differences such as branding, are not exactly alike). In it, a firm takes the prices charged by its rivals as given but ignores the impact of its own prices on the prices of other firms.[1] In monopolistic competition, firms can behave like monopolies in the short run, including using market power to generate profit. In the long run, other firms enter the market and the benefits of differentiation decrease with competition; the market becomes more like perfect competition where firms cannot gain economic profit. However, in reality, if consumer rationality/innovativeness is low and heuristics is preferred, monopolistic competition can fall into natural monopoly, at the complete absence of government intervention.[2] At the presence of coercive government, monopolistic competition will fall into government-granted monopoly. Unlike perfect competition, the firm maintains spare capacity. Models of monopolistic competition are often used to model industries. Textbook examples of industries with market structures similar to monopolistic competition include restaurants, cereal, clothing, shoes, and service industries in large cities. The "founding father" of the theory of monopolistic competition was Edward Hastings Chamberlin in his pioneering book on the subject Theory of Monopolistic Competition (1933).[3] Joan Robinson also receives credit as an early pioneer on the concept
Monopolistic competition is a form of imperfect competition where many competing producers sell products that are differentiated from one another (that is, the products are substitutes but, with differences such as branding, are not exactly alike). In it, a firm takes the prices charged by its rivals as given but ignores the impact of its own prices on the prices of other firms.[1] In monopolistic competition, firms can behave like monopolies in the short run, including using market power to generate profit. In the long run, other firms enter the market and the benefits of differentiation decrease with competition; the market becomes more like perfect competition where firms cannot gain economic profit. However, in reality, if consumer rationality/innovativeness is low and heuristics is preferred, monopolistic competition can fall into natural monopoly, at the complete absence of government intervention.[2] At the presence of coercive government, monopolistic competition will fall into government-granted monopoly. Unlike perfect competition, the firm maintains spare capacity. Models of monopolistic competition are often used to model industries. Textbook examples of industries with market structures similar to monopolistic competition include restaurants, cereal, clothing, shoes, and service industries in large cities. The "founding father" of the theory of monopolistic competition was Edward Hastings Chamberlin in his pioneering book on the subject Theory of Monopolistic Competition (1933).[3] Joan Robinson also receives credit as an early pioneer on the concept
Saturday, 19 March 2011
Monopoly.
Lecture Series No:10
In economics, a monopoly (from Greek monos / μονος (alone or single) + polein / πωλειν (to sell)) exists when a specific individual or an enterprise has sufficient control over a particular product or service to determine significantly the terms on which other individuals shall have access to it. (This is in contrast to a monopsony which relates to a single entity's control over a market to purchase a good or service, and contrasted with oligopoly where a few entities exert considerable influence over an industry)[1][clarification needed] Monopolies are thus characterised by a lack of economic competition to produce the good or service and a lack of viable substitute goods.[2] The verb "monopolise" refers to the process by which a firm gains persistently greater market share than what is expected under perfect competition.
Characteristics
- Single seller: In a monopoly there is one seller of the good who produces all the output.[3] Therefore, the whole market is being served by a single firm, and for practical purposes, the firm is the same as the industry.
- Market power: Market power is the ability to affect the terms and conditions of exchange so that the price of the product is set by the firm (price is not imposed by the market as in perfect competition).[4][5] Although a monopoly's market power is high it is still limited by the demand side of the market. A monopoly faces a negatively sloped demand curve not a perfectly inelastic curve. Consequently, any price increase will result in the loss of some customers.
- Firm and industry: In a monopoly, market, a firm is itself an industry. Therefore, there is no distinction between a firm and an industry in such a market.
- Price Discrimination: A monopolist can change the price and quality of the product. He sells more quantities charging less price against the product in a highly elastic market and sells less quantities charging high price in a less elastic market.
Saturday, 12 March 2011
PERFECT COMPETITION
This topic the principles which guide firms in their price and quantity decisions will be set out in the short and long run. Perfect competition is defined. The demand and marginal revenue are derived. The equivalence between profit maximization and equality of marginal revenue and marginal cost is established. The long run equilibrium is studied. The economic effect of this market form is shown to be optimum for society.
Definition:
Theoretical free-market situation where (1) buyers and sellersdegree of individualcontrol over prices, (2) all buyers and sellers seek to maximize their profit (income), (3) buyers and seller can freely enter or leave the market, (4) all buyers and sellers have access to information regarding availability, prices, and quality of goodshomogeneous, hence substitutable for one another. Also called perfect market or pure competition.
introduction:
A perfectly competitive industry is highly unlikely to exist in its entirety given the strong assumptions made about the operation of the market.All markets are “competitive” to one degree or another, but the vast majority of markets are characterised as “imperfectly competitive”. We do, though get closer to perfect competition in many markets for agricultural and other primary commodities. These are the only markets where there are enough sellers of products that are near perfect substitutes for each other.
Main Assumptions of Perfect Competition
• Each firm produces only a small percentage of total market output. It therefore exercises no control over the market price. For example it cannot restrict output in the hope of forcing up the existing market price. Market supply is the sum of the outputs of each of the firms in the industry
• No individual buyer has any control over the market price - there is no monopsony power. The market demand curve is the sum of each individual consumer’s demand curve – essentially buyers are in the background, exerting no influence at all on market price.
• Buyers and sellers must regard the market price as beyond their control.
• There is perfect freedom of entry and exit from the industry. Firms face no sunk costs that might impede movement in and out of the market. This important assumption ensures all firms make normal profits in the long run.
• Firms in the market produce homogeneous products that are perfect substitutes for each other. This leads to each firms being price takers and facing a perfectly elastic demand curve for their product.
• Perfect knowledge – consumers have perfect information about prices and products.
• There are no externalities which lie outside the market.
LECTURE SERIES NO.9
Saturday, 5 March 2011
long run costs of production
The time periods that we use in Economics can sometimes appear somewhat arbitrary – they help to provide a framework within which we can analyse the behaviour of businesses in different markets and industries, but the length of time that constitutes the short run clearly varies across industries and the reality is that most businesses can vary the amount of capital input in the short run by leasing items of machinery and renting additional commercial property and factory space if it is available.
The key point about the long run is that all factors of production are assumed to be variable, in other words a business can vary all of its inputs and change the whole scale of production. How a firm’s output responds to a change in factor inputs is called returns to scale. The hypothetical returns for a business varying the scale of production is shown in the table below
Labour Input | Plant 1 | Plant 2 | Plant 3 | Plant 4 |
10 | 40 | 100 | 130 | 150 |
20 | 100 | 160 | 180 | 210 |
30 | 130 | 180 | 240 | 250 |
40 | 150 | 200 | 255 | 275 |
50 | 160 | 210 | 270 | 290 |
| Capital Input | 10 | 20 | 30 | 40 |
In the example shown when the business increases the scale of production from Plant 1 (with 10 units of labour and 10 units of capital) to Plant 2 (a doubling of the inputs used), total output quadruples. This shows increasing returns to scale leading to a fall in the average total cost of production. A further increase in scale to Plant 3 demonstrates constant returns to scale where both inputs and output have increased by 50% and a further expansion of scale to Plant 4 illustrates decreasing returns to scale where inputs have grown by 33% but output has grown by just 15%. When a firm experiences decreasing returns to scale, then average total cost will rise – in other words diseconomies of scale exist.
Economies and Diseconomies of Scale
In the long run the scale of production can be increased or reduced, because all factors are variable. This allows the firm to move on to new average cost curves. For each size of firm there is an equivalent short run average cost curve. As the firm expands, it moves on to different short run average cost curves. If expanding the scale of output leads to a lower average cost for each level of output then the firm is said to be experiencing economies of scale.
The long run average total cost curve (LRAC) shown in the diagram below is the locus of points representing the minimum average total cost of producing any given rate of output, given current technology and resource prices. The LRAC curve or envelope curve is drawn on the assumption of infinite plant sizes. The points of tangency do not occur at the minimum points of the SRAC curves except at the point where the minimum efficient scale (MES) is achieved. MES is the minimum level of output required to fully exploit economies of scale in the long run:
One way of interpreting the minimum efficient scale is to consider the cost disadvantage of producing an output below the estimated MES. Consider the diagram below. The lowest point of the LRAC occurs at an output of 90,000 per month where average total cost = £10 per unit. At an output level of ½ of MES (45,000 per month) the average cost is estimated to be £25 per unit. At an output level of just 1/3 of MES the cost disadvantage is even greater with AC rising to £40 per unit.
The steeper the fall in the LRAC up to the MES, the greater the cost advantage in exploiting economies of scale. The LRAC will tend to fall steeply when the overhead costs of production are high and the marginal costs of producing extra output are low – the classic examples of industries where this occurs are in markets such as steel production, motor car manufacturing, pharmaceuticals and computer software.
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