ECON 2302 Long Run Size Adjustments, Economies/Diseconomies of Scale

Summary

In this engaging video session, Prof. Hank Lewis dives into long-run size adjustments within microeconomics, particularly focusing on economies and diseconomies of scale. He explains the critical decisions businesses face regarding staying or exiting the market based on long-run average total costs. Prof. Lewis expertly outlines how companies can optimize their operations through economies of scale by increasing their size, resulting in reduced per-unit costs. Conversely, he warns of the pitfalls associated with diseconomies of scale, illustrated through practical examples of large corporations like General Motors. The session emphasizes the importance of achieving the minimum efficient scale and managing resource allocation efficiently to maintain competitive advantage and profitability in the long run.

Highlights

• Exploring long-run decisions to stay or leave the market. 🌎
• Understanding the long-run average total cost curve's role. 📊
• Utilizing economies of scale for cost-effective growth. 📈
• Recognizing diseconomies of scale through real-world examples. 🚨
• Achieving the minimum efficient scale for optimal efficiency. 🎯

Key Takeaways

• Staying or exiting the market is a key long-run decision for businesses. 🌟
• The long-run average total cost curve helps firms decide on production levels. 📉
• Economies of scale occur when increasing size reduces per-unit costs. 🚀
• Diseconomies of scale arise when larger sizes increase per-unit costs. 🏢
• Minimum efficient scale maximizes resource efficiency and profit. 💡

Overview

Long-run decisions in businesses primarily involve whether to stay in the market or exit, hinging on the critical analysis of long-run average total costs. Prof. Hank Lewis highlights that a firm's decision is influenced heavily by the optimal market price (P star) and how it compares to these costs. 🚪💼

The concept of economies of scale is crucial in helping firms reduce average costs as they expand their operations. Larger businesses can exploit discounts and advanced technology, as discussed with the example of burger joints reducing costs per unit through bulk purchasing. 🍔⚙️

Conversely, diseconomies of scale present challenges when a firm grows too large, leading to inefficiencies like bureaucracy, as seen in large corporations. Prof. Lewis mentions General Motors as a case of excessive management layers hindering quick decision-making and efficiency. 🏢🔍

Chapters

• 00:00 - 03:00: Long-Run Decisions in Business This chapter discusses long-run decisions in microeconomics, focusing on whether businesses should stay in or exit a market. It explains that in the long run, companies do not have the option to temporarily shut down but must decide to continue operating or leave the market entirely. The decision revolves around the optimal price (denoted as P star) and considerations of profitability and sustainability within the market. The chapter integrates an analogy from the song 'Should I Stay or Should I Go' to illustrate the decision-making process businesses face.
• 03:00 - 05:00: Long-Run Cost Function Graphs The chapter discusses the concept of long-run cost functions in the context of competitive markets. It highlights that in a perfect competition scenario, the market equilibrium price must at least equal the minimum long-run average total cost for firms to remain in the market. If the market equilibrium price falls below this threshold, firms are likely to exit the market due to economic losses, which are undesirable for entrepreneurs. The chapter essentially emphasizes the relationship between market prices and long-run average costs in determining a firm's sustainability in the market.
• 05:00 - 08:00: Minimum Efficient Scale and Productive Efficiency This chapter discusses the concept of long-run cost functions and their graphical representations, emphasizing the bowl-shaped curve of the long-run average total cost (LRATC). It underscores the importance of understanding these curves for assessing productive efficiency and minimum efficient scale within a business context. As the quantity (q) increases, these cost representations become increasingly significant.
• 08:00 - 15:00: Economies and Diseconomies of Scale The chapter discusses the concepts of economies and diseconomies of scale, focusing on how a firm's physical size changes. It distinguishes between the short run, where a firm's scale of operation is fixed, and the long run, where the scale is variable. In the long run, as output quantity increases, a business can expand in size, while a decrease in output can lead to a reduction in size, highlighting the flexibility available in the long run.
• 15:00 - 18:30: Market Structures and Long-Run Adjustments The chapter 'Market Structures and Long-Run Adjustments' discusses the relationship between long-run marginal cost (LRMC) and long-run average cost (LRAC) curves. It explains that the LRMC will intersect the LRAC at its minimum point. This relationship is consistent and is explained by calculus principles. The chapter also highlights that there is only one long-run average cost curve, which serves as both the average total cost and average variable cost curve in the long run, as all costs are considered variable over this time period.
• 18:30 - 19:30: Example of Firm Size Adjustments In this chapter titled 'Example of Firm Size Adjustments,' the discussion revolves around the long-run marginal cost curve, specifically its role as the individual business's long-run supply curve. It is stated that a firm will not participate in the market if the price is below a certain point on this curve but will supply if the price equals or exceeds that point. Additionally, it is highlighted that business size adjusts as one moves along the curve, reflecting changes and strategies of firms in response to market conditions.
• 19:30 - 20:00: Conclusion and Recap The chapter focuses on the concept of Minimum Efficient Scale (MES), which is deemed the ideal size for production. This is the point where the long-run average total cost of producing one unit is minimized. Sizes smaller than the MES result in a higher average total cost.

ECON 2302 Long Run Size Adjustments, Economies/Diseconomies of Scale Transcription

• 00:00 - 00:30 everybody welcome back to microeconomics here I'm talking a little bit about some long-run adjustments for the individual business first thing I want to mention here is about long-run decisions in the long run there isn't no shutting down in the long run the decision is either stay in the market or exit the market stay in produce or leave as the old class song went darling you've got to let me know should I stay or should I go and that's the thing here though as long as P star which means an optimal
• 00:30 - 01:00 price for not perfect competition and market equilibrium for perfect competition is greater than or equal to the minimum long-run average total cost we just say long-run average cost but it's actually technically long-run average total cost either one it's correct firm remains in the market but if P star for the long-run is below the minimum long-run average total cost that firm is going to decide to exit the market because long-run economic losses are not something any entrepreneur wants to experience and so we just do not want
• 01:00 - 01:30 to go there now I'm gonna skip a little bit ahead here and talk about long-run cost function graphs because this is some that kind of matters tremendously here in the long run the long-run average total cost curve is a bowl-shaped curve and we also just have the upper sloping piece of the long-run marginal cost because that is the business end of things but I want to mention here that the actual scale of length to the horizontal average is a lot longer reason as q gets bigger the
• 01:30 - 02:00 firm's physical size is changing now when we learned about short and long run not too long ago we talked about the fact that in the short run the scale of operation our physical size is fixed but in the long run the scale of operation or physical size is variable and so when quantity of alpha gets bigger in the long run you get a bigger size business and some less output means a smaller size business a lot more flexibility in the long run please notice also that's
• 02:00 - 02:30 similar to the short run the long run marginal cost will penetrate the long run average cost or intersect I should say at this minimum that is just a standard that's just the way it always works with these two curves because of an actual calculus relationship that's not less sorry to know for the survey courses in micro please just also remember there's only one long-run average cost curve it is both average total and average variable for long-run because Y all costs are if you said variable in the
• 02:30 - 03:00 long-run you were correct now also this personal this purple segment of the long-run marginal cost curve serves as the individual businesses long-run supply curve the firm is not in the market and not supplying if the price is below this point but if it's equal to or greater than it will be supplying and so this is the long run supply curve what's important to know though here is that business size keeps changing as you move along the curve but the thing is the
• 03:00 - 03:30 size that is associated with this minimum point has a special name M e s which stands for minimum efficient scale this represents an ideal size the reason why the size is considered ideal is if you look at the long-run average total cost the average cost to produce one unit of output is as low as possible at whatever size contains the minimum sizes that are smaller you'll notice the dollar value for the average total cost
• 03:30 - 04:00 is higher they have larger per unit cost of production and then sizes that are bigger than this one also have higher per unit cost of production this is where the per unit cost of production is minimized and so that means the business is productively efficient meaning it is using his resources in its most best way possible its allocated Li efficient meaning you don't have resources sitting idle or being wasted so both production and allocation of resources production of goods and services are as efficient as possible and you can't squeeze more
• 04:00 - 04:30 blood from that turnip as the saying goes now some other things to talk about when the firm's size changes in the long run we have concepts that are going with this here when the firm's size gets bigger and the average total cost drops per unit of output we say the firm experiences economies of scale so when the firm is getting a larger it may be able to take advantage of economies of scale that it could not take advantage of it I mean you don't see assembly lines and automation in a lot of small businesses
• 04:30 - 05:00 because they're too expensive they're too large and really labor is a better thing to use in those instances but in factories especially there's a lot more automation now assembly line robots they don't ask for coffee breaks don't ask for two-week vacations and don't call in sick those types of areas there can actually be exploited much better because you're producing a lot more items in a lots larger space and so the bigger businesses can take advantage that large machine capital is one example of an economy of scale another example is at a friend of mine that owns
• 05:00 - 05:30 some burger joints and he has opened up more locations with every location is cost per pound of beef its cost per area of buns is cost per pound of cheese is cost per bushel of onions and tomatoes has dropped because he's buying so much more from his material suppliers they are charging him less per unit which means is the cost to make one single burger keeps getting smaller and smaller volume discounts and raw materials is an example of an economy of scale now minimum efficient scale is at the bottom but notice you get sizes that are bigger you start seeing as the sizes get bigger
• 05:30 - 06:00 the average total costs per unit is getting bigger again or higher that's where like some inefficiencies are setting in but we don't call those any efficiencies we call those diseconomies of scale class have you ever had to deal with a business we had to go through so many departments just to get a simple task fixed for customer service that's what you call a situation called bureaucracy or red tape too many layers of management too many people who've got too many subdivided jobs and simple jobs it should be completed to help a
• 06:00 - 06:30 customer aren't being depleted because you're hearing too much that's not my job and not enough well let me take care of it or I can do this thing General Motors had these problems that's part of the reason why they didn't closing about half their divisions about a decade ago is because they had so much bureaucracy a batch of parts that was shipped to a factory that was defective the floor manager couldn't call the parts supplier directly to where new parts he had to go up a chain of command to a vice-president who called a vice president the parts supplier and then went down the chain of command they should have eliminated all those
• 06:30 - 07:00 middlemen and taking care of the problem faster and otherwise it wouldn't have assembled a bunch of cars with defective gear shifter boxes or defective air bags and ended up having a bunch of recalls and pay off a bunch of lawsuits those diseconomies of scale cost General Motors and several car companies dearly and if you take a look at some of the car companies they tell you that Mitsubishi and Honda they have a lot fewer layers of management and people at lower levels have greater authority to take care of things so a small problem is less likely to turn to a big one now I show the minimum
• 07:00 - 07:30 efficient scale where the sperm is taking advantage of all the economies of scale but not experiencing diseconomies of scale as a point minimum but in reality some market structures you have a flat bottom minimum instead of a point minimum if this thing was like a long flattened bottom here we would say that the firm is experiencing constant returns to scale need their economies Nordisk economies of scale sometimes there are multiple sizes that result in mm an efficient scale to market structures are likely to have them - others are not we'll talk about
• 07:30 - 08:00 that in a minute now here are some of examples of the economies and diseconomies of scale I've already mentioned volume discounts and raw materials and the use of large machine capital and technology as examples of economies of scale another one is specialization of Labor and management it's a lot easier for an owner who owns fire burger joints to be like a district manager and have a head manager and an assistant manager for each individual location and they make the operational decisions at the location level but something that involves a lot of money or a major issue
• 08:00 - 08:30 that's what they pass up to the district manager or the owner and he handles the bigger marketing and overall operations versus individual location things like schedules and whatnot dividing up the labor and management makes the job easier to do but again really small businesses don't have that capability usually the owner is the head manager and does the scheduling and does everything as businesses get larger the owner can't do that they can't wear that many hats some examples of diseconomies of scale I've mentioned the bureaucracy but here's a couple of others
• 08:30 - 09:00 really big companies like Walmart and Target have a lot of money they set aside every year and their budget to settle what are called nuisance lawsuits these are like slip and fall lawsuits and whatnot where somebody's trying to basically get some money from a big company and the unfortunate reality is in some cases it's cheaper to settle those lawsuits than it is to fight them and win which they probably would that's kind of crazy but again smaller businesses less likely to get sued about this stuff because they don't have the money to pay off these things large companies also are frequently on the target of the
• 09:00 - 09:30 regulator's as a business gets bigger the regulator's will scrutinize them much more which means it's much more likely that they're going to end up being the Soviet of an antitrust lawsuit an investigation by the Health Department or without this leads to higher costs and of course the one I did not mention is inventory shrinkage that is a term in retail that means merchandise or equipment are items from a store or from a business are either stolen or destroyed by customers by employees or even by suppliers there was
• 09:30 - 10:00 a case of a Walmart in Hawaii where a person that was working for a shipping company that was shipping product from a supplier to Walmart was stealing a bunch of stuff off the truck as they were being scanned into the Walmart they're being diverted into another truck and then being resold basically illegally somewhere else millions of VCRs and DVD players are stolen this is in the 1990s as you can tell and Walmart finally caught them but only if they had lost by 10 million dollars worth of merchandise because this was a supplier or a vendor employee
• 10:00 - 10:30 on a truck driver that was diverting merchandise there's a couple of Walmart employees were complicit class a small business owner like the owner of a convenience store so they have a lot less problems with shoplifting because that's their bread and butter and they can't afford to let that happen however a large company like Walmart has insurance against some of this this is part of the reason why if something goes running out of a warmer with a bunch of merchandise the Securities yardage don't try to shoot them nobody's allowed to chase them because it's gonna cost and less money and that person that gets shot or chased may end up suing Walmart and winning a decision like I said
• 10:30 - 11:00 really big businesses have these diseconomies of scale the smaller businesses do not now some amusing things to look at some market structures the economies of scale come quickly you'd have to be small to achieve mes but if you get much bigger than that small size you experience diseconomies of scale quickly like on this graph on the Left I'm saying that to achieve mes a business has to produce only 5/100 of 1% that's a really small fraction of the
• 11:00 - 11:30 market output class's noticed thing is more than a hundred percent of the market output 100 divided by point zero five is equal to two thousand two thousand very small businesses now what market structure does that sound like if you said perfect competition you were correct now the second long-run average total cost curve man this firm gets bigger and bigger and bigger and bigger and it takes a long time before they're big
• 11:30 - 12:00 enough to take advantage of all the economies of scale but then after they hit mes there's a sudden perky jerk wick arise at the end it says here that in order to see of mes for the second market the firm has to produce 90% class 100 divided by 90 is 1.11 bottom line here yo this market can only support one firm at 90% and the problem is a firm producing 10% would have a much higher
• 12:00 - 12:30 average cost of production so there wouldn't it not be a second firm this market can only support one firm it'll end up producing the entire market output what market structure has one very large business if you said monopoly of some sort or other you were correct now remember I told you all about the flat bottoms here sometimes you have a constant returns to scale area and what can happen here is you get some economies of scale you hit mes and there's a smallest size
• 12:30 - 13:00 for mes their sizes in the middle and there's a largest size for mes now I gave two possibilities possibility number one suppose the smallest size that sheave mes is 1% of the market output and the largest size is two and a half percent 100 divided by one is a hundred firms the most firms this market support at mes is a hundred and in the largest size two and a half a hundred divided by two point five is 40 but the reality is we probably wouldn't have all
• 13:00 - 13:30 the firms the max size we might have say 50 firms with some of them at the largest size summits the size in between two and a half percent is a medium-sized firm 1% is a small size firm so we're looking at 50 to 100 small to medium-sized firms what marker structures is that sound like he be said monopolistic competition you're correct but here's one more possibility for the same graph suppose the smallest size to achieve mes is 5% of market output and the largest size is
• 13:30 - 14:00 40% if we had all the firms at the smallest size for minimum efficient scale one hundred divided by five is twenty firms the moment a firm is producing five percent of the market output we call that large now the thing is we could have two firms produce forty percent but that we could have another one producing twenty percent because twenty percent is in the range for me yes so that means we have three firms if you're in the twenty to forty percent range are still considered large so we're looking at three to twenty large
• 14:00 - 14:30 businesses how many firms is that three to twenty what market structure would have three to twenty large businesses if you said that this is naturally going to be some kind of an Ola gobbly you are correct I want you to understand that market structure has a number of attributes to it and how big a firm needs to be in order to achieve the minimum efficient scale size will determine how many businesses the market could support naturally our buy cost structure the small of the firms are and
• 14:30 - 15:00 the more they are the more competitive the market is the larger the firms are the fewer firms the market could support the less competitive and the more like an oligopoly or monopoly it becomes there's a lot of factors that determine the actual market structure for a producing firm be mindful of this now here's one last thing I want y'all to look at here this is the basis of a test problem on your first on your second unit test pardon me I've got a long-run average total cost curve I've got seven different possible size ranges marked
• 15:00 - 15:30 off if they're producing quantities where I've got my cursor here that's gonna be skill one if they're producing in between these two hash marks where a firm a is that means that they're at scale to in between the next pair scale three and you notice where the minimum efficient scale is that's scale for the minimum point on the long-run average total cost curve is scale 4 and firm B is currently producing in the short-run at scale for scale 5 has passed the mes level scale 6 is further to the right and firm C is currently producing at
• 15:30 - 16:00 scale 7 which is way far there right now a couple things on the ask before we kind of deal with the problem which sizes would affirm be passing through if it were to experience economies of scale in other words its average total cost would drop in the long run as it got bigger well if you look at the vertical height of long-run average total cost as the firm increases from scale one to scale two to scale three that's where it experiences economies of scale all right through
• 16:00 - 16:30 which size ranges with a firm experience diseconomies of scale in this particular example diseconomies of scale or where the long-run average total cost is getting bigger excise it's bigger scale five scale six scale seven so notice firm a at scale two is not taking advantage of all the economies of scale firm C is not is actually experiencing diseconomies of scale so now that we've kind of take a look at
• 16:30 - 17:00 this here what adjustments should firm a make to its size remember they can stay the same get smaller or get bigger well firm a is not taking advantage of all possible all possible economies of scale so firm a which would increase its size from scale two to scale for it would take advantage of more economies of scale maybe it's fishing at missing on some volume discounts on raw materials or maybe there's some large machine capital to take advantage of as it gets bigger now firms C is a
• 17:00 - 17:30 different situation firms C you'll notice is experiencing diseconomies of scale it is to be firm C needs to downsize but we don't just say downsize or reducing the size cuz downsizing from seven to one would not improve the situation cost wise now you want to have them shrink their size enough so their average total cost in the long run is minimized and so reducing size from scale seven down to scale four would achieve that point it would get rid of
• 17:30 - 18:00 those inventory shrinkage issues it would get rid of the bureaucracy and red tape that is set in so firm C should reduce its size down to scale for firm B doesn't need to change like they say in the yearbook sign-off never change firm B is too advantage of all the possible economies of scale but it is not experiencing any diseconomies of scale firm B is at the minimum efficient scale it's the right size now I want you to notice one last thing here perfectly competitive
• 18:00 - 18:30 producing firms class one of the things we learned already with the other graphs we've worked on is that firms that producing their perfect competition if they survive and remain the mark in the long run they will not only achieve the minimum efficient scale but also they will achieve a long-run normal profit which means the owners will be happy to keep the business running in perpetuity having a long-run normal profit is what's good enough to keep the business
• 18:30 - 19:00 going the thing is if they stayed at scale - or at scale 7 they might have a long-run economic loss and be forced out of the market because of cost overruns or because of a lack of ability to compete but scale for guaranteeing the long-run normal profit is a good thing all right so let's wrap the sucker up here just a moment ok students I hope that this helps talk a little bit more about these long-run adjustments I meant to do this video before but I got sidetracked I had a little time today so
• 19:00 - 19:30 I'm filling this one in for unit 2 so success to y'all I'll see you in class