E312. Lecture 7
15 September 2005
Assignments
Hand out Problem Set #3 (Due Tuesday)
Review
Intermediate run equilibrium for the firm
C. Economies of Scale, and Long Run Considerations
1. The Long Run ATC Schedule
Economics of Scale
Diseconomies of Scale
Minimum Efficient Scale
Preview
2. Optimal Plant Size and Long Run Competition
3. MES and industry structure
D. Barriers to Entry
E. Monopoly Pricing
G. Dominant Firm Pricing
LECTURE______
2. Optimal Plant Size and Long Run Competition. If competitive conditions are satisfied, firms are forced to the optimal plant size in the long run (e.g., to Minimum Efficient Scale. This process occurs through the expansion and contraction of firms.
Observe that if a firm expandsand enjoys economies of scale, then market supply will expand, for 2 reasons.
- To copy economic profit
- To avoid being left behind as a high cost producers.
Consider now what happens if firms suffer a diseconomy of scale with an expansion
Result: Firms are driven to produce the socially optimal quantity, at the optimal plant size, with zero economic profits. This is an important great result, as it implies that when competitive assumptions hold, markets drive firms to product the most desired goods efficiently.
However, there are numerous reasons to believe that we may not see it, particularly in many information goods markets..
3. Minimum Efficient Scale and the Structure of an Industry. Given Market Demand, and the MES, it is possible to identify the maximum number of firms that might efficiently exist in an industry. For example, suppose that at a price equal to the LRATC min, the market would purchase 40,000 units. If MES is 10,000 units, then at most 4 sellers could exist in that market. The rate at which diseconomies of scale set in determines whether 4 firms must compete in the market, or whether the industry could efficiently consist of 3 or 2 firms.
D Barriers to Entry. The free entry/exit, expansion/contraction dynamic that generates efficient outcomes may not always work. Impediments would cause for imperfectly competitive market structures
- Continuously Diminishing LR Costs. In some industries, Long Run Costs continuously decrease. Old-style Markets where the seller constructs a physical networks, such as local telephone service or local electricity service. are the primary example of this. In such a market only a single producer can efficiently survive.
Information Goods have some of these characteristics, in the sense that the marginal cost of a first unit is high and the marginal costs of additional units are low. However, people can copy these products, giving rise to different structures altogether.
- Network Industries: Some goods have the feature that value increases as others use it. A particular EMAIL service for example may facilitate communications between people. Similarly similar cell-phone technologies allow conversations to fellow users of the same technology. Microsoft is the most notable example of a Network Industry Effect.
- Economies of Scope. Sometimes, production of a single product reduces the costs of producing another product. In traditional industries, such effects most typically arose when one product was a by-product of another. For information goods, economies of scope arise when the production of one digitalized good requires resources particularly well adapted to producing another. For example, production of federal tax forms and state tax forms may exhibit economies of scope.
- Learning Curve. It may also be the case that one enjoys advantage from being the first to produce a particular product. One may develop a customer base, or experience in the details of an operation that may be hard to duplicate without repeating the same process. The “learning curve” is not a long-term barrier to entry. But it does prompt entrepreneurs to get in “early” into a business. This may explain the rush to get into e-commerce in the late 1990’s
- Government Regulations. Finally, regulations, such as patents and standards or other laws can impede entry. Government regulations are probably the biggest impediment to entry.