JC Economics Essay Economies of Scale & Market Structures Model Answers
In the entire section on Market Structures, a firm’s behaviour tends to depends on a few important factors, which in turn, then determine the performance in a market. One of the factor is economies of scale, aka EOS.
(a) Explain how the existence of economies of scale can affect the behaviour and performance of firms.
(b) Discuss the extent to which economies of scale determines the types of market structure in Singapore.
JC Economics Essay – Economies of Scale & Firms’ Behaviour & Performance
Command: Explain the relationship between EOS and firm’s pricing and output behaviour and implication on profits
Content: EOS as a form of BTE, effect of BTE on prices, output, profits
Context: nothing specific, choose own preferred examples to illustrate
Suggested answer key:
(Internal) EOS refers to cost savings that accrue directly to the firm from the expansion of the firm’s output, independently of what is happening to other firms. It is an important source of barriers to entry which may be sufficiently strong to prevent potential rivals from entering the industry
In many industries such as the aviation and automobile manufacturing industries, larger firms through their expansion are better able to tap on benefits of IEOS derived from technical, managerial and even marketing economies. The minimum efficient scale (MES) of the firm, which is the level of output beyond which there is no significant additional IEOS to be achieved, occurs at a high percentage of the market output and a large firm supplying a large share of the market will experience lower average cost compared to a small firm. Since smaller firms often cannot compete on costs, only a few large firms or even a single firm may survive in these industries, thus IEOS plays an important role in adding to the market power of firms, allowing the existing firms to set their own prices and output.
In the case of a natural monopoly commonly found in the utilities or train services public transport market, the firms enjoy such substantial IEOS that long run average costs may continuously decline over the entire range of market demand. In this case, the average cost is lowest when a single firm supplies the entire market implying that the incumbent firm can operate on such a vast scale and produce at lower average cost which potential new firms are unable to match. This deters new firms from entering the industry as they do not have the customer base to warrant a high output level and are unable to match the price offered by the existing producer. Given the reduced number of competitors, this gives each firm sufficient market power to charge higher prices by restricting output.
Since IEOS is a sufficiently effective BTE to deter the entry of new firms into the industry to compete away any supernormal profits made in the short run, the existing firm can continue to earn supernormal profits even in the long run. In addition, firms which are able to reap extensive EOS will experience a decrease in their marginal cost of production such that the MC curve will shift to the right. This will affect the profit maximising level (MR=MC) prices and profit. Such firms are able to increase their output and charge lower prices. They may engage in predatory pricing, take advantage of their ability to produce at lower costs to drive out smaller competitors who cannot operate on a sufficiently large scale to match the larger firm’s ability to price compete. Hence, the existence of EOS can further strengthen a firm’s market power and this has also allowed some firms to practise price discrimination and further increase their total revenue.
As for firms who can only enjoy a small scope of EOS, they have little or not market power to charge high prices. Instead will rely on product differentiation to charge lower prices and earn more revenue. Though they can supernormal profits in the short run (SR), they can only earn normal profits in the long run (LR).
Hence, the existence of EOS can give rise to market power which enhances the firm’s ability to charge higher prices by varying its output level and improving the profitability of the firm.
Comments from JC Econs tutor:
1. Other possible approaches/content areas which merit award of marks:
External EOS where the cost savings enjoyed by the firm due to the expansion and growth of the entire industry as a whole regardless of its individual size. External EOS can affect the firms’ behaviour in terms of location decision.
Knowledge, Understanding, Application & Analysis
L3: Developed explanation of how EOS affects
Behaviour: price, output, competitive behaviour
Performance: profits in the LR
L2: Developed explanation of how EOS affects either
Behaviour: price, output, competitive behaviour or
Performance: profits in the LR
Undeveloped explanation of how EOS affects both the behaviour and performance of firms.
L1: Smattering of valid points
JC Economics Essay – Economies of Scale & Market Structures
Command: 2 POV. EOS is a key determinant of the size of firm in different market structure vs other DD/SS factors /other BTE are more important in determining size of firm and market structure
Content: EOS, MES and size of firms, DD and SS factors or other BTE affecting size of firms
Context: application to industries in S’pore
The determinants of the size of the firms and hence the market structures they belong to can be categorized into supply-side and demand-side factors. Whilst economies of scale (EOS) is an important supply-side determinant of the size of firms, there are other factors which can influence why firms in certain industries are more prevalent in the existing market structures of Oligopoly (OG), Monopolistic Competition (MoC) and Monopoly (MY) in SG.
IEOS is an important determinant of the size of firms and type of market structure they operate in. In order to reap significant cost savings arising from IEOS, many firms will choose to expand and produce at the minimum efficient scale of operation. For industries which require high capital outlay, the scope for technical economies is huge and substantial cost savings can be reaped through expansion of production of goods and services.
Take for example the telecommunication service providers in Singapore which is dominated by 3 main players Singtel, M1 and Starhub, each has invested considerable capital in starting up the infrastructure and upgrading the telecommunication network required, there are substantial technical economies of scale in such capital-intensive industries. In the retail petrol market in Singapore, high capital requirement is necessary to acquire the retail petrol sites which add on to the fixed cost of starting a petrol station. Larger firms such as Exxon-Mobil and Shell can also reap significant marketing EOS which towers their per unit product development and advertising costs. Hence in the retail petrol market, firms need to operate a critical number of stations to tap on IEOS and remain viable and this is evident in that even the smallest player SPC operates on a considerable scale of at least 30 stations all over the island.
In such industries like telecommunication, banking and retail petrol, the average costs continue to decrease until a significant level of output is produced. The MES occurs at a high level of output, in relation to the market demand and such firms tend to be large in size and the market is only able to support one or a few of such firms. In the extreme case of s natural monopoly, IEOS is so huge that the LRAC continues to fall over the entire range of the market demand such that the market can only sustain one single supplier eg the Utilities market in Singapore. Hence, the existence of high EOS tends to lead to a small number of large-sized firms being oligopolistic or even monopolistic in market structure.
In addition, as mentioned in part (a), besides cost advantages causing firms to expand, they might be motivated to grow in size to reap the revenue advantages of greater market power and to dominate the market by reducing competition. The higher the market power, the more price inelastic is the demand curve which allows the firm to charge higher prices and extract greater consumer surpluses. This contributes to the firm tending towards oligopolistic and monopolistic in market structure.
In some industries, IEOS may not be an important determinant of the size of firms and the ensuing market structures they operate in since the scope of economies of scale differs across industries. Some firms may not have incentive to grow due to factors such as the nature of the product and size of the market demand.
In Singapore, industries such as hairdressing, car repair, legal and accounting services tend to be characterized by large numbers of small-sized firms. The nature of the product/service necessitates the provision of unique, customized or personalized services where personal attention is required and any attempts to introduce standardization and mass production methods are not feasible. Such industries have generally low start-up costs and there is limited scope for EOS such as technical, marketing or financial EOS.
Expansion for such firms may not be economically efficient if the size of the market demand for the product is small. This is a major limiting factor on the size of the firm, for example the numerous sundry provision shops, dental and medical clinics, bakeries that operate in the neighbourhood stores may not have the incentive to expand unless the demand for their goods and services increase.
In addition, large scale production derives cost savings from mass production of standardised products which lacks individuality while consumers differentiated products in terms of styles and designs.
Government policies may also influence the size and market structure of different types of business to some extent. In the local context, the relationship between government involvement/intervention and the size/market structure of firms works both ways i.e. it can legislate or encourage the formation of both large and smaller firms.
The government may intervene to open the market to greater competition. Through legislation, the government has control over the number of firms in some critical industries to increase the competition. This is done through the issuance of licenses to operate in the telecommunication and public transport market. For example, in liberalizing the telecommunications market, the S’pore government paid off Singtel to end its monopoly licence as the sole supplier of mobile services to allow other service providers, M1 and Starhub, to enter the market. This increased the number of firms in the industry and made it more contestable and oligopolistic.
On the other hand, the SG government’s pro-business stance and encouragement of local entrepreneurship through various grants for start ups, tax incentives, loans to SMEs have led to more local small business setting up. For example, the relaxing of the rule of being able to operate a business from home i.e SOHO concept or the investment in building the technological infrastructure such as Wireless@sg has led to the proliferation of numerous small business start-ups, which previously may not have been viable, leveraging on technology to lower their cost of operation e.g. blog shops. Hence, firms in these industries tend to be small, numerous and operating in the monopolistic competitive market structure.
1. The extent to which IEOS determines whether the firm operates as a monopoly depends on the size of the demand in the market and also the nature of the goods or services. Whilst the utilities industries with high IEOS may not necessarily be a natural monopoly in a country with larger domestic demand, this is not the case in S’pore as the small domestic demand for the non-tradable service compounds the effect of the EOS such that the market can only sustain one supplier.
2. Increasingly in the context of the Singapore market for food and beverage, apparels, consumers enjoys greater affluence and purchasing power and often places a high premium and value on variety, personalized services and choices such as unique dining experience or customized fashion apparel which serves a niche market and are not available from large firms. This implies that the preference for individuality would necessitate a smaller scale of operation which is likely to be more monopolistic competitive and where EOS may not longer be an important determinant of size and market structure.
In the food & beverages (F&B) and fashion retail industries in SG, it can be observed that both large and small firms can co-exist. This implies that the MES can be reached at a low level of output and the AC tends to remain constant such that big firms do not necessarily gain any significant cost advantage over small firms. Hence, EOS may not adequately explain the size of firm since firms in these industries can be both oligopolistic (eg McDonalds and other major fast food chains) or monopolistic competitive (e.g. hawker food stalls). The choice of the size of firms and hence the market structure then depends on the target market the firm aims to serve.
3. Whilst government policies have influenced the formation and structure of businesses in Singapore, they may not be a primary cause given that in a market based economy like Singapore’s, government intervention may be limited to areas where there it serves strategic interest e.g. telecommunication, public transport and utilities or where the market has severely failed in its role of resource allocation.
In conclusion, whilst EOS is an important determinant of the size of a firm and hence the market structure within which the firm operates depends on the nature of the good or service and the role of the government in that industry.
Examiner’s Report & Comments:
Other possible approaches/content areas which merit award of marks:
1. Other sources of BTE which may determine the number of firms and hence the market structure e.g. legislations, awards of patents/copyrights, advertising expenditure etc.
2. Other Possible EV
Whilst consumers may increasingly shun mass produced goods in favour of customized goods which better reflect their individuality and meet their preferences, many firms could still tap on IEOS to serve this market. Technology and improvement in production processes have allowed firms to practise “mass-customisation” e.g. DELL computers was able to standardize part of the production process to reap cost advantages and yet allow customers to assemble/configure their preferred lap top features and functions as an end-product. Hence, IEOS can still be an important determinant of size and market structure depending on the nature of the goods.
Level 3 (7-10 marks)
For a developed discussion on how EOS and other DD/SS factors determine the market structure of firms in the context of S’pore.
Level 2 (5-6m)
For an undeveloped answer on how EOS and other DD/SS. factors determine the market structure of firms in the context of SG
For a developed answer on how either EOS or other DD/SS factors determine the market structure of firms in Singapore context
Level 1 (1-4m)
Smattering of valid points
For an evaluative discussion based on economic analysis
For an unexplained judgment, or one that is not supported by economic analysis
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