Archive for the 'Economies of scale' Category

Mar 04 2013

Monopoly prices – to regulate or not to regulate, that is the question!

Competitively Priced Electricity Costs More, Studies Show – New York Times

The problem with monopolies, as our AP students have learned, is that a monopolistic firm, left to its own accord, will most likely choose to produce at an output level that is much lower and provide their product at a price that is much higher than would result from a purely competitive industry.Regulated Monopoly A monopolist will produce where its price is greater than its marginal cost, indicating an under-allocation of resources towards the product. By restricting output and raising its price, the monopolist is assured maximum profits, but at the cost to society of less overall consumer surplus or welfare.

Unfortunately, in some industries, because of the wide range of output over which economies of scale are experienced, it sometimes makes the most sense for only one firm to participate. Such markets are called “natural monopolies” and some examples are cable television, utilities, natural gas, and other industries that have large economies of scale. (click graph to see full-sized)

Government regulators face a dilemma in dealing with natural monopolistic industries such as the electricity industry. A electricity company with a monopoly in a particular market will base its price and output decision on the profit maximization rule that all unregulated firms will; they’ll produce at the level where their marginal revenue is equal to their marginal cost. The problem is, for a monopolist its marginal revenue is less than the price it has to charge, which means that at the profit maximizing level of output (where MR=MC), marginal cost will be less than price: evidence of allocative inefficiency (i.e. not enough electricity will be produced and the price will be too high for some consumers to afford).

Here arises the need for government regulation. A government concerned with getting the right amount of electricity to the right number of people (allocative efficiency) may choose to set a price ceiling for electricity at the level where the price equals the firm’s marginal cost. This, however, will likely be below the firm’s average total cost (remember, ATC declines over a WIDE RANGE of output), a scenario which would result in losses for the firm, and may lead it to shut down altogether. So what most governments have done in the past is set a price ceiling where the price is equal to the firm’s average total cost, meaning the firm will “break even”, earning only a “normal profit”; essentially just enough to keep the firm in business; this is known as the “fair-return price”.

Below AP Economics teacher Jacob Clifford illustrates and explains this regulatory dilemma. Watch the video and see how he shows the effect of the two price control options on the firm’s output and the price in the market.

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The article above examines the differences in the price of electricity in states which regulate their electricity prices and states that have adopted “market” or unregulated pricing, in which firms are free to produce at the MR=MC level:

“The difference in prices charged to industrial companies in market states compared with those in regulated ones nearly tripled from 1999 to last July, according to the analysis of Energy Department data by Marilyn Showalter, who runs Power in the Public Interest, a group that favors traditional rate regulation.

The price spread grew from 1.09 cents per kilowatt-hour to 3.09 cents, her analysis showed. It also showed that in 2006 alone industrial customers paid $7.2 billion more for electricity in market states than if they had paid the average prices in regulated states.”

The idea of deregulation of electricity markets was that removing price ceilings would lead to greater economic profits for the firms, which would subsequently attract new firms into the market. More competitive markets should then drive prices down towards the socially-optimal price, benefiting consumers and producers by forcing them to be more productively efficient in order to compete (remember “Economic Darwinism”?). It appears, however, that higher prices have not, as hoped, led to lower prices:

“Since 1999, prices for industrial customers in deregulated states have risen from 18 percent above the national average to 37 percent above,” said Mrs. Showalter, an energy lawyer and former Washington State utility regulator.

In regulated states, prices fell from 7 percent below the national average to 12 percent below, she calculated…

In market states, electricity customers of all kinds, from homeowners to electricity-hungry aluminum plants, pay $48 billion more each year for power than they would have paid in states with the traditional system of government boards setting electric rates…”

That $48 billion represents higher costs of production for other firms that require large inputs of energy in their own production, higher electricity bills for cash-strapped households, and greater profits and shareholder dividends for the powerful firms that provide the power. On the bright side, higher prices for electricity should lead to more careful and conservative use of power, reducing Americans’ impact on global warming (since the vast majority of the country’s power is generated using fossil fuels).

Here arises another question? Should we be opposed to higher profits for powerful electricity firms if their profits result in much needed energy conservation and a reduction in greenhouse gas emissions? An environmental economist might argue that if customers are to pay higher prices for their energy, it might as well be in the form of a carbon tax, which rather than increasing profits for a monopolistic firm would generate revenue for the government. In theory tax revenue could be used to subsidize or otherwise promote the development and use of “green energies”.

Whether customers paying higher prices for traditionally under-priced electricity is a good or bad thing depends on your views of conservation. But whether higher profits for a powerful electricity company are more desirable than increased tax revenue for the government are beneficial for society or not seems clear. If we’re paying higher prices, the resulting revenue is more likely to be put towards socially desirable uses if it’s in the government’s hands rather than in the pockets of shareholders of fossil fuel burning electricity monopolies.

Discussion Questions:

  1. Why do governments regulate the prices in industries such as natural gas and electricity?
  2. Why would a state government think that de-regulation of the electricity industry might eventually result in lower prices in the long-run?
  3. Why, in reality, did the price of electricity in unregulated electricity markets ultimately increase so much that consumers in the market states paid billions of dollars more than in regulated states?
  4. What industries besides that for electricity share characteristics that might qualify them as “natural monopolies”? Which of the industries you identified should be regulated by government, and WHY?

224 responses so far

Nov 24 2010

Lesson Plan: Costs of Production Presentation for Y1 IB Economics

Unit 2.3.1 Costs of Production: Team Presentation Activity

Learning Objectives:

  • Distinguish between fixed and variable costs of production
  • Understand how the law of diminishing returns affects the shape of a firm’s short-run total costs and short-run average costs.
  • Understand the relationships between marginal cost and the average costs faced by a firm
  • Distinguish between the short-run and the long-run and understand how economies of scale determines the shape of a firm’s long-run ATC curve.
  • Evaluate the importance to a business firm of understanding its short-run and long-run costs of production.

Process: Work with a partner in the class to prepare a presentation on the theories behind and the relationships between a firm’s short-run and long-run costs of production. Pairs will create a shared Google Presentation (which should also be shared with Mr. Welker) and collaborate on creating a presentation demonstrating your understanding of the topics outlined below. The presentations that are created will be shared among group members, and edited in class and over the weekend.

The assignment: Each team is to make one Google Presentation on an assigned topic based on what they learn using the web-resources provided by Mr. Welker below. Presentations will be shared with Mr. Welker and presented during our first meeting next week.

Guidelines for presentation:

  1. Presentations must be at least 10 slides long, but no more than 15.
  2. Presentations must include definition, explanations, illustrations and examples (when possible) for the key concepts identified below
  3. Presentations must include graphs from the resources provided to illustrate concepts where necessary
  4. Presentation must use each group’s own words. Copying and pasting text from the resources provided is not permitted.

Shor-run – Key Concepts

Resources on Short-run Costs of Production:

Long-run: Key Concepts

Resources on Long-run Costs of Production:

Grading Presentation: Total – 40 marks

Area of assessment

High marks (7-10)

Medium marks (4-6)

Low marks (1-3)

Organization Easy to read. Font size varies appropriately. Text is appropriate length. Presentation falls within the required length limits (10-15 slides) Overall readability is difficult. Too much text. Too many different fonts. Presentation falls within the required length (10-15 slides) Text is difficult to read. Too much text. Inappropriate fonts. Small font size. Presentation is either too short or too long.
Graphs All graphs are related to content. All graphs are appropriate size and good quality. Graphics are explained clearly and illustrate the concepts from the presentation Some of the graphs are unrelated to content. Too many graphics on one page. Some of the graphics distract from the text. Graphs are explained, but explanations are incomplete or unclear Most of the graphs are unrelated to content. Too many graphics on one page. Most of the graphs distract from the text. Explanations are incomplete and unclear
Concepts The economic concepts that were assigned have been completely and accurately incorporated into the presentation. Definitions, explanations, illustrations and examples fully reflect the team’s understanding of the concepts The economic concepts assigned are all addressed in the presentation, but analysis is superficial and lacks original insight from the team members. The economic concepts assigned are not all addressed in the presentation. One or more have been left out completely, and those that were addressed were explained or illustrated incorrectly.

Mark Bands:
27-30: A, 23-26: B, 19-22: C, 15-18: D, 0-15: F

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Nov 22 2010

From short to long: Economies of scale and the long-run average total cost curve

Look closely at the two cost curves below:


The curve on the left is a firm’s short-run average total cost curve. The one on the right represents a firm’s long-run average total cost curve. See the difference?

I didn’t think so. The shape of a typical firm’s short-run and long-run ATC curves may in fact be identical. But there are some very important differences to understand about the short-run costs and long-run costs faced by firms.

The Short-Run: In microeconomics, we define the short-run as the period of time over which a firm’s plant size is fixed. The only variable resource is labor and raw materials, meaning that when demand increases for a firm’s product, the firm is able to increase employee work hours, hire more workers and use existing capital more intensively, but it does not have the time to acquire new capital or expand factory size. Likewise, when demand falls for a firm’s products, it can cut back on work hours, fire workers, but cannot downsize its plants or factories.

The Long-Run: The long-run is defined as the variable-plant period. A firm can adjust the number of all its inputs: land, labor and capital. One way of thinking about the difference between the short-run and the long-run is imagining the long-run as several different short-runs spread out over a larger range of output. The graph below will illustrate this concept for you.


When we examine the long-run ATC more closely, it becomes apparent that there are in fact lots of little short-run ATC curves along the length of the long-run curve. Each of the gray lines in the graph above represent a short-run period in which this firm opened a new factories. There are three distinct phases of this firm’s long-run ATC:

  • Economies of scale: As this firm first begins to grow and open new factories, it becomes better and better at what it is producing, is able to get more output per unit of input, and thus experiences lower and lower average total costs as it grows larger. “Scale” is a synonym for size. The bigger the firm’s size, the lower its costs of production: this is called “economies of scale”. My favorite illustration of the concept of economies of scale is to think about two shoe companies: Nike and Luigi’s Fine Italian Shoes. Nike makes shoes in giant factories in Indonesia, ships them in giant containers to all corners of the world in shipments containing 100,000 shoes each. Luigi makes shoes in his basement in Milan, has two employees, and ships shoes one at a time to customers around Europe. Who will have a lower average total cost of producing shoes? Luigi or Nike? Clearly, Nike has economies of scale, Luigi does not. If Luigi were to grow his business, chances are his average total costs would decline.
  • Constant Returns to Scale: For the firm above, economies of scale assure that the larger it becomes, the lower its average total costs get. Efficiency in production improves whether through the lower price of inputs achieved through bulk-ordering, its ability to attract and hire skilled managers, the lower per unit cost of shipping larger quantities of products, or other such benefits of being big. At a certain point, however, the benefits of getting larger begin to diminish. This firm’s tenth factory is its minimum efficient scale: The level of total output this firm must achieve to minimize its long-run average total cost. Beyond this level of production, as this firm continues to grow, it will see no further cost benefits; in other words, it will achieve constant returns to scale (size).
  • Diseconomies of scale: Why did the Mongol, the British and the Soviet empires collapse? Some historians argue it was because they became too big for their own good. When an organization (whether it’s a country or a firm) becomes TOO big, it begins to experience inefficiencies. When a firm grows so large that it has factories in all corners of the world, a dozen levels of management, and countless opportunities for corruption and miscommunication, its efficiency decreases and its average total costs begin to increase. In the 1980′s General Motor Company began to lose lots of business to smaller Japanese rivals. The outcome was the gigantic corporation broke up into smaller divisions, which then began to operate as different firms. For a while, GM remained competitive, partially because as a smaller firm, it was more efficient and able to compete on cost with its foreign rivals.

Diminishing Returns versus Economies of Scale: A common area of confusion for economics students is the difference between these two seemingly similar concepts. The difference lies in the two curves above, the short-run ATC and the long-run ATC.

  • The shape of short run costs (MC, ATC and AVC) are determined by the law of diminishing returns. Since short-run costs are determined by the productivity of the variable resource in the short-run (labor), diminishing returns assures that at first, since a firm can expect to get MORE output for additional units of labor (as fixed capital is used more efficiently) ATC declines as output increases. But beyond a certain point, diminishing returns sets in and the additional output attributable to more units of the variable resource declines. Inevitably, a firm will experience higher and higher average costs as its output continues to grow, since it’s only able to vary the amount of labor used, not capital.
  • The shape of long run ATC is determined by economies of scale (and diseconomies of scale). All resources are variable in the long-run, but lower costs cannot be guaranteed the larger a firm gets. At first, efficiency is improved as the firm grows, but at some point it becomes “too big for its own good” and costs start to rise as productivity of resources (land, labor and capital) is inhibited due to the firm’s massive size.

Discussion Questions:

  1. What does it mean that a firm can become “too big for its own good”? Can you think of any other organizations (economic or otherwise) that have gotten so big that they’ve failed?
  2. Why does your hometown have only one electricity company? Why aren’t utility industries such as water, natural gas, and garbage collection more competitive? How does the concept of economies of scale lead to certain industries being “natural monopolies”?
  3. Why don’t more companies make jumbo jets?

78 responses so far

Nov 17 2007

Does Apple stand a chance?

China Mobile negotiating with Apple to carry iPhone

Try try as he might, Steve Jobs and Apple can barely launch their hottest new product, the iPhone, before the Chinese have copied it and put a knockoff on the market as quickly as you can say “can you hear me now?” But what is Apple doing making a cell phone anyway? Isn’t the mobile phone market pretty much dominated by a few big name companies already? How will apple ever survive in a market with such well established firms as Nokia, Samsung, and Motorola?

The answer is through product differentiation. The iPhone is truly an innovative little gadget. More than an MP3 player, more than a cell phone, the iPhone has features that differentiate it from most products available from the established firms in the mobile phone market. Like any firm, Apple advertises its iPod through commercials and other media in order to inform consumers about what makes its product special. What message does the following advertisement send about the iPhone?

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The table below shows the market shares of the larges mobile phone makers as of late last year (before the release of the iPhone). A simple calculation finds that the four firm concentration ratio in the mobile market was 75.6%, clearly putting the market in the realm of an oligopoly (a market in which the four firm concentration ration is 40%).


With 75% of the market being controlled by Nokia, Motorola, Samsung and Sony Ericsson, the question arises whether Apple will be able to overcome the barriers to entry in the mobile market and establish itself as one of the big boys. Apple’s strategy for profits and market penetration certainly leverages the power of product differentiation and non-price competition, both firm behaviors common among firms in oligopolistic markets.

To make matters worse for Apple, only months after the iPhones release, and in the midst of negotiations between Apple and China Mobile to officially launch the product in China, a cheap, 4 GB knock-off of the fancy device comes along to entice Chinese consumers away from the 5,000 RMB (nearly $700) real deal. Check this thing out… would you be able to tell the difference?

Discussion Questions:

  1. What barriers to entry exist in the market for mobile phones?
  2. Why do you think so few firms produce mobile phones?
  3. Do you think Apple will be able to successfully penetrate the mobile market?
  4. What threat do cheaper “knock-offs” of the Apple iPhone pose to Apples attempts to compete in China’s mobile market?

165 responses so far

Oct 21 2007

China’s automobile market – an example of Economies of Scale

Gulfnews: Economies of scale should drive China’s auto market

Last week in AP Economics we introduced the concept of Economies of Scale. The graph below was created and added to our Wiki page by student Kevin Chiu to illustrate the concept, as well as two other concepts: constant returns to scale and diseconomies of scale. Notice that the section of a firms long-run average total cost curve over which ATC is decreasing is identified as the period over which the firm is experiencing economies of scale.

The idea is that as firms open new plants during these early stages of production, they increase their efficiency in production, thus experience a decline in their average costs. Click the “read the rest of this entry” link below to learn how the Chinese automotive market is struggling with economies of scale in their attempt to compete with each other and foreign car manufacturers…

The Long-Run Cost Curve - courtesy of Kevin Chiu

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