IB Economics 2.11.9 Advantages of Large Firms Having Significant Market Power Notes

Economies of Scale: Bigger Firms, Lower Average Cost

1. A firm with market power is not automatically bad, because its size can reach cost advantages a small firm cannot.
2. Economies of scale are the savings a firm gains as it grows, since a larger scale of production lowers the average cost per unit.
3. That is why the long-run average total cost curve, $LRATC$, slopes downward over its early range.
4. As output keeps rising, the curve passes through three regions.
   1. Economies of scale, where average cost is still falling.
   2. Constant returns to scale, where it is roughly flat at its lowest.
   3. Diseconomies of scale, where it eventually rises as the firm grows too big to coordinate.

Where the Cost Savings Come From

1. The savings come from four main sources.
   1. Purchasing economies: buying inputs in bulk wins discounts, lowering the cost of each unit of raw material.
   2. Technical economies: advanced machinery that only a large output can justify spreads its cost over far more units.
   3. Managerial economies: specialist managers for each department raise productivity without a matching rise in cost.
   4. Marketing economies: advertising and branding are largely fixed, so a bigger output base cuts the marketing cost carried by each unit.
2. Building bigger plants also moves the firm down the $LRATC$, since each larger plant reaches a lower minimum average cost than the last.
3. These savings can help society, not just the firm, because lower average cost frees resources and, where competition or regulation forces it, reaches buyers as lower prices.

Minimum Efficient Scale Shapes the Market

1. Minimum efficient scale, or MES, is the smallest output at which a firm reaches the lowest point of its long-run average cost.
2. How large the MES is relative to total market demand decides how many firms can compete.
   1. When MES is a small fraction of the market, many small firms can each reach lowest cost and compete on equal terms.
   2. When MES is a large fraction of the market, only a few firms can reach lowest cost, which favours oligopoly or a natural monopoly.

Natural Monopoly: When One Firm Supplies Most Cheaply

1. A natural monopoly is the extreme case of economies of scale, where one firm can supply the whole market most cheaply.
2. It arises when production needs very high fixed costs but low variable costs, so average cost keeps falling across the market and never turns back up.
3. Because cost is still falling at the scale of the entire market, one firm serving everyone reaches a lower cost per unit than several firms splitting the customers.
   1. Splitting the market would force each firm to duplicate the infrastructure, pushing every firm's average cost higher.
4. These are usually essential network industries like electricity, water, railways, and telecommunications.
   1. The UK's National Grid runs a single electricity transmission network for exactly this reason.

Abnormal Profit: Funding Innovation and Competing Globally

1. Market power lets a firm earn abnormal profit, any profit above the normal return needed to stay in business.
2. In perfect competition that profit would be competed away, but behind barriers to entry it can persist, becoming a surplus the firm is free to reinvest.
3. That surplus funds research and development that a firm earning only normal profit could never afford.
   1. Once developed, those innovations spread as smaller firms adopt them, so the whole economy's production possibilities grow.
4. The same financial strength lets a large domestic firm invest heavily and compete against large foreign rivals in global markets.
   1. Samsung's scale and profits fund one of the world's largest research and development budgets, keeping it competing globally against rivals such as Apple.
5. Whether these gains reach society depends on the firm choosing to pass on savings and reinvest its profit rather than simply bank it.