- Large firms with substantial market power play a crucial role in shaping market dynamics and economic development.
- The advantages large firms access stem from their ability to leverage size and resources effectively.
- The two primary benefits large firms gain are:
- Economies of scale.
- The use of abnormal profits for innovation and development.
Economies of scale
Definition
Economies of scale
Reductions in average production costs that arise when a firm increases its output by scaling up all its inputs in the long run.
- Economies of scale can be understood as cost advantages that arise when a firm increases its scale of production, leading to a decrease in average costs per unit.
- Economies of scale explains the downward-sloping section of the long-run average total cost curve, as larger firm sizes lead to lower costs per unit of output.
Economies of scale can include:
- Purchasing economies: bulk buying of inputs like raw materials reduces costs per unit.
- Technical economies: large firms can afford advanced machinery or technology that smaller firms cannot, increasing efficiency.
- Managerial economies: specialized managers can oversee various departments, improving productivity and reducing inefficiencies.
- Marketing economies: large firms can spread advertising and branding costs over a larger output base.
Economies of scale can be beneficial for society since:
- They allow firms to reduce costs and increase efficiency as they grow.
- This expands the production possibilities of the economy.
Natural monopolies
Definition
Natural monopoly
A monopoly that can serve the entire market at a lower average cost than if the market were divided among smaller firms. This occurs when the total market demand is small enough for the monopoly to benefit from economies of scale, keeping its long-run average costs falling.
- Natural monopolies occur in industries where the production process involves very high fixed costs and relatively low variable costs.
- This makes it more efficient for a single firm to serve the entire market.
- These industries often provide essential services, such as electricity, water supply, railways, or telecommunications.
- In natural monopolies, having multiple firms would result in unnecessary duplication of infrastructure and resources.
- Natural monopolies achieve significant economies of scale by spreading their high fixed costs over a large volume of output.
- Natural monopolies can be difficult to understand.
- However, picture the following example:
- If two companies built separate electricity grids or water pipelines to serve the same area, the total costs would rise significantly without improving the service.
- Instead, a single firm operating the network minimises waste and ensures better use of resources.
The use of abnormal profits for innovation and development
Definition
Abnormal profit
When a firm's average revenue is greater than its average costs.
- Abnormal profits refer to profits earned above the normal (zero) return required to keep the firm running.
- These profits provide large firms with the financial resources to fund innovation, which can lead to advancements in technology, products, and services.
- These innovations can later be adopted by smaller firms, leading to a growth in the overall production possibilities of the economy.
- In summary, large firms with market power can reduce costs through economies of scale, invest in R&D (research and development), and drive innovation.
- This increases the efficiency of the factors of production of the economy, increasing the production possibilities.
- Can you explain how economies of scale benefit large firms?
- What are natural monopolies, and why are they advantageous for society?
- What are the advantages of abnormal profits for innovation?
