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GM 04 Managerial economics assignment AIMA PGDM
Yes, I agree with the statement Because of economics of scale, it is
sometimes more cost effective for a firm to operate a large plant at less than
maximum efficiency than a small plant at maximum efficiency. Economies of scale
refer to the cost savings made possible as plant size increases. A firm is said
to achieve economies of scale if its long-run average costs decline as it
increases the size of its plant. All
costs are variable in the long run and they give rise to a long run cost curve
which is roughly L-shaped. In the beginning, the LAC curve rapidly falls but
after a point, the curve remains flat, or may slope gently downwards due to
benefits of economies of scale are neutralized after achieving a certain level
of production without reaching to its maximum production capacity.
Various reasons
attributed to LAC curve to be L shaped due to which it is cost effective to
produce less than maximum efficiency in a large plant than producing at maximum
efficiency in a small plant include-
1. Production and Managerial costs:
In the
long-run, all costs being variable, production costs and managerial costs of a
firm are taken into account when considering the effect of expansion of output
on average costs. As output increases, production costs fall continuously while
managerial cost may rise at very large scales of output. But the fall in
production costs outweighs the increase in managerial costs so that the LAC
curve falls with increases in output. We analyze the behaviour of production
and managerial costs in explaining the L-Shaped of the LAC Curve.
As a firm
increases its scale of production, cost fell steeply in the beginning and then
gradually. This is due to the technical economies of large scale production
enjoyed by the firm. Initially, these economies are substantial, but after a
certain level of output, when all or most of these economies have been
achieved, the firm reaches the minimaloptimal scale or minimum efficient scale (MES). Given the technology of the
industry, the firm can continue to enjoy some technical economies at outputs
larger than the MES for the following reasons.
(a) From
further decentralization and improvement in skills and productivity of labour.
(b) From lower
repair costs after the firm reaches a certain size; and
(c) By itself
producing some of the materials and equipment cheaply which the firm needs
instead of buying them from other firms.
In modern
firms, for each plant there is a corresponding managerial set-up for its smooth
operation. There are various levels of management, each having a separate
management technique applicable to a certain range of output. Thus, given a
managerial setup for a plant, its managerial costs first fall with the
expansion of output and it is only at a very large scale of output, they rise
very slowly.
In summary,
production costs fall smoothly at very large scales, while managerial costs may
rise slowly at very large scales of output. But the fall in production costs
more than offsets the rise in managerial costs so that the LAC curve falls
smoothly or becomes flat at very large scales of output, thereby giving rise to
the L-shape of the LAC curve.
Each SAC curve
includes production costs, managerial costs, other fixed costs and a margin for
normal profits. Each scale of plant is subject to a typical load factor capacity so that points A, B and C represent
the minimal optimal scale of output of each plant. By joining all such points
as A, B and C of a large number of SACs, we trace out a smooth and continuous
LAC curve.
2. Technical progress:
The L-shape of
the LAC curve due to technical progress can be explained using below figure:
Suppose the firm is producing 0Q1 output on LAC1 curve at per unit cost
of 0C1 output on LAC1 curve at a
per unit cost of 0C1. If
there is an increase in demand for the firm's product to 0Q2, with no change in technology, the firm will produce 0Q2 output along the LAC1 curve at per unit cost
of 0C'. If, however, there is technical
progress in the firm, it will install a new plant having LAC2 as the long-run average cost curve. On this plant,
it produces 0Q2 output at
a lower cost 0C2 per
unit. Similarly, if the firm decides to increase its output to 0Q3 to meet further rise in
demand, technical progress may have advanced to such a level that it installs
the plant with the LAC3
curve. Now it produces 0Q3
output at a still lower cost 0C3
per unit. If the minimum points, L, M
and N of these U-shaped long-run average cost curves LAC1, LAC2 and LAC3 are joined by
a line, it forms an L-shaped gently sloping downward curve LAC.
3. Learning:
Yet another
reason for the L-shaped long-run average cost curve is the learning process.
Learning is the product of experience. If experience in this context can be
measured by the amount of a commodity produced, then higher the production is,
the lower it is per unit cost. The consequences of learning are similar to
increasing returns. First, the knowledge gained from working on a large scale cannot
be forgotten. Second, learning increases the rate of productivity. Third,
experience is measured by the aggregate output produced since the firm first
started to produce the product. Learning by doing has been observed when firm
starts producing new products. After they have produced the first unit, they
are able to reduce the time required for production and thus reduce per unit
cost. Growing experience with making the product leads to falling costs as more
and more of it is produced. When the firm has exploited all learning
possibilities, costs reach a minimum level.
Thus the LAC
curve is L-shaped due to learning by doing.
The planning of
the plant (or the firm) consists of deciding the size of the fixed and indirect
factors which determine the size of the plant, because they set limits to its
production capacity. Direct factors such as labour and raw materials are
assumed not to set limit on size; the firm can acquire them easily from the
market without any time lag. The business man will start his planning with a
figure for the level of output which he anticipates selling, and he will choose
the size of plant which allows him to produce this level of output more
efficiently, and with the maximum flexibility, the business man will want to be
able to meet seasonal and cyclical fluctuations in his demand. Reserve capacity
will give the business man greater flexibility for repairs of broken down
machinery without disrupting the smooth flow of the production process.
The
entrepreneur will want to have more freedom to increase his output if demand
increases. All businessmen hope for growth. In view of anticipated increase in
demand, the entrepreneur builds some reserve capacity because he would not like
to let all new demand go to his rivals as this may endanger his future hold in
the market. It also gives him some flexibility for minor alterations of his
product, in view of changing tastes of customers.
Technology
usually makes it necessary to build into the plant some reserve capacity. Some
basic types of machinery (e.g. a turbine) may not be technically fully employed
when combined with other small types of machines in certain numbers. More of
which may not be required, given the specific size of the chosen plant.
Furthermore, some machinery may be so specialized as to be available only on
order, which takes time. In this case, such machinery will be bought in excess
of the minimum requirement at present numbers, as a reserve.
Some reserve
capacity will always be allowed in the land and buildings, since expansion of
operations may be seriously limited if new land or new buildings have to be
acquired. Finally, there will be some reserve capacity on the organizational
and administrative level. The administrative staff will be hired at such
numbers as to allow some increase in the operations of the firm.
In summary, the
businessman will not necessarily choose the plant which will give him the
lowest cost, but rather, that equipment which will allow him the greatest
possible flexibility for minor alterations of his product or his technique of
production.
