Question

a) Two methods of measuring economies of scale ( 20 marks)

b) Three factors that determine the degree of market concentration ( 20 marks)

c) The relationship between concentration and market performance ( 20 marks)

Answer 1

a)

The two methods of measuring economies of scale are:

i) Estimating cost-elasticity - It is calculated by dividing the percentage change in total costs by percentage change in the output:

Cost Elasticity  %Change in Total Costs / % Change in Output

Where ∆C is the change in total costs, the percentage change in total costs equals ∆C/C. Similarly, the percentage change in output is ∆Q/Q. It follows that:

Cost Elasticity = (∆C/C) / (∆Q/Q)

A production process is said to exhibit economies of scale if the cost elasticity is less than 1 and diseconomies of scale when the cost elasticity is greater than 1.

ii) Estimating change in total cost per unit change in output over time - It the trend is downward, this indicates there are economies of scale in the production process

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b)

The factors that determine market concentration includes:

i) A number of buyers and sellers - Larger the number of buyers and sellers, lesser the degree of influence on the price prevailing in the market. Hence, the lesser would be the market power and lower would be the market concentration

2) Nature of commodity sold in the market - If it a homogeneous good, the lower would be the market concentration. If the good is differentiated good, higher will be the market concentration.

3) The degree of freedom of entry or exit of the firms - If there are restrictions on the entry of new firms and exit of old firms, then a firm can influence the price as it has no fear of competition from other or new firms. There will in this case be market concentration.

4) The degree of dissemination of the market knowledge among buyers and sellers - In the case of imperfect knowledge, sellers are in a position to charge different prices, and the market is said to have market concentration enjoyed by some firms.

5) The degree of mobility of goods & factor inputs - In the case of immobility of goods and factors, different prices may prevail in the market, and the market is said to have market concentration enjoyed by some firms.

6) The initial investment level required - Higher the scale of investment required to set up the firm, higher will be the market concentration it will enjoy as other firms may not have adequate funds to bring such a large set-up for production & supply of the given product. Such as in the airplane industry, one a handful of companies operate as the initial investment scale required is too high. Thus, the firms already in this space enjoy market concentration.

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c)

Though the relationship between market shares and market performance (e.g., profitability) is industry-specific, in general, a higher degree of market concentration would lead to poor firm performance.

This is because it is the competition that drives the best outcome. It promotes innovations and efficiency and eventually results in increase in productivity and supply of better quality products in the market.

In the presence of market concentration, the firm would not have the incentive to drive innovative technology for production purposes. It may end up compromising on the quality of the product. In the long-run, this would not be good for the firm. the firm is at the risk of bad reputation that would drive it away from the market, as the potential customers moves away from it.