Question

3-2 Please provide details and examples

How can the long-run average cost (LRAC) curve be derived from the short-run average total cost (SRATC) curve? Describe economies of scale and diseconomies of scale. What are the determinants of economies of scale and diseconomies of scale, respectively? Using a real-world company (other than Sysco), explain the causes of economies of scale for your company. How would economies of scale help your company compete in its industry?

Answer 1

LRAC & SRAC

To understand the derivation of a long run average cost curve, let’s consider three short run average cost curves (SACs) as shown in Fig. below.

These SACs are also called plant curves. In the short run, a firm can operate on any SAC, given the size of the plant. For the sake of our understanding, let’s assume that there are only three plants that are technically possible. Therefore, the firm increases or decreases its outputs by changing the amount of the variable inputs.

However, in the long run, the firm examines each SAC to find the curve that allows it to produce a given level of output at the minimum cost. Hence, it chooses between SAC1, SAC2, and SAC3. From Fig. above, you can see that to generate OB amount of output, the firm can choose between SAC1 and SAC2. Note that the firm will choose SAC1 due to the lower costs as compared to SAC2.

If a firm has a choice of varying a plant by infinitely small gradations leading to infinite average cost curves. In such a case, the smooth curve enveloping all these short-run average cost curves is a long run average cost curve. The long run average cost curve is drawn tangential to all SACs. In other words, every point on the long run average cost curve is a tangent point on some SAC. Hence, whenever a firm desires to produce a certain output, it operates on the corresponding SAC.

ECONOMIES AND DISECONOMIES OF SCALE

Economies of scale are when the cost per unit of production (Average cost) decreases because the output (sales) increases. The most common reason for Economies of scale is that some production costs are fixed (as production increseases these costs stay constant). Therefore since costs per unit (Average Costs) are calculated by dividing the cost by the number of units of output

AC=Costs/quantity

Then any average involving Fixed Costs must decrease as quantity produced increases.

AFC=FC/Quantity

Diseconomies of scale are when the cost per unit of production (Average cost) increases because the output (sales) increases. The most common reasons for disconomies of scale are:

1. Communication - becomes more complex

2. Coordination - between departments

3. X- Inefficiency - management costs increase (non-productive costs)

4. Principle agent problem - delegating to employees who are not as committed as the owner

DETERMINANTS

Determinants of economies of scale are internal and external. Internal economies are controllableby managers because they are internal to the company. For example, large businesses are able to buy in bulk which in turn can lower the cost per unit of materials needed to make the product. Whereas external economies depend upon external factors which most often occurs with government aid, for example, a state often reduces taxes to attract the companies that provide themost jobs. Big real estate developers convince cities to build roads to support their buildings. This is a bi-product from real estate developers to convince cities to build roads to support their buildings because it saves the developers the cost of paying the taxes to build the roads that support their businesses.

PROCTER AND GAMBLE (PG)

Companies that have large economies of scale have durable advantages over their competitors because they have logistic or price advantages, and therefore attract more customers and solidify their size advantage even more. It creates a feedback loop of success that rivals have a difficult time dealing with. Companies that compete against larger rivals have price and efficiency disadvantages, and usually must sacrifice profitability levels to even stay in the game, or must try to change the nature of the game to circumvent the moat.

Procter and Gamble (PG) is a large brand management company. The company owns more than 20 billion-dollar-brands, and another 20 or more half-billion-dollar brands, mostly in the area of consumer products. Procter and Gamble’s extensive distribution network allows it to reach over 4 billion customers, with plans to reach up to 5 billion customers in the next few years as they continue their international expansion. The company spends more money on consumer and market research than any other corporation.