Economies of Scale

Mass production and batch processing techniques such as the division of labor, use of complex machin­ery, and the assembly line are most effective in large operations. How

large a firm must be before it pays to use such methods varies from case to case. But when a firm reach­es that size, economists say that it can begin to enjoy the economies of scale—a reduction in costs resulting from large-scale production. Firms enjoy economies of scale for the following reasons:

• They can afford to use the full benefits of the divi-

sion of labor.

• They can buy in quantities that entitle them to

discounts on raw materials.

• They can afford to purchase specialized machin-

ery and equipment to reduce unit costs (costs per item).

• They can afford to invest in research and develop­ment programs that enable the company to re­duce production costs and produce new and improved products.

Summary

Societies obtain goods and services either by producing them themselves or by trading what they pro­duce for what they want. It follows that if living standards are to be improved, ways must be found to increase production.

There are two ways to increase production: use the economy's resources to the fullest; increase the econ­omy's ability to produce with its available resources. Productivity, the measure of how efficiently we use our available resources to produce, is directly affected by the quality of our labor force, our technology, and the effectiveness with which management uses our resources.

Productivity gains are important to both individual firms and the nation as a whole. When productivity is improving, workers can receive salary increases without reducing the profit margins of their compa­nies. Today, American businesses are using the principles of Total Quality Management to improve pro­ductivity. However, government regulations, the tax code, education policies, and other programs also impact productivity. Many people do not agree on the most appropriate government policies.

Large firms often achieve greater productivity than small firms because ofeconomies of scale. Because of these economies, unit costs are reduced to levels that smaller firms could not match. Unit costs contain both fixed and variable costs. Fixed costs per unit will always decrease as output increases. Variable costs per unit will decline at first, but as output increases still further, they will increase due to the law of diminishing returns.

Reading for Enrichment

The Profit-Maximizing Firm

Economists say that the primary goal of every firm is to make the largest possible profit, or to put it another way, to maximize profits. If it does any­thing else, it would soon be out of business. In its quest for profits, one of the first things a firm must decide is its level of production.

To understand a firm's reasoning, look at how prof­its are determined. A firm's total profit is the dif­ference between its earnings from the sale of its product (or its total revenue) and the amount it pays to produce that product (or its total cost).

Total Revenue-Total Cost=Total Profit

The firm selects the production level at which it makes the greatest profit. This is not necessarily the same as its highest possible production level.

After conducting a market survey, the Ajax Doughnut Bakery discovered the following:

Daily Production Profits

50 boxes $30

75 boxes 40

100 boxes 35

If you were the manager of Ajax Doughnuts, how many boxes of doughnuts would you produce each day: 50? 75? 100? In this case it makes sense to produce 75, since that will yield the greatest profit.

How does a firm calculate its profit-maximizing output level? One way would be through trial and error. That is, the bakers could produce one box of doughnuts the first day, two the second, and so on until they reached their maximum daily output. But this method is time-consuming and costly. An easier method is what economists call marginal analysis. Marginal analysis uses pencil and paper to examine what happens when a firm decides to produce one more unit of output. Here is how it is done.

As long as the production of one more box of dough­nuts adds to Ajax's profits, it pays to bake that box. To an economist, the income from the production of one more unit is marginal revenue. Marginal profit is the difference between marginal revenue and marginal cost-the cost of producing one more box:

Marginal Revenue - Marginal Cost = Marginal Profit

In general, marginal revenue declines as produc­tion increases because firms eventually lower their prices in order to sell more. As production increases, marginal costs decline at first, but then increase. That is because a firm's greatest efficiency lies somewhere between its level of minimum and max­imum output. As output increases toward that point, the cost of producing each additional unit (its marginal cost) falls. Once the point of maxi­mum efficiency is reached, diminishing returns set in, and marginal costs increase.

Marginal profit is the difference between marginal revenue and marginal cost. Like marginal cost and marginal revenue, marginal profits will be positive up to a certain level of output and then become negative. ("Negative profits" are losses.)

How does a firm calculate its profit-maximizing level of production?

If producing one more box of doughnuts adds more to total revenue than cost (marginal cost increases with production), then the firm should produce it. If producing one more box of doughnuts adds less to revenue than cost (profits are negative or less than zero), it should not be produced by a profit-maxi­mizing firm.

Since marginal profits generally turn negative as production exceeds the point where labor and machinery are most efficient, a firm's profit-maxi­mizing output is the level at which marginal profits are zero. This can be stated in a simple rule: Increase output until...

Marginal Revenue = Marginal Cost.

Figure 7-4 explains these concepts. The graph shows how marginal cost (MC) rises and marginal revenue (MR) declines as the bakery increases its output of doughnuts. Since marginal profit (MP) is the difference between the two, the graph shows it declining with output and eventually becoming neg­ative when MC is greater than MR. Now it is clear why a firm wants to produce more until MR equals MC. Up to that point the firm is adding to profits; after that point profits are becoming smaller.

Date: 2015-02-16; view: 1418