Macroeconomic Policy Objectives,IGCSE,GCEO NOTES

Macroeconomic Policy Objectives

Introduction

What are objectives and how are they different from instruments?

1. Objectives are the aims or goals of government policy

2. Instruments are the means by which these aims might be achieved

For example, the government might want to achieve an objective of a low rate of inflation.

The main instrument to achieve this are changes in monetary policy interest rates and since 1997 they have been set by the Bank of England. Fiscal policy could be another instrument to achieve this aim. This is in the hands of the government. Supply-side policies can also be used to control inflation and promote growth.

The government might have another objective – namely to make the distribution of income and wealthmore equal. It would then choose the policy instruments it thinks are best suited to reaching to this aim, perhaps a change in the income tax system or a rise in the national minimum wage .

The main policy instruments available to meet macroeconomic objectives are

• Monetary policy –changes to interest rates, the supply of money and credit and also changes to the value of the exchange rate
• Fiscal policy – changes to government taxation, government spending and borrowing
• Supply-side policies designed to make markets work more efficiently

Objectives of UK Macroeconomic Policy

The key objectives for the UK are:

• Stable low inflation - the Government’s inflation target is 2.0% for the consumer price index. TheMonetary Policy Committee sets interest rates at a level it thinks will meet the inflation target over a two year horizon.
• Sustainable growth – as measured by the growth of real gross domestic product – sustainable in keeping inflation low and in reducing the environmental impact of growth.
• Improvements in productivity – this is designed to improve competitiveness and trade performance. The pressures of globalisation and the increasing competition within the European Single Market make this one of the key objectives of the government.
• High employment - the government wants to achieve full-employment – a situation where all those able and available to find work have the opportunity to work. At the time of writing, the key aim is to limit the effects of the recession on the level of unemployment.
• Rising living standards and a fall in relative poverty – for example the objective of cutting child poverty and reducing pensioner poverty.
• Sound government finances - including control over government borrowing and the total national debt.

What is meant by economic stability?

Economic stability occurs when there is an absence of big swings in prices, output and jobs.

The national output of a country does not grow in a steady fashion from one year to the next.  All countries experience an economic cycle which tracks the fluctuations in the rate of growth of a country’s Gross Domestic Product (GDP).

Here is a reminder of some key terms that we will return to in later topics

Economic cycle	Variations in the annual rate of growth of an economy over time
Forecast	A prediction made about the likely future performance of an economy
GDP	The monetary value of goods and services produced within the geographical boundaries of a country in a given time period
Recession	A period of at least six months when an economy suffers a fall in output
Recovery	An upturn phase in the business cycle when GDP recovers from a trough
Slowdown	A fall in the rate of growth of an economy but not a full-scale recession
Sustainable growth	The rate of growth “which meets the needs of the present without compromising the ability of future generations to meet their own needs”.
Target	A target is an aim or an objective of government policy e.g. low inflation

Divorce between ownership and control

Ownership and control

• The owners of a private sector company normally elect a board of directors to control the business’s resources for them.
• However, when the owner sells shares, or takes out a loan or bond to raise finance, they maysacrifice some of their control. Other shareholders can exercise their voting rights, and providers of loans often have some control (security) over the assets of the business
• This may lead to conflict between them as these different stakeholders may have different objectives. The flow chart below attempts to show the divorce between ownership and control.

The Principal Agent Problem

How do the owners of a large business know that the managers they have employed operate with the aim of maximising shareholder value in both the short term and the long run? This lack of information is known as the principal-agent problem or “agency problem”.

• The principal agent problem revolves around a simple issue - how best to get your employees to act in your interests rather than their own?
• Shareholders tend to want good returns in the form of dividend payments and a rising share price.
• Managers may have different objectives such as power, bonuses, large expense accounts, prestige and status. The problem is the many shareholders - have no day-to-day control over managers. Pension fund managers cannot dictate what CEOs and CFOs of businesses decide to do and senior executives may have little knowledge of what their managers are doing.
• Many investors in a business are 'passive'. The biggest investors in UK listed companies tend to be large institutional shareholders such as pension funds and insurance companies.

Examples of the principal-agent problem that have hit the headlines recently in the UK include the mis-management of financial assets on behalf of investors (e.g. Equitable Life.) The classic case in the United States was the Enron fraud and debacle.

The credit crunch focused attention on the failure of shareholders in the major banks to understand the complex and risky behaviour that was being undertaken by bank employees involved in the sub-prime mortgage boom and the growth of securitised lending.

In the banking crisis it became clear that senior management at many of the world's biggest banks simply did not understand the complexity of what their traders were doing. Traders stood to earn huge bonuses if their risky loans worked, but faced little sanction or loss if they went bad. This skewed their incentives and created a problem of moral hazard. This term originated in insurance, recognising the idea that people with insurance may be careless – for example, paying for secure off-street parking looks less attractive if your car is insured.

A separation of ownership and control in banks and insurance companies contributed to the sub-prime crisis and the result has been a collapse in shareholder value as the stock market prices of banks and insurance companies has fallen sharply.

Employee Share Ownership Schemes

There are various strategies available for coping with the principle- agent problem. One is the expansion of employee share-ownership schemes.  But the use and occasional misuse of share options schemes has been controversial for several years. A recent example involved the US computer giant Apple.

The growth of "shareholder activism"

• Increasingly we are seeing shareholders who are more proactive in putting executive management under pressure - these are known as activist shareholders. In 2012 some commentators pointed to the emergence of a “shareholder spring” prompted by investor anger over huge remuneration packages alongside poor financial performance
• At the forefront of this change has been the expansion of hedge funds and a number of wealthy private investors. Latterly, the sovereign wealth funds have appeared on the scene.
• An activist shareholder uses an equity stake in a corporation to put pressure on its existing management.
• The goals of activist shareholders range from financial (e.g. increase of shareholder value through changes in dividend decisions, plans for cost cutting or investment projects etc.) to non-financial(e.g. dis-investment from particular countries with a poor human rights record, or pressuring a business to speed up the adoption of environmentally friendly policies and build a better reputation for ethical behaviour, etc.).
• Activist shareholders do not have to hold large stakes in a business to make an impact. Even those with relatively small stakes or 3 or 4 per cent can launch publicity campaigns and make direct contact with the senior management. Private equity / hedge funds have been among those most involved in the rise of shareholder activism. They tend to focus on under-performing businesses

Is this new breed of shareholder activists an important voice and counter-balance to the power of entrenched management and willing to stand up to corporate corruption and highlight poor management?

Can they help to overcome the principle-agent problem? Or are they aggressive corporate raiders seeking short-term corporate change merely for their own personal gain?

Environmental groups such as Friends of the Earth have also latched onto the potential for shareholder activism to impact on businesses especially in the areas of the environmental impact of their business activities.

It remains the case that ownership and control within British industry is dispersed. Typically the largest shareholder in any large business listed on the stock market is likely to own a minority of the shares. Majority ownership by a single shareholder is unusual.

Corporate Social Responsibility (CRS) and Business Ethics

• Business ethics is concerned with the social responsibility of management towards the firm’s stakeholders, the environment and society in general.
• There is a growing belief that ethical and ‘green’ business are linked to improved business performance because of increased public concern for human rights and the environment.
• For example, many businesses are now trumpeting their progress in making their activities carbon neutral by offsetting the impact of their production activities on their environment through offset activities. Businesses such as Carbon Clear provide a means by which organisations can find ways to offset their carbon emissions.
• Business ethics extends to treating stakeholders ‘fairly’; hence the growing emphasis on health and safety issues, good working practices and the like in business decision-making.
• According to the Ethical Investment Research Service (EIRIS) £6.7 billion is invested in ethical and environmental investment funds in the UK (and rising)

For more reading on this try this link to the Institute for Business Ethics. The Times 100 Case Studies includes one on Cadbury’s and corporate social responsibility.  Click here for BBC news articles on carbon neutrality.

Examples of private benefits from corporate social responsibility projects

• Marks & Spencer Plan A to cut carbon emissions: Estimate of £50m extra profit (20% cut in packaging costs; 19% increase in energy efficiency) – their aim is to be the world’s most sustainable retailer
• GE (Ecomagination): $70bn of extra revenue in first 5 years (new products for the green economy)
• Unilever (Project Shakti): $100m extra sales by selling to rural Indian communities – their Sustainable Living Plan aims to double sales & halve environmental impact of its products by 2020. 15 years of sustainability projects = CO2 from energy down 41%; water use down 65%; total waste down 73%
• British Telecom: BT’s commitment to its sustainability agenda has helped it win £2.2bn worth of business in the financial year 2007-2008, up from £1.8bn the year before.
• Sony: A vision of being a zero carbon emission firm by 2050 with staged targets along the way
• Dow Jones: A.T. Kearney looked at 99 companies who have a strong commitment to sustainability (as defined by the Dow Jones Sustainability Index) and compared their performance with industry averages. They found that In 16 out of the 18 industries studied, companies committed to sustainability outperformed industry averages by 15%

Multinationals are increasingly seeing CSR as a key driver of product innovation - CSR has grown in strategic importance during a period of uncertain / weak economic growth

Profits,The Nature of Profit

Profits

The Nature of Profit

Profit measures the return to risk when committing scarce resources to a market or industry.

Entrepreneurs organise factors of production and take risks for which they require an adequate rate of return. The higher the market risk and the longer they expect to have to wait to earn a positive return, the greater will be the minimum required return that an entrepreneur is likely to demand.

Economists distinguish between different types of profit:

Normal profit - is the minimum level of profit required to keep factors of production in their current use in the long run.

Normal profits reflect the opportunity cost of using funds to finance a business. If you put £200,000 of savings into a new business, those funds could have earned a low-risk rate of return by being saved in a bank account. You might use the rate of interest on that £200,000 as the minimum rate of return that you need to make from your investment

Because we treat normal profit as an opportunity cost of investing financial capital in a business, we include an estimate for normal profit in the average total cost curve, thus, if the firm covers its AC then it is making normal profits.

Sub-normal profit - profit less than normal (P < average cost)

Abnormal profit - is any profit achieved in excess of normal profit - also known as supernormal profit. When firms are making abnormal profits, there is an incentive for other producers to enter a market to try to acquire some of this profit. Abnormal profit persists in the long run in imperfectly competitive markets such as oligopoly and monopoly where firms can successfully block the entry of new firms. We will come to this later when we consider barriers to entry in monopoly.

Calculating economic profit

Consider the following example:The table shows data for an owner-managed firm for a particular year.

• Total revenue £320,000
• Raw material costs £30,000
• Wages and salaries £85,000
• Interest paid on bank loan £30,000
• Salary that the owner could have earned elsewhere £32,000
• Interest forgone on capital invested in the business £20,000

In a simple accounting sense, the business has total revenue of £320,000 and costs of £145,000 giving an accounting profit of £175,000. But profit according to an economist should take into account the opportunity cost of the capital invested and the income that the owner could have earned elsewhere. Taking these two items into account we find that the economic profit is £123,000.

Accounting Profit and Economic Profit

Short Run Profit Maximisation

Profits are maximised when marginal revenue = marginal cost

Price Per Unit (AR) (£)	Demand / Output (units)	Total Revenue (TR) (£)	Marginal Revenue (MR) (£)	Total Cost (TC) (£)	Marginal Cost (MC) (£)	Profit (£)
50	33	1650		2000		-350
48	39	1872	37	2120	20	-248
46	45	2070	33	2222	17	-152
44	51	2244	29	2312	15	-68
42	57	2394	25	2384	12	10
40	63	2520	21	2444	10	76
38	69	2622	17	2480	6	142
36	75	2700	13	2534	9	166
34	81	2754	9	2612	13	142

Consider the example in the table above. As price per unit declines, so demand expands. Total revenue rises but at a decreasing rate as shown by the column showing marginal revenue. Initially the firm is making a loss because total cost exceeds total revenue. The firm moves into profit at an output level of 57 units. Thereafter profit is increasing because the marginal revenue from selling units is greater than the marginal cost of producing them. Consider the rise in output from 69 to 75 units. The MR is £13 per unit, whereas marginal cost is £9 per unit. Profits increase from £142 to £166.

But once marginal cost is greater than marginal revenue, total profits are falling. Indeed the firm makes a loss if it increases output to 93 units.

As long as marginal revenue > marginal cost, total profits will be increasing (or losses decreasing). The profit maximisation output occurs when marginal revenue = marginal cost.
In the next diagram we introduce average revenue and average cost curves into the diagram so that, having found the profit maximising output (where MR=MC), we can then find (i) the profit maximising price (using the demand curve) and then (ii) the cost per unit.

• The difference between price and average cost marks the profit margin per unit of output.
• Total profit is shown by the shaded area and equals the profit margin multiplied by output

The Short Run Supply Decision - The Shut-down Price

A business needs to make at least normal profit in the long run to justify remaining in an industry but in the short run a firm will continue to produce as long as total revenue covers total variable costs or price per unit > or equal to average variable cost (AR = AVC). This is called the short-run shutdown price.

The reason for this is as follows. A business’s fixed costs must be paid regardless of the level of output. If we make an assumption that these costs cannot be recovered if the firm shuts down then the loss per unit would be greater if the firm were to shut down, provided variable costs are covered.

• Average revenue (AR) and marginal revenue curves (MR) lies below average cost, so whatever output produced, the business faces making a loss
• At P1 and Q1 (where marginal revenue equals marginal cost), the firm would shut down as price is less than AVC. The loss per unit of producing is vertical distance AC. No contribution is made to fixed costs
• If the firm shuts down production the loss per unit will equal the fixed cost per unit AB.
• In the short-run, provided that the price is greater than or equal to P2, the business can justify continuing to produce
• In the long run the shut down point is AVC=AR because all cost are variable

Recession and factory closures

• The concept of the shutdown point has become topical due to the recession and the weak subsequent recovery
• Many businesses have opted to close down loss-making production plants and retailers have announced the closure of retail outlets in a bid to cut their losses.

Some of the plant closures have been temporary, for example some high-profile car manufacturers mothballed their factories and reduced the number of shifts. But for other businesses, the downturn brought about an end to trading. We have seen the demise of a large number of well-known retail businesses.

Deriving the Firm’s Supply Curve in the Short Run

• In the short run, the supply curve for a business operating in a competitive market is the marginal cost curve above average variable cost.
• In the long run, a firm must make a normal profit, so when price = average cost, this is the break-even point. It will therefore shut down at any price below this in the long run. 
• As a result the long run supply curve will be the marginal cost curve above average total cost.

The concept of a ‘supply curve’ is inappropriate when dealing with monopoly because a monopoly is a price-maker, not a “passive” price-taker, and can thus select the price and output combination on the demand curve so as to maximise profits where marginal revenue = marginal cost.

Changes in demand

• A change in demand and/or production costs will lead to a change in the profit maximising price and output.
• In exams you may often be asked to analyse how changes in demand and costs affect the equilibrium output for a business. Make sure that you are confident in drawing these diagrams and you can produce them quickly and accurately under exam conditions.
• In the diagram below we see the effects of an outward shift of demand from AR1 to AR2 short run costs of production remain unchanged). The increase in demand causes a rise in the price from P1 to P2 (consumers are now willing and able to buy more at a given price) and an expansion of supply (the shift in AR and MR is a signal to firms to move along their marginal cost curve and raise output). Total profits have increased.

Functions of Profit in a Market Economy 

Milk farmers could lose thousands of pounds a year after suppliers imposed a huge cut in milk prices. The average cow produces 7,500 liters of milk a year, meaning an annual loss of £45,000 for a typical herd of 120 cows. The number of dairy farmers has halved in the past ten years.
Robert Wiseman Dairies, Arla Foods UK and Dairy Crest – intend to cut the prices paid to farmers for milk. The processors say the move is a result of deterioration in the commodity markets for skimmed milk powder and wholesale cream. Some of the major retailers have corporate responsibility strategies which include terms to protect farmers. Tesco and Sainsbury's pay a price per liter that covers the cost of production, with Sainsbury's paying 30.56p per liter. Waitrose pays a market leading price, aiming to top the prices paid by the other retailers

Profits serve a variety of purposes in a market economy:

1. Finance for investment Retained profits are source of finance for companies undertaking investment. The alternatives such as issuing new shares (equity) or bonds may not be attractive depending on the state of the financial markets especially in the aftermath of the credit crunch.
2. Market entry: Rising profits send signals to other producers within a market. When existing firms are earning supernormal profits, this signals that profitable entry may be possible. In contestable markets, we would see a rise in market supply and lower prices. But in a monopoly, the dominant firm(s) can protect their position through barriers to entry.
3. Demand for factor resources: Scarce factor resources flow where the expected rate of return or profit is highest. In an industry where demand is strong more land, labour and capital are then committed to that sector.
4. Signals about the health of the economy: The profits made by businesses throughout the economy provide important signals about the health of the macro economy. Rising profits might reflect improvements in supply-side performance (e.g. higher productivity or lower costs through innovation). Strong profits are also the result of high levels of demand from domestic and overseas markets. In contrast, a string of profit warnings from businesses could be a lead indicator of a macroeconomic downturn.

Business this week

The superlatives came thick and fast to describe Alibaba’s IPO on the New York Stock Exchange. It was the world’s biggest, raising $25 billion after underwriters exercised an option for extra shares at the debut price of $68, and it was far ahead of Facebook’s IPO, which had held the record for a tech flotation. Alibaba’s share price rose 38% on the first day of trading, though it fell back somewhat in following sessions. Capping it all Jack Ma, who founded the company, was declared China’s wealthiest man and worth $25 billion, according to the Hurun Report in Shanghai. See article

Freeing Citizens

Royal Bank of Scotland erred on the side of caution by pricing the shares in its flotation ofCitizens Financial below the price range it had previously indicated. Citizens, based in Rhode Island and which RBS bought in 1988 during a period of expansion, raised $3 billion, making it the second-biggest stockmarket debut in America this year. Its share price rose 7% on the first day of trading. RBS still owns 75% of the bank.

In this section

• Politics this week
• Business this week
• KAL's cartoon

Reprints

Related topics

• Oracle
• Tesco
• China
• Banking
• Royal Bank of Scotland

Rocket Internet, a firm in Berlin that has backed e-commerce startups in 100 countries, said that it now expects to raise around €1.5 billion ($1.9 billion) from its IPO next month, double its initial target.

America’s Treasury department took its “first steps” to discourage companies from moving their tax base abroad to escape the taxman. Procedures that are used to qualify for such a move, called an inversion, are being curtailed, and companies that do invert will find it harder to tap their overseas cash piles without paying tax. Share prices wobbled in several companies that have plans to invert, including Medtronic and AbbVie. Still, the Treasury stopped short of prohibiting “earnings stripping”—piling debt onto the American unit to reduce taxes.

Still smarting over the imposition of Western sanctions, Russia’s Duma overwhelmingly backed a bill in its first reading that would limit foreign ownership of the media to 20%. If passed the legislation would markedly affect business titles such as Vedomosti, which has criticised the Kremlin for damaging the economy.

The tills don’t tally

Although it is trying to make a fresh start under a new chief executive, Tesco, Britain’s biggest retailer, became entangled in new difficulties after finding that it had overstated its first-half profit by £250m ($417m) because of an accounting irregularity. It suspended four executives ahead of an investigation and issued yet another profit warning. Investors headed for the checkouts; Tesco’s share price fell 12% in one day. See article

Mario Draghi, the president of the European Central Bank, said that an initial take-up of €82.6 billion ($106 billion) in new ultra-cheap financing by banks had been “within the range” he had expected, though it fell short of most economists’ forecasts. Around €400 billion in four-year loans at 0.15% is available to banks in two rounds. The second round is in December.

GlaxoSmithKline’s local subsidiary in China was found guilty of bribing doctors and hospitals and fined almost $500m, the biggest corporate penalty so far in China, according to state media. Mark Reilly, who ran GSK’s Chinese operations, was given a suspended prison sentence. The twists and turns in the case have been watched closely by foreign businesses. GSK, meanwhile, decided to replace Christopher Gent as chairman with Philip Hampton, who is currently the chairman of RBS.

This year’s frenzy of dealmaking in the drugs industry continued when Merck of Germany agreed to buy Sigma-Aldrich, which is based in St Louis and supplies laboratories with chemicals and other products, in a transaction valued at $17 billion.

Air France conceded to its pilots’ demands to end a crippling strike and offered to withdraw its plans to expand Transavia, its low-cost carrier.

He’s not sailing away just yet

Larry Ellison stepped aside as chief executive at Oracle to become chairman and chief technology officer, a move similar to that taken by Bill Gates at Microsoft in 2000. Oracle appointed two co-chief executives to replace Mr Ellison: Mark Hurd, who used to run Hewlett-Packard before resigning under a cloud in 2010, and Safra Catz, a longtime confidante of Mr Ellison. See article

BlackBerry’s new smartphone, the Passport, went on sale. It is the first device BlackBerry has developed under John Chen’s leadership and is a return to its roots; its square screen is designed for reading spreadsheets and documents and aimed at businesspeople, not general consumers.

DHL said that it would begin dispatching medicine to an island off the German coast bydrone. It is the first time that a “parcelcopter” will be used to make regular deliveries.

From the print edition: The world this week

Long-run costs - economies & diseconomies of scale

Economies of Scale

• In the long run all costs are variable and the scale of production can change (no fixed inputs)
• Economies of scale are the cost advantages from expanding the scale of production in the long run. The effect is to reduce average costs over a range of output.
• These lower costs represent an improvement in productive efficiency and can give a business acompetitive advantage in a market. They lead to lower prices and higher profits – this is called apositive sum game for producers and consumers (i.e. the welfare of both will improve)
• We make no distinction between fixed and variable costs in the long run because all factors of production can be varied.
• As long as the long run average total cost curve (LRAC) is declining, then internal economies of scale are being exploited. The table below shows a numerical example of falling LRAC

Long Run Output (Units)	Total Costs (£s)	Long Run Average Cost (£ per unit)
1000	12000	12
2000	20000	10
5000	45000	9
10000	80000	8
20000	144000	7.2
50000	330000	6.6
100000	640000	6.4
500000	3000000	6

Returns to Scale and Costs in the Long Run

The table below shows how changes in the scale of production can, if increasing returns to scale are exploited, lead to lower long run average costs.

	Factor Inputs				Production		Costs
	(K)	(La)	(L)		(Q)		(TC)	(TC/Q)
	Capital	Land	Labour		Output		Total Cost	Average Cost
Scale A	5	3	4		100		3256	32.6
Scale B	10	6	8		300		6512	21.7
Scale C	15	9	12		500		9768	19.5
Costs: Assume the cost of each unit of capital = £600, Land = £80 and Labour = £200

Because the % change in output exceeds the % change in factor inputs used, then, although total costs rise, the average cost per unit falls as the business expands from scale A to B to C.

Increasing Returns to Scale

Much of the new thinking in economics focuses on the increasing returns available to a company growing in size in the long run.

An example of this is the software business.

• The overhead costs of developing new software programs or computer games are huge - often running into hundreds of millions of dollars
• But the marginal cost of one extra copy for sale is close to zero, perhaps just a few cents or pennies.
• If a company can establish itself in the market, positive feedback from consumers will expand the installed customer base, raise demand and encourage the firm to increase production.
• Because marginal cost is so low, the extra output reduces average costs creating economies of size.

Capacity utilisation, fixed costs and profits

Lower costs normally mean higher profits and increasing financial returns for the shareholders. What is true for software developers is also important for telecoms companies, transport operators and music distributors.

We find across many different markets that, when a high percentage of costs are fixed the higher the level of production the lower will be the average cost of production. Strong demand means that capacity utilization rates are high and this lowers the unit cost of supply.

Long Run Average Cost Curve

The long run average cost curve (LRAC) is known as the ‘envelope curve’ and is usually drawn on the assumption of their being an infinite number of plant sizes – hence its smooth appearance in the next diagram below.

The points of tangency between LRAC and SRAC curves do not occur at the minimum points of the SRAC curves except at the point where the minimum efficient scale (MES) is achieved.

If LRAC is falling when output is increasing then the firm is experiencing economies of scale.  For example a doubling of factor inputs might lead to a more than doubling of output.

Conversely, When LRAC eventually starts to rise then the firm experiences diseconomies of scale, and, If LRAC is constant, then the firm is experiencing constant returns to scale

The working assumption is that a business will choose the least-cost method of production in the long run. Moving down the LRAC means there are cost advantages from a bigger scale of operations.

Sources of Internal Economies of Scale (IEoS)

Internal economies of scale come from the long-term growth of the firm. Examples include:

1. Technical economies of scale:

These refer to gains in productivity from scaling up production.

1. Expensive (indivisible) capital inputs: Large-scale businesses can afford to invest in specialist capital machinery. For example, a supermarket might invest in database technology that improves stock control and reduces transportation and distribution costs.
2. Specialization of the workforce: Larger firms can split the production processes into separate tasks to boost productivity. Examples include the use of division of labour in the mass production of motor vehicles and in manufacturing electronic products.
3. The law of increased dimensions (also known as the “container principle”) This is linked to the cubic law where doubling the height and width of a tanker or building leads to a more than proportionate increase in the cubic capacity

1. The application of this law opens up the possibility of scale economies in distribution andfreight industries and also in travel and leisure sectors with the emergence of super-cruisers such as P&O’s Ventura. Consider the new generation of super-tankers and the development of enormous passenger aircraft such as the Airbus 280 which is capable of carrying over 500 passengers on long haul flights.
2. The law of increased dimensions is also important in the energy sectors and in industries such as office rental and warehousing. Amazon for example has invested in several huge warehouses at its central distribution points – capable of storing hundreds of thousands of items.

4. Learning by doing: The average costs of production decline in real terms as a result of production experience as businesses cut waste and find the most productive means of producing output on a bigger scale. Evidence across a wide range of industries into so-called“progress ratios”, or “experience curves”, indicate that unit manufacturing costs typically fall by between 70% and 90% with each doubling of cumulative output.

1. Marketing Economies - Monopsony Power: A large firm can purchase its factor inputs in bulk at discounted prices if it has monopsony (buying) power. A good example would be the ability of the electricity generators to negotiate lower prices when finalizing coal and gas supply contracts. The national food retailers have monopsony power when purchasing their supplies from farmers and wine growers and in completing supply contracts from food processing businesses. Other controversial examples of the use of monopsony power include the prices paid by coffee roasters and other middlemen to coffee producers in some of the poorest parts of the world.
2. Managerial economies of scale: This is a form of division of labour where firms can employ specialists to supervise production systems. Better management; increased investment in human resources and the use of specialist equipment, such as networked computers can improve communication, raise productivity and thereby reduce unit costs.
3. Financial economies of scale: Larger firms are usually rated by the financial markets to be more‘credit worthy’ and have access to credit with favourable rates of borrowing. In contrast, smaller firms often pay higher rates of interest on overdrafts and loans. Businesses quoted on the stock market can normally raise new financial capital more cheaply through the sale of equities to the capital market. The credit crunch and fragility of the banking system has made raising finance harder for businesses of all sizes – bank overdraft and loan interest rates have increased across the board, but it remains true that larger corporations can still access credit at a cheaper cost.
4. Network economies of scale: There is growing interest in the concept of a network economy. Some networks and services have huge potential for economies of scale. That is, as they are more widely used (or adopted), they become more valuable to the business that provides them.

Case Study: Small businesses and financial economies of scale
A Bank of England survey on financial and credit conditions finds that smaller businesses are finding it tough to get the credit they need to finance an upturn in sales and production.
Interest rate spreads on new loans are rising and it is larger firms that seem to be benefitting from lower borrowing costs. According to the report “larger businesses are enjoying a reduction in the cost of borrowing and improved access to credit as banks favour lower-risk custom.”
The main commercial banks continue to adopt a risk-averse approach to new lending and this may hamper prospects of recovery. Unsecured loans for consumers have also become harder to get and more expensive despite the ultra-low interest rate policy of the Bank of England. In 2006, the top 10 average rate for a £3,000 personal loan was 6.49%, but today it is 14.92%, analysis by price comparison website moneysupermarket.com has shown.   Source: Tutor2u economics blog, April 2010

What are Network Economies of Scale?

The power of networks is becoming increasingly recognized in the economics of long run costs, revenues and profits.
Many networks have huge potential for economies of scale. That is, as they are more widely used (or adopted), they become more valuable to the business that provides them.
Good examples to use include online auction sites such as eBay, social networking sites, wireless service providers, air and rail transport networks and businesses such as Amazon.
In most cases, the marginal cost of adding one more user or customer to a network is close to zero, but the resulting financial benefits may be huge because each new user to the network can then interact, trade with all of the existing members or parts of the network.
Given the high fixed costs of establishing a network, the more users there are the lower are the fixed costs per unit. Thus as the network expands, not only are there potential gains from extra revenues, but the long run cost per user diminishes - an internal economy of scale.
In some cases an industry that requires a network to fulfill customer needs and wants across a country or region might be classified as a natural monopoly - an industry where long run average cost falls over a huge range of output and where the minimum efficient scale is a large percentage of market demand.
Consider as examples the networks required by the major utilities such as water, gas, electricity and (fixed line) broadband suppliers. And perhaps businesses such as Network Rail and the Royal Mail might also claim to have aspects of a natural monopoly given the requirement for the former to maintain and improve a national rail infrastructure and, for the latter, to keep a universal postal service running to add postal addresses in the country - this is of course a loss-making aspect of their business model.
Where there are strong grounds for believing an industry is a natural monopoly, there might be a case for nationalizing and/or regulating the network element of the business but introducing competition into the actual service provision - e.g. franchise bids for train operating companies, and partial or complete deregulation of parcel and letter collection, sorting and delivery.
Source: Tutor2u Economics Blog

Analysis: Economies of Scale – Effects on Price, Output and Profits

Consider the diagram:

• Scale economies allow a supplier to move from SRAC1 to SRAC2
• A profit maximizing producer will produce at a higher output (Q2) and charge a lower price (P2) as a result – but the total profit is also much higher (compare the two shaded regions)
• Both consumer and producer surplus has increased – there has been an improvement in economic welfare and efficiency – the key is whether cost savings are passed onto consumers!

Analysis Diagram for External Economies of Scale (EEoS)

• External economies of scale occur outside of a firm but within an industry.
• For example investment in a better transportation network servicing an industry will resulting in a decrease in costs for a company working within that industry.
• Another example is the development of research and development facilities in local universitiesthat several businesses in an area can benefit from.
• Likewise, the relocation of component suppliers and other support businesses close to the centre of manufacturing are also an external cost saving.
• Agglomeration economies may also result from the clustering of businesses in a distinct geographical location e.g. software in Silicon Valley or investment banks in the City of London

Economies of Scale – The Importance of Market Demand

The market structure of an industry is affected by the extent of economies of scale available to individual suppliers and by the total size of market demand.

• In many industries, it is possible for smaller firms to make a profit because the cost disadvantages they face are relatively small. Or because product differentiation allows a business to charge a price premium to consumers which more than covers their higher costs.
• A good example is the retail market for furniture. The industry has major players in different segments (e.g. flat-pack and designer furniture) including the Swedish giant IKEA. However, much of the market is taken by smaller-scale suppliers with consumers willing to pay higher prices for bespoke furniture owing to the low price elasticity of demand for high-quality, hand crafted furniture products.
• Small-scale manufacturers can extract the consumer surplus that is present when demand is estimated to have a low elasticity of demand.

Economies of Scope

• Economies of scope occur where it is cheaper to produce a range of products rather than specialize in just a handful of products.

For example, in the competitive world of postal services and business logistics, service providers such as Royal Mail, UK Mail, Deutsche Post and parcel carriers including TNT, UPS, and FedEx are broadening the range of their services and making better use of their collection, sorting and distribution networks to reduce costs and earn higher profits from higher-profit-margin and fast growing markets.

• A company’s management structure, administration systems and marketing departments are capable of carrying out these functions for more than one product.
• Expanding the product range to exploit the value of existing brands is a good way of exploiting economies of scope.
•  A good example of “brand extension” is the Easy Group under the control of Stelios where the distinctive Easy Group business model has been applied (with varying degrees of success) to a wide range of markets – easy Pizza, easy Cinema, easy Car rental, easy Bus and easy Hotel to name just a handful!
• Procter and Gamble is the largest consumer household products maker in the world. Its brands include Crest, Duracell, Gillette, Pantene, and Tide, to name just a few. Twenty four of its brands make over $1 billion in sales annually.

Another example of an economy of scope might be a restaurant that has catering facilities and uses it for multiple occasions – as a coffee shop during the day and as a supper-bar and jazz room in the evenings.
A computing business can use its network and databases for many different uses.

Long Run Costs – Importance of Minimum Efficient Scale (MES)

• The minimum efficient scale (MES) is the scale of output where the internal economies of scale have been fully exploited.
• MES corresponds to the lowest point on the long run average cost curve and is also known as an output range over which a business achieves productive efficiency.
• MES is not a single output level – more likely, the MES is a range of outputs where the firm achievesconstant returns to scale and has reached the lowest feasible cost per unit.

The minimum efficient scale depends on the nature of costs of production in a specific industry.

How many firms can "fit" in a market?  It depends on the size of the market compared to the size of the minimum efficient scale

In industries where the ratio of fixed to variable costs is high, there is scope for reducing unit cost by increasing the scale of output. This is likely to result in a concentrated market structure (e.g. an oligopoly, a duopoly or a monopoly) – indeed economies of scale may act as a barrier to entry because existing firms have achieved cost advantages and they then can force prices down in the event of new businesses coming in

There might be only limited opportunities for scale economies such that the MES turns out to be a small % of market demand. It is likely that the market will be competitive with many suppliers able to achieve the MES. An example might be a large number of hotels in a city centre or a cluster of restaurants in a town. Much depends on how we define the market!

With a natural monopoly, the long run average cost curve continues to fall over a huge range of output, suggesting that there may be room for perhaps one or two suppliers to fully exploit all of the available economies of scale when meeting market demand.

Diseconomies of scale

Nokia, diseconomies of scale and lost competitive advantage
Nokia is a Finnish conglomerate business that turned itself into the world’s leading mobile phone company in the 1990s. Nokia is profitable, but revenues are under pressure and in 2010, Nokia appointed a new CEO - Stephen Elop - to drive strategic change
In February 2011 - Elop issued the famous “burning platform” memo bluntly explaining the strategic challenges facing Nokia. Elop announced a strategic partnership with Microsoft to jointly-develop smart phones using the Windows mobile platform - ditching Nokia’s investment in its homegrown Symbian platform
Nokia had missed the major change in its market - the Smartphone revolution. It had continued to focus on mobile phone devices (hardware) rather than applications (software). The consumer transition from traditional mobile phones to smart phones has been dramatic and caught Nokia off-guard. According to Elop "There is intense heat coming from our competitors, more rapidly than we ever expected. Apple disrupted the market by redefining the Smartphone and attracting developers to a closed, but powerful ecosystem.”
Nokia has also faced intense competition from mobile phone producers in emerging markets who can make fast, cheap handset. At the same time there was recognition within the business that diseconomies of scale were hurting its competitiveness. Many in Nokia regretted that the business had become too product-led rather than customer-led. It was felt that the business lacked innovation with an overly-bureaucratic organisational structure with poor accountability.

Diseconomies are the result of decreasing returns to scale and lead to a rise in average cost
Diseconomies of scale a business may experience relate to:

1. Control – monitoring the productivity and the quality of output from thousands of employees in big corporations is imperfect and expensive – this links to the concept of the principal-agent problemi.e. the difficulties of shareholders monitoring the performance of managers.
2. Co-ordination - it can be difficult to co-ordinate complicated production processes across several plants in different locations and countries. Achieving efficient flows of information in large businesses is expensive as is the cost of managing supply contracts with hundreds of suppliers at different points of an industry’s supply chain.
3. Co-operation - workers in large firms may develop a sense of alienation and loss of morale. If they do not consider themselves to be an integral part of the business, their productivity may fall leading to wastage of factor inputs and higher costs. Traditionally this has been seen as a problem experienced by the larger state sector businesses, examples being the Royal Mail and theFirefighters, the result being a poor and costly industrial relations performance. However, the problem is not concentrated solely in such industries. A good recent example of a bitter industrial relations dispute was between Gate Gourmet and its workers.

Avoiding diseconomies of scale

Here are three of the reasons to doubt the persistence of diseconomies of scale:

1. Human resource management (HRM) focuses on improvements in recruitment, training, promotion, retention and support of faculty and staff. This becomes critical to a business when the skilled workers it needs are in short supply.
2. Performance related pay schemes (PRP) can provide financial incentives for the workforce leading to an improvement in industrial relations and higher productivity. Another aim of PRP is for businesses to reward and hang onto their most efficient workers. The John Lewis Partnership is often cited as an example of how a business can empower its employees by giving them a stake in the financial success of the organization.
3. Increasingly companies are engaging in out-sourcing of manufacturing and distribution as they seek to supply to ever-distant markets. Out-sourcing is a tried and tested way of reducing costs whilst retaining control over production although there may be a price to pay in terms of the impact on the job security of workers whose functions might be outsourced overseas.

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