Relationship between the law of diminishing returns and the concept of economies of scale: Law of diminishing returns. The tendency for a continuing application of effort or skill toward a particular reject or goal to decline in effectiveness after a certain level of result has been achieved. The law of diminishing returns say that each time we do something to receive a benefit, the benefit will be less and less. (Reference – Michael W. Newell, Marina N, Grassing : The Project Management).
The main features of this law are as follows:
- Only one variable input is varied and all others are held constant.
- No change in technique of production.
- Variable proportions production functions. It means more of a variable factor can be used with the constant input of the fixed factors.
- All units of variable factor are homogeneous.
Adequate or standard doses of variable factor are applied. Explanation. The law of diminishing returns means that the productivity of available declines as more is used in short-run production, holding one or more inputs fixed.
This law has a direct bearing on market supply, theosophy price, and the law of supply. If the productivity of a variable input declines, then more is needed to produce a given quantity of output, which means the cost of production increases, and a higher supply price is needed. The direct relation between price ND quantity produced is the essence of the law of supply. Total Product Curve: The curve labeled TAP in the top panel is the total product curve, the total number of goods produced per hour for a given amount of labor.
The increasing slope of the TAP is attributable to the law of diminishing marginal returns. Marginal Product Curve: The Marginal curve indicates how the total production of goods changes when an extra worker is hired. The negatively-sloped portion of the PM curve is a direct attributable to the law of diminishing marginal returns. Average Product Curve: The average product curve indicates the average umber of goods produced by workers. The negatively-sloped portion of the AP curve is indirectly caused by the law of diminishing marginal returns.
As marginal product declines, due to the law of diminishing marginal returns, it also causes a decrease in average product. Arleen J. Hoax, John H. Hoax(2006), Business and Economics, peg. 122 (London: World Scientific Publishing Co. Ltd. ) Returns to scale, in economics is the quantitative change in output of a firm or industry resulting from a proportionate increase in all inputs. If the quantity of output rises by a greater proportion if output increases by 2. Times in response to a doubling of all inputs?the production process is said to exhibit increasing returns to scale.
Such economies of scale may occur because greater efficiency is obtained as the firm moves from small- to large-scale operations. Decreasing returns to scale occur if the production process becomes less efficient as production is expanded, as when a firm becomes too large to be managed effectively as a single unit. Com downloaded on 19th May 2013. According to Illiberally, “Returns to scale relates to the behavior of total outputs as all inputs are varied and is a long run concept.
Explanation: In the long-run, output can be increased by increasing all factors in the same proportion or different proportions. Ordinarily, law of returns to scale refers to increase in output as a result of increase in all factors in the same proportion. Such an increase in output is called Returns to Scale. Aspects of Returns to Scale. As in the case of returns to a factor, there are three aspects of returns to scale, biz.
- Increasing Returns to Scale,
- Constant Returns to Scale,
- Diminishing Returns to Scale.
Increasing return of scale:-Every firm tries to earn more and more profit by ululating its output. Initially production increases at faster rate than increase in the input. It is evident from the following schedule that by doubling additional labor and capital, output increases from 16 units to 25 units. It shows that inputs increased by 100%, whereas capital increased by 150%. By doubling, production increased from 25 to 60 showing that input increased by 100% but the output increased by 140%. This shows the law of increasing return. Thus, any percentage increase in inputs is causing a greater percentage increase in output. Increasing returns to scale are thus operative.
The main cause of its operation is that when scale of production is increased then due to indivisibility of factors such as labor, tools, implements and machines, division of labor and specialization and many types of economies are available. On account of these economies, proportional increase in returns is more than the proportionate increase in factors of production. All these economies are only internal economies as these are related to the scale of production of the concerned firm. Constant Return to Scale:-elf the scale of production is further increased, it is found that the both input and output increase at equal rates At the same percentage. Thus increasing the production, the increase in output remains constant i. E. , 100%.
This situation arises, when after reaching a certain level of production, economies of scale are counter-balanced by discomposes of scale. In mathematical terminology, that production function which reflects constant returns to scale is called Linear and ‘Homogeneous Production Function’ or homogeneous function of First degree and is important in elucidating Lure’s Theorem in distribution.
This function states that if labor and capital are increased in equal proportion then output will also increase in the same reapportion. 3. Decreasing Return of Scale:-The increase in percentage of input is more than the output. Len the following diagram, with every increase in input i. E. , 100%, output increases at lesser than 1 00%, showing the law of decreasing return of scale. S. A. Squid (2006), Managerial Economics and Financial Analysis, peg. 107 (New Delhi: New Age International Publishers) – Returns to scale are thus diminishing.
The main cause of its operation is that discomposes outweigh economies of scale, e. G. Unwieldy business, indivisible factors becoming inefficient and less reductive, difficulties of control and rigidities due to large managements, higher cost of skilled labor, price of raw material going up, high transport charges, etc. (Reference – TRY Gain and POP Khan, Business Economics p. 142). Answers. ) (a) ‘In the real world there is no industry which conforms precisely to the economist’s model of perfect competition. This means that the model is of little practical value’.
Perfect competition:
- buyers and sellers are too numerous and too small to have any degree of individual control over prices,
- All buyers and sellers seek to maximize their profit (income),
- buyers ND seller can freely enter or leave the market,
- all buyers and sellers have access to information regarding availability, prices, and quality of goods being traded,
- All goods of a particular nature are homogeneous, hence substitutable for one another.
- Also called perfect market or pure competition.
A perfect competition is unrealistic as many of its conditions are quite difficult to fulfill. Especially no barriers to entry, is very rare as even start up cost can act as a significant barrier. While other conditions like perfect information and identical products are though possible not common. Apart from these there are many other conditions like no transportation cost which is again highly rare. The example of perfect competition would be in agriculture. Identical products (fruits, vegetables, etc. , and not really need any advertising. There are no barriers to enter.
It is the most realistic example, in reality perfect competition does not exist. Short Run Price and Output for the Competitive Industry and Firm: 1. Short Run Equilibrium of the Firm A firm is in equilibrium in the short run when it has no tendency to enlarge or contract its productivity and needs to earn maximum profit or to incur minimum losses. The short run is a period of time in which the firm can vary its productivity by changing the erratic factors of production.
The number of firms in the industry is fixed since neither the existing firms can leave nor new firms can enter it. 2. Short Run Equilibrium of the Industry An industry is in equilibrium in the short run when its total output remains teddy there being no propensity to enlarge or contract its productivity. If all firms are in equilibrium the industry is also in equilibrium. For full equilibrium of the industry in the short run all firms must be earning normal profits. But full equilibrium of the industry is by sheer accident for the reason that in the short rum some firms may be earning super normal profits and some losses.
Even then the industry is in short run equilibrium when its quantity demanded and quantity supplied is equal at the price which clears the market. Roger A. Arnold,(2005,08) Economics, 8th De. (USA: Thomson Learning, Inc. 008) In the short run the equilibrium market price is determined by the interaction between market demand and market supply. In the diagram shown above, price Pl is the market-clearing price and this price is then taken by each of the firms. Because the market price is constant for each unit sold, the AR curve also becomes the Marginal Revenue curve (MR.). A firm maximizes profits when marginal revenue = marginal cost.
In the diagram above, the profit-maximizing output is IQ. The firm sells IQ at price Pl. The area shaded is the economic (supernormal profit) made in the short run because the ruling market price Pl is rater than average total cost. Not all firms make supernormal profits in the short run. Their profits depend on the position of their short run cost curves. Some firms may be experiencing sub- normal profits because their average total costs exceed the current market price. Other firms may be making normal profits where total revenue equals total cost (i. E. They are at the break-even output).
In the diagram below, the firm shown has high short run costs such that the ruling market price is below the average total cost curve. At the profit maximizing level of output, the firm is making an economic loss (or sub-normal profits) The Effects of a change in Market Demand In the diagram below there has been an increase in market demand (setters Paramus). This causes an increase in market price and quantity traded. The firm’s average revenue curve shifts up to ARE (=MR.) and the profit maximizing output expands to Q. Notice that the MAC curve is the firm’s supply curve. Higher prices cause an expansion along the supply curve.
Following the increase in demand, total profits have increased. An inward shift in market demand would have the opposite effect. Think also about the effect of a change in market supply – rephrase arising from a cost-reducing technological innovation available to all firms in a competitive market. The long-run perfectly competitive equilibrium for the firm:- Economic profits bring entry by new firms. The industry supply curve shifts rightward and reduces the market price. The fall in price reduces economic profit and decreases the incentive to enter the industry.
New firms enter until it is no longer possible to earn an economic profit. Economic losses lead to exit by existing firms, which shifts the industry supply curve leftward. The price rises, and the higher price reduces economic losses. Firms exit until no firms incur an economic loss. Firms change their plant size if it increases their profits. D=P= MR. = AR ? the firm maximizes its profits. P minimum short-run average cost (SARA) The firm’s economic profit is zero. P = minimum (LIRA) ? the firm’s plant size cannot be changed in order to increase its profits.
Frank Machete, (2003), Perfect Competition and Transformation of Economics, (New York: Taylor& Francis e-Library, 2003). Answer 4. ) Monopoly pure monopoly is a single supplier in a market. For the purposes of exultation, monopoly power exists when a single firm controls 25% or more of a particular market
Less Efficient
- ABACA :-Supernormal Profit (AR-AC)
- Shaded portion:- Deadweight welfare loss (combined loss of producer and consumer surplus) compared to competitive market
- Higher Prices:-Higher Price and Lower Output than under Perfect Competition.
Supernormal Profit. Leads to an unequal distribution of income. Higher Prices to Suppliers – A monopoly may use its market power and pay lower prices to its suppliers. E. G. Supermarkets have been criticized for paying low prices to farmers. Discomposes of Scale – It is possible that if a monopoly gets too big it may experience discomposes of scale. – higher average costs because it gets o big Charge higher prices to suppliers. Monopolies may use their supernormal profits to charge higher prices to suppliers. Economic organization(2013) Website:-http://view. Economically. Org/microscopes/markets/monopoly. HTML more Efficient:-
Research and Development. Monopolies can make supernormal profit; this can be used to fund high cost capital investment spending. Successful research can be used for improved products and lower costs in the long term.. Economies of scale. Increased output will lead to a decrease in average costs of production. These can be passed on to consumers in the form of lower prices. If a monopoly produces at output IQ , average costs (AC 1) are much lower than if a competitive market had firms producing at Q (AC 2).
A firm may become a monopoly through being efficient and dynamic. A monopoly is thus an efficient. For example – Google has gained monopoly power through being regarded as best firm for search engines. Texan R. Petting, Economic Economics Blob, 2013)
Economic governance in Australia has undergone radical changes since the sass. Many of these changes are associated with the market-oriented policies collectively referred to as ‘microeconomic reform’. Broadly speaking, microeconomic reform can be defined as government policies or initiatives aimed at improving the performance and/or the efficiency of industries or sectors in the economy (Forsyth 1992). Remarkably, such a quest for efficiency was not a major policy focus for much of the twentieth century in Australia. However, since the sass, growing pressure on the economy, together with evidence of widespread inefficiency, saw microeconomic reform become a key aspect of economic policy in Australia. The era of microeconomic reform in Australia may be divided into three main phases, with a degree of overlap.
In the first, deregulatory, phase, the main focus was on rationalizing public intervention in private sector markets, with the object of ‘getting prices right’. In the second phase, referred to here as the ‘prevarication’ phase, attention shifted to market-oriented reforms of the public sector, including corporations and competitive contracting as well as prevarication. In the third ‘competitive regulation’ phase, the idea of deregulation was replaced by regulation designed to produce, or simulate, competitive arrest outcomes (see also Parker this volume).
The central argument of the chapter is that each of these phases was associated with the prominence of particular institutions and with specific tendencies in economic governance. In particular, whereas the governance models associated with the prevarication phase, the private corporation was taken as the ideal model of public sector governance. By contrast, in the competitive regulation phase, governments have relied on increasingly intrusive systems of regulation to control both public and privately-owned monopolies Prevarication often appears to be driven y political expediency and ideology rather than by economic theory.
This dislocation between theory and practice led Kay and Thompson (1986) to declare prevarication in the United Kingdom a ‘policy in search of a rationale’. In fact, there has been significant economic research on optimal ownership in the past 20 years, including the comparison between government and private ownership. This work provides the basis for understanding both the success and failure of prevarication. Three Causes of Prevarication: Performance in prevarication must be judged on a case-by-case basis.
Three eye prevarications in Australia have been the Commonwealth Bank, the partial prevarication of Tellers and the prevarication of the Victorian electricity system. How do these prevarications ‘stack up’ against the theory? 1. The Commonwealth Bank In the sass and sass the Commonwealth Bank was the central banker for Australia. The Reserve Bank of Australia took over this role in 1959, placing the Commonwealth Bank in a similar position to a number of highly regulated private banks. Deregulation of the Australian banking sector in the sass meant that there was little if any special role for State-owned commercial banks, and the
Commonwealth bank was privatized in three trenches during the sass. The first sale of 30 per cent of the Bank in 1991 was the first large prevarication by share float in Australia and it set the benchmark for future sales, such as the sale of GIG and Santa. Overall, it is likely that the Government sold the Commonwealth at a discount to its true market value (Harris and Lye 2001). But in terms of economic welfare it seems clear that the sale of the Commonwealth Bank made perfect sense. The bank operated in active competition with private banks and its functions were essentially identical to those private competitors.
In fact, given the tendency for politicians to seek short-term electoral kudos by railing against the banking system, it is likely that continued government ownership of the Commonwealth Bank would have opened it up to political exploitation in the sass. In economic terms, the prevarication of the Commonwealth Bank was clearly sensible policy. 2 Tellers Tellers was formed in 1992 by the merger of Telecoms Australia and the Overseas Telecommunications Corporation (ETC). Both of these were fully owned by the Commonwealth Government.
Telecoms Australia controlled Australia’s domestic loophole network while ETC controlled overseas telecommunications. In the late sass, 49. 9 per cent of Tellers was sold by the Government in two trenches. This partial prevarication is the largest by value in Australia, reaping over $30 billion for the Commonwealth. That first blush, the sale of Tellers might appear similar to the sale of the Commonwealth Bank. After deregulation in July 1997, Tellers competed vigorously with privately-owned carriers. Since then, Tellers has lost market share in both domestic long-distance calls and overseas calls.
Tellers also currently faces vigorous competition in mobile telephony. Kinglike Nanking, however, telecommunications involves a key natural monopoly element, the customer access network (CAN) that provides the ‘last link’ in the telephone network between a switch and a customer’s phone. Tellers owns the CAN and its private competitors rely on Tellers providing them access to the CAN in order to compete. Tellers could eliminate its private competitors outside the CB areas of Australia if it refused them the right to either originate or terminate calls using the CAN.
Tellers faces a wide range of regulations, including retail price controls, procedures for setting wholesale access prices and rules to prevent any anticompetitive behavior. This regulation has been modified over the past five years and in 2001 the Productivity Commission recommended further reform of Telltale’s regulatory regime (Commonwealth of Australia 2001). In 2002 the Federal Government investigated and rejected reforming Tellers by accounting separation to ‘isolate’ the CAN. The partial prevarication of Tellers failed to adequately recognize the source of market failure?the natural monopoly CAN.
Neither did it establish appropriate procedures to deal with this problem. One solution might have been vertical separation of the CAN from the rest of Tellers. The CAN could have remained in public ownership with open access while the remainder of Tellers could have competed with other telecommunications companies. Alternatively, the management of the CAN could have changed. For example, the CAN could be jointly owned by a number of licensed carriers. These carriers would have a mutual obligation to maintain the CAN but otherwise would compete.
The sharing of infrastructure facilities between competing firms sometimes occurs with gas pipelines. Discontent with the partial prevarication has made it politically difficult to sell the remainder of Tellers. In the absence of a structured approach to the CAN, further prevarication will simply mean ongoing costly regulation. Such regulation will continue into the future as the CAN grows in importance for data rather than voice telecommunications traffic. The Victorian electricity system The creation of a National Electricity Market (MEN) was a key part of the Hillier reforms.
This market involves generators competing to sell power into a grid connecting South Australia, Victoria, New South Wales and Queensland. The proposed construction of Basilisk will connect Tasmania to the MEN. Prevarication is not required under the MEN but private generators are able to impute with government-owned facilities. The Kenneth Government in Victoria decided to sell the State’s electricity assets to the private sector. Prevarication was preceded by vertical and horizontal restructuring, including the creation of five distribution/retail companies, five competing generation businesses and a single transmission business.
The total proceeds of the prevarications in the mid-assess were approximately $22. 5 billion; second only to Tellers in terms of total revenue raised. Baby separating competitive generation from natural monopoly elements, like transmission and distribution, the Victorian electricity repatriations avoided the issues of access and competitive abuse that have dogged telecommunications. Further, some measures of performance, such as the reliability of the distribution, have significantly improved. However, both transmission and distribution have limited scope for competition and these prices need ongoing regulation.
