BUSINESS ECONOMICS

Sessions 7 & 8: COST ANALYSIS - II

1. 1.1 Pre-Work Introduction Value maximization is central to a profit maximizing firm. There are a number of approaches to value maximization at the firm level. In the short run, where technology or capacity is defined for a firm, value maximization takes the form of identifying cost efficient output level/input use. through In the long run, value maximization can take place creation of new competencies, outsourcing,

innovation,

identifying and producing of new products. Consider the value maximization efforts by the Indian Corporate sector under the new liberalized regime. In order to remain competitive, companies have consolidated their businesses, expanded their business operations internationally through joint ventures and mergers & acquisitions and have coordinated production from a manufacturing network of decentralized plants in different locations closer to markets. One of the recent examples is that of the Tata-Daewoos commercial vehicle factory at Gunsan (S. Korea) which is targeting the growing market for trucks in China. In the Telecom sector, Reliance Infocumms deal with Lucent technologies in 2002 set the benchmark for the lowest equipment prices in the world. In all these efforts for diversification and consolidation, the aim of the business firm is to arrive at the optimum scale of operation which maximies the scale economies. The economic framework for identifying the optimum scale is provided by the Long Run Average Cost Curve (LRAC), which is the focus of this session.

1.2

Long Run Total Cost & Average Cost Curves We defined the long run as the time period during which all inputs are variable. Thus, all costs are variable in the long run (i.e., the firm faces no fixed costs). The length of time of the long run depends on the

industry. In some services industries, such as dry-cleaning, the period of the long run may be only a few months or weeks. For others that are capital intensive, such as the construction of a new electricity-generating plant,, it may be many years. It all depends on the length of time required for the firm to be able to vary all inputs. The firms long-run total cost (LTC) curve is derived from the firms expansion path and shows the minimum long-run total costs of producing various levels of output. It is important to keep in mind, however, that while the U shape of the short-run average cost (SAC) curve is based on the operation of the law of diminishing returns (resulting from the existence of fixed inputs in the short run), the U shape of the LAC curve depends on increasing, constant, and decreasing returns to scale.

The long run-average cost (LAC) curve shows the lowest average cost of producing each level of output when the firm can build the most appropriate plant to produce each level of output. As the number of scales of plants that the firm can build in the long run increases, the LAC curve approaches the smooth curve indicated by the LAC curve. Thus, the LAC curve is the tangent or envelope to the SAC curves and shows the minimum average cost of producing various levels of output in the long run, when the firm can build any scale of plant.

1.3

Plant Size and Economies of Scale The shape of the LRAC curve is determined by the relationship between average cost and scale of operation. If the average costs decline as scale of operation increases then economies of scale exist and LRAC curve will be falling. If the average costs rise as scale of output increase then diseconomies of scale exist and LRAC will rise. In the conventional U shaped LRAC curve economies of scale arise initially and after the optimal size diseconomies of scale arise.

Economies of scale or decreasing costs arise because of technological and financial reasons1. At the technological level, economies of scale arise because as the scale of operation increases, a greater division of labor and specialization can take place and more specialized productive machinery can be used. and

Specifically, with a large-scale

operation, each worker can be assigned to perform a repetitive task rather than numerous different ones. This results in increased proficiency and the avoidance of the time lost in moving from one machine to another. At higher scales of operation, more specialized and productive machinery can also be used. For example, using a conveyor belt to upload a small truck may not be justified, but it greatly greatly increases efficiency in uploading a train or ship. Furthermore, some physical properties of

equipment and machinery also lead to increasing returns to scale. For example, doubling the diameter of a pipeline more than doubles the flow without doubling costs, doubling the weight of a ship more than doubles its capacity to transport cargo without doubling costs, and so on. Thus, per-unit costs decline.
1

The technological forces for economies of scale are sometimes referred to as plant economies because they operate at the plant level. On the other hand, the financial reasons for economies of scale are often referred to as firm economies because they arise at the firm (as opposed to the plant) level.

Besides the above technological reasons for decreasing costs, there are financial reasons that arise as the size of the firm increases. Because of bulk purchases, larger firms are more likely to receive quantity discounts in purchasing raw materials and other intermediate (i.e., semi-processed) inputs than smaller firms. Large firms can usually sell bonds and stocks more favorable and receive bank loads at lower interest rates than smaller firms. Large firms can also achieve economies of scale or decreasing costs in advertising and other promotional efforts. For all these technological and financial reasons, the LAC curve of a firm is likely to decline as the firm expands and becomes larger.

Diseconomies of scale, on the other hand, arise primarily because as the scale of operation increases, it becomes ever more difficult to manage the firm effectively and coordinate the various operations and divisions of the firm.

In the real world, the forces for increasing and decreasing returns to scale often operate side by side, with the former prevailing at small levels of output (so that the LAC curve declines) and the latter tending to prevail at much larger levels of output (so that the LAC curve rises).

This implies that economies of scale are rather quickly exhausted and constant or near-constant returns to scale prevail over a considerable range of outputs in many industries. In these industries, small firms

coexist with much larger firms2. There are some industries, however, in which the LAC curve declines continuously as the firm expands output, to the point where a single firm could satisfy the total market for the product
2

The inability to observe rising LAC in the real world may be due to the fact that firms avoid expanding output when LAC begins to rise rapidly.

or service more efficiently than two or more firms. These cases are usually referred to as natural monopolies and often arise in the provision of such utilities as electricity and public transportation.

1.4

Learning Curves As firms gain experience in the production of commodity or service, their average cost of production usually declines. That is, for a given level of output per time period, the increasing cumulative total output over many time periods often provides the manufacturing experience that enables firms to lower their average cost of production. The learning curve shows the decline in the average input cost of production with rising cumulative total outputs over time. For example, it might take 1,000 hours to assemble the 100th aircraft, but only 700 hopurs to assemble the 200th aircraft because managers and workers become more efficient as they gain production experience. Contrast this to economies of scale, which refer instead to declining average cost as the firms output per time period increases.

1.5

Learning Activity The Road to Gunsan Business World, August 9, 2004.

http://www.businessworldindia.com/aug0904/coverstory01.asp

(i)

Examine the market implications of acquiring the Daewoo plant by Tata Motors Analyse how new markets technology and policies are influencing Tata Motors Costs?

(ii)