DHS Y5 H2 Economics Content Clinic 3 Firms & Decisions

1 H2 Economics – Content Clinic 3 (Firms & Decisions) a. Key Definitions: i. Short Run is defined as a period over which at least one factor input is fixed. ii. Long Run is defined as a period over which all factors used in the production process are variable. iii. Economies of Scale refers to costs savings enjoyed from large-scale production. iv. Barriers to entry refers to anything that prevents or impedes the entry of new firms into an industry and thereby limits the degree of competition faced by existing firms. v. Allocative efficiency refers to the current combination of goods produced and sold that gives the maximum satisfaction for each consumer at the current level of income. vi. Productive efficiency refers to the situation when output is produced with the least costly combinations of inputs given the current level of technology. vii. Dynamic efficiency refers to the situation where firms are technologically progressive through investing in R&D to meet the changing needs and wants of consumers over time. viii. Equity is defined as a distribution of income that is considered to be fair or just.

2 Characteristics Internal Economies of Scale Diagram Explanation 1. Internal Economies of Scale (IEOS): • Increase in output → Less than proportionate increase in total cost → Average cost decreases • Sources of IEOS: Specialisation & division of labour, indivisibilities of machinery, bulk purchases, large scale advertising etc. • Example: By increasing its scale of production, a firm gets to enjoy marketing economies as its cost of advertising campaigns can now be spread over a larger output. This will lower average costs for the firm. With reference to the diagram above, an increase in the firm’s output from Q1 to Q2 allows it to enjoy lower average costs from C0 to C1, which is a movement along the firm’s LRAC. 2. Internal Diseconomies of Scale (IDOS): • Increase in output → More than proportionate increase in total cost → Average cost increases • Sources of IDOS: Managerial difficulties, low morale etc.

3 External Economies of Scale Diagram Explanation 3. External Economies of Scale: • Reduction in unit costs from expansion or growth of industry → LRAC shifts downwards • Sources: Better infrastructure within an area of concentrated operations, joint efforts in R&D by firms within the same industry • Example: As the chemical industry expands, more firms relocate their operations to Jurong Island. Due to the concentration of operations within the area, facilities such as better transport, roads and telecommunication systems may be set up to serve the needs of the industry, thereby lowering operating costs. With reference to the diagram above, the expansion of the industry thus leads to a downward shift in the firm’s LRAC from LRAC0 to LRAC1. The firm experiences a fall in its average cost from C0 to C1 for the same output level Q0. 4. External Diseconomies of Scale: • Increase in unit cost from expansion or growth of industry → LRAC shifts upwards • Sources: Increased competition for FOP such as labour or raw materials, increased strain on infrastructure Note: For external economies of scale, the shift in LRAC is not due to the firm increasing its own output but due to the growth of the industry in general.

4 Barriers to Entry (BTEs) Structural: Generally related to basic industry conditions such as cost and demand Examples High capital outlay: Technology required is very costly (eg. Extensive amounts of infrastructure, large machinery or equipment) Internal economies of scale: If there are extensive economies of scale such that MES occurs at high levels of output, only the larger firms would be able to reap the benefits of EOS whereas new (often smaller) firms would struggle to compete due to higher costs. Strategic: Created intentionally or enhanced by incumbent firms in the market for the purpose of deterring entry Examples Aggressive pricing strategies: Price wars, predatory pricing or limit pricing, to drive out rivals within the market or deter potential entrants Product recognition: Use of marketing to create product differentiation and brand loyalty to decrease substitutability of own product vs other products Control of essential FOP/Exclusive deals: Deny key factors of production to competitors by signing exclusive deals with suppliers mandating that they only supply the firm and not others Statutory: Created by the government through laws and regulations Examples Licenses: Government can issue a limited number of licenses to operate within an industry, without which firms are not able to enter the market Intellectual property rights: Patents, copyrights or franchises. These property rights prevent others from imitating and duplicating a firm’s idea or product, granting them monopoly power. How to explain BTEs Step 1: Explain what the firm/government does (if applicable). Step 2: Explain the effect of these actions on the firm/market. Step 3: Link back to the primary concerns of a firm and explain why potential entrants are deterred. Example Predatory Pricing: Predatory pricing is a strategic barrier to entry that an incumbent firm may carry out to eliminate new competitors from the market. The firm could lower its price below its average costs. (Step 1) Competitors may have to engage in a price war to maintain their market share. As the products offered by the firms within the market are substitutes, firms that do not follow suit and lower their prices face a fall in demand for their goods due to the price of available substitutes falling. Given that price is lowered significantly, all firms may end up

5 with subnormal profits. However, the incumbent firm is likely to have sufficient financial reserves to tide out these subnormal profits. New competitors on the other hand may not have as much reserves and would eventually be forced to exit the market in the long run. (Step 2) New entrants may thus be deterred from entering the market due to the likelihood of the incumbent firm conducting predatory pricing against them, resulting in subnormal profits and their eventual exit from the market. (Step 3) Note: More in-depth economic analysis and a diagram may be required depending on the mark allocation of the question.

6 Behaviour Objectives Decision of firm: To stay in the market When does a firm need to decide whether to shut down or not? It must be making subnormal profits for it to have to make this decision. Otherwise, it does not need to consider exiting the market. Shutdown Conditions Short Run AVC>AR or TVC>TR Long Run AC>AR or TC>TR • Shut down if total revenue is unable to cover total variable costs (i.e. TVC>TR) • Fixed cost cannot be avoided even if the firm chooses to shut down • If the firm ceases production, it can at least avoid variable cost • Continuing production means continuing to incur TVC, which cannot be fully covered with total revenue earned • On the other hand, shutting down means no revenue is earned and no variable cost is incurred, the only cost incurred is TFC Being rational, the firm should minimise losses by shutting down and only incurring TFC instead of continuing production and incurring a larger loss of TFC plus part of TVC Key idea: Even when making subnormal profits in SR, due to presence of fixed costs, shutting down may not always be the optimal decision compared to continuing production. • In long run, all costs are variable • The firm must make at least normal profits to stay in the industry • The firm earns nothing if it shuts down and leaves the industry • If it is making a loss in the long run, it is better to exit the industry and earn nothing than to incur losses

7 Objective of firm: Profit Maximising MC=MR & MC cuts MR from below How to explain the profit-maximising equilibrium: