Having covered the macro part of the course with my A2. I’ve made a start on productive and allocative efficiency. One concept that the course covers is the Long-Run Average Cost (LAC).
In the short run at least one factor of production is fixed but In the long run the firm can alter all of its inputs, using greater quantities of any of the factors of production. It is now operating on a larger scale. So all of the factors of production are variable in the long run. In the very long run, technological change can alter the way the entire production process is organised, including the nature of the products themselves. In a society with rapid technological progress this will shrink the time period between the short run and the long run.
The long-run average cost (LAC) curve shows the least costly combination of producing any particular quantity. The graph below shows short-run average costs (SATC) and the LAC. The LAC forms a tangent with the SATC and it is therefore the lowest possible average cost for each level of output where the factors of production are all variable – it is formed from a series of SATC curves. The diagram shows:
From the diagram A is the least-cost way to make output Q1 in the short run. B is the least-cost way to make an output Q2. It must be more costly to make Q2 using the wrong combination of factors of production, for example the quantity corresponding to point E. For the combination of factors of production at A, SATC1 shows the cost of producing each output, including Q2. Hence SATC1 must lie above LAC at every point except A, the output level for which the combination of factors of production is best
The LAC is a flatter U-shape than the SATC curves and can be explained by economies of scale and diseconomies of scale. However it is really important to note that the firm does not necessarily produce at the minimum point on each of its SATC curves. Thus the LAC curve shows the minimum average cost way to produce a given output when all factors can be varied, not the minimum average cost at which a given plant can produce.
The Long-Run Average Cost is sometimes abbreviated to LRAC The Short-Run Average Cost is sometimes abbreviated to SRAC
This LAC is also know as the envelope curve (looks similar to the back of an old style envelope) – see image.
With the A2 exam not far away here is something on Economies of Scale – also a mind map which I have edited from Susan Grant’s book.
When the average cost curve slopes downwards it means that average costs are decreasing as output increases. Whenever this happens the firm is experiencing economies of scale . If on the other hand the average costs are increasing as output increases the firm is experiencing diseconomies of scale . Why do firms experience economies of scale?
Technical Economies: large firms can take advantage of increased capacity machinery. For example, a double-decker bus can carry twice as many passengers as a single decker bus. But without the purchase costs and the running costs are not doubled.
Managerial Economies: In a small firm the manager may perform the role of cost accountant, foreman, salesman, personnel officer, stock controller etc. However, as a firm increases in size it can take advantage of specialisation of labour.
Commercial Economies: The large firm can buy it raw materials in bulk at favourable rates.
Financial Economies: the larger firm can negotiate loans from banks and related institutions easily and at favourable rates.
Risk-Bearing Economies: All firms are subject to risk at sometime or other. However, the larger firm has distinct advantages in this area as small changes in supply and demand can often ruin a small company and larger firms can cover itself by producing a variety of products for a variety of markets.
What a difference a year makes for Indian low cost airline Spicejet. On the verge of shutting down in December 2014 with $300m of debt with suppliers refusing to refuel planes unless paid upfront and staff not been paid their monthly salaries, the airline has made a remarkable recovery. Today it is filling 93% of available seats and has made a profit in the last 4 quarters.
What has been the cause of the turnaround?
Aircraft fuel expenses dropped nearly 35 percent
Demand has increased – compared to the previous year Indian airlines carried 20% more passengers in 2015.
Negotiated better terms with aircraft-leasing firms
Cut jobs and managers pay
Scrapped unprofitable routes
Measures to reduce inefficiencies of Spicejet
Reducing the time to second-tier cities and thereby making it possible to fit in an extra flight a day.
Steel brakes on wheels of Boeing 737 were replaced with lighter carbon brakes
In-flight magazines reduced – less weight
Meals served in cardboard boxes instead of plastic trays – reducing fuel consumption
Planes were filled with just enough fuel within safety margin
Landing gear was deployed 8km from touchdown instead of 14km – reduce drag
Taxi on the runway using just one engine – more fuel efficient
Stocks of spares parts are now more readily available so planes spend less time on the ground
Although the airline still has a long way to go to reduce its debt its recent performance has enabled it to think about long-term expansion.
Time magazine ran an interesting article on the tomato market in the Holland and Greece. The Greeks produces twice as many tomatoes than the Dutch but very little of it is sold in export markets. This is a concern in that it is a missed opportunity for the Greeks to earn income. What is more ironic is the fact that in the summer imports of tomatoes come in from Holland because the Greek farmers are still struggling to grow a crop during the hottest time of the year – Holland employs high-tech green houses and is able to produce significantly more during the summer months than Greece.
However, Greece has the potential to produce tomatoes for domestic consumption as well as for export but only has two harvests a year and is at the mercy of the elements – poor weather = poor harvest. The Dutch in contrast have temperature controlled greenhouses helping to create ideal growing conditions and they can produce 70kg of tomatoes in a square metre of his greenhouse whilst the Mediterranean grower gets approximately 7kg. They can also produce all year round.
Single Currency and Productivity
With the introduction of the euro in 2002 Greece could no longer devalue its currency to control the price of its products. With a weaker currency their exports were much more competitive but this had the effect of making the Dutch work even harder to achieve more efficiency and greater economies of scale. Therefore the only way that the Greeks can now compete is by cutting costs and embracing technology.
But it is not just the tomato market that has been hard hit. Greece’s agricultural sector’s productivity levels are 44% below the European average and labour costs have increased by approximately 90% and this is in contrast to Germany where unions agreed to a 3% rise. What is more concerning is that the acreage given over to growing tomatoes in Greece is 10 times that in Holland but they hardly export any of them. The Dutch have seen their exports increase by 30% since 2005. Some economists have laid the blame on the oligopoly market structure that controls the distribution. These middlemen pay farmers low prices and take a big mark-up on tomatoes even as they have failed to put in place a more efficient distribution system, including for exports.
The Greeks could become a thriving exporter of tomatoes once again but will need to embrace the Dutch technology and make use of its natural conditions – sunshine.
The Economist Free Exchange looked at how economies of scale for some firms have started to run out. When the average cost curve slopes downwards it means that average costs are decreasing as output increases. Whenever this happens the firm is experiencing economies of scale. If on the other hand the average costs are increasing as output increases the firm is experiencing diseconomies of scale – see graph below A-C economies of scale and C-D diseconomies of scale.
Container ship are a good example of economies of scale.
* 1950’s – they could carry 480 twnety-foot equivalent (TEU) containers
* 2006 – they could carrry 15,000 TEUs
* By 2013 – they will be able to carry 18,000 TEUs
As shipping costs per container keeps coming down container ships are expected to keep getting bigger.
Diseconomies – Skyscrapers and European Farmers
However, the idea of building something bigger will generate increasing economies of scale is not always the case. Think about a skyscraper, as you start to get above a certain height the cost per floor level starts to increase as there are structural aspects of the buidling that must be addressed and also with the core of the building getting larger as teh the building gets taller the amount of useable office space get reduced. Therefore if developers were looking at cost structures for buildings they would probably build mid-size buildings.
Many of the eastern bloc countries in the European Union are economic basket cases, still struggling to pick themselves up after the fall of communism in the early 1990’s, and this worries exporters who fear the big Western European economies maybe dragged down by their influence. The majority of their economies are weighed down by inefficient agricultural sectors inherited from the communist era and massive diseconomies of scale. If we look at Poland’s milk production, it is equivalent to New Zealand’s however this is spread over 500,000 farms and processed by 414 processing applications (US Department of Agriculture statistics). In New Zealand there are approximately 12,000 dairy farms.
The Economist had interesting piece on the economics of very big ships. If you wanted a good example of economies of scale look no further than sending a T shirt from China to Europe – 2.5cents is the cost. What allows it to be so cheap is the enormous scale of the new container ships that are now being produced – mainly in South Korea.
Maersk container ships transport a considerable percent of the world’s ocean freight and they have a fleet of over 500 container ships that sail every major trade lane. The big ships are 400m long and the ship can carry 7,500 40ft containers each of which can hold 70,000 T shirts – that makes a total of 525,000,000 T Shirts per container ship. Furthermore it only takes 3 weeks for the T shirts to arrive in Europe and the combination of the largest combustion engine ever built and a minimum crew of 13 personel to run the ship leads to signifiacnt economies of scale (see graph below – Point A being the lowest point on the long-run average cost curve LAC).
Given the rising price of fuel many companies feel they need bigger ships to improve efficiency and ultimately improve their margins. Maersk are looking to increase the size of container ship so that it can hold 18,000 x 20ft units. Freight rates have dropped significantly over the last year with the downturn in global demand and the oversupply of container ships in the market – the main players are:
Maersk – Neptune – K Line – Orient Overseas
According to The Economist shippers will seek economies of scale not only from bigger ships but also from mergers.
A hat tip to A2 student and airline fanatic Andrew Larkey, for this piece from the Emirates website.
Emirates Airline has unveiled plans for the construction of the most technologically-advanced Engine Overhaul Shop in Asia. The state-of-the-art Engine Shop will complement the present Test Cell Facility in Dubai and will be constructed on a 90,000 square meter piece of land at an estimated cost of US $120 million. The growth of the Emirates fleet and the subsequent number of operating engines have necessitated the need for an in-house Engine Shop in Dubai to provide the most cost-effective, efficient engine maintenance.
The Engine Shop will have the capability of performing 300 engine repairs per annum for the GE90 and GP7000 engines fitted to the B777 and A380 aircraft. Emirates has signed a Letter of Intent with General Electric (GE) to oversee the design and construction of the Shop using the most advanced technology, equipment and best practices in the industry.