Transcript 2 - Homework Market

Economics of Small Business
Second Week
NAICS
• NAICS stands for North American Industrial
Classification System.
• Much data on industries is available, with the
industries classified by this system.
• It is a numerical classification, with broader
categories distinguished by 2-digit classifications,
and narrower classifications by 3, 4, 5 or 6 digits.
NAICS Example
• Optometrists’ offices – NAICS 621320
• Part of 6213 – Offices of Other Health
Practitioners
• Part of 621 – Ambulatory Health Care
Services
• Part of 62 – Health Care and Social
Assistance
Finding a NAICS Code 1
Finding a NAICS Code 2
Third Link
First Link
1. Review of Some Important
Microeconomic Topics
Many Small Businesses
• The picture of SMEs that we got last week – in
particular, the fact that they are numerous as well
as small – recalls the concept of “perfect
competition” from microeconomic principles.
• But, as we will see, that could be misleading in
some cases.
Perfect Competition
• A “perfectly competitive” market structure
is defined by four characteristics:
–
–
–
–
• Many small buyers and sellers
• A homogenous product
• Perfect knowledge
• Free entry
Imperfect Competition
• Other, more or less noncompetitive market structures are
also defined in terms of these characteristics. The other
three market structure models can be defined in terms ofthe
ways in which they deviate from the characteristics of
Perfect Competition.
– In a Monopoly there is just one seller of a good or
service for which there is no close substitute.
– In an oligopoly there are two or more, but only a few
firms.
– In Monopolistic Competition, the products are not
homogenous but are "differentiated."
Cost
• For either sort of firm,
cost is an important
determinant of supply.
• In the short run, we
have two major
categories of costs:
– • fixed costs, and
– • variable costs
Average Cost
• The figure shows
the average cost
(AC), average
variable cost
(AVC) and
average fixed
cost (AFC) in a
diagram. (Same
data as previous
diagram.)
Marginal Cost
• In economic theory, we often focus particularly on
the marginal variation. In this case, of course, it is
marginal cost. Marginal cost is defined as
• Suppose ΔC=330000-280000=50000, ΔQ=36253120=505 – then
Marginal Cost Diagram
• Here is a picture
of marginal cost
for our
spreadsheet
example firm,
together with
average cost as
output varies.
Demand
• The demand curve
for a perfectly
competitive firm is
a horizontal line
corresponding to the
going price.
• Profit is maximized
where MC=price.
The Industry and the Firm
Monopolistic Competition
• Monopolistic competition differs from perfect
competition in that products (or services) are
differentiated. To say that products are
differentiated is to say that the products may be
(more or less) good substitutes, but they are not
perfect substitutes.
• Small business products and services will often be
differentiated.
Hairdressers 1
• For an example of a monopolistically competitive
"industry" we may think of the hairdressing
industry.
• There are many hairdressers in the country, and
most hairdressing firms are quite small.
• There is free entry.
• At the very least, however, their services are
differentiated by location.
Hairdressers 2
• Their styles may be different;
• the decor of the salon may be different, and that
may make a difference for some customers;
• A very good friend of mine changed hairdressers
because her old hairdresser was an outspoken
Republican.
The Product Group
• When products or services are
differentiated, the boundaries of the
“industry” become very blurred.
• Thus, we speak instead of a “product
group” of companies providing goods or
services that are relatively good substitutes.
Entry
• If a particular firm is profitable with its
distinct product or service, “Free entry”
means that new or established firms may
offer goods or services that are closer
substitutes for the profitable one.
Short Run
• In the short run, then, the monopolistically
competitive firm faces limited competition.
• “Every firm has a monopoly of its own
product.”
• Accordingly, the short run analysis for
monopolistic competition is a monopoly
analysis.
Monopoly
• For a monopoly
analysis we
need to think in
terms of
marginal
revenue.
MR =
DTR
DQ
Maximize Profits
• The rule for
maximization
of monopoly
profits is
• MR=MC
A Qualification
• This is the standard monopoly model.
• It assumes relations between the seller and the
buyers are noncooperative.
• However, we know from game theory that longterm relationships may instead be cooperative.
• In this case would mean that output would be
expanded to the MC=price level.
• In some small businesses, these relationships are
personal, which makes it even more likely.
Long Run 1
• In the picture we just looked at, the product
or service offered is profitable.
• (“Economic profit” is positive.)
• For monopolistic competition, with free
entry, this will attract more competition.
• The firm’s demand curve will shift
downward until profit is eliminated.
Long Run 2
What Does This Mean for Small
Business?
• A small business may nevertheless have some
“pricing power,” some power to increase the price
by cutting back on the supply of the product or
service.
• In theory, that is an advantage in the short run
(since it can result in profits) but only a temporary
advantage for the short run.
Advantage or Dilemma?
• For a small business that sells a differentiated
product or service, pricing power is no less a
dilemma than an advantage:
• “Just how high should I set my price, allowing
both for the decrease in marginal revenue as I sell
more output and for the threat of new competition
in the long run?”
• Mark-up pricing rules are widely used in practice.
2. Economies of Scale
Scale
• For small businesses, among the most important
microeconomic concepts are those related to
economies of scale.
• We say that there are “economies of scale,” or that
“returns to scale are increasing,” if an increase in
the scale of the firm can result in lower average
cost.
• This could be a challenge to a small business.
Long Run, Again
• Economies or diseconomies of scale, or
returns to scale, can be understood in terms
of the long-run cost curves of the firm.
• For this purpose, we may think of the “long
run” as a perspective of investment
planning.
Cost Minimization
• Suppose you were planning to build a new plant -- perhaps
to start up a new company -- and you know about how
much output you will be producing. Then you want to
build your plant so as to produce that amount at the lowest
possible average cost.
• To make it a little simpler we will suppose that you have to
pick just one of three plant sizes: small, medium, and large.
The three possible plant sizes are represented by the short
run average cost curves AC1, AC2, and AC3 in The
following figure.
Small, Medium and Large
The LRAC
curve is the
“lower
envelope
curve,” shown
in gray in the
picture.
Scale, in the Example
• We see that in this example, a larger plant
size together with sufficiently larger
production can result in lower cost, so in
this case, economies of scale are
predominant – “returns to scale increase” –
at least, in the range shown.
More Realistically,
• More realistically, an investment planner
will have to choose between many different
plant sizes or firm scales of operation, and
so the long run average cost curve will be
smooth.
LRAC, Again
U-Shape
• We often assume that the long-run average cost curves
have the shape shown in the figure, roughly a u-shape,
with first “increasing” and then “decreasing returns to
scale.”
• This is convenient, because it means that there is a definite,
well-defined optimal scale as shown at 30.
• Why should average cost decrease as the scale of
production increases? or, thereafter, why should it
increase?
Increasing Returns
• There are two influences that could lead to
increasing returns to scale.
– Increasingly complex division of labor.
– Indivisibilities
• Indivisible machines
• Professional services, e.g. full-time managers.
• Economies of scale, then, reflect something
about the technology.
Decreasing Returns
• Alfred Marshall argued that more
production will require a larger
organization, and the cost of management of
the larger organization will increase more
than in proportion to the capacity of the firm
to produce goods and services, so that
overall average costs would rise beyond
some limit.
Increasing, no Decreasing
Returns
• Some
economists
accept the
first
argument
but not the
second.
Minimum Efficient Scale
• In this
example,
the
minimum
efficient
scale is
about
175.
Small Business and Scale
• In any case, small businesses are more likely to
experience economies than diseconomies of scale.
• Thus, there are some things we know about
economies of scale.
1. Different industries are differently affected by
economies of scale.
2. There are industries in which economies of scale
are important so that the minimal efficient scale of
operation is quite large by any reasonable
standard.
What We Know, Continued
3. There are other industries in which economies
of scale are not important.
4. There are still other industries in which there
are some economies of scale but nevertheless
a firm can operate approximately efficiently at
what any reasonable standard would regard as
a small scale.
A Possible Exception
• In general we would not expect a small
business to survive in an industry with
strong economies of scale and established
competition. (Next slide.)
• An exception would be if there were no
established firm. (Following slide.)
• This might occur if the product or
technology is new.
Unlikely to Survive
Promising
Innovation
• If this course were about “entrepreneurship”
or “innovation” that would be a major
focus.
• For small business, though, the case shown
in the next slide will be more representative.
A More Representative Case
How to Measure Scale?
• The diagrams and definitions given so far refer to
a relationship between average cost and the
quantity of output.
• In order to compare the scales of firms in different
industries, we may choose to use the scale of the
inputs, rather than the scale of output.
• The number of employees is most often used.
Production Function
• Economies of scale can be defined in terms
of the production function, but that will
require a bit of mathematics.
• The production function would be written
Q=f(R1, R2, … Rn)
– Q is output
– Ri is an input
Proportions
• Suppose that each of the inputs is increased
by the same factor (percent increase) λ.
Then Q is increased by a factor μ.
• If μ=λ, then we have constant returns to
scale.
• If μ≠ λ, then returns to scale are not
constant.
Local
• However, returns to scale are a local property of
the production function.
m
• Consider lim
l ®0 l
• Starting at R1, R2, … Rn, if the limit is >1 then we
have increasing returns to scale at R1, R2, … Rn; if
the limit is <1, decreasing.
Why?
• Why do businesses remain smaller than the
“minimum efficient scale?”
• There are several reasons.
–
–
–
–
Limited demand, e.g. in local markets.
Search frictions.
Finance.
Preference.
Search Frictions
• In order to grow, to attract and select a
larger, appropriate work-force, it would be
necessary for the company to commit its
resources to the search for those employees.
This is in effect an investment, and the
investment might not be a profitable one,
despite the gain in efficiency of day-to-day
operations.
Preference
• The proprietor or partners may like it that way. A
small enterprise that employs family members or a
few long-term employees may be a more attractive
life-style than one that brings in new employees,
strangers, and that faces uncertainty as to whether
demand will be adequate and that bears the burden
of borrowed money with the risk that the business
will be lost through bankruptcy.
Start-ups
• Economies of scale are also recognized as a
barrier to new entry, that is, to startups. If
there are economies of scale, the new
enterprise may face a period of losses
before it “gets up to scale,” that is, finds a
market and a business plan for a minimum
efficient scale.
Conclusion
• All in all, economies of scale are something
we must keep in mind throughout our study
of small business. They will not be
applicable in every case, but because our
focus is small business, we cannot assume
them away.