## A2 Economics: Micro – Long-Run Average Cost – Envelope Curve

Another post geared towards the A2 exam next week. Long-run and short-run average costs curves are part of economies of scale and market structures essays.

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.
Note:

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.

Source: Economics by Begg 7th Edition

## Mega ships and diseconomies of scale

The mega ship the Ever Given was a familiar name in the news recently with it getting stuck in the Suez canal and thus preventing any marine traffic in both directions. The Ever Given is operated by the Taiwan-based firm Evergreen and is a so called mega ship and was carrying over 18,000 containers.

Mega (container) ships have been built in increasingly larger sizes to take advantage of economies of scale and reduce expense as part of using multiple forms of transport without actually handling of the freight itself. The big container ships can carry up to 23,964 twenty foot equivalent unit (TEU) whilst the smaller capacity ships have a maximum capacity of 1,000 TEU.

Herd Mentality and Prisoner’s Dilemma
This being said there is some dispute over the extent that the mega ships achieve economies of scale. A follow the leader mentality in ordering bigger ships have been since the mid 1990’s with firms following Maersk in ordering bigger capacity ships. In most cases it only takes two years for other carriers to catch-up to Maersk and in some cases they can hold more TEU. This has led to operators facing prisoner’s dilemma. Operators are trying to outdo their rivals by building larger ships which help increase its market share through their reduced costs but are fully aware that what actually is needed is capacity rationalisation. This strategy has not only fuelled the never-ending competition for large ships but also led to mistrust among operators, entangling them in the prisoner’s dilemma. The ideal scenario is for operators to refrain from acquiring mega ships and let supply and demand prevail.

Infrastructure costs to cope with mega ships
The graph below shows the savings and costs increases from increasing the capacity of mega ships. There is a saving with carrying more TEU’s but terminals will incur significant capital expenditure to handle larger vessels and terminal yards areas will need to increase by 33% to avoid congestion, even with no growth in volume. There are negative externalities to consider that arise from upsizing as dredging deeper channels and expanding yard area will have environmental effects.

Source: Diminishing economies of scale from megaships? Marine Money Japan Ship Finance Forum, Tokyo 12th May, 2016

## Aussie Car Industry: Diseconomies of Scale.

You will no doubt have covered economies and diseconomies of scale in a some form in economics courses. A recent example of the latter is the car manufacturing industry in Australia with Mitsubishi, Ford, Holden, and Toyota all closing, or in the process of closing, manufacturing operations.

At the turn of the century Australia produced over 400,000 cars a year but this was soon halved to 200,000 by the end of 2013. The global market has become ever smaller and Australian car manufacturers have struggled especially as consumers now want less of the gas guzzling V8’s to middle of the range, fuel efficient cars. Holden and Ford haven’t focused on these models. Some of the key points responsible for their demise:

1. In order to achieve economies of scale car plants need to be producing at least 200,000 cars a year – most plants in Australia produce 100,000.
2. Car plant employees in Australia earn very high wages and only German workers earn more.
3. Manufacturing costs in Australia are 4 times greater than Asian manufacturers and 2 times that of European plants.
4. The resource boom has meant the AUS\$ has appreciated which has made Australian exports more expensive. With a lot of spare capacity in the global market for cars prices are very competitive.
5. For a long time generous state handouts have kept the industry solvent. That has now dried up.

Below are graphs explaining economies and diseconomies of scale.

## The Journey of the Indian Onion – A diseconomies of scale story

No doubt you have come across the movie documentary “Black Gold” which looks at the global coffee industry focusing on the plight of coffee farmers in Southern Ethiopia. The Indian onion market has similar characteristics and it is the farmers that lose out the most. Here are some of the issues that they have encountered:

* Higher rural wages have pushed up farmer’s costs
* Farms are small and therefore lack potential economies of scale
* The supply chain involves 5 middlemen who take their cut on the way through
* The onion is loaded, sorted or repacked at least 4 times
* Retail prices are double what farmers get
* Poor quality onions get dumped as there is no modern food-processing industry in India where they could be put to use.
* Little stock of onions is held in reserve so prices can vary greatly

Foreign food companies, including Walmart, Carrefour and Tesco, have been keen to make inroads into the Indian market. This would undoubtedly reduce the number of middlemen who take their cut on the way through and the development of modern storage facilites would assist in stabilising onion prices.

## When Economies of Scale have been exhausted.

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.