Economies Of Scale, Business Cycle Theory, And Policy Recommendations

Types and importance of economies of scale

Question:

Discuss About The Business Cycle Theory Survey Of Methods?

In economics, the term economies of scale takes into account the phenomenon of decrease in the cost of production, on average terms, with the gradual increase in the scale of production of goods and services by any enterprise. In other words, as a company goes no expanding and increasing its production, if its average cost of production goes on decreasing eventually, then the company is said to achieve economies of scale. Economies of scale can be of two types, external as well as internal. Internal economies of scale usually occur when a firm itself reduces its cost of production and enjoys an increased production. This is entirely specific to the firm. On the other hand, external economies of scale occurs when the industry, of which the firm is a part, as a whole experiences cost effectiveness and efficiency due to increased scope of operations (David Myers CEcD 2015).

Economies of scale, though can be found in many market structures, is of large importance in those markets where it is good to have a natural monopoly. In several scenarios, it may so happen that the presence of a single large firm in an industry is more efficient in terms of cost production and pricing aspects as the presence of more than one firm may increase the cost of productions for both the firms and none can enjoy economies of scale (Lewis 2013).

If the commodity provided by that industry is of necessary or merit in nature, like electricity, then it is better to allow only one big firm to enjoy economies of scale and become a natural monopolist such that it can provide the commodity at a much cheaper price due to its low cost of production. It can be seen from the above diagram.

As can be seen from the case study provided, the airlines industry in Australia, before the collapse of the Ansett group was more of a duopoly-structured industry with both the competitors Quantas and Ansett, enjoying nearly same market power and a considerable size of the market. However, in 2002-2003, after the collapse of the Ansett group and the emergence of the Virgin Blue group, though apparently the market structure remained of that of a duopoly, it can be considered to be an industry with one and a half enterprises (Aph.gov.au, 2017). This is because, the Quantas emerged as the more powerful and expansive and cash rich one with larger domain of operations. Virgin Blue on the other side, though started as a moderately sized enterprise, was seen to be gaining market importance in the market in spite of their services being limited and constricted, the restraints being imposed by the enterprise purposefully (Varian 2014).

Economies of scale in markets with natural monopolies

As can be seen from the above figure, if only one single firm would have been present in the market, under monopolistic situation, the profit of the firm would have been OP0SN, under Cornot Duopoly Model. However, with the advent of another firm, the profit of the first firm decreases to OP1CN as the price falls due to competition between the two firms. The profit of the second firm becomes NHCD (Carfì and Perrone 2013).

This can be related to the scenario prevailing in the aviation industry in Australia in 2002-2003, with two prominent competitors in the market. Cornot however assumes zero cost of production, which is purely hypothetical and not true for this case. However, the profits of the firms get shared as suggested by the above diagram.

The business cycle of a country shows the dynamics in the economy of that country with time, including both the positive and the adverse ones, which can be seen from the performance of the country with respect to the economic indicators like the growth rates of GDP, inflation and the overall level of unemployment (Gabisch and Lorenz 2013).

In this context, taking reference to the data provided for the economy of France in the current period, it can be interpreted that the economy is in its recovery phase of the business cycle. The economy went to a severe recessionary situation, in 2008-2010, much of which can be attributed to the occurrence of the Global Economic Crisis during that period of time, which had immense negative implications on the European countries as a while (Sherman 2014). The economy, with the government budget hitting as low as -7.2 during that time, is seen to slowly recover from the shock, though the budget is still in deficit, the magnitude being much less (-3.4). The GDP growth rate of the country is still low (0.4%). However, the unemployment rate prevailing in the economy has decreased from 10% to 9.6% and there has also been a moderate decrease in the rate of inflation, from 1.2% to 0.8% in the recent times. Thus, it can be asserted that the economy, though not performing extraordinarily, is consistently coming out of the recessionary situation and is currently in the recovery period of the business cycle.

The current phase of recovery of the economy of France can be represented with the help of the AD AS Model:

With the recovery in the economy, as can be seen from the improvement in the budget statistics and the decrease in the unemployment scenario, the aggregate demand of the economy is expected to increase.

Business cycle theory with reference to the economy of France

As can be seen from the above figure, with the increase in the government budget and the decrease in the trends of unemployment, the aggregate demand is expected to increase slowly, which in turn is expected to increase the GDP as well as the overall price levels. Persistence of this trend may help in increasing the supply in the economy in the long run (Benigno 2015).

Economic growth, according to the AD AS model, can be achieved if both the management demand as well as the aggregate supply goes on increasing sustainably in the economy, such that the long term goals can be achieved. The aggregate demand consists of investment expenditures, consumption expenditures, government spending and net exports. Increase in these factors helps in increasing the aggregate demand, which in turn facilitates increase in the aggregate supply.

In this context, France can experience economic growth by decreasing the interest rates, thereby facilitating investments in the economy. The government can also increase its investments in sectors like health, education and infrastructure, which helps in long-term capacity building, thereby contributing to the economic growth of the country. Employment generation is also a key method for economic growth as it facilitates increase in the aggregate household consumption spending, thereby contributing to the increase in the aggregate demand, which in turn increases the aggregate supply, thereby taking the economy on the path of sustained long term economic growth (Benigno 2015).

The policy taken by Macron, regarding the reforms in the labor market of France, is that of deregulation in order to make the labor market activities more flexible. However, the policy, though targeted to increase the number of good jobs available in the market of the economy, does not specifically work towards that goal (Theweek.com, 2017).

In this context, a more fruitful policy would have been investing in the development of the skills of the workers and the infrastructure in the economy, which facilitates creation of new jobs. As can be said with the help of the Cobweb Model, an increase in the skill development of the workers and a better infrastructure, in short run may create fluctuations in the labor market due to alterations in the wages and demand for more skilled workers. However, in the long run, stability can be achieved in the labor market in the following way:

As can be seen from the above diagram, the Cobweb Model suggests that due to the investment in education and infrastructure, which augments the skill and efficiency of the workers, in the long run the supply as well as the demand for skilled labors increase. This in turn pushes up the real wage rate from W0 to W1 (Ehrenberg and Smith 2016). A higher wage rate, in its turn, increases the purchasing power, thereby increasing the aggregate demand in the economy:

The increase in the AD, leads to an increase in the AS too, which in turn creates more scopes of employment, income generation and again an increase in the AD. This cycle goes on continuing such that in long run the economy moves to the point E1, on the Long Run supply Curve. Thus, the policy of investing on the skill development and enhancement of the workers would have been proved to be more beneficial, had it been implemented properly (Benigno 2015).

References

Aph.gov.au (2017). Australian Airline Industry – Parliament of Australia. [online] Aph.gov.au. Available at: https://www.aph.gov.au/About_Parliament/Parliamentary_Departments/Parliamentary_Library/pubs/rp/rp0203/03RP10#dthe [Accessed 28 Sep. 2017].

Benigno, P., 2015. New-Keynesian Economics: An AS–AD View. Research in Economics, 69(4), pp.503-524.

Carfì, D. and Perrone, E., 2013. Asymmetric Cournot duopoly: A game complete analysis. Journal of Reviews on Global Economics , 2, pp.194-202.

David Myers CEcD, M.A., 2015. economies of scale. Economic Development Journal, 14(3), p.11.

Ehrenberg, R.G. and Smith, R.S., 2016. Modern labor economics: Theory and public policy. Routledge.

Gabisch, G. and Lorenz, H.W., 2013. Business cycle theory: a survey of methods and concepts. Springer Science & Business Media.

Lewis, W.A., 2013. Theory of economic growth (Vol. 7). Routledge.

Sherman, H.J., 2014. The business cycle: growth and crisis under capitalism. civil-engineering University Press.

Theweek.com (2017). Emmanuel Macron has misdiagnosed France's ailing economy. [online] Theweek.com. Available at: https://theweek.com/articles/705135/emmanuel-macron-misdiagnosed-frances-ailing-economy [Accessed 28 Sep. 2017].

Varian, H.R., 2014. Intermediate Microeconomics: A Modern Approach: Ninth International Student Edition. WW Norton & Company.