Economies Of Scale, AD-AS Model, And Investment In Human Capital

1. What are economies of scale? In what market types (i.e. perfect competition, monopoly, oligopoly, monopolistic competition) are economies of scale most important? Why?

2. Based on the article above and some limited research what type of market form you think the airline industry in Australia was in 2002/03? Support your answer with reference to theory.

The concept of economies of scale and how they contribute to cost savings

• Economies of Scale refers to the advantages accrued by firms as the firms increase the level of production.(Chauhan, 2009)For example, in the beginning, the per capita cost for every seat of every airline is high. However, as the number of seats sold increases, the cost per unit or the marginal costs decreases. This is simply due to the fact that the fixed costs of running an air line are high. As the number of seats sold increases, the per fixed costs get divided among a greater number of seats. The variable costs also, vary according to the number of seats.

Economies of scale are also achieved due to the costs advantages gained from bulk buying. As a greater number of units are sold, the firm is in position to take advantage of the bulk buying costs. As a result, the costs of production can be minimized further. For example,  the airline can buy more number of planes and seek discounts. The flight can order more supplies and seek discounted rates. (Chauhan, 2009)

Economies of scale , in some cases, are also achieved due to specialization. As there is a greater degree of specialization, production become more efficient and losses are minimized. There also, a greater utilization of the capital and labour capacity. For example, if an airline employs a flight stewardess, the flight can employ here on three flights on three different routes in one week instead of just one route twice in a week. This increases the efficiency of the allocation of resources.(Chauhan, 2009)

In the diagram below, variable cost curves of different output sizes or production level are given. However, in the long run, as the firm keeps increasing the output level, the marginal cost reduces. The Long term Average Total Costs Curve (Fixed Costs + Variable Costs) keep reducing until a minimum floor price is reached. (Marginal Cost cannot be zero). However, there is a minimum marginal cost of production as the cost of production cannot be reduced completely. This is depicted as point “M” in the diagram below, This is the point where the Marginal cost is minimized. Increasing the output (in this example, the total number of seats) will still lead to higher Marginal costs. This is the point where economies of scale cease to exist.

Economies of scale are particularly important in cases of monoposony, oligopsony, oligopoly and duopoly markets. In an Oligopoly, the entry barriers to a firm typically tend to remain high due to large capital costs. In such cases, a high level of production is required and economies of scale become an important factor for a firm to remain within the market.(Chauhan, 2009)

• The Australian Airline industry can be characterized as an Oliopoly in the year 2002- 2003 (if the international airlines that provided services to and fro from Australia are excluded).  This was at a time when some major airlines had been priced out of the market (such as Ansett Airlines).

According to  Kain & Webb, (2003) “the so-called 'domestic trunk routes', where there were four airlines in 2000, there are now only two.” However, there were new entrants into the market at the time. This type of a oligopoly was a non-collusive Oligopoly since the Commonwealth of Australia placed restrictions on the output of the flights. Ansett was priced out of the market as it was not competitive enough. When output is fixed (such as in this case), profits are determined by price competition and technological innovation both.(Chauhan, 2009) The nature of the demand would depend on whether the competitors match the price changes. The demand (DD) and price (Marginal Revenue MR) are at D₂  D₂   and MR₂ MR_2.  Generally, rivals will ignore a price increase but follow a price cut.  This is depicted in diagram below.

The importance of economies of scale in monopsonies, oligopolies, and duopolies

This causes the demand curve of the airlines to be kinked i.e  D₂ P D₁ and a broken Marginal Revenue curve (MR₂  MR_{1 )}. This explain the price inflexibility that characterizes Oligopolistic markets like airlines.

Oligopolies have entry barriers in the form of high investment costs and therefore, must keep MR high, in order to be competitive. If prices are inflexible, marginal costs are high and firms do not innovate, then some airlines were priced out of the market, because they cannot achieve the economies of scale that some other firms may have.

1)The current data suggests that the economy is in expansion mode, albeit the economic expansion is very small in magnitude. The inflation is low suggesting that the Aggregate Demand is not increasing at a greater level (aggregate supply data isn’t considered). Unemployment seems to be high. The French economy seems to be at the peak of  expansionary phase where the rate of growth declines even if  the economy is expanding.

2)  In the AD- AS Model, the Gross Domestic Product is determined the intersection of Aggregate Supply and Aggregate Demand.

The Aggregate Supply is the total output in the highest level ‘sustainable output’ that can be produced without destabilizing the economy is known as the potential output.(Samuelson & NordHaus, 2004) In the Short Run, the supply curve has diminishing returns and is represented as AS. In the long run AS is inelastic and is represented as “Potential Output”.

The Aggregate Demand Curve depicts the “total quantity of output that is willingly bought at a general price level” Aggregate demand is the total demand from the four broad components viz: Consumer Consumption Demand (C); Private Investment (I); Government expenditure (G); Net Exports or the total residual of Exports and  Imports of the country (X)(Samuelson & NordHaus, 2004)

The French Economy is at Equilibrium E given a level of emplyment and output which determines the general price level/ inflation. The 0.4 % expansion shifts the curve to the right and the inflation increases by 0.8% at  E’ .

3) According to the AD- AS Model, economic growth can be increasedeither by increasing the Aggregate Supply or Aggregate Demand. The Aggregate Supply is determined by the quality and quantity of labour technological innovation and the natural resources available in the country.(Samuelson & NordHaus, 2004)

In the long run, changes in variables of AD such as the tax receipts, social and military spending by the government, consumer spending etc. result in the  increase or decrease in the Aggregate Demand which leads to a shift in the curve towards the right or the left respectively.

The AD-AS model and the factors that contribute to economic growth

In the short run, supply is difficult to increase.(Samuelson & NordHaus, 2004) Hence, increasing government spending (G) (by investment in infrastructure) and increasing consumer spending  (C ) by lowering taxes are the best recommended policies to attain growth. These policies will shift the AD curve from “B” to “D” in the diagram.

• According to the article above, the French Government should try to increase the aggregate demand by way of increasing Government spending. Increased government spending will help stimulate the economy. It  increase the money supply in the economy and increase the number of employment opportunities for people, in the short and medium term. (Spross, 2017)

In the long term, the effects will however, be amplified since the article recommends social spending in “productive sectors” of the economy i.e public infrastructure and public education. These activities would increase the social capital of the economy.(Samuelson & NordHaus, 2004)

The article advocates improvement in “human capital”. France need to look at its work force as human capital and less like labour and seek to increase its productivity. The OECD has expressed concerns over “weakening productivity trends” . Investment in human capital, in the short run and long run can help increase the productivity of the workers which gives the employers a cause to increase wages.  (Organization for Economic Co-operation and Development, 2017)

The need for skills is especially dire among the poor who do not live in urban areas as there is lack to basic public services such as education. Workers with low skills do not have adequate access to jobs or to skill development programs. Access is especially restricted to poor people who are not from urban areas as lack of public infrastructure such as public transport, public education etc. is relatively greater among these demographics. Investment in infrastructure will help solve this problem.(Organization for Economic Co-operation and Development, 2017)

Investment in skill development will improve the quality of human capital in the long run as firms will tend to be attracted to increase production in France, if there is an availability of skilled workers.(Wilson & Briscoe, 2004)

The increase in wages will increase the consumption in the economy and thereby increase the Aggregate Demand. In the diagram below, if the Aggregate demand shifts closer to the potential supply, the total output or  Gross Domestic Product will tend to increase while if the aggregate demand decreases, the Total Output or GDP will tend to decrease. Investment in education and infrastructure will shift the curve to the right.(Samuelson & Nordhaus, 2004)

Chauhan, S. (2009). MICROECONOMICS: Theory and Applications, Part 1. New Delhi: PHI.

Kain, J., & Webb, R. (2003). Turbulent Times: Australian Airline Industry Issues 2003. Canberra : Commonwealth of Australia.

Organization for Economic Co-operation and Development. (2017). OECD Economic Surveys: France. Paris: Organization for Economic Co-operation and Development.

Samuelson, P. A., & NordHaus, W. R. (2004). Economics: Seventeenth Edition (2002 ed.). New Delhi: Tata- McGraw Hill Publishing Company.

Samuelson, P., & Nordhaus, W. (2004). Economics: Seventeenth edition (17th ed.). New Delhi: Tata McGraw Hill.

Spross, J. (2017, June 13). Can Macron solve France's economic riddle? Retrieved January 27, 2018, from The Week: https://theweek.com/articles/705135/emmanuel-macron-misdiagnosed-frances-ailing-economy

Wilson, R. A., & Briscoe, G. (2004). The impact of human capital on economic growth: a review. Luxembourg: Cedefop, Office for Official Publications of the European Communities.