2019 Nov (EOS) Paper 1 HL

2019 Nov (EOS) Paper 1 HL 

Microeconomics

(2)  (a) Explain how 2 types of Economies of Scale (EOS) can lead to a fall in long-run average costs.

 

·      Definitions of economies of scale, long run average costs.

·      Diagram to show movement along the downward-sloping portion of the long-run average cost curve.

·      Explanation of how economies of scale lead to lower average costs as a firm increases scale of production in the long-run that refers to 2 clearly different types of economies of scale, such as specialization, efficiency, marketing and indivisibities.

·      Examples of specific firms (or industries) that have possibly experienced falling long run average costs in practice because of economies of scale.

Definitions

EOS = a decrease in long-run unit costs gained by an increased level of production.

Long-Run Average Costs = all possible combinations of fixed and variable factors.

 

 

Diagram to show movement along the downward-sloping portion of the long-run average cost curve.

Explanation of how economies of scale lead to lower average costs as a firm increases scale of production in the long-run that refers to 2 clearly different types of economies of scale, such as specialization, efficiency, marketing and indivisibities.

Specialization and Division of Labor – at large scale firms can have employees specialize in specific roles, which they are best at. (Think lawyers, accountants, managers)

Bulk Buying – buying more allows for negotiation of a lower price.

Financial Economies – easier for large company to take out money with less interest, due to relationships.

Transport Economies – same amount of energy to move more stuff, so cost per item is reduced.

Large Machines – small companies can’t justify large machines, large machines can produce at lower costs.

Promotional Economies – larger companies are better at advertising with larger budgets.

Indivisibilities – the physical inability, or economic inappropriateness of running a machine or some other piece of equipment at below its operational capacity and as a result the machine would be under-utilized and the unit of average cost would be greater than if the machine were optimally employed.

Examples of specific firms (or industries) that have possibly experienced falling long run average costs in practice because of economies of scale.

Procter and Gamble (PG) is a large brand management company. The company owns more than 20 billion-dollar-brands, and another 20 or more half-billion-dollar brands, mostly in the area of consumer products. Procter and Gamble’s extensive distribution network allows it to reach over 4 billion customers, with plans to reach up to 5 billion customers in the next few years as they continue their international expansion. The company spends more money on consumer and market research than any other corporation.

 

Walmart (WMT) is the largest US supplier of groceries, and the largest US general retailer. They can buy in such enormous bulk, and force suppliers to accept such low prices, so they can sell at low prices to customers. Costco has been piercing Walmart’s moat by accepting a net profit margin of half of what Walmart has, in an attempt to compete on price and to grow. Amazon’s amazingly quick growth with its online retail model poses a threat as well. But the United States has the largest income inequality among any large and developed nation, and it’s also one of the only developed countries that is expected to have sustained population growth over the next several decades. Walmart, with its low prices, targets the millions of low income Americans and so even with well-performing competitors, I find it unlikely that Walmart will be dislodged from its position any time soon. I believe the next ten years will likely result in much better returns for WMT stock than the last ten years, since I expect their EPS growth to continue, and the stock is not overvalued as it was ten years ago.

 

United Parcel Service (UPS)

In 2002, Deutsche Post, the world’s largest logistics company, acquired DHL Express, a US-based carrier. In 2003, Deutsche Post acquired Airborne Express, an express carrier and air cargo company. The plan was to compete with UPS and FedEx in domestic US shipping. After five years and over $10 billion in losses, Deutsche Post gave up and left the US domestic shipping market. They simply couldn’t compete with the duopoly of UPS and FexEx. UPS and its rival FedEx are simply too large, and have such breadth of entrenched distribution networks, that one of the largest companies in the world couldn’t dislodge them even after a sustained effort. With the takeoff in online retailers (which need to ship individual packages all over the country), as well as the continued net losses of the United States Postal Service, I can only expect that UPS and its smaller rival FedEx will continue to grow and further strengthen their already formidable positions. UPS alone delivers over 15 million packages a day, and regularly delivers to over 200 countries and territories.