Economics of Small Business

1. Economics of Small Business Drexel University Spring Quarter 2014 Second Week

2. 1. Review of Some Important Microeconomic Topics

3. 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.

4. Perfect Competition • A “perfectly competitive” market structure is defined by four characteristics: • • Many small buyers and sellers • • A homogenous product • • Perfect knowledge • • Free entry

5. Imperfect Competition • Other, more or less noncompetitive market structures are also defined in terms ofthese 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."

6. 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

7. 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.)

8. 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=3625-3120=505 – then

9. Marginal Cost Diagram • Here is a picture of marginal cost for our spreadsheet example firm, together with average cost as output varies.

10. Demand • The demand curve for a perfectly competitive firm is a horizontal line corresponding to the going price. • Profit is maximized where MC=price.

11. The Industry and the Firm

12. 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.

13. 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.

14. 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.

15. 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.

16. 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.

17. 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.

18. Monopoly • For a monopoly analysis we need to think in terms of marginal revenue.

19. Maximize Profits • The rule for maximization of monopoly profits is • MR=MC

20. 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 long-term 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.

21. 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.

22. Long Run 2

23. 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.

24. 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.

25. 2. Economies of Scale

26. 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.

27. 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.

28. 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.

29. Small, Medium and Large The LRAC curve is the “lower envelope curve,” shown in gray in the picture.

30. 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.

31. 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.

32. LRAC, Again

33. 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?

34. 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.

35. 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.

36. Increasing, no Decreasing Returns • Some economists accept the first argument but not the second.

37. Minimum Efficient Scale • In this example, the minimum efficient scale is about 175.

38. 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. • Different industries are differently affected by economies of scale. • 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.

39. What We Know, Continued • There are other industries in which economies of scale are not important. • 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.

40. 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.

41. Unlikely to Survive

42. Promising

43. 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.

44. A More Representative Case

45. 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.

46. 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

47. 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.

48. Local • However, returns to scale are a local property of the production function. • Consider • 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.

49. 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.

50. 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.