A2: ESSAY Unit 3 - ECON 3: Do you agree that large firms are always better than small firms? (25 marks)

Here I have attached my essay answer for this question; it is graded an A. Remember a good essay needs a balance of knowledge, application, analysis, and evaluation. My essay isn't perfect but I hope you can benefit from it nevertheless. This is essentially a Monopoly vs. Perfect competition essay and there is a lot to talk about. Please note I did not do this in timed conditions. *please do not repost without credit, thanks!

Do you agree that large firms are always better than small firms? Justify your answer. (25 marks)

 

Large firms can experience certain advantages that small firms cannot achieve thus can be argued to be better; however this may not always be true as they may also face disadvantages for example from diseconomies of scale. Furthermore the market is fundamental to determine if large firms are better than small firms, as perfectly competitive and monopoly markets varies the advantages and disadvantages of being a small or large firm.

Large firms tend to benefit more due to several factors from economies of scale; this means that the firm can benefit from falling average costs in the long run – however small firms cannot achieve such benefits. For example purchasing benefits whereby large firms are able to bulk buy raw materials as they are producing on a larger scale thus are able to receive discounts and therefore reducing production costs. Or they may experience technical economies whereby investment in more advanced machinery or larger premises will allow firms to experience increasing returns to scale where output is greater than input thus improving productive efficiency through division of labour and specialisation resulting again in lower costs. Economies of scale can be illustrated in diagram 1, whereby when output increases (Q to Q1), cost decreases (C to C1). Minimum efficient scale is illustrated at the constant part of the LRAC labeled QA firms are operating at the optimum point experiencing constant long run average costs where economies of scales are exhausted; the firm therefore is operating at long-run productive efficiency. This is the reason why large firms are considered to be better than small firms. However as the LRAC curve rises; large firms will experience diseconomies of scale. For example as a firm grows control becomes more difficult, monitoring productivity of each worker in a large firm will become more challenging thus may result in a loss of productive efficiency and therefore rising average costs. Additionally coupled with poor communication and co-ordination due to increasing size of firms increasing average costs are accelerated. Furthermore as large firms are often public limited companies ownership and control is often divided among a group of shareholders thus control over the firm is not subject to one person and instead are run by several directors who carry the interest of the shareholders. This makes management over large firms more difficult as negotiations and meetings are needed to carry out various operations thus reducing the efficiency of the firm whereas small firms are usually owned by one person thus management and decisions are able to be made swiftly. Also communication and co-ordination in small firms are much easier to manage and is less costly due to smaller amount of factors of production. In this sense, small firms can be argued to work more efficiently than large firms.

 

 

 Some large firms strive for monopoly market power therefore enjoying greater market power and influence thus larger profits which may be used to finance and promote innovation can result in dynamic efficiency and therefore economic growth. Additionally it enables them to obtain supernormal profits however this is impossible for small firms to achieve. This is illustrated in diagram 2 where profit maximisation occurs at MC=MR output ‘Q’, ATC is ‘Pn’ however monopolists will charge ‘Ps’ exploiting consumers at the point of demand thus will make supernormal profits illustrated in the shaded region of the diagram.  Monopolies are also able to protect their market position through the use of entry barriers. However monopolies are very rare thus such a market is not very likely to occur in the real world. Furthermore at the point of supernormal profits monopolists are not productively efficient as they are not operating at the optimum point of the ATC curve, this is because as a monopoly they face no threats to compete with others firms therefore can be considered X-inefficient as they are ‘slacking’ in efficiency if they were to be in a more competitive market. Also monopolies may not use their profits to invest to innovate thus may prevent growth. Therefore it can be argued that small firms are better as their objectives do not include exploiting consumers with high prices for supernormal profits thus may operate where they are productively efficient. Additionally since small firms cannot operate as a monopoly, there will be no abuse of monopoly power therefore small firms can be argued to be better.

 

However a perfectly competitive market is made up of a large number of small firms; the industry equilibrium of supply and demand which establishes the price – firms who try sell above this amount, consumers will not buy the product, similarly if the firm sells below this price consumers will purchase their goods however they will not be maximising returns. And thus the individual firms have no choice but to accept the price given by the industry and therefore act like price takers in a perfectly competitive market. However they can benefit from allocative efficiency; this is where the optimum allocation of scarce resources that best accords with the consumers’ pattern of demand. As shown in diagram 3 price is equal to marginal cost (P=MC) thus allocative efficiency is achieved in both the short and long run, as at the ruling price ‘P’ firms are producing the exact quantity consumer’s demand and thus there are no wasted resource thus total economic welfare is maximised.

Furthermore small firms in a perfectly competitive market often also benefit from productive efficiency as well as dynamic efficiency thus will lower costs. However the conditions for a completely competitive market are based on several assumptions such as perfect information – consumers will have all available information about price and products from competing suppliers and can access freely, many sellers and buyers, no externalities etc. however this is impossible to have in reality thus such market does not exist.

 

Overall large firms are better in terms of the benefit of economies of scale however there are pull backs if the firm becomes too large and diseconomies sets in. Additionally if a large firm becomes a monopoly; they can achieve high profits but only at the expense of exploiting consumers and they may not use profits to invest further thus abusing monopoly power this therefore suggests that large firms may not be better than small firms in all cases. In perfectly competitive market small firms has the advantage of great economic efficiency and are able to minimise costs unlike monopoly firms. However it must be emphasized that such markets are impossible in reality. Therefore overall both large firms and small firms are only better in than each another in certain cases.