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Optimum Size

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Published in: Economics
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Topic of this sample note is Optimum Size.

Nehal A / Delhi

1 year of teaching experience

Qualification: M.A (Amity University, Uttar Pradesh - 2015), B.B.A (Maharshi Dayanand University , Rohtak - 2013)

Teaches: Economics

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  1. OPTIMUM SIZE The concept of optimum size of the firm is attributed to E.A.G. Robinson (the structure of competitive industry). By optimum firm Robinson means —"a firm operating at that scale at which in existing conditions of technique and organizing ability, it has the lowest average cost of production per unit, when all those costs which must be covered in long run are included. Robinson further states that the optimum firm is likely to result where market is perfect and sufficient to maintain large number of firms of optimum size. The concept can be illustrated with the help of diagram.. FACTORS DETERMINING OPTIMUM SIZE 1. Technical factors:-These usually tend to increase the size of the firm. The technical economies operate mainly through (i) division of labour and (ii) integration of processes Greater specialization leads to the development of specialized machinery to perform the different tasks into which the manufacture has been divided. The gains from integrated process arise from the unification of a number of processes hither to perform in series, so that they might be performed simultaneously. 2. 3. 4. 5. 6. Managerial factors: - here also economies flow from specialization and integration. A large firm can divide the functions of management into many parts and employ a specialized and best fitted man for it. Financial forces: - A large firm has certain advantages in the field of finance. o In raising long term capital a large public issue is relatively cheaper. o Able to obtain loans at comparatively cheaper rates o Greater possibility of making one part of business temporarily financed by another o Requires smaller reserves to cover contingencies o Easier to raise loans from financial institutions Marketing forces: - A large firm can appoint specialist for purchasing and it is in a better bargaining position. Sales force can be made productive and R&D can be effectively carried. Forces of risk and fluctuations: - Four types of variations are generally observed-permanent change, cyclical variations of demand, seasonal variations and erratic variations. External economies: - It refers to factors common to all firms like better transport facilities or other subsidiary activities. One industry in growing promotes the growth of others and the optimum size of firm in each industry is increased. 1
  2. MARKET CONCENTRATION Market concentration or, more specially, the degree of sellers' concentration in the market, is an important element of the market structure which plays a dominant role in determining the behaviour of a firm in the market. By market concentration we mean the situation when an industry or market is controlled by a small number of leading producers who are exclusively or at least very largely engaged in that industry. Two variables that are of relevance in determining such situation are: (i) the number of the firms in industry, and (ii) their relative size distribution. In the context of industrial economies, however, the implications of market concentration are far wider than whatever we find in the theory of the firm. For example, concentration in the ownership of the industry, concentration of decision- making power, and concentration of the firms in a particular location or region, etc, all being elements of market concentration, may have considerable impact on the market performance of the firms such as profitability, price-cost margin, growth, technological progress and content. These links are to be understood properly, because all of them are very much relevant from the point of view of decision- making and regulation of industries. In the context of market concentration, one would naturally be interested in knowing the factors that cause such a situation. They are called called as 'barriers to entry'. All of them may be placed in three general categories namely absolute cost advantages may arise from (1) control of superior production techniques by established firms maintained either by patents, or by secrecy: (2) exclusive ownership by established firms of superior deposits of resources required in production; (3) inability of entrant firms to acquire necessary factors of production (management services, labour, equipment, materials) on terms as favorable as those enjoyed by established firms; and (4) less favoured access of entrant firms to liquid funds for investment reflecting a higher effective interest cost or in simple unavailability of funds in the required amount8. Similarly, product differentiation advantages (or barriers to new firms) arise from (1) patent control of superior product designs by established firm; (2) the possible accumulated preference of buyers for established firms products and their reputation; (3) ownership or contractual control of favourable distributive outlets by established firms, and (4) advertisement, marketing strategies, R&D and other conditions favourable to the established firms. In the same way, scale economy barriers arise when (1) the real economies of scale accrue to the established firms by virtur of their having attained the minimum efficient size absolutely and in relative term to the size of the market, and (2) the pecuniary benefits accruing to the established firms as compared to new one. 2
  3. Measurement of Market Concentration and monopoly power In order to test empirically the behavioural hypotheses about the firms and industries, we need a measurement of market concentration. Various quantitative indexes have been suggested for this purpose. Some of them are used to measure the monopoly power of the firms and some for market concentration. These two terms, i.e. monopoly power and market concentration, are closely interrelated and cannot be separated from each other in the measurement process. The degrees of market concentration world vary with the monopoly power in a particular industry. The measures for monopoly power would be more appropriate at firm level. They indicate the actual monopoly power exercised by the firms. The measures of concentration on the other hand would give us the potential monopoly power in the market or industry as a whole. Before discussing the indexes it will be useful here to mention some general conditions or requirements which should be satisfied by each one of them. The conditions are. (a) The measure must yield an unambiguous ranking of industries by concentration. (b) The concentration measure should be a function of the combined market share of the firms rather than of the absolute size of the market or industry. (c) If the number of firms increases then concentration should decease. However, if the new entrant is large enough, then concentration may go up. (d) If there is transfer of sales from a small firm to a large one in the market, then concentration increases. (e) Proportionate decrease in the market share of all firms reduces the concentration by the same proportion. (f) Merger activities increase the degree of concentration. The concentration ratio Simplest index for measurement of market concentration or monopoly power is the use of the concentration ratio, that is, the share of the market or industry held by some of the largest firms. The market share of such firms may be taken either in production or sales or employment or any magnitude of the market. C = E pi, m = 4, 8, 10, 12, 20, Where pi = market share of ith firm in descending order. The normal practice is to take the four- firm (m = 4) concentration ration. 3
  4. There are some limitations of this index. It does not take the entire concentration curve (as shown in fig. 7.1) into account; it rather indicates market concentration at a point of the curve. The ranking of industries depends on the point chosen. Further, the concentration ration depends to a great extent on how the market is defined. A broad market would tend to reduce the computed concentration ratio whereas a narrow one would usually have the opposite effect. The Hirschman — Herfindahl It is the sum of the squares of the relative sizes (i.e. market shares) of the firms in the market, where the relative sizes are expressed as proportions of the total size of the market. 10 symbolically, Herfindahl Index (H) = c = E (Pi)2 Where pi = qi/Q, qi is output of ith firm and Q is total output of all the firms in the market, and n is the total number of firms in the market. This index takes account of all firms in the market (i.e. industry). The Rosenbluth Index This index is based on the rank of each firm in the market and its market share. It gives more weight to the number of the firm and importance of small firm. 12 it is computed as, Where n = number of firms, Pi = market share of ith firm. This index has the apparent properties as the H index but it is rarely used in practice. The Linda Index 15 This index is used in the statistical work of the European Economic Community. To compute the index, first a ratio is constructed as 4
  5. Where Ai = Total market share of the first i top firms among the k large firms; Ak = Total market share of the k firms, k may be any number of firms between 2 to n. Qi is the ration between the average market shares of the first top i firms and the average market share of the remaining k i firms. The Dispersion Measures These measures take into account the dispersion of the market share across the firms in the industry. The simplest one of them is the use of the coefficient of variation. This is expressed as 1 Where p = Pi — 1 n) is the average market share of the firms. a = standard deviation of the market shares, Pi = share of ith firm (in proportion), n = number of the firms, The coefficient varies between 0 and n — 1. Greater the coefficient of variation, more will be the inequality in distribution of the market shares and hence more concentration. The Lerner Index These are some other indexes which are mainly used to measure monopoly power of a firm but some of them can be applied to the market as a whole with little modification or by simply reinterpreting the variables concerned. The Lerner index is the best known of them. 21 It is expressed as. Price - Marginal Cost Price We know, under perfect competition price will be equal to marginal cost. If there is a difference between the two, such that price > marginal cost, this is because of market imperfection or what we call as the monopoly power of the firm. 5
  6. The Profit Ratio 25 This was suggested by Bain. according to him, when a firm persistently earns excess profit for a long period of time, then it should be attributed to its monopoly power. Monopoly power and profit rate are assumed to be linked positively. The profit rate is defined as "that rate which, when used in discounting the future rents of the enterprise, equates their capital value to the cost of those assets which would be held by the firm if it produced its present output in competitive equilibrium.26 This rate of profit is then compared with the normal rate of profit to assess the monopoly power of the firm. Concentration and the market Performance of a Firm There are many behavioural hypotheses about concentration and market performance. Let us presume that concentration is an appropriate measure of such power, we are then in a position to verify the various propositions of the economic theory which reflect the relationships between concentration and market performance of the firm. This will naturally be based on empirical evidences available so far but no attempt will be made to make an exhaustive survey of this here. Only few selected studies will be referred in connection with the individual hypotheses. Concentration and profits A firm derives market power or monopoly power in the situation of concentration. Such market power, via market conducts activities or directly leads to an increase in the profitability of the firm. Concentration and Price —cost Margins Price-cost margin is another way to define profitability. Empirical studies particularly those conducted by Collins and Preston supported the positive relationship between concentration and the price-cost margin for the American four digit industries. Concentration and growth of the firm The growth of the firm is a topic which requires a full chapter for discussion. According to one view, a firm with market power, as a consequence of concentration, may prefer to maintain its high rate of profit by restricting the output and charging high price. Thus, we expect that higher the monopoly power of the firm lesser may be its growth. The few firms in the concentrated industry may be dominant enough to restrict the growth of the other firms and to stop the entry of new ones because of the various barriers to entry at their disposal. 6
  7. The second view about the concentration and growth of the firm and hence of the market, is a positive one. In order to maximize the long — term profit, firms may like to grow over time even under market concentration. They may prefer to create excess capacity to meet the future growing demand and to discourage new entry in the market. Concentration and Technological Change The issues related to technological change and market structure will be examined. They will be having stability, financial resources and ability to initiate the processes of R&D and gain the benefits from them. It may not be the concentration but the other attributes of market structure like size of firm, product differentiation possibilities etc, which may be having collinearity with concentration and thus causing a spurious positive correlation between concentration and technological change. Concentration and Other Aspects of market Performance Some other aspects of market performance which may be having some association with market concentration. Stability in the business, which may be judged either by persistent profit rates or sales volume or market share, is one of them. Greater the market power of a firm the more we expect its stability. The uncertainties faced by the firm may be smaller. Further, if there is high concentration in the market the existing few large firms may maintain their size ranking in order to keep the leadership with them. If the size ranking of the firms, which is defined as 'turnover', is changing, this implies that the competitive forces are in action in the market. 7

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