Minimum efficient scale and market concentration
Minimum efficient scale (MES) is the quantity at which a firm’s long run average total cost curve stops falling, and the size of a firm’s MES relative to the size of the market has a strong influence on market structure— large MES is associated with more concentrated markets.
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- How do you determine whether a services business (which has no unit of production) is operating at efficient scale? Can you point me to some literature that deals with the concepts of scale, efficiencies etc in the specific context of services industries?(3 votes)
- Perhaps you can think of the unit of production as one hour (or other unit of time) of service sold(2 votes)
- At3:30, Sal said that there isn't any advantage for a company to operate above MES (minimum efficient scale). Though what if the price of the item being produced was a lot higher than the cost to produce that item? For our taco example, say the tacos were being sold for $2.00 each. Couldn't this food truck business sell 300 tacos per day because they are still making so much extra profit for each taco?
200 tacos sold * $1.50 profit per taco < 300 tacos sold * $1.40 profit per taco.
Obviously this is a bit of an extreme example, but would this kind of thing ever happen?(3 votes)
- Yes, that is correct. This, however, means that your competitors (who are operating at the MES), will have lower costs than you. Then, if, like Sal mentions, the price of tacos falls or the costs increase, you won't be able to produce tacos any more. Your competitors will still be able to, however. The main point to note is that your competitors are at an advantage if you choose to produce beyond the MES, and this will encourage more competitors. This is why he says that the market will have more firms if the MES is lower. Hope this was helpful!(2 votes)
- [Narrator] In this video, we're going to think about the concept of minimum efficient scale and then how that impacts market concentration. And we're going to make sure we understand what both of these ideas are. So first of all, minimum efficient scale, you can view it as the smallest scale at which we stop getting economies of scale, or another way of thinking about it is the minimum scale at which we are no longer, our long-run average total cost curve is declining. So in this example, let's see, when we talk about our taco trucks, when we were at about 80 units, we're not at minimum efficient scale yet because our long-run average total cost curve is still declining as we add more and more and more units. We're getting economies of scale all the way until, at least in this example, it looks like our long-run average total cost curve stops declining around 200 units. So in this example, that would be our minimum efficient scale, which is sometimes abbreviated as MES. And one way to think about it is this is the minimum scale at which an operation needs to run at in order to be very competitive, in order to be truly efficient out there in the market. Because you can imagine, if some operators are able to achieve minimum efficient scale of, let's say, getting to the 200 tacos a day while others are not, let's say they're only able to stay at 100 tacos per day, and if the market were to get very competitive and the price of a taco were to go down to, say, 55 cents per taco, the people who are at minimum efficient scale could still operate and still make money while the people who are not at minimum efficient scale, well, they're not going to be able to participate in the market. And most well-functioning markets, it gets quite competitive. And so economists like to think about what the minimum efficient scale is and compare that to the entire market size. Now, what do we mean by market size? Well, it depends on how you are defining the market. In our example of our taco trucks, it might be the market for tacos, market for tacos in our city. And of course, you can define different markets. You could define it as the market for food trucks in our city. You could define it as the market for tacos in our state or our country. But let's say if we were to say the market for tacos in our city, and let's say that that market is 10,000, 10,000 tacos per day. Well, in this reality, our minimum efficient scale is 200 tacos per day, and it's a very small fraction of the total market. And so that means that you could have many different competitors, each at that minimum efficient scale, so they're able to produce tacos at that 50 cents per taco. And because of that, you are likely to have many competitors. So when this, when our minimum efficient scale is a small fraction of the total market, that is going to lead to fragmentation. So here, we're going to have a fragmented, fragmented market. So if this circle were to represent the 10,000 tacos that are sold per day, if you're able to have a lot of competitors, each operating at minimum efficient scale, in fact, there's no real advantage to operating above minimum efficient scale because then you start getting diseconomies to scale, well, then you are going to have maybe 50 competitors who are splitting this market. So I won't take the trouble of making this into 50 different chunks. So one competitor has that part of the market. Another competitor has that part of the market. Another competitor has that part of the market. And you could imagine we're going to have this market fragmented into maybe 50 different players, and so that's why it's called a very fragmented market. But let's say that the minimum efficient scale was pretty close to the market size. So let's say instead of a market for 10,000 tacos per day, let's say that the market in our city is for 400, 400 tacos per day. Well, then the market is going to be smaller, like this. And so then it makes sense for, if someone's able to get to the minimum efficient scale, they can take up a lot of the market. In fact, they could take up half of the market. So this type of market might only be able to really support two players in this market. So this is considered to be a far more concentrated, concentrated market. And you could go to a reality where your minimum efficient scale is at the market size or is even larger than the market size. So let's say that the market size is not 400 tacos per day, but let's say we had a market, let's say we had a market of 195 tacos per day, per day. Well, in that world, whoever can get to 195 tacos is going to produce most efficiently. They're not even getting to the minimum efficient scale. But the more, the closer that you can get to that number, you're going to have the lowest average total, long-run average total cost of production, and so it's going to be very hard for anyone else to compete with you, especially if you're taking up most of the market. No one else is going to be able to get to scale, so they're going to be operating out here on the long-run average total cost curve. And so in that world, you might only have one player. And when you have one player, where the market dynamics make it so that it is actually efficient for only one player, this is sometimes referred to as a natural monopoly. There's other dynamics that could lead to a natural monopoly. But one way to think about it is, is if you keep getting economies of scale, up to the market size, well, then whoever can get to that market size first is going to be the most efficient producer.