Essential UCLA School of Economics: Confusing Efficiency for Market Power
Welcome to the essential ideas of the UCLA School of Economics.
It's common to think the reason firms in industries with just a few companies have
high profits, is because their size gives them power. Power to charge higher prices, force
competitors out of business, and prevent new companies from entering the market.
This view led governments to be suspicious of large firms, often resulting in heavy
government regulation including preventing large firms from buying competitors.
Harold Demsetz, a key member of the UCLA School of Economics had a different
explanation for why some large firms were successful. He explained that some large
firms were more profitable because they were more efficient.
Let's explore this idea with an example. Ivan's car company is small, and produces
100,000 cars a year. Henry's car company is much larger and produces 1,000,000 cars
a year. Because of its size, Henry's company
achieves what's known as economies of scale. Henry's company builds an assembly line and,
because of the volume of cars produced, it operates three shifts, running
24 hours a day. Ivan's factory can run only one shift because of its lower volume.
This means the costs of building and maintaining the factory are spread over more cars
in Henry's factory, and so his cost per car is less, which leads to higher profits for his
company. With these higher profits Henry can offer higher salaries to attract better
management, and invest more in research and development – both of which can make
his company even more efficient and profitable. And so, Henry's car company is more profitable
because it has economies of scale - not because it has an unfair advantage as a
large firm in an industry with only a few competitors.
This insight from Demsetz led to a substantial
rethinking of government regulations in the United States and around the world.
For more information on the UCLA economics visit EssentialUCLAeconomics.org, and to learn about
more essential scholars, visit EssentialScholars.org