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

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