HowTo: Minimum Efficient Scale

Minimum Efficient Scale refers to a situation in which the economies of scale for a given business/firm/industry have been “fully exploited” – economies of scale in a moment. Minimum Efficient Scale is the name given to the size of a firm when it is achieving the lowest possible Long-Run Average Costs.

To begin, consider a firm – let’s call them a manufacturer of waders (those weird thigh-high boots that fishermen wear):

Suppose this firm starts off quite small, but does reasonably well. As it increases in scale (meaning it expands, builds a new workshop, gets more machinery), one of three things will happen to its Average Total Cost (Total Costs divided by the Number of Pairs of Hip-Waders Produced):

• Economies of Scale: this will occur when increasing scale results in decreasing Average Costs (meaning that production increases, say, 10%, but Total Costs only increase 5% – so Average Cost Per Pair of Hip-Waders will decrease)
• Diseconomies of Scale: this will occur when increasing scale results in increasing Average Costs (production increases 10% but Total Costs increase 15%, so Average Costs are increasing)
• Constant Economics of Scale: this is when Average Cost does not change (both production and Total Costs increase by 10%)

This is not to be confused with Returns to Scale, which is the percentage increase in production that results from a percentage increase in inputs or scale (so if you increase in scale by 10% and production increases 10%, but only increases by 5% after the following 10% increase in scale, you have Decreasing Returns to Scale – for example).

In the Long Run, Economies of Scale vary. Consider the following, from my undergraduate textbook (meaning the one that I use, not one that I wrote):

Click for a larger image. Each smaller curve is Short-Run Average Total Costs (wherein Labour is flexible but Capital – machinery, factory space – is fixed)

As the manufacturer expands, or increases scale, Average Costs decrease until the optimal point: Minimum Efficient Scale. As they expand beyond that, they become inefficiently large, and face increasing Average Costs. Hence (if we assume they expanded too far, and finally settled at the Minimum Efficient Scales) they have exploited all Economies of Scale, and Diseconomies of Scale, in production.

What brought this to mind was, not surprisingly, a story about a manufacturer of hip-waders in England.

Geoff Guyers is one businessman not suffering from the floods. As the only UK manufacturer of fishing waders, his business is booming.

Liverpool-based LC Waders has been inundated with calls. Turnover has doubled; the family business is now operating 24 hours a day, seven days a week. But he still cannot meet demand.

“It has been mental,” says Mr Guyers. “The phone has not stopped ringing and I’ve been getting orders from the Environment Agency, councils, police and fire brigades as well as all my usual customers who are selling out of their stocks.”

If he is currently operating 24 hours per day, his average costs are increasing (if you look at a single one of those Short-Run Average Total Cost curves, say for the small scale, in the short-run Geoff Guyers cannot buy more equipment or move into a bigger space – he just hires people around the clock, which is expensive to do). Ordinarily he would expand – moving to a new Short-Run Average Total Cost curve (the ‘medium’ scale, for example), and his Long-Run Average Total Cost would decrease, meaning his profit margin would increase.

Why will he most likely not do that? Because his is a short-run boom. Assuming this does not become a habit, the odds of such flooding in England again, next Summer (or, hell, Winter) are slim, so he will not face this sort of booming demand again. If he expanded, he would be way to the left on the ‘medium’-scale Short-Run Average Total Cost, facing high Average Costs because his production was too low for the size of his company. If, on the other hand, this boom turns out to be sustained, in the long run, he should increase his scale.

Natural Monopolies and Oligopolies

Related to this is the idea of ‘natural’ Monopolies (a single provider, like ConEd or USPS) or Oligopolies (think oil/energy companies, Telcos, etc.). As consumers, we demand Technical Efficiency – the lowest Averate Cost of production (hopefully equalling lowest price-per-unit). Therefore, as consumers, we implicitly demand that each firm in the economy operates at exactly their Minimum Efficient Scale – such that each firm produces their good or service at the lowest Average Cost, and we get it at the lowest price.

How many firms should there ‘naturally’ be in the market? As many as it takes, at Minimum Efficient Scale, to fulfill total demand at that price. Consider a Natural Monopoly – electricity supply:

Because the infrastructure (or fixed) costs are so high, the Average Total Cost curve is very high. If we forced competition, and made two firms produce 15bn kilowatts each, the Average Cost (and unit price) would be much higher than if we allow only a single firm, producing 30bn kilowatts. Ergo, a Natural Monopoly. In the case of a Natural Oligopoly, we would see Average Total Cost curves such that a few-to-several Minimum Efficient Scale productions would satisfy demand, but the economic principle would be the same.

This is among the things that makes the Royal Mail saga so interesting, to me. Mail is supposed (in the objective, not subjective, sense) to be a Natural Monopoly, yet competition is, so far and with limits to the actual production of the mail service, doing quite well. Once TNT goes through with their plan for complete to-the-door mail delivery the experiment will be complete. Here in the US, I imagine UPS is watching closely.

Ask a Melbournian meteorologist about Wall Street

There’s a famous joke in Australia: if you don’t like Melbourne’s weather, wait half an hour.

I keep considering writing properly about formerly interesting topics: Private Equity and the state of debt; inflation, the state of debt and US economy, etc. but it just isn’t interesting for me. Amongst other things, the way everybody else is writing about the stock market is annoying me more and more. Like political stories that go on and on about some party “slamming” another party, everything in our domestic stock for foreign or futures exchanges seems to bolt one way or another with “unexpected” news.

Here’s a quick sample. From the Guardian:

• Investors stay on edge
• Sale of drinks arm delayed
• Dollar back in favour as safe haven

The first two aren’t interesting; just new examples of the same thing: uncertainty in our stock exchanges and take-overs having trouble finding Other People’s Money to spend. If the third doesn’t embarass the Guardian with its gun-jumping, I don’t know what will.

the Wall Street Journal:

• Stocks declined again
• The U.S. economy resurged
• KKR may have to postpone its IPO

The Financial Times:

• Equity turbulence follows credit market sell-off
• Wall Street struggles for momentum
• Consumer spending slows

And I’m sure that, tomorrow, Wall Street, like Melbourne’s sunshine, will be back. These stories are either correct, and the markets truly are hopping all over the place because traders are honestly being surprised, in which case not a single competent person is in charge and we’re fucked anyway, or they’re just filler because we’d rather have non-contextualised stories about random trees than read about the forest burning to the ground around them (reminds one of a certain war, actually). I’ve complained about that, too, just recently.

Unfortunately I’m also just not that into the minutae of the matter as other (better) bloggers out there (go read the Big Picture and Calculate Risk). To me it’s just more of the same, and all trending downwards.

At least Australian politics is still interesting (given that, unlike America and the stupid conniptions of its media, we are having an election soon). The Dana deal has been blessed by the United Auto Workers and their bankruptcy referrees, but I’m holding out for more information about the separate negotiations between the Union and the Big Three, proper, concerning retirement, healthcare, etc.

Even oil is not that interesting, although it’s nice to go this long without hearing some nut go on about the magicness of biofuels. I also have my own work, but it’s too easy to avoid research during the Summer. Much too easy.

It’s a good thing the Summer is nearly over, I suppose. To England, to defend my thesis, then semester begins – second day of which’s classes I’m cancelling, so that I can go and convince some immigration people that my marriage is not a sham and would they please let me stay in the US (until I leave in a year). I have an interesting August ahead of me.

So, if any of my prospective students read this: you’ll get Wednesday off because it isn’t worth covering those lectures, but I’m giving you a quiz on Friday to make sure you study anyway. And that’s just the first week. It’s not too late to try to transfer…

(Part of) Sydney tries to deal with air-conditioning

Blacktown goes green to beat the heat

Demand for power-hungry air-conditioners on the few really hot days of the year – especially in the booming western suburbs where temperatures are higher and houses are bigger – is so strong the NSW Government is considering building a new coal-fired power plant to cope.

But an ambitious project launched today at Blacktown’s Civic Plaza hopes to prove there is a cheaper, more environmentally friendly way to solve the power problem.

With a $15 million grant from the Federal Government and $22 million from consortium members, the Blacktown Solar Cities project is designed to demonstrate how a combination of solar power, smart electricity meters, energy efficiency and innovative approaches to electricity pricing can meet energy needs and cut greenhouse gas emissions.

By “few really hot days”, the Sydney Morning Herald means the handful or more (and increasing) days when it goes over 40º Centigrade (Americans: 104º Fahrenheit, but up to 115º at times). Needless to say – anyone with an air-conditioner and electricity lights up the grid.

The consequences of this drain are two-fold, and very serious. As well as the strain on the electricity grid, there is the climate/environmental harm that so many cooling engines, running simultaneously, will do to a city as concrete as Sydney. For non-New South Welshmen, Blacktown is a city within the City of Sydney:

It is not uncommon. Sydney – the administrative version – extends almost as far West as the green area on that map (Blacktown has 47 suburbs of its own). Building a new coal-powered plant to manage the load would be a nightmare. The smog generated, for a start, would only exacerbate matters: increasing trapped heat, humidity and the haze would just drive more people indoors for longer hours. Up goes air-conditioner (and other electricity use) still further. Obesity too, probably.

Houses and incomes have grown considerably in Blacktown, as gentrification-sprawl pushes ever-outwards, coupled with the whole financial deregulation thing.

That consortium:

The project is backed by BP Solar, Integral Energy, ANZ Bank, Landcom, Blacktown Council and energy efficiency expert Big Switch and runs until 2013. The consortium members hope that by avoiding an estimated 25,000 tonnes of greenhouse gas emissions and shaving $3 million off electricity bills each year the project will drive policy changes that favour demand management, energy efficiency and renewable energy ahead of electricity grid expansion and new power plants.

Not bad at all. I’d need Landcom’s involvment explained to me – although, if they can aid in demonstrating sustainable urban development, they do make their own lives easier. It could also just be state politics, helping out. People often assume that energy companies have little invested interest in such affairs, but that is not the case. New Yorkers need only look around to realise that Con Edison’s life would be a lot less troublesome if demand-management could be brought to bear. Same for any other city. If the loads placed on the electricity grid could only be better-managed, things would go more smoothly for everyone.

Related to which. This article mentions, in passing, something that is key to demand-management, and which I’d like to see discussed more:

The Doherty family are among 1000 locals who have already registered their interest in the project.

Living on a tight budget, but maintaining a home equipped with air-conditioning, several computers and a pool, Gordon and Janet Doherty have had their energy use audited by Integral Energy, and are thinking about taking part in a trial in which their pool pump will be turned off automatically on 12 hot days over summer, during peak energy periods. It won’t affect the cleanliness of the pool but should cut the family’s power bill.

The family of four has already switched its lights to less energy-intensive compact fluorescent bulbs, and has begun turning off at the wall appliances that use standby power.

Setting up intelligent devices, that conserve energy during peak periods (water heaters that operate during the cheapest periods of the day, for example) is usually thought of in the vein of households saving money, but it can save an entire city a blackout, or an entire city of computers the threat of a power surge during the evenings. It also goes a long way towards making the use of renewable energy, even with current storage limitations, all the more feasible.

I hope something comes of this trial/project long before 2013, which will most likely be too late to save anybody. I would expect, though, government and energy companies to respond within a couple of years, if it looks like paying off as it should. At the very least the incentives, on both sides, all make perfect sense.