Question on Price system and Tucker’s statement.
Refer to 12:00 in video at http://mises.org/media/4528/How-The-Price-System-Works
My Question: How can it be that volume of sales does not benefit a firm through “economies of scale”? Tucker states here “the bigger business does not benefit”. How is this so?
With economies of scale come increased capital investment in the factors of production, sending price signals there, which may raise the cost of those commodities.
In terms of the basic problem - correctly anticipating the total profit from a given investment - a larger business does not have an advantage as the “real” selling price is not known until the exchange occurs.
The goal of any firm or business enterprise is almost always to maximize profits and avoid losses. This does not change whether or not the firm is large or small. No firm size necessarily has an advantage in all cases, the firm size that is preferred by the market depends upon the industry and the period, or, more simply put, the mass of consumers. However, a priori we know just this, that there is no great benefit to any particular firm size because costs can rise at about the same rate as the firm size. So, as Tucker said, it could simply be seen as “Adding on more zeroes” to the equation.
So let’s take a super cool scenario with a fixed ratio of costs to profit: “Jon’s Lemonade stand”, which if the poor guy tries really hard he might make 500 dollars in a month. He’s trying to maximize his profits, but he has to spend 450 to buy all of his equipment and other inputs, which means that poor Jon only makes 50 dollars in total profit. Then we have “Mom and Pops Lemonade store” which has a few small areas in parks. They pull in 5,000 dollars but spend 4500, they have made 500 dollars in profit, but their total percentage of profit has not actually risen. Finally we have “Industrial lemonade” which makes 50,000 a month, but spends 45,000 a month. Once again, the total profit margins has not increased, but the total profit has.
Now you might say: “Hey! See this means that Jon’s at a total disadvantage because if he were to, say, reinvest his profits then he’d have much less money to put in”, which is true, but proportionately to everything that he has available to him this 500 dollars would do as much as the 5,000 dollars in profit. It’s also essential to note the potential size of loss increases, so in a real world of uncertainty you might want to take the safer bet and invest your money with Mom and Pop’s Lemonade stand. But at any rate if we assume All else equal then profit here literally is not increasing for each person, because here if we assume a constant ratio of EVERYTHING, like we currently are, then the shares of profits remain constant because we’d have to assume that the amount of ownership increased ten times as well, so ownership of Mom and pop’s store was split between ten people, and “Industrial Lemonade” is divided between 100 (This is especially likely because of the difficulty that often accompanies spending large amounts of money which often necessitates the selling of some sort of stock).
Anyway, in the real world it’s likely that any one of these firms could have a competitive advantage: Jon’s Lemonade Stand could be able to employ friends at a decreased price, or have other friends buy. Jon could be very “In” with events in the town and be able to selectively target areas where he will receive a large amount of businesses, as well as having the freedom to curtail his consumption during periods where lemonade consumption is very small. So his ratio could be 7:3, a very large profit.
Mom and Pop could be very popular with a wide variety of people, and their pretty locations in parks and lack of any major work could mean that people would work at a reduced price there. Furthermore they might be very good at making lemonade, making it a local phenomenon that people from all around would visit when they were near. This might make their Ratio 6:3.5
Meanwhile Industrial lemonade might be big and bulky, it has a hard time employing enough people during parts of the year where lemonade is in full demand and then laying them off in the months when there is little demand. It also has a hard time keeping up efficiency and quality at such a scale, making the lemonade just not that good. This makes their ratio a measly 4.5:4.25.
This is an example of how all enterprises attempt to maximize their profits and that the actual profitability in the real world depends upon the particular aspects of the firm, and in a theoretical world where all conditions increase proportionately an increase in profit margins would not increase, nor would profit returns.
Does that answer your question?
Neodoxy thank you for your time. It is greatly appreicated.
It mostly answers my question, but forgive me for one more potentially freshman question:
Will not the Lemon Supplier always have an incentive to provide the Lemon Stand Operator lemons for lower per lemon cost, because of the volume?
If so, then isn’t the smaller Lemon Stand (unable to secure such deals from lemon producers) at a perpetual disadvantage? I understand the market plays into this in terms of consumers choosing who of the two makes better quality juice, in which case the smaller producer if better quality may be elevated by consumer demand to the level of a higher producer.
Lemon Supplier will want to sell at the price which secures the highest total revenue, which is the product of quantity and price. Hence, he only wants to reduce the price if reducing it by that much will increase his quantity sold by a larger factor than that by which he reduced his price. Otherwise, he will want to increase the price. If he cannot increase his revenue by changing his price, then he is probably selling at the market price and cannot improve his revenues by changing the price he is selling at.
“Quantity discounts” are really a different topic since the reason for the discount is not “higher quantity” but, rather, reduced production costs. If the Lemon Supplier can retire half of his lemon truck fleet by selling to just one large, close Lemon Stand Operator, he may be able to increase his profits from the savings. In order to attract the Lemon Stand Operator’s cash, he can provide enough of a discount as to beat more distant Lemon Suppliers while still retaining enough of the extra profits from the reduced transport costs as to come out ahead.
So, this is just one of an infinite number of conditions of the business environment which factor into the price. If the Lemon Stand Operator happens to be located north of the Arctic Circle, it is doubtful that the Lemon Supplier can grow lemons on location more cheaply than he can grow them in Florida and have them transported to the Lemon Stand Operator. Either way, it is the prices of the factors of the production versus the price of the finished good which determine which configurations of production are profitable and which are not and it is only the market that can reveal which configurations are profitable and which are not.
To summarize: the cost savings from larger-scale production are not always profitable. There are also “diseconomies of scale” - as an organization becomes larger and more complex, it also becomes more costly to manage. It is the market that determines the correct scale of any line of production through price (profit & loss). Businesses which are overly aggressive and invest in lines of production which are too large will go bankrupt and be replaced by businesses which were more modest and invested in smaller lines of production that achieve higher revenues than costs.
Clayton -
“Will not the Lemon Supplier always have an incentive to provide the Lemon Stand Operator lemons for lower per lemon cost, because of the volume?”
All else equal, yes, although I don’t know what you mean by “because of the volume”. So long as revenue remains the same, or increases upon each lemon, then the lemonade provider will produce another drink.
“If so, then isn’t the smaller Lemon Stand (unable to secure such deals from lemon producers) at a perpetual disadvantage?”
In this instance, yes, because you are taking a scenario where the specific details of this market mean that the large producer can “buy in bulk”, as it were, and secure large deals. Assuming that there are no other defining factors then large lemonade producers would obviously drive all others out of business. This would be because the decrease in uncertainty would mean a decrease in the chance for losses by the producers of factors (be it either lemons or ice in this instance), so the reduction in risk by large shipments of inputs mean ultimately reduced costs to consumers, and their ultimate benefit and equally importantly the movement of entrepreneurs and investment into new areas.
Mises goes into great detail in Human Action talking about the benefits that large businesses granted the vast majority of men. Large firms often have advantages because of the costs of specific inputs, for instance you can’t have a small car company that uses the same equipment as Ford and Chrysler with a similar quality, because the cost of the machinery to build these cars is very high. Let’s say that just to build ANY cars at all there is a fixed cost of 500,000, with each car only fetching 20,000 each. It is hard to argue that a small car company could exist with these factors, when they may only sell 20 cars a month, making the average cost of each car VERY high, as opposed to Ford which can build a plant and turn out so many cars, due to its “bigness” that it can pay for itself (or at least that it can in a world where Ford is actually turning a profit). Think of it like a big slope. To build any cars you must invest a lot of money in machinery. After that, however, the cost of building any more cars tanks, and so it will be much more profitable to sell a lot of cars. The beauty of our scenario above is that it took a situation where there were exactly fixed ratios, so no advantage was given to any firm size.
With this said the ultimate point is that there is nothing inherent in business that means that large firms are necessarily more efficient. So to answer your question, in your example the lemon stand would be at a “perpetual disadvantage”, but in all markets they need not be. As Rothbard repeats many times in his section on competition in MES, all markets tend towards their optimal firm size.
Yes, depending on the opportunity cost of offering a discount to sell the goods sooner. For example, a higher turnover over a given time for a retailer.
Let’s do some hypothetical math. Remeber this is over time; in this case, one year.
Givens: Cost of goods: $50.
Strategy 1 – One turnover
1,000 quantity X $100 price = $100,000.
Total profit in one year: $100,000 total revenue - $50,000 cost of goods sold = $50,000.
Strategy 2 – Lower price, two turnovers
Because the price is lower, more will sell sooner; so, to make things simple, we’ll assume that all initial inventory is sold and then that all the cash generated will be reinvest into new inventory. Also, that all new inventory is sold within the year.
Turnover 1: 1,000 quantity X $80 price = $80,000.
New inventory purchased: 1,600 qunantity X $50 cost = $80,000.
Turnover 2: 1,600 quantity X $80 price = $128,000.
Total profit in one year: $208,000 total revenue - $130,000 cost of goods sold = $78,000.
As you can see, by lowering the price, total profit was increased by $28,000.
No, because the future is uncertain. The bigger producer could mess up and go bankrupt.
This scenario just begs the question. You simply are just adding zeros so that your percentages come out the same and you can show there is no difference in profit margin between the firms. This is not necessarily how it would work in the real world.
What in the world makes you think that just because it costs one individual $450 to bring in $500 in revenue that it would take $45,000 just to bring in $50,000? I’m sorry but economies of scale are not a myth.
A video just uploaded from LearnLiberty touches on this, although it’s not the focus of the video. They even provide a nice graph showing how while fixed cost may be high in the beginning, average cost per unit falls quite smoothly…thanks to “economies of scale”.
Tucker isn’t talking about economies of scale. All he’s saying is that the “problem” is the same no matter what the size of the business is…that is, “[to properly anticipate] what is the total selling proceeds that you can realize with the given investment, and then in relation to this, see whether you can buy the factors of production necessary to bring this result about.”
Hülsmann’s point is simply that entrepreneurs aren’t concerned so much with price, but ultimately the total revenue and total expenses.
When Tucker says “in this sense the bigger business has no real advantage”, he sounds to be talking about simply the fact that no matter what size you are, your problem is the same…making total revenue greater than total expenses…and you don’t necessarily have an easier time making that happen just based solely on your size. This is not to say that economies of scale do not exist.
"This scenario just begs the question. You simply are just adding zeros so that your percentages come out the same and you can show there is no difference in profit margin between the firms. This is not necessarily how it would work in the real world.
What in the world makes you think that just because it costs one individual $450 to bring in $500 in revenue that it would take $45,000 just to bring in $50,000? I’m sorry but economies of scale are not a myth."
I thought I made it amazingly clear, if not in my first post than in my second, that I was simply stating that there was no all-encompassing reason why the market would favor any one firm size, to display this I picked a hypothetical example where cost to profit proportions are perfectly equal, there is no reason why this would have to be, and I even said that in the real world the market was likely to favor some firm size or other. In my second post I talked about how large firms often have a huge competitive advantage because they can sell goods in such bulk that it marginalizes the cost, something that small producers don’t have, especially in industries which require a lot of expensive machinery.
So at any rate, I did not beg the question, I did not say that is necessarily how it would work in the world, and I did not say economies of scale were a myth, I talked about them and explained why that’s often a key factor that favors larger over smaller businesses. We’re on the same page, and I don’t know what in my post made you think that we aren’t.