HWA CHONG INSTITUTION Year Two H2 Economics 2014

Tutorial #23: Microeconomics III – Theory of the Firm & Market Structure

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TUTORIAL #23: THEORY OF THE FIRM & MARKET STRUCTURE Question 2 Banks have to merge to reap economies of scale a) Identify the type of economies of scale Deputy Prime Minister stated in the extract.

Internal economies of scale. b) Define the type of economies you have identified in question 1.

It is a fall in unit costs when the firm increases its scale of production. c) Explain how bigger banks can enjoy cost savings.

i. Explain two examples of economies of scale that might occur in banking. Reminder: Link to the banking context.

Any two of the following: Technical Economies (Indivisibility of capital): Banks and customers have become increasingly reliant on new and expensive technologies e.g. Cash Deposit Machines, mobile telephony, online banking etc. The costs of such machines can be spread over a large number of customers when the bank increases its scale of operation. (2m) Note: Banks usually do not do R&D. Instead they buy the latest technology to improve their productivity and thus lowering costs. Marketing Economies: Through large scale advertising - for large firms, although the advertising expenditure may be substantial, the advertising cost per unit because of the larger output level. (2m) Administrative & Managerial Economies: Generally, administrative costs will not rise in proportion to the size of an order. For instance, after the banks merged, one human resource manager can oversee more staff and thus unit cost falls. (2m) ii. Explain rationalisation in the banking industry.

Note: You have not learnt about this concept so do find out more about it. Rationalisation: the reorganising of production so as to cut waste and duplication and generally to reduce costs. Some mergers do result in closing down of branches and layoffs. However, many banks reduce their staff largely through attrition to ease the transition (e.g. 40% annual turnover rates are not unusual among tellers.)

d) Explain how bigger banks can enjoy revenue advantages.

x A large bank is able to generate more revenue because it can receive more deposits and give out more loans as compared to a smaller bank. Also they are more likely to offer a broader array of services.

x A merger of two banks with different expertise can result in a combination more to the liking of customers looking for a one-stop banking services. Hence, enabling them to capture a greater market share.

HWA CHONG INSTITUTION Year Two H2 Economics 2014

Tutorial #23: Microeconomics III – Theory of the Firm & Market Structure

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x A large bank is able to set aside a bigger budget for advertising. A successful advertising campaign establishes a strong brand name, increases services awareness and fosters consumer  loyalty.  The  demand  for  the  bank’s  services  increases  and  becomes  more  price  inelastic.

Hence, a large bank is ensured of high profit (due to barriers to entry) and thus has the avenue to do R&D and will be able to improve the quality of its services and thus compete better than a small bank. In the banking scene, most banks are moving from retail banking to investment banking and thus revenue advantages are of real importance for them to compete better. Banks need the revenue to maintain a high profile and reputation to attract consumers especially from overseas.

e) i. Explain diseconomies of scale.

A large bank may incur higher unit cost if disEOS sets in due to lack of co-ordination in the different departments of a large business, increasing complexity of the organisation creating communication barriers between management, staff and customers, low morale of individual workers due to lack of identity and at leads to low productivity.

ii. Comment whether diseconomies of scale will outweigh the internal economies of scale the big banks enjoy. Hint:   Compare   the   customers   of   Singapore’s   five   banks   and   that   of   the  largest international bank in the extract.

According to the extract, the largest international bank had an estimated 100 million customers  but  the  largest  of  Singapore’s  five  banks  had  just  five  million  customers.  So  in  terms of size, our merged banks still cannot match to our bigger foreign counterparts. Also, it will take years and much effort for Singapore's banks to gain high or worldwide recognition/reputation to that of Citibanks. Thus, we may not have reached our MES yet. Also, banks can always include a good system such as message board to enhance communication  and  ‘delay’  diseconomies of scale from setting in.

f) i. Explain X-inefficiency in the banking industry.

Note: You have not learnt about this concept so do find out more about it.

A large bank may experience X-inefficiency which leads to higher cost - without competitive pressures on profit margins, cost controls may become lax. The result may be overstaffing and spending on prestige buildings and equipment, as well as less effort to keep technology up to date, scrap old machines, research new services/products, or develop new domestic and export markets. ii. Comment if X-inefficiency really takes place in the banks.

In such a competitive industry, banks will try to minimise unnecessary costs which means they most likely won't experience X-inefficiency as they cannot afford to use outdated technology or offer 'old' services. Staff hoarding will also be minimised through

HWA CHONG INSTITUTION Year Two H2 Economics 2014

Tutorial #23: Microeconomics III – Theory of the Firm & Market Structure

� Hwa Chong Institution. All Rights Reserved. Tutors' Copy 3

rationalisation. To stay competitive, they have to minimise mismanagement and thus reduce costs. Also, in Singapore, the presence of a large number of foreign banks makes the market "contestable", hence our local banks have incentives to keep X-inefficiency to a minimum in the presence of potential competition.

Note: The above structured questions are steps to answer the following essay question:

Since it is a discursive essay, you need to take a final stand whether you agree bigger banks can compete better and justify your stand. Unseen question (to stretch students): So can bigger local banks compete better with foreign banks internationally?

FOR TUTORS ONLY Some supplementary info on Singapore acquiring foreign banks: Local banks can also acquire or own a large percentage of other foreign banks: � DBS acquired medium sized Thai bank, Thai Danu Bank in 1996 � DBS Thai Danu merged with the Thai Military Bank (Jan 2004) � UOB merger with small sized Thai bank, Bank Radnasin in 2004 � UOB Radnasin merged with Bank of Asia in Thailand (2005) Some supplementary info on the largest banks in the respective countries: Switzerland: UBS (Union Bank of Switzerland) and Credit Suisse Netherlands: ABN Amro, Postbank, Rabobank Australia: Commonwealth Bank of Australia (CBA), National Australia Bank (NAB), Australia & New Zealand Banking Group (ANZ) and Westpac Bank

Some supplementary info on Investment banking Investment Banks help companies and governments raise money by issuing and selling securities in the capital markets (both equity and debt), as well as providing advice on transactions such as mergers and acquisitions. Until the late 1980's, the United States and Canada maintained a separation between investment banking and commercial banks. A majority of investment banks also offer strategic advisory services for mergers, acquisitions, divestiture or other financial services for clients, such as the trading of derivatives, fixed income, foreign exchange, commodity, and equity securities. Trading securities for cash or securities (i.e., facilitating transactions, market-making), or the promotion of securities (i.e., underwriting, research, etc.) is referred to as the "sell side". Dealing with the pension funds, mutual funds, hedge funds, and the investing public who consume the products and services of the sell-side in order to maximize their return on investment constitutes the "buy side". Many firms have both buy and sell side components.

HWA CHONG INSTITUTION Year Two H2 Economics 2014

Tutorial #23: Microeconomics III – Theory of the Firm & Market Structure

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Section C – ESSAY PRACTICE Question 1 N2003 Q2 In 2001 there was a world-wide reduction in airline business. Smaller airlines with lower costs and cheaper discount fares suffered less than the high-cost larger airlines such as Air France, Swissair and Lufthansa.

(a) Explain why, according to economic analysis, there are benefits from large scale organisations. [12]

(b) Discuss to what extent the above extract concerning costs disproves that economic analysis. [13]

Suggested Answers (a) INTRODUCTION (Key Terms, Issue and Approach) There are many large scale companies that exist in an economy, such as Air France, Volkswagen and Giant Hypermarket. The size of these firms are often determined by quantity of output sold, sales revenue or  market  share.  As   firms’   traditional  objective   is   to  maximize  profits,   their existence do show that there are advantages enjoyed by large scale companies. These large companies tend enjoy cost savings due to internal economies of scale (EOS) and revenue advantages. Internal EOS is cost savings enjoy by a firm when it expands its scale of production while revenue advantages are in terms of pricing power and ability to practice non-price competition. This essay will explain the above benefits enjoyed by large companies. Note: Students can explain and illustrate internal economies of scale in the context of the airline industry - such as Air France, Swissair and Lufthansa OR use a variety of examples since the question  is  on  ‘large  scale  organisations’.

HWA CHONG INSTITUTION Year Two H2 Economics 2014

Tutorial #23: Microeconomics III – Theory of the Firm & Market Structure

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BODY Part 1: Explanation with diagram on how large firms experience lower unit cost of production through its ability to reap internal economies of scale. Note: Falling LRAC is when internal EOS outweighs internal diseconomies of scale and beyond Q at MES, internal EOS are outweighed by internal diseconomies of scale and thus unit costs rise. Large scale organisations usually have high MES relative to the industry demand. MES occurs at the output level where LRAC first stops falling, and it corresponds to the lowest point on LRAC. As firms get bigger by increasing scale of production, the high cost savings they enjoy from the various internal EOS can offset the higher cost that may occur due to some mismanagement and the overall unit cost will fall. Any 3 points: Technical economies (indivisibilities): With such higher annual revenue and large international consumer base, international airline such as the American Airline (merged with US airways in 2013) is able to reap technical economies of scale through indivisibilities. For example, large airlines have the financial ability to purchase large aircrafts such as Airbus A380, which is a double deck aircraft with maximum capacity of 500 seats. A380 is now able to have double the load factor (depending on the proportion of luxury suites), its cost associated with fuel cost has increased, but in fact is less than proportionately. This is because airlines are now able to fly a single flight, rather than 2 separate flights to a location. Furthermore, Some 25 per cent of the A380 structure is made of composites, generating a total weight saving of 15 tonnes, which contributes to its low fuel consumption. Therefore, large airlines which are able to purchase such aircrafts are able to make its average cost of production (provision of service) lower, as shown by a downward movement along the LRAC from AC1 to AC2. Marketing economies: The car manufacturing industry is considered to be highly capital and labor intensive. The major costs of

AC1 AC2

Cost ($)

LRAC

Q1 Q2 QMES Output

Figure 1: Internal Economies of Scale are reaped by Large Scale Organisation

SRAC small firm

SRAC large scale organisation

HWA CHONG INSTITUTION Year Two H2 Economics 2014

Tutorial #23: Microeconomics III – Theory of the Firm & Market Structure

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car manufacturer such as Volkswagen for producing and selling automobiles include labour cost, raw materials to be purchased such as steel, aluminium, seats, tires. They can buy raw material such as steel in bulk at favourable (discount) rates. It is also able to dictate its requirements with regard to quality and delivery much more effectively than smaller firm. All these mean that the firm can sell their product and/or services at a reduced unit cost. In addition, Volkswagen can spend billions on print and broadcast advertising. They spent large amounts of money on market research to anticipate consumer trends and preferences in order to strategise and compete with other rivals. These advertising cost can only be spread across large output (of cars), reducing their average cost from AC1 to AC2. Administrative and managerial economies: In a large supermarket, it is possible to practice functional specialisation by employing specialist such as accounting manager, sales manager, finance manager, departmental manager, etc. These middle-management staffs are allocated to tasks according to their skills and abilities thus raising productivity and lowering unit costs. Different expertise are required, such as to examine market trends and do market research, finance management, etc. The cost of employing these managers and expertise is also spread over a larger output. This means that cost per unit of output is lower. Financial economies: It is cheaper for big airlines to raise capital either through bank loans or issue shares. They have a higher sales volume and more assets to offer as collateral, is deemed by lenders to be more credit-worthy compared to a small airlines. Hence banking & financial institutions are more willing to offer loans or extend credit to them. They could get access to capital through public listing of their companies. All these cost savings can be translated to lower pricing to capture larger market share. Most important of all – link these internal EOS to fall in per unit costs. Part 2: Explain how large scale organisations enjoy revenue advantages A large firm is likely to be one that controls a significant share of the market. American Airlines (after merger with US airway for eg) is now the largest airline in US, taking up about 25% of the domestic market. Thus it has market power and is able to set the price at a level that generates more revenue than a small firm. The large firm can increase price if demand is price-inelastic and output will fall less than proportionate since consumers have few substitutes to turn to. (Note: In traditional firm theory, we assume firms aim to maximize profits.)

A large Firm is able to set aside a bigger budget for advertising. A successful advertising campaign establishes a

strong brand name, increases product awareness and fosters consumer loyalty e.g. Singapore Airline - The  Singapore  Girl.  The  demand  for  the  firm’s  product  increases  and  becomes  more  price  inelastic.  Thus,  at a given price, a large firm is able to sell a substantially larger quantity than a small firm. Since demand is relatively price-inelastic, the firm can increase its price to raise total revenue. A large firm earns supernormal profits (due to barriers to entry) and thus have the avenue to do R&D and will be able to improve the quality of its services and thus compete better especially when the market is getting more contestable.

HWA CHONG INSTITUTION Year Two H2 Economics 2014

Tutorial #23: Microeconomics III – Theory of the Firm & Market Structure

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CONCLUSION Extra: For high ability classes

From the figure above, we can see that a bigger firm that enjoys more internal economies of scale will have a lower average cost at AC1 (this is SRAC) and marginal costs at MC1. The unit cost decreases from C0 to C1 and is translated to lower price from P0 to P1 and higher output from Q0 to Q1. Profit increases from P0C0BA to P1C1YX. Teaching this diagram links well to part (b) where large firms are able to enjoy cost saving and lower price to capture market share. (b) In 2001 there was a world-wide reduction in airline business. Smaller airlines with lower costs and cheaper discount fares suffered less than the high-cost larger airlines such as Air France, Swissair and Lufthansa. Discuss to what extent the above extract concerning costs disproves that economic analysis. [13] Step 1: Paraphrase the question in the context: This question requires me to discuss whether smaller airlines can have costs savings which help them to suffer less than bigger airlines even though the latter are the ones which enjoy internal EOS and revenue advantage as explained in part (a). Step 2: Dissect using 3 Cs Command Discuss…  use  a  thesis/anti-thesis framework/approach Content/concept Focus on the advantages of small firms Context Airline industry

Schematic Plan

INTRODUCTION BODY

Price/Revenue/Cost ($)

MC0 AC0 P0 A MC1 AC1 P1 X C0 B C1 Y MR AR 0 Q0 Q1 Output

HWA CHONG INSTITUTION Year Two H2 Economics 2014

Tutorial #23: Microeconomics III – Theory of the Firm & Market Structure

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Thesis: YES, the extract seems to disproves the economic analysis in part (a)

Anti-thesis: NO, the extract does not disproves/contradicts the economic analysis in part (a).

Smaller airlines seem to have: (a) lower costs –

contradicts/disproves the concept of internal economies of scale

(b) cheaper discount fares – contradicts/disproves the concept of pricing power which bigger airlines enjoy.

(a) Performance by Big Airlines during a Recession x Fall in Demand for Premium Services during a Recession x The fall in demand leads to excess capacity and thus higher unit costs x Big airlines are more bureaucratic & inflexible in responding to solve the

problem of excess capacity Note: They key problem to why the extract contradicts the theory in (a) is that  there’s  the  assumption  of  a  LARGE  output  that  may  not  hold  during  a  recession for national carrier services. Evaluation? (b) Performance by SMALL AIRLINES, i.e. LOW-COST or Budget Airlines during a Recession x Rise in Demand for No-Frills Services during a Recession x Niche or specialised markets. x Nimble and flexible

CONCLUSION Suggested Answers: INTRODUCTION Key words: For this question the link between (a) and (b) is almost seamless. There is therefore no necessity to begin with key words all over again. Contextual Issue: Better to start off by bridging (a) + (b), linking them to a common contextual issue: Economic analysis as explain in part (a) suggests that larger airlines such as Air France, Swissair and Lufthansa enjoy both cost and revenue advantages and thus should incur less losses than smaller airlines. However, it is stated in the extract that smaller airlines actually suffered less than the high-cost larger airlines. Approach: Thus in this essay, I shall discuss the extent the extract disproves the economic analysis in part (a) of my answer. BODY Thesis: YES, the extract seems to disproves the economic analysis in part (a) The extract seems to disprove the economic analysis in part (a) for 2 key reasons: Smaller airlines seem to have:

(a) lower costs – contradicts/disproves the concept of internal economies of scale (b) cheaper discount fares – contradicts/disproves the concept of pricing power which bigger

airlines enjoy.

HWA CHONG INSTITUTION Year Two H2 Economics 2014

Tutorial #23: Microeconomics III – Theory of the Firm & Market Structure

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In theory, the big airlines should have lower average costs because they can reap potential internal economies of scale. Hence it would be much easier for them to lower or cut fares or offer cheaper discount fares without sustaining losses. Small firms in theory on the other hand, do not have as much pricing power as their bigger counterparts because of their lack of resources to sustain losses. With vast reserves of accumulated supernormal profits, it is easier for big airlines to sustain temporary losses by cutting fares. However, in the context of the question what actually happened is the exact opposite of what economic analysis suggests/predicts. It was the smaller airlines and not the big airlines that were able to operate at lower costs and offer cheaper discount fares. So the extract does seem to disapprove the theory.

HWA CHONG INSTITUTION Year Two H2 Economics 2014

Tutorial #23: Microeconomics III – Theory of the Firm & Market Structure

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Anti-thesis: NO, the extract does not disproves/contradicts the economic analysis in part (a). HOWEVER, on closer examination of the circumstances related to the extract/context/stem it can be inferred that the ability of small airlines to operate at lower costs and offer cheap discounted fares do not disprove the economic analysis in part (a). In the context of the extract, the entire industry was hit by a world-wide reduction in airline business – fall in demand due to probably the fear of travelling since the terrorist attack and also the recession that followed. (a) Performance by Big Airlines during a Recession Thus, in the context of falling demand in a recession, big airlines tend to suffer more for the following reasons:

x Fall in Demand for Premium Services during a Recession Big airlines that provide premium services (i.e. luxury goods) tend to suffer drastic fall in demand due to the fact the YED for luxury travel tends to be high and positive (income-elastic).

x The fall in demand leads to excess capacity and thus higher unit costs State Higher Costs faced by Larger Carriers due to Excess Capacity

Big airlines would suffer from excess capacity. Large planes tend to be under-utilised when demand falls. Even though the seats are only half filled, the planes still have to take off as scheduled. Thus, whilst revenue falls, unit costs rises for big airlines.

Elaborate by linking to part (a)

Economies of scale and Market size The economic analysis in part (a) suggests that big airlines can enjoy cost savings in terms of various forms of technical and non-technical. However these cost savings assumes/presupposes that the airline is able to operate on a big scale and produce a LARGE   output.     Thus,   like   “big   fishes”   they   can   better   survive   or   thrive   in   an   ocean  environment. However, when the market size shrinks, as it will in a recession, these big firms find themselves with excess capacity (i.e. over-size scale) and hence they become inefficient in utilising the existing over-sized capacity. For example, unlike small airlines that use smaller planes, big airlines use jumbo jets. In times of recession, it is much harder for big airlines using jumbo jets to sell enough tickets to fill up all available seats. Many big aeroplanes fly half-empty (unable to fully uilitise load factor). Moreover overcapacity in the industry makes it difficult for big airlines to reap potential economies of scale. During  such  times,  it  is  best  for  such  big  firms  to  “downsize”  or  right-size to be efficient in producing the output. In short big firms thrive when the market is large enough for them to reap potential economies of scale. However when the market size shrinks (e.g. recession) they faced more problems to stay afloat compared to small firms as their unit costs rises whilst their revenue falls.

HWA CHONG INSTITUTION Year Two H2 Economics 2014

Tutorial #23: Microeconomics III – Theory of the Firm & Market Structure

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x Bureaucratic & inflexible Large airlines are more bureaucratic and take a longer time to response to changes in market conditions. They are less flexible due to the need to upkeep the reputation and image they have built up over the years. They find it a struggle to generate enough revenue to cover their high fixed costs (e.g. large fleet of aircrafts and crew). Evaluation: Larger Carriers do survive in such a situation

x Ways to cut costs - retrench redundant workers x Ways to minimise loss and increase revenue - cut services to some cities and shift focus to

money-making destinations (may want to concentrate on services like long-haul flights which face little/no competition from the smaller rivals).

x Continue to exhaust the revenue advantages by using the funds they have to attract more customers - continue their frequent flyer programmes, provide good services which smaller counterparts cannot provide, emphasize the safety of travelling on reputable airlines, etc

(b) Performance by SMALL AIRLINES, i.e. LOW-COST or Budget Airlines during a Recession

x Overall demand might fall less than the big airlines Demand rose during recession During bad times, business for small airlines assuming budget air travel services tends to grow. This is because the demand for such so-called cheap or inferior goods has negative YED. As incomes fall due to recession, demand increases because consumers tend to switch to consuming more of a cheaper/inferior substitute. (DD↑) Demand fell due to fear for traveling + air-traveling – luxury service? However, one has to be careful not to conclude demand actually rose during that period as there was a world-wide reduction for airline services probably due to the fear of travelling after the terrorist attack (DD↓). Also air travel for tour purposes on a whole might still be considered a luxury service and demand will fall. (DD↓)

x Ability to charge a lower fare due to no-frills services & niche/specialised markets Lower cost for providing no frills/budget services. Lower overheads or fixed costs. No need to spend a lot on differentiating the product e.g. advertising cost is saved; no in-flight entertainment; catered food etc. Small airlines cater to niche markets e.g. short-haul rather than long-haul operations, using smaller and cheaper airports, lower pay scale and more flexi-working hours, small airlines do have an edge over the bigger counterparts in cost savings even without much internal economies of scale of that of bigger airlines.

x Nimble and flexible Small airlines are quicker to respond to changes in market conditions. They have less overheads or fixed costs to worry about in bad times (e.g. small fleet of aircrafts and crew to maintain).They are usually budget airlines and thus they can be more flexible in their airfare and number of flights. For example, they could more easily cut fares and cancel number of flights without much worry about reputation in response to an economic downturn. To conclude, budget airlines probably suffered a lesser overall fall in demand as compared to their bigger counterparts and together with the lower costs due to the no-frills services, they are able to survive during the worldwide reduction for airline services.

HWA CHONG INSTITUTION Year Two H2 Economics 2014

Tutorial #23: Microeconomics III – Theory of the Firm & Market Structure

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CONCLUSION Synthesis It is clear from the above discussion that in theory/principle, big airlines do enjoy cost advantages in the form of potential economies of scale. However this potential economies of scale cannot be realised in a depressed market (i.e. 2001 recession) when the market size or industry is shrinking. Thus in the context of the extract, they appear to suffer more than small airlines. {Analogy: Like putting a big  fish  in  a  small  tank.  The  big  firms  are  just  “too  big”  to  survive  in  a  small  tank}.   On the other hand, a depressed market (2001) offers opportunities for small airlines to take advantage of the demand for no frill travel services. Thus small airlines are likely to suffer less because the nature of their business enables them to operate at lower costs (no frills) and still be able to offer cheap discounted fares to boost sales. Stand: Thus I would say the above extract does not disprove the economic analysis related to benefits from large scale organizations.