Four part question answer section 3 test

a Total cost is the full cost of producing a given output. It includes both fixed
and variable costs. In contrast, average total cost is total cost divided by
output. It is sometimes known as average total cost.

b There are a number of reasons why so many firms exist in the car repair
industry. People will not travel far to have their car repaired and in a given
area, demand for the service may be somewhat limited. The service is not a
standardised one. A variety of cars with different problems are likely to be
taken to a car repairer. This means that it would not be advantageous to be
large. Indeed, a car repair firm would benefit from being flexible. Small firms
can build up a relationship with their customers, getting to know their cars and
their requirements. It is also relatively easy to set up a small car repair firm.
Not much capital equipment is required and the premises may be small. The
owner of a car repair firm may also want it to stay relatively small so that
she/he can keep control of the firm.

c Many car manufacturing companies are large because they can take
significant advantage of economies of scale. Technical economies of scale are
important in the manufacturing industry. Large car companies use large-scale
equipment to mass produce cars. They are likely to experience research and
development economies as they can operate research and development
departments that develop new car designs and new features. They can also
benefit from buying, selling, managerial and financial economies of scale.
They can buy tyres, for instance, in bulk. As important customers, they are
likely to be charged a discounted price. Transporting a high number of cars
out to car dealers can be relatively cheap per car as the delivery vehicles can
carry a number of vehicles. A large car manufacturer, employing a relatively
large labour force, can take advantage of managerial economies of scale by
allowing its labour force to specialise. Some of its workers can be
accountants, some can be paint sprayers and some can be human resource
managers.
A large car manufacturer can reap financial economies of scale. Banks may
be more willing to lend to a car company they have heard of and which has
considerable collateral than a small, unknown car manufacturer. As a large
company is likely to borrow a large amount of money, it may be charged a
relatively low rate of interest. This is because the administrative costs of
processing and managing a large loan per dollar lent are lower than those
involved with a small loan. A large firm may also find it easier to sell its shares
as again it is likely to be better known.

d There are both potential benefits and costs for a car manufacturer from both
merging with another car manufacturer and with a firm selling cars. The
merger with the car manufacturer might, in practice, prove to be more
beneficial. A merger with another car manufacturer may reduce average costs
if the new, merged firm can take greater advantage of economies of scale. A
larger firm should be able to make use of larger, more technologically
advanced equipment and exploit division of labour to a greater extent. It will
also have greater buying power, may be able to gain more loans on more
favourable terms from banks and may face greater demand for its shares.
One reason why people may want to buy shares from a new, larger merged
car manufacturer is because they may expect it will make more profit. This is
because a horizontal merger, such as that between two car manufacturers,
will increase the firm’s market share. Having more market power can enable a
firm to widen the gap between the cost per unit and the price it charges.
A horizontal merger can also reduce average costs as a result of
rationalisation. The new firm may be able to reduce costs by cutting out any
unnecessary duplication. There is a risk, however, that the merger between
two car manufacturers may increase average costs. This may occur if the new
firm is too large and so experiences diseconomies of scale such as problems
of managing the new firm. These problems are more likely to arise if the two
firms were located some distance apart, although advances in information and
communications technology are reducing this problem. There is initially likely
to be some extra costs involved in seeking to harmonise, for instance, wage
rates and accounting systems in the two firms. Management problems may be
more serious in the case of a vertical merger forwards, such as that between a
car manufacturer and a car dealership. This is because of the different nature
of the firms and the different skills required in running them. There may also
be a problem if the size of the two firms does not match. For example, if the
car manufacturing part does not produce enough cars for the car dealership,
there will be a waste of resources in the car dealing part. There would,
nevertheless, be some advantages that could be gained from such a merger.
One is that it will guarantee a market outlet for the cars. The car manufacturer
will know that the cars it produces will get into car showrooms. It will be able to
control how its cars are sold, seeking to ensure that they are well presented
and that the sales staff are fully informed about the advantages. Having the
direct link to the sale of the product should also mean that it will receive
feedback from its customers. It could use this information in the design of new
models. The merged firm is also likely to use its control of car dealers to stop
them selling rival firms’ cars.