scale efficiency expresses whether a firm is operating at it's "optimal size." If it is not, then using further comparisons of DEA outputs (using increasing or decreasing returns to scale) it is possible to see whether the firm is too large or too small. However, I'm confused if it's possible to conclude that a firm operating at constant return scale for long period is operating at it's optimal size? In addition, which of the return scales (INCREASING, DECREASING, CONSTANT) is a best operating condition for a firm?
Dear Tesfaye,
A clear picture is obtained from the firm's long-run ATC curve. The first phase of the curve is increasing returns. The point where the falling range becomes flat is the constant return phase. That point is also callled the Minimum Optimal Size (MOS). The term efficient size has been used as well. As an example, a Nursing home operates at the MOS when its size is at 99 or 120 beds. The number of firms that can operate when constant return is attained is limited by the extent of the market. For instance, only three domestic auto companies can operate in the US, namely Ford, Chrysler, and GM,
When you compare this with DEA analysis, you should take a look at what Pareto, Hicks, Kaldor and others have to say about optimality.
Good luck in your research.
Lall makes a good point about using the Long Run Average Cost (LRAC) curve. In addition, his nursing home example is a good one.
An additional distinction might be worth considering because we can distinguish between returns to scale and economies of scale. They are not exactly the same.
Economies of Scale (ES) and Diseconomies (DS) determine the shape of the LRAC. Both probably exist to some extent over the firm's typical operating range and the LRAC is negatively sloped when Economices of Scale outweigh Diseconomies of Scale (I.e., ES>DS) and LRAC is positively sloped when DS>ES. In other words ES and DS go a long way to determine the shape of LRAC.
Returns to scale (i.e., increasing, decreasing, and constant) determine the shape of the Long Run Production Function which is a key factor in the long run marginal cost. Increasing returns to scale leads to decreasing marginal cost. Since marginal cost reaches its minimum and begins to increase before LRAC reaches its minimum, the disconnect between returns to scale exists in this area. For example, as decreasing returns to scale emerges, we find the transformation of the marginal cost to a positive slope.
The differences in these are attributable to the technical differences between returns to scale and economies (and diseconomies) of scale. The former, effectively requires homogeneous inputs; whereas, the latter effectively allows for differing qualities of inputs used. Economies of scale may result from specialization of labor and/or management, the use of more efficient use of capital and/or the more efficient use of capital, and/or the use of by-products. In other words for example, using bigger, more powerful tools can drive down the average cost of large scale production.
All of this is getting rather complicated; however, the key point goes directly to your questions. We expect the optimal position from the firm's perspective is where profits are maximized (i.e., MR=MC). This typically occurs at the minimum of LRAC in purely competitive industries. In virtually all other industries (e.g., monopoly, monopolistic competition, and oligopoly), this profit maximizing point for the firm is in location other than at the minimum of LRAC.
Thus, neither returns to scale nor economies of scale are the exclusive factors determining the profit maximizing output; for that we also need elements from the demand side as it is manifest in marginal revenue to find profit maximization, which is what I think you are asking about optimal size of the firm and its output.
Many other perspectives on optimality and efficiency, such as allocative efficiency, are interesting and require a different approach, of course.
I hope this helps.
Rob
Hello,
I would recommend to to go through the following Literatures by Coelli et al. Dr. T Coelli of the University of Queenslamd has done tremendous work in this field.
I hope these references will help you.
Wishes of the Best.
Scale efficiency expresses whether a firm is operating at its "optimal size. It depends on which industry you carry out your study. For example, if you study on the airline industry, you should use variable return to scale. You can also check this paper
Article Performance Evaluation and Ranking of Turkish Banking Sector
May be a late response but it may help at least for others.
Please refer to the book " Coelli, T. J., Rao, D. S. P., O’Donnell, C. J. and Battese, G. E 2005. An Introduction to Efficiency and productivity Analysis. Springer, New York. Page 272
it is clearly stated there and an example is done.
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