Lecture Notes 1: Review of Basic Microeconomics
What is industrial organization?
The classical definition of industrial organization is the study of the structure of firms and markets. But isn’t that basically the core of what microeconomics is? What makes industrial organization different? Here are a few important things.
• Classical microeconomics emphasizes competitive markets. Supply/demand-type models have a long history in economics and are tremendously useful for understanding and approximating large-scale market forces. The problem is that, realistically, most markets do not operate under perfectly competitive conditions. Perfectly competitive models are a nice way to introduce broad economic forces, but are not adequate for understanding markets that violate the perfectly competitive assumptions, which is almost every market in one way or another. Industrial organization focuses on imperfect competition.
• You might have spent a little bit of time on pure monopoly. But again, with a few important exceptions, there really aren’t a lot of markets that fall on this extreme either. Industrial organization spends most of its time on the more realistic case of markets that fall somewhere in between perfect competition and monopoly.
• Strategic interaction is barely treated at all by classical microeconomics. You may have spent a few minutes talking about some oligopoly models, but the distinguishing feature of imperfect competition is the nature of the interaction between the firms in the market. This problem is completely ignored in competitive markets, because the idea is that the market has a very large number of firms and that each firm is very small, so each firm can ignore the interactivity effect of its own decisions with the rest of the market. And pure monopoly obviously does not feature strategic interaction since there is only one firm. Industrial organization spends a lot of time on the ways in which firms interact with each other.
• Industrial organization studies a lot of real-life, practical issues in the operation of firms and industries. For example, we will spend quite a bit of time on advertising, patents, pricing plans, price fixing, etc… These are topics that classical microeconomics usually breezes over but fall squarely in the industrial organization domain.
• Industrial organization also has a heavy policy focus. Understanding how firms interact with each other is the key to understanding the impact that market structure and firm behavior has on society. In the United States, we have a significant regulatory infrastructure that deals with things like antitrust laws and anticompetitive behavior. Economists who work on these issues need a good understanding of how firms and markets work in order to design regulation that produces the best outcomes for society, which is in principle the goal of policymakers.
Before we get started, we need to review some basic microeconomics that we are going to use throughout the course.
Cost Functions
In the short-run, firms typically have both fixed costs and variable costs.
Fixed costs are costs that do not vary with the level of output. For example, a firm might have to pay rent for its office space or pay insurance premiums for its truck fleet. In a simple sense, fixed costs are sunk costs in the short-run because the firm is forced to incur them regardless of how much output it produces. Total fixed cost (TFC) is all fixed costs.
Variable costs are costs that increase as the firm produces more output. For example, a restaurant would probably have to buy more food and pay more waitresses if it gets more customers (variable costs) but its lease on the building wouldn’t change (fixed costs). Total variable cost (TVC) is all variable costs.
Total cost (TC) includes fixed and variable costs.
Economists often find it more convenient to state things in per unit terms rather than as overall figures, so we have the following.
• Average fixed cost (AFC) is the fixed cost per unit of output.
• Average variable cost (AVC) is the variable cost per unit of output.
• Average total cost (ATC) is the total cost per unit of output.
Finally, marginal cost (MC) is the incremental cost of producing one additional unit of output.
Cost Concept Definition
TFC Cost of fixed inputs
TVC Cost of variable inputs
TC TFC + TVC
AFC TFC / q
AVC TVC / q
ATC TC / q = AFC + AVC
MC Additional cost of one more unit
For a numerical example, consider a firm with fixed costs of $100 and with the variable costs given on the table for each level of output (q) that the firm can produce.
q TFC TVC
0 100 0
1 100 20
2 100 50
3 100 100
4 100 300
The table below shows the total, average and marginal costs. All are calculated using the definitions above.
q TFC TVC TC AFC AVC ATC MC
0 100 0 100 - - - -
1 100 20 120 100 20 120 20
2 100 50 150 50 25 75 30
3 100 100 200 33.33 33.33 66.66 50
4 100 300 400 25 75 100 200
A couple of things are important in constructing this graph.
• Total costs are always higher than variable costs. This is obvious since total costs include variable costs and fixed costs.
• The difference between ATC and AVC is the average fixed cost AFC. Notice that the fixed cost per unit AFC always declines as output rises. That is why AVC and ATC get closer as output increases.
• The ATC curve is typically parabolic. In the beginning, expanding output reduces costs per unit because the fixed costs are spread over more and more units. But, eventually, expanding output too much causes the firm to run into diminishing returns, so at some point the average cost will start to rise as the firm expands.
• Marginal cost intersects ATC and AVC at their low points.
Finally, in this class we will frequently express cost functions quantitatively. For example, suppose that a firm’s total cost of producing 𝑞𝑞 units of output is given by the following
𝑇𝑇𝑇𝑇 = 2400 + 400𝑞𝑞 − 60𝑞𝑞2+ 𝑞𝑞3
From the equation, you can see that the fixed cost is $2400 and the variable cost is the part of the cost that depends on output. Using the definitions of the cost function, we can calculate the rest of the cost functions as shown below.
Total Fixed Cost 𝑇𝑇𝑇𝑇𝑇𝑇 = 2400
Total Variable Cost 𝑇𝑇𝑇𝑇𝑇𝑇 = 400𝑞𝑞 − 60𝑞𝑞2+ 𝑞𝑞3
Total Cost 𝑇𝑇𝑇𝑇 = 𝑇𝑇𝑇𝑇𝑇𝑇 + 𝑇𝑇𝑇𝑇𝑇𝑇 = 2400 + 400𝑞𝑞 − 60𝑞𝑞2+ 𝑞𝑞3
Average Fixed Cost 𝐴𝐴𝑇𝑇𝑇𝑇 =𝑇𝑇𝑇𝑇𝑇𝑇
𝑞𝑞 = 2400
𝑞𝑞
Average Variable Cost 𝐴𝐴𝑇𝑇𝑇𝑇 =𝑇𝑇𝑇𝑇𝑇𝑇
𝑞𝑞 =
400𝑞𝑞−60𝑞𝑞2+𝑞𝑞3
𝑞𝑞 = 400 − 60𝑞𝑞 + 𝑞𝑞2
Average Total Cost 𝐴𝐴𝑇𝑇𝑇𝑇 =𝑇𝑇𝑇𝑇
𝑞𝑞 =
2400+400𝑞𝑞−60𝑞𝑞2+𝑞𝑞3
𝑞𝑞 =
2400
𝑞𝑞 + 400 − 60𝑞𝑞 + 𝑞𝑞2
Marginal Cost 𝑀𝑀𝑇𝑇 = 𝑑𝑑
𝑑𝑑𝑞𝑞(𝑇𝑇𝑇𝑇) = 400 − 120𝑞𝑞 + 3𝑞𝑞2
Long Run Costs
In the long run, there are no fixed costs because the firm can change all of its production inputs. For example, a restaurant might be stuck paying a lease for a certain restaurant space in the short run, but in the long run it can choose to not renew its lease or it can rent a bigger space. That is, all costs are variable in the long-run.
Each choice of fixed input will have a particular ATC curve associated with it. When a firm can choose multiple ways to produce the same level of output, over the long-run it will always choose the cheapest way.
In the long run, the firm will always choose the cheapest production plan. For example, if the firm wants to produce 100 units of output, it might be stuck at plant 3 in the short-run, but in the long-run it will always operate at plant 2.
Thus, the long run average cost (LRAC) curve is the minimum points of all the short-run average cost curves. For each output level, the firm will over the long-run choose the cheapest production plan.
What happens to average costs as output rises?
• Diseconomies of scale means that average cost rises when output rises. In other words, the cost per unit of production rises as the firm expands. Larger firms are less efficient.
• Economies of scale means that the average cost falls when output rises. The cost per unit of production is lower as the firm grows. Larger firms are more efficient.
Some firms will feature economies of scale over some ranges of output and then diseconomies of scale over other ranges. For example, the firm in the diagram above initially features economies of scale (the LRAC curve falls as output rises) but eventually runs into diseconomies of scale.
Surplus
Economists use consumer surplus and producer surplus to measure welfare gains in a market.
• Consumer surplus is the difference between what a consumer is willing to pay for a product and what he actually pays. Think of consumer surplus as value provided to consumers over and above what they pay.
• Producer surplus is the difference between the minimum price at which a producer would offer something for sale and the actual price received.
In industrial organization, the price will often come by way of firms exercising price-setting power rather than from a market equilibrium. Even in cases like this, you can graph out the demand curve and calculate the consumer surplus.
For example, suppose the demand curve in a market is 𝑄𝑄 = 120 − 2𝑃𝑃 and you want to calculate the consumer surplus earned by the buyers in the market when the firm sets the price at $20. When the price is 𝑃𝑃 = 20, the output sold is 𝑄𝑄 = 120 − 2 ⋅ 20 = 80.
First of all, the demand curve is drawn with the price on the vertical axis, so you need to invert the demand curve and solve it for 𝑃𝑃 in order to draw the diagram.
𝑄𝑄 = 120 − 2𝑃𝑃 2𝑃𝑃 = 120 − 𝑄𝑄
𝑃𝑃 = 60 −12 𝑄𝑄
As shown on the diagram, the consumer surplus is the area under the demand curve down to the
price of $20. Using the formula for the area of a triangle 𝑇𝑇𝐶𝐶 =1
Efficiency
Depending on the context, economists can be referring to many different things when they talk about efficiency. In this class, we will mainly be talking about two kinds of efficiency.
• Productive efficiency refers to producing output at the minimum possible average cost. In other words, a firm is productively efficient when it chooses the level of output that minimizes the cost of each unit of output produced (average cost).
• Allocative efficiency means that the market is set up in a way that maximizes gains from trade (surplus). The gold standard for allocative efficiency in a market is when price is set equal to marginal cost. Any time price is set higher than marginal cost, there are some customers kicked out of the market who would have been willing to pay more than the marginal cost of supplying the product to them. This destroys potential surplus, but it can increase profit for the seller.
Accounting Profit and Economic Profit
Businesses face two kinds of costs.
• Explicit costs are costs where money is actually laid out. Wages, interest on loans and the cost of materials are explicit costs.
• Implicit costs represent the value of sacrifices made even when there is no direct payment. Some economists refer to these as opportunity costs. For example, an owner might spend 20 hours a week of his time on company business or he might use a building that he owns. While there is no direct payment, the owner gave up his time or the rent he could have earned on the building, and so these are sacrifices that he makes to run the business. Another example is what economists call the holding cost of capital. If a firm owner has $1 million tied up in machines, he loses out on the interest he could have earned on the money over the year.
While accounting statements consider only explicit costs, economists emphasize the need to include implicit costs in making decisions. For example, a business might earn a $200,000 accounting profit, but if the business’ resources could have been used elsewhere to earn a $300,000 profit (the implicit cost of the resources), then an economist would actually say that the owner is losing money by keeping his resources in their current use. This leads to two definitions of profit.
• Economic profit is total revenue minus all costs, inclusive of both explicit and implicit costs.
Market Structures
We are going to cover market structures in great detail in this course – how firms operate and the kinds of outcomes that they produce for society. But it’s a good idea to just briefly review the four basic market structures that economists usually talk about.
• Perfect competition – Lots of firms selling an identical (homogeneous) product. Because the number of buyers and sellers is large and they are all selling identical an identical and indistinguishable product, no individual buyer or seller has any influence on the market price. Furthermore, perfectly competitive markets feature easy entry of new firms, which drives economic profits to zero in the long-run. Farming at the raw materials level is close to perfectly competitive.
• Monopolistic competition – Lots of firms, but their products are differentiated (branded). Examples are restaurants, clothes, soap, etc… You have lots of choices, but the products are differentiated from each other. Monopolistic competition also features easy entry of new firms, so economic profits are driven to zero in the long-run here as well.
• Oligopoly – A few big firms control a large part of the market. Good examples are airlines and cigarettes. Oligopoly typically arises because of some kind of barrier to entry, which makes it difficult for new firms to enter and compete. These barriers to entry can potentially allow firms to earn long-run profits.
• Monopoly – One firm controls the market. Monopoly typically arises from a barrier to entry, although there are some other explanations as well.
Market Number of
firms
Type of
product Ease of entry Pricing power Example
Perfect
Competition Many Homogeneous Easy None Farming
Monopolistic
Competition Many Differentiated Easy Some Soap, Cereal
Oligopoly Few control most of market
Homogeneous
or Differentiated Barriers Yes (strategic)
Airlines, Cigarettes
Exercises
Problem 1
A firm can choose between two different plants. Its fixed costs and variable costs are shown for each plant.
Plant 1
q TFC TVC TC AFC AVC ATC MC
0 10 0 - - - -
1 10 3
2 10 6
3 10 9
4 10 12
5 10 15
6 10 18
7 10 21
8 10 24
Plant 2
q TFC TVC TC AFC AVC ATC MC
0 20 0 - - - -
1 20 1
2 20 2
3 20 3
4 20 4
5 20 5
6 20 6
7 20 7
8 20 8
a. Complete the tables.
Problem 2
The cost of a license paid by a business to operate inside of Chester county increases from $400 per year to $500 per year.
a. What effect will this increase have on the firm’s marginal cost?
b. What effect will this increase have on the firm’s average variable cost? c. What effect will this increase have on the firm’s average total cost?
Problem 3
Consider a firm that faces the demand curve 𝑞𝑞 = 500 − 50𝑃𝑃
a. Calculate the consumer surplus when the firm sets its price at $8. b. Calculate the consumer surplus when the firm sets its price at $4.
Problem 4
Chloe produces orange juice. She makes $400 of revenue per month. However, she has to pay $300 per month for oranges and $100 per month to rent a juicer. She could have worked instead of running her juice business, in which case she would have earned a salary of $500 per month.
