Industrial Organization: Class 1
Firm: ownership and cost structures
• U.S.: 76% of value added to GDP in 2024
• Firm: organization that transforms inputs into outputs
• Objectives
• Ownership and control
• Cost structures
Firm objectives
• Firm’s main objective is to produce efficiently to maximize profits
• Real world: firm operators make decisions for the firms – interests
must be aligned with profit maximization
• One Part of IO: Study how firms are organized
• Second Part of IO: how industry where firms operate is organized
Firms: ownership and control
• Ways firms are owned and managed:
• Sole proprietorships
• Partnerships
• Corporations
Firms: corporations
• Limited liability
• Financing opportunities
• Firm size
• Expansion through financing
• Mergers
Firms: cost structures
• Why should we study firms’ costs?
• Entry and exit decisions (Target in Canada)
• Where to locate (where to locate next Starbucks, Uniqlo)
• Pricing and output (how to price Netflix, Amazon Prime, Prime without ads?)
• Competition and market structure
• Firms costs (review):
– Fixed cost
– Variable cost
– Marginal cost
– Total cost
Firms: Fixed and variable costs
• Fixed costs
• Does not vary with output: examples?
3. Firms: Fixed and variable costs
• Fixed costs
• Does not vary with output: examples?
• Sunk costs: non-recoverable
• Variable costs
• Varies with output: examples?
Firms: marginal and total costs
• Marginal cost:
Firms: marginal and total costs
• Marginal cost: cost of producing an additional unit of output
• First derivative of total cost function
Firms: marginal and total costs
• Marginal cost: cost of producing an additional unit of output
• First derivative of total cost function
• Total cost:
• Sum of variable and fixed costs
• Average costs:
• Fixed: Fixed cost/output
• Variable: Variable cost/output
• Total: Total cost/output
Firms: cost curves
2
ππΆ
π
=
5π
− 5q + 10
• Examples: Total cost curve is
Fixed cost: FC
Average fixed cost:
AFC(q)
Variable cost: VC(q)
Average variable cost:
AVC(q)
Marginal cost: MC(q)
Average total cost:
ATC(q)
Firms: cost curves
2
ππΆ
π
=
5π
− 5q + 10
• Examples: Total cost curve is
Fixed cost: FC=10
Average fixed cost: AFC(q)
Variable cost: VC(q)=
Average variable cost: AVC(q)
πππ − ππͺ
Marginal cost: MC(q) =
πππ − π
Average total cost: ATC(q)
Firms: cost curves
2
ππΆ
π
=
5π
− 5q + 10
• Examples: Total cost curve is
Fixed cost:
FC=10
Average fixed cost:
AFC(q)=ππ/π
Variable cost: VC(q)=
πππ − ππͺ
Average variable cost: AVC(q)=ππ − π
Marginal cost: MC(q) =
πππ − π
Average total cost: ATC(q)=ππ − π + ππ/π
Firms: cost curves
2
ππΆ
π
=
5π
− 5q + 10
• Examples: Total cost curve is
Fixed cost:
FC=10
Average fixed cost:
AFC(q)=ππ/π
Variable cost: VC(q)=
πππ − ππͺ
Average variable cost:
AVC(q)=ππ − π
Marginal cost: MC(q)
=
πππ − π
Average total cost:
ATC(q)=ππ − π +
ππ/π
Cost
functions
MC(q)
AVC(q)
ATC(q)
AFC(q)
Output (π)
Firms: cost curves
• Relationship between ATC and MC: returns to scale (more or less costeffective to produce larger quantities)
• ATC(q)>MC(q): increasing returns to scale
• ATC(q)=MC(q): constant returns to scale
• ATC(q)<MC(q): decreasing returns to scale
• Duality of profit maximization: costs provide information on firm’s
technology (pharmaceutical versus pens )
Second Part of IO: Market structures
• Most common market types and characteristics:
Market structure
Entry
barriers
Sellers
Buyers
Price
Product
Perfect competition
No
Many
Many
Takers
Homogeneous
Monopolistic
Competition
No
Many
Many
Depends
Differentiated
Oligopoly
Yes
Few
Many
Depends
Depends
Monopoly
Yes
One
Many
Setters
Homogenous
Market structures
More competition
Perfect
competition
Monopolistic
competition
• Focus on:
• Prices and quantities
• Product variety/quality
• Consumer surplus
• Profits
• Deadweight loss.
Less competition
Oligopolies
Monopolies
Perfect competition
• Assumptions:
• Free entry / no transaction costs
• Homogenous, divisible product
• Perfect information
• Price taking
• No externalities
Perfect competition
• In a competitive market, firms are identical and their profits are
π = ππ − πΆ(π)
Where:
• π is the price of the product (taken as given)
• π is the output produced by each firm
• πΆ(π) is the total cost of producing π
Perfect competition
• In a competitive market, firms are identical and their profits are
π = ππ − πΆ(π)
Where:
• π is the price of the product (taken as given)
• π is the output produced by each firm
• πΆ(π) is the total cost of producing π
Perfect competition
• In a competitive market, firms are identical and their profits are
π = ππ − πΆ(π)
Where:
• π is the price of the product (taken as given)
• π is the output produced by each firm
• πΆ(π) is the total cost of producing π
Perfect competition
• In a competitive market, firms are identical and their profits are
π = ππ − πΆ(π)
Where:
• π is the price of the product (taken as given)
• π is the output produced by each firm
• πΆ(π) is the total cost of producing π
• Firm’s objective: maximize profits
Perfect competition: profit maximization
• Firm chooses quantity π ∗ to solve
max ππ − πΆ(π)
π
• First order condition for π ∗ > 0 :
dπΆ(π ∗ )
∗
π
−
=
0
Φ
π
=
ππΆ(π
)
ΰΈ
dπ
ππ
• But is π ∗ > 0 optimal for the firm? Yes, if profits of producing are
greater than not producing.
Profit maximization: short-run
• In short-run, all fixed cost are sunk costs (cannot be recovered, avoided)
• If quantity π∗ = 0, still need to pay fixed costs:
ππ∗ − πΆ π∗ = π0 − πΆ 0 − πΉ
In short run, quantity π∗ > 0 is optimal if and only if:
ππ∗ − ππΆ π∗ ≥ 0
ππΆ π∗
∗)
π≥
=
π΄ππΆ(π
π∗
• Short-run: firm produces if π ≥ π΄ππΆ(π∗ )
Profit maximization: long-run
• Firm will not continue enduring losses in the long-run – fixed costs are
no longer assumed sunk.
• Shutdown decision:
ππ ∗ − πΆ π ∗ < 0
ππ ∗ < πΆ π ∗
πΆ π∗
∗
π<
=
π΄ππΆ(π
)
∗
π
• Long-run: firm produces if π ≥ π΄ππΆ(π ∗ ). Otherwise, it shuts down.
Perfect competition: short-run equilibrium
• Price and quantity for given demand and number of firms (π)
• Given prices, firms maximize profits
• Prices are such that industry supply equal total demand (at that price)
• Assuming it is optimal for firms to produce a positive quantity, the
equilibrium is determined by:
(1)
π∗ = ππΆ(π ∗ )
(2) Demand π· π∗ = ππ ∗
Perfect competition: long-run equilibrium
• Number of firms, price and quantity for given demand
• Given prices, firms maximize profits
• Prices are such that industry supply equal total demand (at that price)
• Free entry: zero profit condition
• Assuming it is optimal for firms to produce a positive quantity, the
equilibrium is determined by:
(1) π∗ = ππΆ π ∗
(2) π· π∗ = π∗ π ∗
(3) π∗ = π΄ππΆ π ∗
Free Entry Condition and Zero Profits
In the short-run, firms may make either positive or negative profits.
a. If positive profits, this cannot be a long-run equilibrium, more firms
will enter.
b. If negative profits, this cannot be a long-run equilibrium, some
firms will leave.
c. If zero profits, this is also a long-run equilibrium.
Perfect competition: example
Suppose the demand of a market is π· π = 6 − π. In the short-run,
there 10 identical firms, with total cost function πΆ π = π 2 + 2π + πΉ,
with 0 < πΉ < 4.
1. What is the short-run equilibrium (prices and market quantity)?
2. What is the long-run equilibrium (prices, market quantity and
number of firms) when πΉ = 1/4? And when πΉ = 1?
Perfect competition: example
1. What is the short-run equilibrium (prices and market quantity)?
Note that since πΆ π = π2 + 2π + πΉ, MπΆ π = 2π + 2 and AVC π = π + 2.
Suppose π∗ > 0. Then,
π = MπΆ π∗ = 2π∗ + 2
Note that π = 2π∗ + 2 ≥ AVC π∗ = ?
Perfect competition: example
1. What is the short-run equilibrium (prices and market quantity)?
Note that since πΆ π = π2 + 2π + πΉ, MπΆ π = 2π + 2 and AVC π = π + 2.
Suppose π∗ > 0. Then,
π = MπΆ π∗ = 2π∗ + 2
Note that π = 2π∗ + 2 ≥ π∗ + 2 = AVC π∗ . Therefore, π∗ > 0
Since there are 10 firms operating, then in equilibrium
π· π = 6 − π = 10π∗ (demand = supply)
Perfect competition: example
1. What is the short-run equilibrium (prices and market quantity)?
Note that since πΆ π = π2 + 2π + πΉ, MπΆ π = 2π + 2 and AVC π = π + 2.
Suppose π∗ > 0. Then,
π = MπΆ π∗ = 2π∗ + 2
Note that π = 2π∗ + 2 ≥ π∗ + 2 = AVC π∗ . Therefore, π∗ > 0
Since there are 10 firms operating, then in equilibrium
π· π = 6 − π = 10π∗
And,
6 − (2π∗ + 2) = 10π∗
π∗ =. , p =.
Perfect competition: example
1. What is the short-run equilibrium (prices and market quantity)?
Note that since πΆ π = π2 + 2π + πΉ, MπΆ π = 2π + 2 and AVC π = π + 2.
Suppose π∗ > 0. Then,
π = MπΆ π∗ = 2π∗ + 2
Note that π = 2π∗ + 2 ≥ π∗ + 2 = AVC π∗ . Therefore, π∗ > 0
Since there are 10 firms operating, then in equilibrium
π· π = 6 − π = 10π∗
And,
6 − (2π∗ + 2) = 10π∗
1
8
∗
π = ,p =
3
3
Perfect competition: example
2. What is the long-run equilibrium (prices, market quantity and
number of firms) when πΉ = 1/4? And when πΉ = 1?
Note that ATπΆ π = π + 2 + πΉ/π. In the long-run, for π ∗ > 0 , we
must have
(1) π = MπΆ π ∗
(3) π = AππΆ π ∗
MπΆ π ∗ = ATπΆ π ∗
2π ∗ + 2 = π ∗ + 2 + πΉ/π ∗
π ∗ = πΉ/π ∗
π∗ = πΉ
Perfect competition: example
2. What is the long-run equilibrium (prices, market quantity and number of
firms) when πΉ = 1/4? And when πΉ = 1?
Note that AπΆ π = π + 2 + πΉ/π. In the long-run, for π∗ > 0 , we must have
(1) π = MπΆ π∗
(3) π = AπΆ π∗
MπΆ π∗ = AπΆ π∗
2π∗ + 2 = π∗ + 2 + πΉ/π∗
π∗ = πΉ/π∗
π∗ = πΉ
From π = MπΆ π∗ , we get that
π = 2π + 2 = 2 πΉ + 2
Perfect competition: example
Note that for each firm, if π∗ = π and π∗ = π π + π
In equilibrium, we must have
(2) π· π = 6 − π = π∗ π ∗
6 − 2 πΉ + 2 = π∗ πΉ
4 − 2 πΉ = π∗ πΉ
4
∗
π =
−2
πΉ
Therefore,
1
a) πΉ = → π ∗ =? , p =? , π∗ =?, π· π =?
4
b) πΉ = 1 → π ∗ =? , p =? , π∗ =?, π· π =?
Perfect competition: example
Note that for each firm, if π∗ = π and π = π π + π
In equilibrium, we must have
(2) π· π = 6 − π = π∗ π ∗
6 − 2 πΉ + 2 = π∗ πΉ
4 − 2 πΉ = π∗ πΉ
4
∗
π =
−2
πΉ
Therefore,
1
1
a) πΉ = → π = , p = 3, π∗ = 6, π· π = 3
4
∗
2
b) πΉ = 1 → π ∗ =? , p =? , π∗ =?, π· π =?
Perfect competition: example
Note that for each firm, if π∗ = π and π = π π + π
In equilibrium, we must have
(2) π· π = 6 − π = π∗π∗
6 − 2 πΉ + 2 = π∗ πΉ
4 − 2 πΉ = π∗ πΉ
4
∗
π =
−2
πΉ
Therefore,
1
1
∗
a) πΉ = 4 → π = 2 , p = 3, π∗ = 6, π· π = 3
b) πΉ = 1 → π∗ = 1, p = 4, π∗ = 2, π· π = 2
Notice what happens when fixed cost F goes up?
0
