ECN 349 Industrial Economics ECN 349 Industrial Economics-Asst. Prof. Evrim Turgutlu

ECN 349 Industrial Economics-Asst. Prof. Evrim Turgutlu Introduction In this course we will focus on the economics of industrial organization (IO). IO is the study of the structure of the firms, markets and of their interactions. In microeconomics, idealized models of firms and markets are analyzed. IO takes a more realistic look at them. It adds to the perfectly competitive model the real world frictions: limited information, transaction costs, barriers to entry, etc. IO considers how firms are organized and how they compete in such a world. ECN 349 Industrial Economics-Asst. Prof. Evrim Turgutlu

ECN 349 Industrial Economics-Asst. Prof. Evrim Turgutlu Cost Concepts Costs provide improtant information to analyze the firm behavior. Types of costs: Fixed costs (F): An expense that do not vary with the level of output. (Rent, fee government charge to operate, etc.) When the production (operation of a firms stops), if the fixed cost could not be recovered at all: Sunk costs The portion of the fixed costs that can be recovered even though firm stops operating: Avoidable costs Variable costs (VC): Costs that change with the level of output, q.: VC (q) ECN 349 Industrial Economics-Asst. Prof. Evrim Turgutlu

ECN 349 Industrial Economics-Asst. Prof. Evrim Turgutlu Cost Concepts Total costs (TC): C= F+ VC Average cost (AC or ATC): TC/q Average variable cost (AVC): VC(q)/q Average fixed cost (AFC): FC/q AC (q)= AFC + AVC Can AVC and AFC exceed AC? Marginal cost (MC): Increment or addition to cost that results from producing one more unit of output. MC= dC(q)/dq ECN 349 Industrial Economics-Asst. Prof. Evrim Turgutlu

ECN 349 Industrial Economics-Asst. Prof. Evrim Turgutlu Cost Concepts Complete the following table: Q FC VC TC MC AFC AVC ATC 1 300 70 370 70 2 60 3 70 4 315 ECN 349 Industrial Economics-Asst. Prof. Evrim Turgutlu

ECN 349 Industrial Economics-Asst. Prof. Evrim Turgutlu Cost Concepts Q FC VC TC MC AFC AVC ATC 1 300 70 370 70 300 70 370 2 300 130 430 60 150 65 215 3 300 210 510 80 100 70 170 4 300 315 615 105 75 78.75 153.75 ECN 349 Industrial Economics-Asst. Prof. Evrim Turgutlu

ECN 349 Industrial Economics-Asst. Prof. Evrim Turgutlu Cost Concepts A cost curve summarizes an enormous amount of information. For example, knowing that cost curve changes as wages or other factor prices change, one can infer a firm’s production technology (relation between inputs and output reflecting the maximum possible output that can be produced from a given set inputs). Short-run verus the Long-run: Short run Long run SRAC and LRAC ECN 349 Industrial Economics-Asst. Prof. Evrim Turgutlu

ECN 349 Industrial Economics-Asst. Prof. Evrim Turgutlu Cost Concepts Oppotunity cost: An action’s opportunity cost is the value of the best forgone alternative use of the resources employed in that action. E.g. Suppose that there are three workers in a firm. One of them is the owner of the firm and he does not receive a wage. The others receive a wage of $10 per hour. Hence, an economist should measure the opportunity cost of three workers as $30 per hour. How can we use this information? To decide whether it is profitable to continue an activity. If each worker produces 1 unit of output each hour which is sold for $9, then in one hour the owner will calculate the profit as: revenue-cost: 27-30=-3 This means, the owner of the firm should stop producing and work for someone else for $10 per hour. ECN 349 Industrial Economics-Asst. Prof. Evrim Turgutlu

ECN 349 Industrial Economics-Asst. Prof. Evrim Turgutlu Cost Concepts If all costs are valued at their opportunity cost, the profit need only be zero to make remaining in business worthwhile. If revenues cover costs, then all resources are used in an efficient manner. Since opportunity cost values each resource at its most profitable alternative use, economists sometimes say that opportunity cost attributes a normal profit to all of the firm’s resources. ECN 349 Industrial Economics-Asst. Prof. Evrim Turgutlu

ECN 349 Industrial Economics-Asst. Prof. Evrim Turgutlu Cost Concepts Economies of scale Average costs changes with the level of output. If AC falls as output increases, firm is said to have economies of scale (increasing returns to scale). If AC stays constant as output increases, firm is said to have constant returns to scale. If AC decreases as output increases, firm is said to have diseconomies of scale (decreasing returns to scale). ECN 349 Industrial Economics-Asst. Prof. Evrim Turgutlu

ECN 349 Industrial Economics-Asst. Prof. Evrim Turgutlu Cost Concepts Scale economies exist, if MC is below AC. Scale disceonomies exist if MC is above AC. Hence, a measure of scale economies can be expressed as: s=AC/MC If s>1: Economies of scale If s<1: Diseconomies of scale ECN 349 Industrial Economics-Asst. Prof. Evrim Turgutlu

ECN 349 Industrial Economics-Asst. Prof. Evrim Turgutlu Cost Concepts Minimum efficient scale (MES): A firm’s minimum efficient scale is the smallest output (q*) it can produce such that its LRAC are minimized. What information can be drawn from MES? The size of the MES plant, especially in relation to the overall market, is useful for judging how many firms could operate in the market. ECN 349 Industrial Economics-Asst. Prof. Evrim Turgutlu

ECN 349 Industrial Economics-Asst. Prof. Evrim Turgutlu Cost Concepts In real life, firms usually produce more than one product. How can we specify average and marginal costs then? Suppose a multiproduct firm, producing two products, q1 and q2. Specification of TC and AC. Ray scale economies (RAC) Product-specific economies of scale (PS) Economies of scope ECN 349 Industrial Economics-Asst. Prof. Evrim Turgutlu