Industrial organization Chapter review 1-3.

(Price decision use bigger than average margainal cost)

1. Opportunity Cost: The cost of a resource is the highest value it receives else where. (future
revenue/future%
2. (已支付成本)Sunk Cost: The value of a resource that is used or committed to certain use and
not recoverable.（sunk after the point of spending）
3. TC = C(q) = total cost
AC = C(q)/q = average cost
MC = dC(q)/dq = marginal cost
• Also TC=FC+VC
▫ FC = fixed cost, costs that do not depend on the scale of operation
▫ VC = variable cost, costs that depend on the scale of operation
▫ If FC=C(0), then VC(q)=C(q)-C(0)
• Note: By definition, in the long run, all costs are adjustable(可调节), so TC=VC.
4. Economies of scale： When output increases, average cost decreases. (example: Credit
card processing. First Data, 44% ; National Processing, 13%)
S= (q/AC)(dAC/dq) = MC/AC – 1 S<0: economies of scale
5. Minimum efficient scale=MES
▫ determination of firm/plant size
▫ If MES is larger than the market size, natural monopoly may be efficient
6. Economies of scope: Total cost of production is lower with joint than with separate
production
• Source: Joint cost – cost of inputs that do not change with scope of production
• Examples
▫ product mix: multiple products using the same base product
– Movie and game sharing a title/story
– One wire network provides: TV broadcasting, internet access, telephone
▫ brand extensions: multiple products sharing the same brand
– skin cares products
7. We can use elasticity of residual demand.
Price elasticity of demand= Qd/P
Price elasticity of supply= Qs/p
8. Residual demand:
▫ Dr (p)= D(p) – So(p)
▫ I.e., the residual demand for one firm’s output is the difference between
market demand and other firms’ supply

residual demand curve is much flatter than the market demand curve because that almost price
taker.
9. firm produces q and other firms produce Qo,
The elasticity of one firm’s residual demand= eM*(Qo+q)/q –eo*Qo/q (eM is the elasticity of
market demand and eo is the elasticity of other firms’ supply).
**If market demand is inelastic and firms are aggressive competitors-------supply elasticity eo is

high; Qo/q is large; still almost a price taker.

10. Welfare: the sum of net gains of all participants
• Efficiency: Welfare is maximized
• Dead weight loss: The loss of welfare

The deadweight loss due to an excise tax:

Single firm as a Price taker.

Profit = P∙ q – C(q) = (P-AC(q)) q

Market supply :Short run supply

markets are termed Contestable markets
free entry & exit: absolutely, no skill limitation, firm can sell any price.
.entry is absolute: sell 任何数量；price 低于 current price;then firm satisfy residual demand.
. exit is costless: Exit does not create sunk costs (hit-and-run).
▫ Telephone service / utilities (exit).
▫ Driveway snow removal / services (enter).
▫ Hospitals / professional services (exit).

• They think this concept can replace perfectly competitive markets.

11. a massive entry of small firms is followed by a shakeout

Baumol Model
How about startup (fixed) costs?
▫ If new firms have to start small due to large capital requirement and constrained
budget, then the existing firm’s residual demand cannot be affected much by
new firms’ supply
How about the sunk cost?
▫ In a short period, more costs are likely to be sunk. A hit-and-run entry will be
costly for new firms.
How do existing firms respond?
▫ They could threat to cut prices or create strategic entry barrier.