Econ 370E

Industrial Organization
Tolga Yuret
Cabral Chapter 2.

Acknowledgement: I prepare these slides by incorporating

Professor Murat Usman’s course slides that he cordially give
permission for us to use.
Consumer Surplus
Consumer Surplus
• the consumer’s surplus is the difference between willingness to pay
and price for all units purchased
A “quick” review of cost concepts
AC, MC, etc
The long list of cost functions
• the total cost
• the fixed cost
• the variable cost
• the average cost
• the average fixed cost
• the average variable cost
• the marginal cost
The total cost function, denoted by C(q), gives the minimum cost level associated
with a given level of output q.

C(q) has two components: C(q) = FC + VC(q)

Fixed costs FC, and variable costs VC(q)
Variable and Fixed Costs

Variable costs VC(q)

• change as the output level changes
• are zero if output level is zero
• e.g. cost of materials: as you produce fewer PC’s you need fewer
motherboards, memory chips, hard disks, etc.

Fixed costs FC
• do not depend on the output level
• e.g. lease payments for the machinery and equipment
Average cost and marginal cost

Average cost (aka “unit cost”):

total cost C divided by the output level q,
AC(q) = C(q)/q

Start with C(q) = FC(q) + VC(q), divide all terms by q

C(q)/q = FC/q + VC(q)/q
Average cost, AC Average variable cost, AVC
Average fixed cost, AFC
 the marginal cost!
The most important cost function that we need to make “good” decision
is
Marginal cost is

the increase in costs C when output q is increased by one unit.

the change (increase or decrease) in costs C when output q is changed by one unit.
the rate of change of costs C as output q is changed by an infinitesimal (infinitely
small) amount

C  q 
MC  as q  0
q
MC is computed as the derivative of the total cost function C(q) with respect to
output q.
Now it is your turn!
Pen and paper!
 Costs of a small…
“one-worker, one-machine” t-shirt factory
Factory Example
A small t-shirt factory uses one machine to
produce t-shirts. The machine is leased at
€20 a week, is operated by one worker and
produces 1 t-shirt per hour.
The worker is paid €1 per hour on weekdays
(Mon – Fri), €2 per hour on Saturdays , and
€3 per hour on Sundays. Working day is
max 8 hours by law. (strictly enforced.)
Other costs, such as raw materials,
electricity, etc., are €1 per t-shirt.
The factory produces 40 t-shirts per week.
For q = 40, please compute
• the total cost
• the fixed cost,
• the variable cost,
• the average cost, and
• the marginal cost.
Let’s define MC as the additional cost of
producing the last unit:
MC at q = 40 is the additional cost of producing
the 40th unit.
Figure 1.
Marginal cost and average cost in the T-shirt factory

0
Answers
Costs at the one-worker, one-machine t-shirt factory

The FIXED cost is €20: It is the lease for the machine.

When 40 t-shirts/per week are produced:
The raw material and labor costs are the VARIABLE costs: €80.
The TOTAL cost is €100: €20 for the machine, + €40 raw materials (40 units x €1), +
€40 labor cost (40 units x €1 per hour wage).

The machine is leased at €20 a week, is operated by one worker and

produces 1 t-shirt per hour.
The worker is paid €1 per hour on weekdays (Mon – Fri), €2 per hour
on Saturdays , and €3 per hour on Sundays. Working day is max 8
hours by law. (strictly enforced.)
Other costs, such as raw materials, electricity, etc., are €1 per t-shirt.
Costs at the one-worker, one-machine t-shirt factory

When 40 t-shirts/per week are produced:

TC = €100.
FC = €20
VC = €80.
The AVERAGE COST (aka the UNIT cost) is €100/40 = €2.5
The AVERAGE FIXED cost is €20/40 = €0.5
The AVERAGE VARIABLE cost is €80/40 = €2
Costs at the one-worker, one-machine t-shirt factory

For this specific example we define MC as the increase in costs when the
production of t-shirts is increased by 1 unit.
Suppose we produce one more t-shirt, the 40th.
Additional costs are €1 (labor) + €1 (raw material) = €2.
This €2 is the MARGINAL cost of producing the 40th t-shirt.

The machine is leased at €20 a week, is operated by one worker and

produces 1 t-shirt per hour.
The worker is paid €1 per hour on weekdays (Mon – Fri), €2 per hour
on Saturdays , and €3 per hour on Sundays. Working day is max 8
hours by law. (strictly enforced.)
Other costs, such as raw materials, electricity, etc., are €1 per t-shirt.
Now a bit of profit
maximization
The t-shirt factory

Benetton, the only buyer of t-shirts from our small factory, is offering a price of
Po per t-shirt. They will buy as many as the factory can supply.
The t-shirt factory

Benetton’s price is non-negotiable

Benetton’s price doesn’t depend on the quantity produced by the small firm, (it is a
constant unit price)
This makes our small firm a perfectly competitive (a price taking) firm!
The t-shirt factory

Benetton, the only buyer of t-shirts from our small factory, is offering a price of Po per t-shirt.
They will buy as many as the factory can supply.

1. What is the AC at full capacity?

2. What is the lowest price Benetton needs to offer so that the factory supplies at full capacity (56
t-shirts)?

The machine is leased at €20 a week, is operated by one worker and

produces 1 t-shirt per hour.
The worker is paid €1 per hour on weekdays (Mon – Fri), €2 per hour
on Saturdays , and €3 per hour on Sundays. Working day is max 8
hours by law. (strictly enforced.)
Other costs, such as raw materials, electricity, etc., are €1 per t-shirt.
Solution
The t-shirt factory

The rule for profit maximization for a competitive firm:

Choose a quantity at which your MC equals the price
P = MC(q*), q* is the profit maximizing q for the firm.
The rule for profit maximization for a competitive firm: P = MC(q*)

The logic is this:

Assuming that the MC is an increasing function of q, Start with q = 0 (assume at q = 0 MC < P!)
and keep increasing q one unit at a time as long as MC < P, and stop when MC > P.
If you can change q by very very small amounts then this rule will land you exactly
at q = q* where P = MC(q*).
The t-shirt factory

1. What is the AC at full capacity?

ANSWER: TC = 20 + 56x €1 + 40x €1 + 8x €2 + 8x €3 = 156
AC = 156/56 = 2.786

The machine is leased at €20 a week, is operated by one worker and

produces 1 t-shirt per hour.
The worker is paid €1 per hour on weekdays (Mon – Fri), €2 per hour
on Saturdays , and €3 per hour on Sundays. Working day is max 8
hours by law. (strictly enforced.)
Other costs, such as raw materials, electricity, etc., are €1 per t-shirt.
Benetton offers P = €3.5 per t-shirt.
How many t-shirts will the firm produce?

MC = €2 for 0 ≤ Q ≤ 40
MC = €3 for 40 < Q ≤ 48
MC = €4 for 48 < Q ≤ 56
Here MC at q = qo is defined as the additional cost of producing the qoth t-shirt!
When the price is €3.5, then P > MC if Q ≤ 48 but P < MC if Q > 48.

The machine is leased at €20 a week, is operated by one worker and

produces 1 t-shirt per hour.
The worker is paid €1 per hour on weekdays (Mon – Fri), €2 per hour
on Saturdays , and €3 per hour on Sundays. Working day is max 8
hours by law. (strictly enforced.)
Other costs, such as raw materials, electricity, etc., are €1 per t-shirt.
End of the cost function review
Try my favorite MC-AC question of all times…
Why AC is not a good cost function to determine the best level of q to produce

Currently you are producing 200 units of output.

1. Should you produce one more unit if you can sell it at P = 300?
2. Assuming that you are a firm in a competitive market, what is the range
of possible prices of your product so that q = 200 is the profit maximizing
output level?

Quantity Average cost

(units)
199 199
200 200
201 201
Opportunity Cost

The opportunity cost of using time, money, or any other resource for a
given purpose is defined as the foregone benefit from not applying the
resource in the best alternative use.
Sunk Cost
• A sunk cost is a cost that has already been incurred and cannot be
recovered. Fixed cost is considered to be a sunk cost.
 Economies of Scale

Economies of ATC
scale: ATC falls
as Q increases.
LRATC
Constant returns
to scale: ATC
stays the same
as Q increases.
Diseconomies of
Q
scale: ATC rises
as Q increases.
Economies of Scale

• Plumbing vs. Newspaper.

• Why there are few newspaper companies whereas lot’s of plumbing

firms.
Economies of Scope
Price Elasticity of Demand
Example
• P=4-3q for an individual firm.

• What is the market demand curve if there are 100 firms?

• What is the price elasticity of market demand?

Example Continued
• Q=(400-100P)/3

• Elasticity=(100/3)/(400-100P/3P)
Profit Maximization
Profit Maximization

• MR=MC

• So in perfect competition elasticity -> infinity: MR=P=MC

Skipped Chapters
• Chapter 3. The firm

• Chapter 4. Games and Strategy. (Review)