Forms of

business organization,
production, and costs
 How is production organised?
 Markets
– work on one’s own-account (e.g., farmers)
– work by service-contractors (e.g., plumbers,
tailors)
 Firms with differing ownership structures:
– individual proprietorships
– partnerships (including share-tenancy)
– corporations
 Markets and firms
 (Firms) employment or wage-relationship
pay a definite amount (wage or salary) in
exchange for worker’s agreement to do the
employer’s bidding (within certain bounds)
 (Markets) sale or contract work
payment of a contract price to perform a pre-
determined piece of work (like paying a
definite price for a given good).
 Class of worker (%)
Philippines

2002* 2015**
Wage and salary workers 48.3 59.3
Own-account workers 38.5 30.8
Unpaid family workers 13.2 10.0

*October; **Full-year data

Note growing share of wage and salary workers.

 Why firms at all?
 transactions costs of using the market
need to draw up and enforce lengthy
contracts
slow to take up new technology
risks loss of control over innovations
 technology: taking advantage of
economies of large-scale production
 expansion: superiority of some types of
firms in raising funds for expansion
 Why firms at all?
Disadvantages from owners’ viewpoint
 monitoring costs
– incentives not directly related to output
– inherent opportunism among employees (so-
called “principal-agent” problem)
 obligations imposed by social legislation
– standards on pay and benefits (social
insurance)
– legal procedures for hiring, training, and firing
 Summary
Markets Firms
 no incentives problem  adaptability to new
 less encumbered by technologies and
social rules changing demand
 costly contracting and  accommodates large-
enforcement scale production
 slow response to or loss  advantage in financing
of control of new  costly monitoring of effort
technology  covered by rigid social
legislation
 Types of firms
 Sole proprietorships
– afford greatest degree of control
– but limited ability to attract outside funds
– expansion based on owner’s ability to borrow
on his own account
– owner’s entire wealth at stake
 Types of firms
 Partnerships
– a middle form permitting sharing of costs and
talents
– difficult to raise outside funds beyond wealth
and creditworthiness of partners
– unlimited liability: partners jointly and
individually liable for debts when bankruptcy
occurs
 Types of firms
 Joint-stock corporations
– a legal personality independent of owners; “immortal”
in principle
– “limited liability”: in case of bankruptcy, owners liable
only for the amount they originally contributed to the
firm
– attractive for outsiders to own shares of the firm,
providing funds for expansion
– but it may dilute control by original owners; (in
modern corporations, true control is with managers,
not the many shareholders)
 Summary
Liability Financing Owner
potential Control
Sole proprietor Full Low High

Partnership Full Low Shared

Corporation Limited High Limited

6.2 Technology and costs
 What are costs?
Objective of most firms is to maximise
profits,
profits the difference between revenue
and costs.
Profits = Total revenue - Total costs
Revenue: what the firm receives as sales
Costs: what the firm must pay to buy inputs.
 What are costs?
Economic costs are different from financial
costs.
Economic cost is opportunity cost -- not just
explicit cost but also implicit costs
(whether or not it requires an outlay of
money from the firm).
Example: using own saving versus
borrowing from a firm. Even own saving
has a cost, i.e., the interest foregone.
 What are costs?
Therefore economic profits are distinct from
accounting profits.

Accounting profit = Revenue - Accounting cost

= Revenue - (Explicit cost)
Economic profit = Revenue - Economic cost
= Revenue - (Explicit + implicit cost)
 Example
Revenue 100,000
Workers’ wages (20,000)
Interest on bank loan (5,000)
Equals: Accounting profit 75,000

Owner’s implicit wages (10,000)

Implicit interest on own capital (5,000)
Equals: Economic profit 60,000
 Why supply curves rise
Production function (definition): relationship
giving the maximum output that can be
produced by given input(s).
Marginal product (definition): increase in
output resulting from an additional unit of
one input, holding other inputs constant.
Law of diminishing marginal productivity:
observation that marginal productivity
declines as input increases.
 Production: digging a ditch
Capital Labour Output
(shovels) (workers) (m/day)
1 0 0 }4
1 1 4 }3
1 2 7 }2
1 3 9 }1
1 4 10
}0
1 5 10
 Total and marginal product
Total
product Total
product
10 (=10)

9
8 Marginal Area under
7 product curve (= 10)
6

4 4
3 3

2 2

1 1

1 2 3 4 5 1 2 3 4 5
Labour Labour
Production: digging a ditch

metres/day

Marginal
productivity
5 curve

1
labour
1 2 3 4 5 6
 Costs of production
Total cost (TC): cost of producing a particular level
of output
inputs used  respective price of inputs
E.g. (shovels used  price of shovels) +
(labour used  wage per person)
Marginal cost (MC): increase in total cost that
results from increasing production by one unit.
MC = TC/Q
Average cost (AC): cost per unit. (TC/Q)
 Again: digging a ditch
Capital Labour Output
(shovels) (workers) (m/day)
1 0 0}5
1 1 5 }4
1 2 9
}3
1 3 12
}2
1 4 14
1 5 15 } 1
 Production and cost:
digging a ditch
Shovel cost Labour cost Total cost Output
P50  1 P100  0 P 50 0
P50  1 P100  1 P150 5
P50  1 P100  2 P250 9
P50  1 P100  3 P350 12
P50  1 P100  4 P450 14
P50  1 P100  5 P550 15
P50  1 P100  6 P650 15
 Finally, marginal cost…
TC/Q TC/Q
TC Q = MC = ATC

50 0 -- --
150 5 100/5 = 20 30
250 9 100/4 = 25 27.8
350 12 100/3 = 33.3 29.2
450 14 100/2 = 50 32.1
550 15 100/1 = 100 36.7
Marginal cost and average cost
Marginal cost
(pesos)

Marginal cost
100

75

50
Average cost

25

Quantity
5 10 15
 Marginal cost and supply
 Marginal cost ultimately rises because
marginal product diminishes.
 Real reason: the contribution of a factor to
output declines because some other inputs
to production are held constant. (I.e., the
shovel in the example.)
 The marginal cost curve is the supply curve.
 (It cuts the average cost curve from below
at its minimum.)
 Why the MC curve
is the supply curve
 The supply curve answers the question:
“What is the minimum price at which a
supplier will sell a given quantity?”
 If producers maximise profits and each
unit can be sold at a price P0, profits are
maximised if output is expanded up to
the point where MC = P0.
 At that point, marginal cost equals
marginal benefit (the price).
Marginal cost and price
Marginal cost
(pesos)
MC
100
Difference
is profits
75

50 P0
Revenue
25
Cost
14
Quantity
5 10 15
 Why the MC curve
is the supply curve
 Since producers maximise profits, they will
produce by equating any price they
encounter with marginal cost.
 What is the same thing: the marginal cost
of producing a quantity is the minimum
they will accept for producing it at all.
 Hence their marginal cost curve is the
supply curve.
 Marginal and average cost
 Falling average cost implies marginal cost is below it.
 Rising average cost implies marginal cost is above it.
 Marginal cost equals average cost when average cost
is at a minimum.
 Many firms in real life don’t know their marginal cost,
but they know their average costs and use it to
approximate their marginal costs. Note that average
costs covers all costs per unit including normal profits.
 Fixed capital and fixed cost
Fixed capital cannot be changed in the
short-run and is part of fixed cost, which
does not vary with output.
Variable cost varies with output
Total cost = Fixed cost + Variable cost
Dividing by quantity:
ATC = AFC + AVC
 Fixed capital and fixed cost
AFC declines with output: its contribution to
average cost becomes smaller with greater
output.
AVC ultimately rises with output: its
contribution to average cost becomes
bigger: the same outlay on input produces
increasingly smaller output (owing to
diminishing marginal productivity of the
input).
 Production and cost:
digging a ditch
Shovel cost Labour cost Total cost Output
P50  1 P100  0 P 50 0
P50  1 P100  1 P150 5
P50  1 P100  2 P250 9
P50  1 P100  3 P350 12
P50  1 P100  4 P450 14
P50  1 P100  5 P550 15
P50  1 P100  6 P650 15
 Production and cost:
digging a ditch
FC VC TC Q AFC AVC ATC

50 0 50 0 -- -- --
50 100 150 5 10 20 30
50 200 250 9 5.6 22.2 27.8
50 300 350 12 4.2 25 29.2
50 400 450 14 3.6 28.5 32.1
50 500 550 15 3.3 33.3 36.6
50 600 650 15 3.3 40 43.3
 A numerical example
TFC = a ; TVC = bQ – cQ 2 + eQ 3
TC = a + bQ – cQ2 + eQ 3
ATC = a/Q + b – cQ + eQ 2
AVC = b – cQ + eQ 2
MC = b – 2cQ + 3eQ 2

a = 1000; b = 100; c = 50; e = 10 yields

TC = 1000 + 100Q – 50Q 2 + 10Q 3
A numerical example
MC

AC

AVC
 Profit-maximisation
and the shutdown point
Marginal cost
(pesos)
MC
Short run
supply
curve ATC

AVC
Breakeven

Shutdown

Quantity
 Profit-maximisation,
breakeven, and shutdown points
Marginal cost
(pesos)
Short run
supply
curve
ATC
P1

P0 AVC
Breakeven

Shutdown

Quantity
Q*
 Profit-maximisation,
breakeven, and shutdown
points
 Above the breakeven point, total revenue
is greater than total cost; economic profits
are positive. At the breakeven point, total
revenue just covers total cost.
 Between breakeven and shutdown points,
total revenue covers total variable cost but
not fixed cost.
 Long run and short run
 In the short-run, only one factor is
changed, all others held constant
 In the long-run all factors can be changed.
 Distinguish between short-run average
cost and long-run average cost.
 Returns to scale and
long run average cost
 How does average cost change if all factors are
changed proportionately?
F(K, L) = Q, e.g. (K L)1/2 = Q
Let F(5, 10) = 100.
F(10, 20) = 150? 200? 300?
 If inputs are doubled, does output double, less
than double, or more than double?
 Respectively constant, decreasing, and
increasing returns to scale.
 Returns to scale
 If inputs rise n > 1 times, total costs also
rise n times. Let TC0 = wL0 + rK0. Then if
the new input levels are nL0 and nK0:
TC1= w(nL0) + r(nK0)
= n(wL0) + n(wK0)
= n(wL0 + rK0)
= nTC0
 So, the new level of total cost will always
be n times the old one.
 Returns to scale
 But by how much does output rise? Suppose
output rises by k when inputs rise by n.
That is, Q1 = kQ0.
AC1 = TC1/Q1
= nTC0/kQ0
= (n/k)(TC0/Q0)
= (n/k)AC0
 So, in general, AC1 = (n/k)AC0.
 Returns to scale
 Let n be the proportional increase in
inputs, and k the proportional increase in
output:
 If k = n (constant returns) then
AC1 = AC0 (average cost is constant).
 If k > n (increasing returns) then
AC1 < AC0 (average cost is falling).
 If k < n (decreasing returns), then
AC1 > AC0 (average cost is rising).
Returns to scale and average cost
Average cost
AC3
AC2
AC1 Diminishing returns

Quantity
Returns to scale and average cost
Average cost
AC1 AC2 AC3

Constant returns

Quantity
Returns to scale and average cost
Average cost
AC1
AC2
AC3

Increasing returns

Quantity
 Implication
CRTS: minimum average cost remains
constant even as the scale of operations is
expanded.
IRTS: minimum average cost falls as the
scale of operations is expanded.
DRTS: minimum average cost rises as the
scale of operations is expanded.
Entrepreneur’s problem is to forecast long-run
price.
 A change in scale changes price
Average cost
MC1 AC1 AC2
MC2

D1

D0
Quantity
The change in scale occurs either because a single firm invests or other
firms enter the industry.
What accounts for
differing returns to scale?
1. Some physical or technological laws (e.g.,
dimensions of containers, pipes, buildings, etc.)
may lead to scale economies.
2. Entrepreneurship or human computational
abilities can be a hidden “fixed factor” that limits
expansion at the same rate.
3. Transactions costs can restrict growth of firms
(monitoring employees, enforcing contracts,
etc.)
Example: Doubling the surface area of a
cylinder quadruples its volume.
C1 = 2π(2r)= 4πr
C0 = 2πr A1 = 4πr2
A0 = πr2

r 2r

h h

2H
S 0 = h  C0 S1 = hC1 = h4πr
= h2πr = 2(h2πr) = 2S0

V 0 = h  A0 V1 = hA1 = 4hπr2
= hπr2 = 4V0
Another example:
volume of a sphere
Doubling the radius of a sphere quadruples the
area and increases its volume eight times.
A0 = 4 πr2 A1 = 4π(2r)2
= 4(4πr2)
= 4A0
V0 = (4/3)πr
(4/3) 3 V1 = (4/3)π(2r)
(4/3) 3

= (4/3)π8r3
= 8(4/3)πr3
= 8V0
Another example:
volume of a sphere
Doubling the radius of a sphere quadruples the
area and increases its volume eight times.
A0 = 4 πr2 A1 = 4π(2r)2
= 4(4πr2)
= 4A0
V0 = (4/3)πr
(4/3) 3 V1 = (4/3)π(2r)
(4/3) 3

= (4/3)π8r3
= 8(4/3)πr3
= 8V0
 Competition and monopoly
A firm’s price and quantity decisions will
depend on what it thinks is the
competition.
Two extremes:
perfect competition: “very many” firms
monopoly: a single seller or supplier
Perfect competition
 Perfect competition
Homogeneous product is sold
Very many firms supplying the market, each
making up only a small part of supply
Firms are free to enter or to leave the
business, as they please
Main implication: firms are “price takers”’,
taking prevailing prices of output and
inputs as given.
 Perfect competition
In the short run, perfectly competitive firms
may earn pure profits (when price is
greater than average cost).
But because of free entry, other firms can
enter the business. New suppliers bring
prices down for all firms.
Pure profits are competed away.
No further entry occurs when all firms
produce where MC = P = AC.
 Perfect competition
Marginal cost
(pesos) P = MC > AC
MC

AC
P

P = MC = AC

Quantity
Monopoly
 Monopoly
Product has few or no substitutes
Only one firm supplying product
Main implication: monopolist knows it can
influence price through its output
decisions.
Monopolist faces a downward-sloping
demand curve.
 Monopoly
What are the implications of confronting the
entire downward-sloping demand curve?
Increasing quantity can affect the price for
the entire supply:
Two opposing effects of selling more:
– revenue increases as more is sold at the same
price
– revenue decreases as the old quantity gets sold
at a lower price.
 Marginal revenue
Marginal revenue: what is the addition to
revenue if one more unit of output is sold
or produced?
For the firm in a perfectly competitive market,
this quantity is just the given price.
But for a monopolist, this will be a changing
quantity. Marginal revenue is always less
than or equal to price.
 Changes in revenue
Quantity Price Revenue R R/ Q
0 100 0 --
5 90 450 450 90.0
10 80 800 350 70.0
15 70 1050 250 50.0
20 60 1200 150 30.0
25 50 1250 50 10.0
30 40 1200 - 50 -10.0
35 30 1050 -150 - 30.0
40 20 800 -250 - 50.0
 The marginal revenue curve is
always below the demand curve
100
90

70

50

D
10

5 15 25
MR
 Monopoly
For the monopolist, marginal revenue is the
additional benefit of producing one more
unit. Marginal cost is the additional cost of
producing that same unit:
MR > MC increase output
MR < MC reduce output
MR = MC optimal output
(Same rule as for the perfect competitor,
except that P does not change.)
 The monopolist’s decision
100

MC
PM = 70
P* AC
MCM = 50
ACM
D

QM = 15 Q*
MR
 Analysing the
monopolist’s decision
1. Use the condition MR = MC to find the
profit-maximising quantity, QM.
2. Use the demand curve to find the price at
QM, namely PM.
3. Use the average cost curve to find the
average cost at QM, namely ACM
4. Compute profits as QM x (PM – ACM).
 Analysing the
monopolist’s decision
5. Note that if the cost curves under pefect
competition are the same as under
monopoly, the socially optimal output and
price are given by P* and Q*, where price
equals marginal cost.
6. P* < PM and Q* > QM so the monopolistic
result is a higher price and a lower output
than is socially optimal.
 Final remarks on monopoly
1. Monopolies tend to set output lower and price
higher than is socially optimal. As a result they
can earn extra profits that are not competed
away.
2. Contrarian view (J. Schumpeter) Even so,
monopoly profits might be necessary to
encourage innovation and entrepreneurship.
3. Hence government policies toward monopoly
must be differentiated: (a) restriction in
industries that involve old technologies; (b)
tolerance in those involving new ones.
 Final remarks on monopoly
Restrictive policies include: forms of price
control and various requirements to
perform or to supply the public.
Tolerant policies include: giving franchises
or concessions; patents and other
intellectual property rights.
 Some reasons for monopoly
State-assigned privileges, e.g., franchises
quotas, patents, etc.
Large capital requirements that deter entry
of competitors
Increasing returns to scale in the industry;
alternatively, a too-small market
Initial advantages of early innovators who
can saturate the markets.
Case 1: Increasing returns
D Left to maximise profits, the monopolist
sets output at Q1 and price at P1 and
MR
earning profits.
P1
If forced to set MC = P at P2 and Q2
the monopolist incures losses and
will lose the incentive to invest or to
innovate.
Controlled price at P = AC is an option.
P3
P2
AC
MC

Q1 Q3 Q2
Customers
 Case 1: Increasing returns
Example: electricity tranmission and distribution
(e.g., Meralco, or National Grid)
High capital requirements for the network not easily
redeployed (sunk costs).
Increasing returns to scale (decreasing average
costs) means entire market can be served more
cheaply by a single supplier.
Solution: allow only one supplier but control price
(mostly average cost pricing to allow a “fair rate
of return”).
 Case 2: Network economies
Some technologies are more useful the more people
use the same device or same standard
Examples: 220 v. 110 AC, phone lines, computer
and media formats (Windows, DVD, mp3, pdf,
docx, etc.), social networks (facebook, twitter),
Wikipedia
Typical result: a dominant format appears almost to
the exclusion of everything else. The
appearance of monopoly.
Frequently also a case of “battle of the sexes”.
 Other forms of industrial
organisation
Perfect competition: rice farmers, fisher folk
Monopolistic competition: restaurants, boutiques,
mall stores and stalls
Oligopoly: energy generation; oil companies;
malls; computer and software firms; cell phone
companies
a. Cournot oligopolies
b. cartel
Monopoly: electricity distribution and transmission
 Cournot oligopolists

B raises B doesn’t raise

A raises 4, 4 0, 5

A doesn’t raise 5, 0 2, 2
 Monopolistic competition
Free entry lowers demand
and eliminates excess profits.
MC
P1 AC

P2

MR1 D1
MR2
D2
 Micro: markets and the state
1. Allowing markets to work (permitting sellers and
buyers to pursue their interest as they see fit)
will generally work to society’s benefit.
2. In such cases, well-intentioned government
intervention can create more harm than good
and can lead to unintended consequences
(e.g., corruption, helping the wrong people,
disincentives to produce).
 Micro: markets and the state
3. But markets work poorly in the case of
public goods, externalities, common-pool
resources, and monopolies.
4. One response to public goods is taxation
and public provision.
5. Pigovian taxes also mitigate externalities;
although private negotiation will also
suffice in some situations where
transactions costs are low.
 Micro: markets and the state
6. Common-pool resources can be managed
by the state or by organisations and
communities, if these are cohesive
enough to make their own rules.
7. Monopolies can be regulated or might be
asked to face competition.
8. But some monopoly may be tolerated in
innovation-based activities.
Microeconomics: End