McGill University Econ 305

Department of Economics Dhanoos (Dee) Sutthiphisal

LECTURE NOTE 1: INTRODUCTION

This note gives an overview of industrial organization as well as provides a brief review on
various cost concepts we will use throughout the course.

1. Overview of Industrial Organization

1.1. What is industrial organization?
Industrial organization (IO) is a field within economics that is concerned with the workings
of markets and industries, particularly the way firms compete with each other. Here are a few
examples of research questions in IO.
 How much freedom a firm has in setting its product prices?
 What type of ownership structure (e.g. partnership and corporation) would be
suitable for a particular business?
 Should two firms merge into one single firm?
 Should a country adopt a more stringent intellectual property rights law?
These questions would be of interests for managers, regulators and policy makers. To
answer these questions, IO economists develop theories and test them against real world
observation. (In other words, IO is an applied economics field.) The literature (topics wise)
can be divided into two main branches:
(i) Market Structure. Treats the firm as a black box and focuses on how firms compete
with each other, sometimes referred to as “horizontal issues” in IO.
(ii) Theory of the Firm. Looks inside the black box, attempting to understand the
essence to the existence/role of firms in our economy, asks the question: why do
firms make some things themselves and buy some things from other firms,
sometimes referred to as “vertical issues” in IO.
In this class, we focus on the horizontal issues.

1.2 A brief history of IO

I. Harvard Tradition (1940–60)
 Develop the methodology called Structure-Conduct-Performance (SCP). The idea is
as follows. Based on a given market structure, firms are expected to conduct
themselves in a certain way. (For example, a firm in a two-firm market would behave
very differently from a firm in a ten-firm market.) These different conducts would
lead to different industry performance (e.g. social welfare and stock values).
o Structure includes number of firms and products which depend on basic
market conditions such as technology, existing constraints, and market
demand for products.

Lecture Note 1: Introduction 1/6 Econ 305

 o Conduct includes prices and quantities and qualities firms set, competition,
whether to advertise and the level of advertisement, firms’ decisions
o Performance includes consumer surplus, government tax revenue, profits,
and stock values.
 Typically, OLS regressions are used to identify correlations between structure and
performance at an industry level, i.e. a cross-industry comparison. For example, the
profit of an industry i is a function of variables that reflect the industry’s market
structure such as number of firms.
 The outcome of the SCP research often argues market power exists and is
detrimental to consumers. This work paved the way for much anti-trust legislation.
 Main weakness of SCP is that it assumes the structure to be exogenous (or pre-
determined). However, this is not realistic because structure probably evolves
together with conduct and performance.

II. Chicago School (1960–80)

 Actually, it is Chicago-UCLA.
 Put emphasis on price theory (by explicitly using utility and profit maximizing
behaviour of market participants in a model – not necessarily one with mathematical
derivation, could be a logical argumentative model).
 Have a strong belief in “free” markets or “market works.”
 De-emphasized market power.
 Firms become big for particular reasons and being big is not a sin.
 More careful application of econometric techniques.

III. Game Theory (1980–90)

 Still utility and profit maximizing behaviour but put emphasis on strategic decision-
making (e.g. Nash equilibrium concept).
 Utilize formal math model.
 There are many many models, but hard to know what is the right model for any
particular real world issue.

IV. New Empirical IO (1990–)

 Bringing together of economic theory and econometrics
 Sophisticated, computationally intense, complex empirical models
 Not all researchers like these approaches, but it is evolving all the time

Lecture Note 1: Introduction 2/6 Econ 305

1.3 Recent focus in IO
 R&D (research and development) spillovers
 Information as a product
 Learning-by-doing
 Advertising
 Firm entry and exit
 Merger Analysis
 Regulation such as anti-trust
 Product choice
 Multi-plant and multinational firms
 Price discrimination
 Boundaries of the firm
 Many others, such as auction

2. Review of Various Cost Concepts

First thing first, in economics we consider opportunity costs rather than accounting costs in our
analysis. An opportunity cost is the value of the best forgone alternative use of resource (for
a particular action). For example, an opportunity cost of using an asset already owned by a
firm is the highest return the asset could have generated if rented to another firm. On the
other hand, an accounting cost is the cost reported on the accounting book.

A fixed cost is a cost that does not vary with level of output, e.g. fee for renting space.

A sunk cost is a fixed cost that is not recoverable. (Typically, it is a very long run fixed cost.)
An example for a sunk cost would be a license fee for alcohol permit. It is a one-time fee,
not transferable. In contrast, the fee for renting space can be recovered by subleasing the
space.
A variable cost is a cost that changes with the level of output, e.g. labor and material costs. In
other words, the total variable cost depends on the number of units produced.
Define the abbreviation for each type of costs as follows.
 Total Cost (TC)  Average Total Cost (ATC)
 Total Fixed Cost (TFC)  Average Fixed Cost (AFC)
 Total Variable Cost (TVC)  Average Variable Cost (AVC)
 Level of Output (q)

We have the following relationships.

Lecture Note 1: Introduction 3/6 Econ 305

 TC  TFC  TVC
TC TVC TFC
ATC  AVC  AFC 
q q q

Hence, it is obvious that

ATC  AFC  AVC .

A marginal cost (MC) is the increase in total cost that results from producing an additional (or
marginal) unit of output.

Example 1. Suppose the fixed cost is 100 and the variable cost is 10q. What is TC, ATC,
AFC, AVC and MC?

Answer: We have
TC  TFC  TVC  100  10 q
This means
TC at q  1 is 100  10  1  110
TC at q  2 is 100  10  2  120 .
Therefore, we have
MC  120  110  10
TC 100  10q 100
ATC     10
q q q
TFC 100
AFC  
q q
TVC 10q
AVC    10 .
q q

Lecture Note 1: Introduction 4/6 Econ 305

How are these costs related in a graph?

MC
ATC
AVC

A
B AFC
q

AFC is always decreasing. More importantly, where point A is the lowest ATC and point B is
the lowest AVC. Why?

Think of MC as your grade for the course, while ATC (or AVC) is your McGill GPA. If your
grade for this course is higher than your GPA (to the right of point A), then your GPA will
increase. If your grade for this course is lower than your GPA (to the left of point A), then
your GPA will decrease. If your course grade is the same as your GPA (point A), then there
will be no change in your GPA.

In the short-run, a firm would likely get stuck with whatever the plant it has for making its
product which may not be optimal for meeting its output level. However, in the long-run, a
firm may build a new plant that is more suitable for its output level, and hence lower the
cost. Consequently, a long-run average cost (LRAC) curve would be the envelope of the
short-run average cost (SRAC) curves as shown in the graph below.

AC1 AC3

LRAC
AC2

Lecture Note 1: Introduction 5/6 Econ 305

What would happen to the SRAC and LRAC if wage rises? Holding all else constant, the
SRAC will shift up because the variable costs are higher. However, in the long-run, firms
may substitute capital for labor. Therefore, the LRAC will shift up as well, but the shift could
be less if there is a possibility of substitution.
Economies of scale (or increasing returns to scale) is a long-run cost concept. A firm is said to
have economies of scale when its (long-run) average cost falls as output increases, i.e. LRAC
is decreasing (when MC < LRAC). We expect economies of scale to exist if:
 There are high fixed costs (e.g. telecommunication industry).
 There are gains from specialization which arises as levels of output increase (e.g.
Ford Model T production).
 There is learning-by-doing.
Economies of scope when it is cheaper to produce multiple products together rather than
separately (e.g. beef and cowhides).

Lecture Note 1: Introduction 6/6 Econ 305