TUTORIAL 1 : ECF 625: 14 APRIL 2023

• Industrial Organisation
• Market Power
• Goal of firm
• Profit, Revenue and Cost
• Short run , Long run production cost theory
• Returns to scale and Economies of scale and scope
• Shut down and Profit Maximising rules
Industrial Organisation
 Industrial organization is a field of economics dealing with the strategic behavior of firms, regulatory
policy, antitrust policy and market competition. Industrial organization applies the economic theory of price to
industries.
 Economists and other academics who study industrial organization seek to increase understanding of the methods
by which industries operate, improve industries' contributions to economic welfare, and improve government
policy in relation to these industries.
 Industrial organization is an analysis of factors, operational or otherwise, that contribute to a firm's overall
strategy and product placement.
 It involves a study of different areas, from market power to product differentiation to industrial policy, that affect
a firm's operations.
The study of industrial organization builds on the theory of the firm a set of economic theories that describe, explain
and attempt to predict the nature of a firm in terms of its existence, behavior, structure and its relationship to the
market.
Rather, industrial organization is defined by its emphasis on market interactions, such as price competition, product
placing, advertising, research and development and more. 
More pertinently, the study of oligopolies (where a handful of big players dominate a market) gives industrial
organization its reason for being (whereas microeconomics focuses on perfect competition or extreme monopolies).

 Examples:
Markets of Interest to IO Economists

•Industrial Organization is concerned with the study of markets where firms have market
power, but more broadly with many aspects of firm decision making.  
•Over the past several decades, there has been extensive use of IO tools to model how firms
interact in markets in order to study a wide variety of policy issues:
 Energy Markets
 Financial Markets
 Healthcare
 Labor Markets
 Antitrust: Antitrust is a group of laws established to regulate business practices in order
to ensure that fair competition occurs in an open-market economy for the benefit of
consumers. Antitrust exist as regulations on the conduct of business and are a part of
competition law in the United States.
Definition of Market Power
What is a Market : a set of suppliers and demanders whose trading establishes the prices of goods.

Play a central role in the allocation of goods

Affect production decisions
Relation between profits, market power, and strategy
•A company with substantial market power has the ability to manipulate the market price and thereby
control its profit margin, and possibly the ability to increase obstacles to potential new entrants into the
market.
Market power refers to a company's relative ability to manipulate the price of an item in the
marketplace by manipulating the level of supply, demand or both. In markets with perfect or near-
perfect competition, producers have little pricing power and so must be price-takers.
•A company with substantial market power has the ability to manipulate the market price and thereby
control its profit margin, and possibly the ability to increase obstacles to potential new entrants into the
market.
•A successful strategy results in high customer retention, lower customer acquisition costs and higher
profitability.
Market Strategy
• A marketing strategy is a long-term plan for achieving a company's goals by
understanding the needs of customers and creating a distinct and sustainable competitive
advantage. It encompasses everything from determining who your customers are to
deciding what channels you use to reach those customers.
The Goal of Firms
 What is a Firm: A firm is a business organisation such as a corporation that produces and
sells goods and services with the aim of generating revenue and making a profit.

 To understand how firms behave , we need to understand what their goals are.
 Firms have objectives
 They attempt to dominate the market by maximising their sales or market share, even
though this might involve reducing their profit margins. Their ultimate aim is to
dominate the market to such an extent that they feel stable and secure
 A variety of managerial, behavioural and other theories have been developed to explain
the behaviour of firms that pursue other, non-profit-maximising goals.
 It is sufficient to focus on profit maximisation.
 Profit is an important objective of any privately- owned firm.
 If a firm is not profitable, it cannot continue to exist in the long run.
 That is why firms are sometimes defined as profit-seeking business enterprises
Profit, Revenue and Cost
What is profit?

Profit is simply the surplus of revenue over cost.

To understand the behaviour of a profit-maximising firm, we therefore

have to examine its revenue structure as well as its cost structure, with
a view to determining at which level of output the difference between
total revenue and total cost (ie the firm’s total profit) is at a maximum.

A firm’s total revenue (TR) is simply the total value of its sales and is
equal to the price (P) of its product multiplied by the quantity sold (Q).
TR= P(Q)
Continued………………….
Average revenue (AR ) is equal to total revenue (TR or PQ)
divided by the quantity sold (Q). AR=TR or PQ/Q

If all units are sold at the same price, then average revenue is
equal to the price of the product.
Marginal revenue (MR ) is the additional revenue earned by
selling an additional unit of the product.
Continue…………………………

A firm’s total revenue (TR) is the value of its sales, and is equal
to the price (P) of its product multiplied by the quantity (Q)
sold, that is TR = P × Q (or simply PQ)

A firm’s average revenue (AR) is equal to its total revenue (TR

or PQ) divided by the quantity sold (Q), that is AR= PQ/Q
If the firm sells all units of its product at the same price, then
average revenue is equal to the price of the product.
A firm’s marginal revenue (MR) is the additional revenue TR)
earned by selling an additional unit of the product (Q), that is
MR=
The short run and the long run-in production and cost
theory
Important distinction in production and cost theory is that between the
short and long run
Short-Run
o The short run is defined as the period during which at least one of the
inputs is fixed.
o Fixed inputs are those that can't easily be increased or decreased in a
short period of time. In the pizza example, the building is a fixed input.
Once the entrepreneur signs the lease, he or she is stuck in the building
until the lease expires. Fixed inputs define the firm's maximum output
capacity.
o An example would be a firm which has a factory in which certain
machinery has been installed and which can only vary its inputs of
labour, raw materials, etc.
Long-Run
In the long run all the inputs are variable.
o Variable inputs are those inputs of production that a firm can use as per its
requirement and make changes in it easily. For example, raw materials of
production, labor, capital, etc 
o For example, this would be a period that is long enough for the firm to
decide whether or not to open another factory or install additional
machines.
o The difference between the short run and the long run in production and
cost theory depends on the variability of the inputs and not on calendar
time.
o In some industries, for example the clothing industry, the actual period
required for all inputs to be variable might be quite short, while in other
industries, for example the steel industry, the actual period might be quite
long.
Costs

o To the economist, the cost of using something in a particular way is the

benefit forgone by not using it in the best alternative way. This is called
opportunity cost
o Whereas accountants, business people and others usually consider only
the actual expenses incurred to produce a product,
o the economist measures the cost of production as the best alternative
sacrificed (or forgone) by choosing to produce a particular product.
o The economist uses the opportunity cost principle to determine the value
of all the resources used in production.
Explicit cost

o The difference between accounting costs and economic costs can be explained
by distinguishing between explicit costs and implicit costs.
o Accountants tend to consider explicit costs only. Explicit costs are the
monetary payments for the factors of production and other inputs bought or
hired by the firm.
o Explicit costs are the out-of-pocket expenses incurred by a business in the
production of goods or services. These costs are easily identifiable and can be
directly attributed to a specific activity or business function. For example,
payments for wages and salaries, rent, or materials.
o These costs are, of course, also opportunity costs, since the payments for
inputs reflect opportunities that are sacriced. For example, if a firm pays R1
million for a certain machine, it means that it has decided not to do something
else with the funds (like purchasing a different machine, purchasing a
building or depositing the funds with a financial institution).
Implicit Costs
o Economists, however, use a broader concept of opportunity cost and consider
implicit costs as well as explicit costs.
o Implicit costs are those opportunity costs which are not reflected in monetary
payments.
o An implicit cost is a non-monetary opportunity cost that is the result of a business
– rather than incurring a direct, monetary expense – utilizing an asset or resource
that it already owns. The cost is a non-monetary one because there is no actual
payment by the business for the use of the existing resource. For example,
expanding a factory onto land already owned.
o They include the costs of self-owned or self-employed resources.
o The economist recognises that the use of resources owned by the firm is not free.
o For example, the owner of an individual proprietorship (ie a one-person business)
must consider what he or she would have earned if he or she had not been
running the firm (ie the opportunity cost of the owner’s time must be included in
the cost of production).
Fixed and variable costs
o Fixed cost is thus formally defined as cost that remains constant irrespective of the
quantity of output produced. The cost of using the land is therefore fxed. It does not
change when the quantity of labour is varied and the total product changes.
o Fixed costs are sometimes also called overhead costs, indirect costs or unavoidable
costs.
o The quantity of a variable input can be varied in the short run.
o In the case of our hypothetical maize farmer, labour is the variable input. We assume
that the price of a unit of labour is given and represents its opportunity cost.
o The cost of labour to the firm for the relevant period can therefore be calculated by
multiplying the number of units of labour employed, by the price per unit of labour.
o Variable cost is formally defined as cost that changes when total product changes –
it represents the cost of the variable input(s).
o Variable costs are sometimes called direct costs, prime costs or avoidable costs.
Total Cost
o The total cost (TC) is simply the sum of the total fixed cost TFC
and the total variable cost TVC associated with each level of
production.
Average and Marginal Cost

o To analyse a firm’s output decisions, we have to examine

average cost and marginal cost,
o Since there are three measures of total cost, there are also three
measures of average cost:
o Average fixed cost AFC (ie total fixed cost TFC divided by total
product TP
o Average variable cost AVC (ie total variable cost TVC divided
by total product TP)
o Average cost AC (ie total cost TC divided by total product TP)
Marginal Cost
o Marginal cost (MC) is the increase in total cost when one
additional unit of output is produced.
o Theoretically, we could distinguish between marginal fixed
cost, marginal variable cost and marginal (total) cost.
o However, total fixed cost remains unchanged when total
product increases.
o Therefore, marginal fixed cost is always zero and marginal cost
is always equal to marginal variable cost .
o By definition, marginal cost only consists of variable cost.
Justification for AFC, AVC, AC and MC Shapes
o AFC is L-shaped: as TP increases from zero, it starts at a very high value and
then keeps on declining until the maximum TP is reached.
o AVC, AC and MC are U-shaped: as TP increases from zero, they start at high
values, decline at decreasing rates, reach minimum points and then increase at
increasing rates.
o AC lies above AFC and AVC, because it includes them both. The vertical
distance between the AC and AFC curves is equal to AVC, and the vertical
distance between the AC and AVC curves is equal to AFC. As AFC declines, the
vertical distance between AC and AVC becomes smaller
o AVC reaches its minimum point before AC
o MC equals AVC and AC at their respective minimum points. Before these
points are reached, MC lies below AVC and AC respectively. Beyond these
points, that is, when total product is increased further, MC lies above AVC and
AC respectively
Revenue
As in the case of revenue, we distinguish between total, average and
marginal cost.
Total cost (TC) is simply the cost of producing a certain quantity of the
firm’s product.
Average cost (AC) is the total cost (TC) divided by the number of units (or
quantity) of the product produced (Q).
Marginal cost (MC) is the addition to total cost ( TC) required to produce an
additional (extra) unit of the product (Q).
Thus AC = TC /Q and
MC = TC/Q, thus if Q=1 then MC=TC
The relationships between total, average and marginal cost are the same as
the relationships between any other set of total, average and marginal
magnitudes.
Profit
Profit is the difference between revenue and cost.
In other words, a firm’s profit is the difference between the revenue it earns by
selling its product and the cost of producing it.
The economist’s definition of profit is, however, not the same as the
accountant’s definition of profit.
 Recall, from our discussion of cost, that accountants record events that have
already occurred.
Accounting profit is therefore an ex post concept based on recorded
transactions.
Economists, on the other hand, are interested in explaining and predicting
behaviour and do not necessarily deal with things that have already occurred.
Also recall that accountants usually consider only explicit costs, whereas
economists consider all costs, including implicit costs.
Normal Profits
The monetary payments that the firm’s resources could have
earned in their best alternative uses is called normal profit.
Normal profit can be regarded as the minimum return required
by the owner(s) of the firm to engage in a particular operation.

Normal profit forms part of the firm’s costs of production.

Thus, when an economist says that a firm is just covering its
costs, it means that all explicit and implicit costs are being met
and that the firm is earning a normal profit.
Economic Profits
Note: Implicit costs are those opportunity costs which are not reflected in actual
payments.
Economists,distinguish between total (or accounting) profit, normal profit and economic
profit:
Total (or accounting) profit is the difference between total revenue from the sale of the
firm’s product(s) and total explicit costs.
Normal profit is equal to the best return that the firm’s resources could earn elsewhere
and forms part of the cost of production. It is the difference between revenue that an
economic entity has received from its outputs and total costs of its inputs: TR-TC
Economic profit is the difference between total revenue from the sale of the firm’s
product(s) and total explicit and implicit costs (ie the total economic, or opportunity, costs
of all resources, including normal profit)
We thus have: Accounting profit =total revenue–total explicit costs.
Economic profit =total revenue–total costs (explicit and implicit), including normal profit
Economic Profit or Loss
Economic profit is the additional return to the owners of the firm, over
and above the opportunity cost of their own inputs (ie over and above
normal profit).
It is sometimes called excess profit, abnormal profit, supernormal profit
or pure profit .
It is equal to the amount by which revenue exceeds the opportunity cost
of all the resources used in production.
If the firm’s total sales revenue (or gross income) exceeds its total
economic costs, the firm makes economic profit
If total revenue equals total economic costs, the firm makes normal profit
If total economic costs exceed total revenue, the firm makes an economic
loss (ie negative economic profit).
Long-Run
In the long run there are no fixed inputs – all the inputs (including all the factors
of production) are variable. In the long run there are thus no fixed costs – all the
costs are variable. Moreover, the law of diminishing returns does not apply.
You will recall that this law refers to a situation where additional units of a
variable input are added to the fixed inputs.
There is therefore no compelling reason why long-run cost curves should exhibit
the same features as short-run curves.
In production theory the long run is defined as a period that is long enough for
the firm to change the quantities of all the inputs in the production process as
well as the process itself.
That would mean, for example, that there is enough time for the firm to build a
new factory, to install new machines and to use new techniques of production.
Returns to Scale
Refers to the long-run relationship between inputs and output.
Returns to scale are measured by varying all the inputs by a certain
percentage and comparing the resulting percentage change in production
with the percentage change in the inputs.
Three possible situations can be distinguished:
Constant returns to scale: where a given percentage increase in inputs will
give rise to the same percentage increase in output (eg a doubling of the
inputs leads to a doubling in output).
Increasing returns to scale: where a given percentage increase in inputs will
lead to a larger percentage increase in output (eg a doubling of the inputs
leads to a trebling of output).
Decreasing returns to scale: where a given percentage increase in inputs
will give rise to a smaller percentage increase in output (eg a 100% increase
in the inputs leads to a 50% increase in output).
Economies and Diseconomies of scale
Economies of Scale
A firm experiences economies of scale if costs per unit of output fall as the scale
of production increases.
Note : This may or may not be the result of increasing returns to scale. If a firm
experiences increasing returns to scale from its inputs, it means that the firm will
be using smaller and smaller amounts of inputs per unit of output as it expands.
Returns to scale refer to the relationship between inputs and output and
specically to a situation where all the inputs are increased by the same
percentage.
Economies of scale, on the other hand, refer to the relationship between costs
and output and specically to a decline in unit costs as output expands.
Moreover, economies of scale can be achieved by increasing the quantity or
productivity of only one or a few of the inputs, and where all the inputs are
increased they do not necessarily have to increase by the same percentage.
Diseconomies of Scale

This occurs when unit costs rise as output increases.

Economies and diseconomies of scale can be classied into two
broad groups: internal and external economies or diseconomies.
Internal economies or diseconomies are those pertaining to the
specific firm – they can be controlled by the firm.
External economies or diseconomies, on the other hand, are
outside the firm’s control and relate to conditions and events in
the industry and the broader environment within which the
firm operates.
Economies of Scope

Sometimes it is cheaper to produce two related goods in a single firm

rather than in two separate firms.
For example, motorcars and trucks , use common inputs such as
technical knowledge, engines and transmissions.
The major motor vehicle manufacturers therefore usually produce
both cars and trucks.
The cost savings achieved by producing related goods in one firm
rather than in two separate firms are called economies of scope.
Thus ,the average costs of a particular product decrease if product
range is increased
 A good South African example is Sasol, which produces a wide
range of related products
Shut down and Profit maximizing Rules

We assume that firms aim to maximise profit (the difference

between revenue and cost).
Cost was examined in detail above, but we still have to examine
revenue in more detail.
Total revenue (TR) from the production and sale of a product is
calculated by multiplying the quantity sold (Q) by the price (P)
of the product.
But the price of the product (and therefore also revenue)
depends on the structure of the market.
Relationship Between Firm and Markets

The behaviour of a firm depends on the features of the market

in which it sells its product(s) and on its production costs.
The major organisational features of a market are called the
structure of the market (or market structure).
These features include the number and relative sizes of sellers
and buyers, the degree of product differentiation, the
availability of information and the barriers to entry and exit
There about eight key features of the four different types of
market structure (perfect competition, monopolistic
competition, oligopoly and monopolistic).
Equilibrium Conditions for any firm
Firms operating in any market structure want to
maximise profit.
Economic profit is the difference between
revenue and cost (which includes normal profit).
To examine the behaviour of firms, we therefore
have to examine and combine their revenue and
cost structures.
 Once these are known, two decisions have to be
taken:
The Shut Down Rule(SDR)

The first rule is that a firm should produce only if total revenue is equal to, or
greater than, total variable cost (which includes normal profit).
This is often called the shut-down (or close-down) rule, but it can also be
called the start-up rule because it does not just indicate when a firm should
stop producing a product – it also indicates when a firm should start (or
restart) production.
The shut-down rule can also be stated in terms of unit costs – a firm should
produce only if average revenue (ie price) is equal to, or greater than, average
variable cost .
In the long run all costs are variable. Production should therefore take place in
the long run only if total revenue is sufficient to cover all costs of production.
This is quite straightforward. But what about the short run, when certain costs
are fixed? Should production occur only if total revenue is sufficient to cover
total costs (ie total fixed costs and total variable costs)?
SDR……………..

No
Once a firm is established, it cannot escape its fixed costs.
Fixed costs are incurred even if output is zero (ie if the firm
does not produce at all).
So, if the firm can earn a total revenue greater than its total
variable costs (or an average revenue greater than its average
variable costs), then the difference can help cover some of the
unavoidable fixed costs of the firm.
It would be advisable for the firm to maintain production in the
short run, even though it is operating at an economic loss.
SDR……………..

If total revenue(TR) is just sufcient to cover total variable costs(TVC)

(ie if average revenue is equal to average variable costs: AR=AVC) it
is immaterial whether or not the firm continues production – its loss
will be the same in both cases (ie equal to its fixed costs).
In such conditions firms tend to continue production in order to
retain their employees and clients.
If total revenue is not sufficient to cover total variable costs (ie if
average revenue is lower than average variable cost), the firm will not
produce, because to do so will result in a loss greater than its fixed
costs.
In other words, the firm’s losses will be minimised by not producing
at all.
Profit Maximising Rule (PMR)
The second rule is that firms should produce that quantity of the product
such that profits are maximised, or losses minimised.
Since the same rule applies for profit maximisation and loss minimisation,
we usually refer to profit maximisation only, and we do not always
mention that the aim is also to minimise losses
Profit maximisation can be explained in terms of total revenue (TR) and
total cost (TC) or in terms of marginal revenue (MR) and marginal cost
(MC).
Since profit is the difference between revenue and cost it is obvious that
profits are maximised where the positive difference between total revenue
and total cost is the greatest.
However, it is usually more useful to express the profit-maximisation
condition in terms of revenue and cost per unit of production.
The rule is that profit is maximised where marginal revenue (MR) is equal
to marginal cost (MC).
PMR………………
To understand why profits are maximised where MR = MC, it
is useful to consider what happens if MR is not equal to MC.
If marginal revenue MR (ie the addition to revenue as a result
of the production of an extra unit of the product) is greater than
marginal cost MC (ie the cost of producing that extra unit), the
firm is still making a profit on the last (extra) unit produced.
The firm can therefore add to its total profit by expanding its
production until no extra profit is made on the last unit
produced, that is, until the revenue earned from the last unit
(MR) is equal to the cost of producing the last unit (MC).
 At that quantity the firm’s profit is maximised.
PMR ……….Loss
If the firm continues producing beyond that point, the cost of
producing each additional unit of output (MC) will be greater
than the revenue gained from selling it (MR).
 In other words, the firm will make a loss on the production of
each additional unit of output and its profit will therefore
decrease.
 Profits are maximised when marginal revenue MR is just equal
to marginal cost MC.
The different possibilities may be summarised as follows:
PMR ………………..Summary
If MR is greater than MC (i.e., MR > MC), output should be
expanded.
If MR is equal to MC (i.e., MR = MC), profits are maximised.
If MR is lower than MC (i.e., MR < MC), output should be
reduced

Note: These are two rules that apply to any firm irrespective of
the type of market in which it operates.

END
 THANK YOU!

I appreciate you coming to the tutorial; the following week's session

will be held on Friday.

Have a great Evening