Industrial Organization

Competition, Strategy, Policy

Kelompok 1
Jemi Juneldi
Panji Adekantari
Resi Yunita
 Microeconomic Foundations
Chapter 2

Learning objectives
1. the Law of Diminishing Returns
2. short-run and long-run production functions
3. the relationship between production and costs
4. returns to scale and the minimum efficient scale
5. demand, revenue and elasticity
6. profit maximization
7. the neoclassical theory of the firm: perfect competition, m
onopoly and monopolistic competition
8. allocative and productive efficiency
9. welfare properties of perfect competition and monopoly
 2.1
Introduction

This chapter reviews the core elements of microecon

omic theory that underpin the economic models of fir
ms and industries developed elsewhere in this book.
The principal topics covered are production and cost
theory, demand theory and the neoclassical theory of
the firm, including the models of perfect competition,
monopoly and monopolistic competition.
2.2 Production and costs

“ Microeconomic theory assumes firms combine factor inputs through an efficient method of produc
tion in order to produce output. Economists distinguish between factors of production that the firm
can vary in the short run, and factors of production that cannot be varied in the short run but can va
ry in the long run. For example, by offering overtime to its current workforce or by hiring more wo
rkers, a firm might easily increase the amount of labour it employs in the short run; similarly, by re
ducing overtime or by laying workers off, a firm might easily reduce the amount of labour it emplo
ys. However, it is not possible for the firm to change the amount of capital it employs at short notic
e. New factories or offices take time to construct. New capital equipment has to be ordered in adva
nce, and orders take time to be fulfilled. Accordingly, for a firm that employs two factors of produc “
tion, labour and capital, it is usual to assume labour is variable in the short run, and capital is fixed
in the short run but variable in the long run.
A general expression for the long run production function of a firm that uses a labour inp
ut and a capital input is as follows:

q = f(L, K)

In the short run, labour is variable and capital fixed. Acc

ordingly, the expression for the firm’s short-run producti
on function, obtained by rewriting the long-run productio
n function, is as follows:
q = g(L)
 Short-run production and costs
Production theory

The short-run relationship between the quantity of labour employed and

the quantity of output produced is governed by the Law of Diminishing
Returns, sometimes alternatively known as the Law of Diminishing Ma
rginal Productivity. As increasing quantities of labour are used in conjuc
tion with a fixed quantity of capital, eventually the additional contributi
on that each successive unit of labour makes to total output starts to dec
line.
Name Here
Programmer
Table 2.1 Short-run production and costs: numerical example
Figure 2.1 illustrates the relationship between MPL and APL. It is important to notice that APL is increasing
whenever MPL > APL, and APL is decreasing whenever MPL < APL. This implies APL reaches its maximum
value at the point where MPL = APL.
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a. If the marginal contribution to total output of the last worker employed is higher t
han the average output per worker (MPL > APL), the last worker must be pulling th
e average up (so APL is increasing).
b. If the marginal contribution to total output of the last worker employed is lower t
han the average output per worker (MPL < APL), the last worker must be pulling th
e average down (so APL is decreasing).
This relationship between MPL and APL is also visible in the numerical exampl
e shown in columns 1 to 4 of Table 2.1.
Cost theory

The short-run relationship between inputs and output that is governed by the Law
of Diminishing Returns has direct implications for the firm’s cost structure in the s
hort run. However, before discussing the mechanics of cost theory, it is worth com
menting that the economist’s idea of items that should count towards a firm’s ‘cost
s’ differs slightly from that of an accountant when preparing a set of company acc
ounts. For an economist, costs encompass ‘rewards’ as well as monetary payments
, since in many cases the supply of an input involves no formal cash or monetary t
ransaction.
a. Opportunity cost of the financial investment: the return that the o
wners could have achieved had they invested their money elsewhere.
b. Normal profit is An economist would include in the firm’s cost fu
nctions an allowance for the reward the firm’s owners require in orde
r to remain in business.
c. Abnormal profit is additional return over and above the normal
profit
Figure 2.2 illustrates the relationship between the firm’s marginal and
average cost functions, SRMC, AVC, AFC and SRAC.

Figure 2.2 Short-run total cost, m

arginal cost, average variable and
fixed cost, and short-run average
cost
If the marginal cost of producing the last unit of output is lower than t
he average labour cost per unit of output (SRMC < AVC), the cost of
producing the last unit must be bringing the average down (so AVC is
decreasing)

If the marginal cost of producing the last unit of ou

tput is higher than the average labour cost per unit
of output (SRMC > AVC), the cost of producing th
e last unit must be pulling the average up (so AVC i
s increasing)
 Long-run production and costs

In the long run, the firm has the opportunity to overcome the short-run constraint
on production that is imposed by the Law of Diminishing Returns, by increasing i
ts usage of all inputs. In addition to employing more workers, it can acquire more
plant and machinery and move into a larger building. In other words, it can alter t
he scale of production.
The long-run relationship between the firm’s inputs and output is governed by ret
urns to scale. This refers to the proportionate increase in output that is achieved fr
om any given proportionate increase in all inputs
Figure 2.3 Increasing, constant and decreasing returns to scale

a. Increasing returns to scale occur

s when output increases more th
an proportionately to the increas
e in inputs
b. Constant returns to scale occurs
when output increases proportio
nately with an increase in inputs.
c. Decreasing returns to scale occu
rs when output increases less th
an proportionately to the increas
e in inputs.
Reading Figure 2.4 from left to right, each successive short run average cost curve refer
s to a larger scale of production.
a. Initially, as we move from K1 to K2 and SRAC1 to SRAC2, a larger scale of prod
uction generates lower average costs. This is due to increasing returns to scale, or ec
onomies of scale. Output increases more than proportionately to the increase in inpu
ts, so the average cost (per unit of output produced) decreases.
b. At some point, however, the opportunities for reducing average costs by increasin
g the scale of production are exhausted. As we move from K2 to K3 and SRAC2 to
SRAC3, a larger scale of production has no effect on average costs. This is the case
of constant returns to scale. Output increases in the same proportion as the increase i
n inputs, so the average cost (per unit of output produced) remains unchanged
c. If the scale of production is increased still further, average costs may eventually st
art to increase. As we move from K3 to K4 and SRAC3 to SRAC4, a larger scale of
production generates higher average costs. This is due to decreasing returns to scale,
or diseconomies of scale. Output increases less than proportionately to the increase i
n inputs, so the average cost (per unit of output produced) increases.
Figure 2.5 Short-run and long-run average cost functions

Figure 2.6 Isoquant and isocost functions

a. LRAC is decreasing when LRMC < LRAC. If the marginal cost of prod
ucing the last unit of output is lower than the average cost per unit of ou
tput, the cost of producing the last unit must be pulling the average dow
n, so LRAC is decreasing. In this case there are economies of scale.
b. LRAC reaches its minimum value at the point where LRMC = LRAC.
At this point there are constant returns to scale.
c. LRAC is increasing when LRMC > LRAC. If the marginal cost of prod
ucing the last unit of output is higher than the average cost per unit of o
utput, the cost of producing the last unit must be pulling the average up,
so LRAC is increasing. In this case there are diseconomies of scale.
Economies of scale

In this subsection, we consider in some detail why long-run average costs

should either decrease or increase as the firm alters its scale of production
in the long run. In other words, we examine the sources of economies of s
cale and diseconomies of scale..
Real economies arise from various technological relationships between inputs and
output that underlie the firm’s long-run production function. Some examples are as
follows:

a. Large-scale production may simply be more cost-effective than small-scal

e production. By producing at large volume, the firm can make use of larg
e machines that would not be feasible for a small-scale producer.
b. Indivisibilities of capital and labour inputs are also an important source of
economies for the large firm. Some types of capital equipment are ‘lumpy’
or indivisible.
c. Learning economies are another important source of cost savings (Spenc
e, 1981). Over time, workers and managers become more skilled as they re
peat the same tasks.
d. Geometric relationships between inputs and outputs can result in cost sa
vings as the scale of production increases. In some cases, costs may be pro
portional to surface area while outputs are proportional to volume.
Thank you