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ECN-337 (Industrial Org.) Chapter 2 Notes

ECN-337 (Industrial Org.) Chapter 2 Notes - Chapter 2 The...

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Chapter 2 : The Firm and Its Costs - Costs are a key determinant of firm behavior such as pricing. - You need to understand various types of costs in order to predict a firms behavior. - Section 2.1 : The Neoclassical Firm Traditional Neoclassical Firm – A firm with a clear set goal that it pursues without any wasted effort. Real World Firms – A firm that operates in many different product and geographical markets and is characterized by many operating divisions and levels. - Analyzing firm conduct becomes much more complicated without the assumption of profit maximization. Once the assumption is abandoned, analyzing firm decisions such as pricing and advertising strategies requires an examination not only of the market structure but also of the objectives of the firm . Section 2.2 : The Theory of the Firm - The Firm unlike the consumer, is not an individual decision maker. It can be regarded as a series of contracts between a number of parties, including: )1 The Workers )2 The Managers )3 The Suppliers of Capital The Contracts can be either: Page 1 of 13
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)1 Explicit - A contract between the firm and an organization such as a union [i.e. Ford and the United Automobile Workers.] )2 Implicit - Reflecting managers’ and workers’ understandings about the conditions of work. - Three Production Cost Advantages of using the market: )1 Production of some input is subject to substantial economies of scale , but an individual firm only requires a small quantity of the input. By aggregating the demands of many such small firms for that input, a single producer can realize economies of scale and produce at a lower average cost than if the firms produced it themselves. )2 Markets may aggregate related demands, allowing realization of economies of scope not available to a single firm. o Economies of Scope occur when it is less costly to produce two products together that to produce each separately. )3 Reduction of Risk – If there are uncertainties in demand for a single firm’s product, a market can reduce risk by pooling demands over many firms. o The risk reduction benefit of pooling occurs as long as the individual firms’ demands are not perfectly correlated. - There are costs of using the market, and in certain circumstances, these costs are high enough to outweigh the production cost advantages of the market. Specifically, if transaction costs are high, firms are likely to turn to internal production. Transaction Costs – Costs of using the market to conduct business; such as transportation, searching for a supplier, negotiating w/ supplier about contract terms, arranging for delivery, monitoring the quality of the input. Page 2 of 13
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- Two assumptions are important in Transaction Cost Economics : )1 Bounded Rationality – Limits on knowledge , foresight, skill, and time constrain individuals’ ability to solve complex problems.
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