Unit 3: Theory of the Firm
In order to understand the mechanics of Industrial Organization, you
must have a solid grasp of microeconomic concepts, especially that of
competitive markets. We will therefore begin by reviewing some
principles of microeconomics. Even if the material seems familiar, take
your time reviewing it to ensure you fully grasp the particulars of each
The first part of this section will focus on the neoclassical theory of the firm that was taught in the principles course and introducing you to some new concepts. We will revisit marginal cost and average cost functions, both in the short run as well as in the long run. The course will then present "Economies of Scale" in order to review the relationship between long run average costs and output. "Economies of Scope," a concept that explains the existence of multiproduct firms, will also be discussed. Finally, we will learn about seller concentration, which will likely be new to you.
The second part of this section will introduce an alternate theory of the firm that was developed in order to counter the neoclassical theory of firm behavior. The neoclassical theory of firm behavior asserts that the firm's existence is a paradox because optimal outcomes can be costless and can be efficiently achieved through the price mechanism, or the "invisible hand." The Transaction Cost Approach to the Theory of the Firm (attributed to Ronald Coase), on the other hand, contends that there are costs involved in operating the market. The firm itself is an example of one of these costs. Thus, in order to fully understand the working of the economic system or establish sound economic policy, one must account for so-called "transaction costs."
Unit 3 Time Advisory
Time Advisory: This unit will take you 4 hours to complete.
· Subunits 3.1: 3 hours
· Subunits 3.2: 1 hour
Unit3 Learning Outcomes
Upon successful completion of this unit, students will be able to:
· Explain the intuition behind costs functions.
· Define and calculate marginal and average cost functions, both in the short run and in the long run, and describe the relationship between the two.
· Relate the cost functions to the behavior of firms.
· Define and calculate each of the following cost concepts:
o Opportunity costs,
o The economic costs of durable inputs,
o Avoidable costs and sunk expenditures,
o Short run versus the long run, and
o Variable and fixed costs.
· Define economies of scale.
· Identify the conditions that lead to, or create economies of scale.
· Define economies of scope.
· Define multiplant economies of scope.
· Distinguish between economies of scale, economies of scope, and multiplant economies of scope.
· Explain the dynamics between economies of scale and seller concentration.
· Describe the transaction cost approach to the theory of the firm, as created by Ronald Coase.
· Describe what is meant by transaction costs.
· Explain as in Ronald Coase's theory, the presence of market transactions despite the existence of large firms who can reproduce the conditions of a competitive market .
· Explain the Coase theorem.
3.1 Perfect Competition and Its Efficiency
3.1.1 Nature of the Firm
- Reading: Berkeley Electronic Press: Jeffrey R. Church and Roger
Ware's Industrial Organization: A Strategic Approach:"Chapter 3,
Section 3.1: A More Formal Introduction to IO"
Link: Berkeley Electronic Press: Jeffrey R. Church and Roger Ware's
Industrial Organization: A Strategic Approach: "Chapter 3, Section
3.1: A More Formal Introduction to
Instructions: If you did not save the PDF file from earlier subunits, please click “Download” to open up the PDF file of this entire book. Please scroll down the file until you reach sections 3.1.1-3.1.3, and then read all of these sections to review the cost concepts. Most of these should be familiar to you from the principles of microeconomics course. Please make sure to read all the Case Studies to further solidify your understanding of costs and how they pertain to a firm. This reading covers subunits 3.1.2-3.1.5.
3.1.2 Review of Cost Functions Note: This subunit is covered by the reading assigned under Unit 3.1.
3.1.3 Economies of Scale Note: This subunit is covered by the reading assigned under Unit 3.1.
3.1.4 Economies of Scope Note: This subunit is covered by the reading assigned under Unit 3.1.
3.1.5 Seller Concentration Note: This subunit is covered by the reading assigned under Unit 3.1.
3.2 Monopoly Pricing and Its Inefficiency
- Reading: Wikipedia.org: “Theory of the Firm”
Link: Wikipedia.org: “Theory of the
Instructions: Please scroll down this article to the section titled "Transaction Cost Theory" to learn the contribution that Ronald Coase made to the theory of the firm.
- Reading: San José State University: Professor Thayer Watkins's
“The Transaction Cost Approach to the Theory of the Firm”
Link: San José State University: Professor Thayer Watkins's “The
Transaction Cost Approach to the Theory of the
Instructions: Please read this article introducing the transaction cost theory and the Coase theorem. Please proceed to the hyperlink at the bottom of the page labeled "An Illustration of Coase's Theorem" and go through the numerical example to understand the basic notion behind Coase's theorem.