EC - 3.3 Revenues, costs and profits

total revenue (TR) formula

price × quantity sold

average revenue (AR) formula

total revenue ÷ quantity sold

marginal revenue (MR) formula

change in revenue ÷ change in quantity sold

What is average revenue?

The price received per unit sold

What is marginal revenue?

The revenue from selling an additional unit

What happens to TR when MR is positive?

TR increases

What happens to TR when MR is zero?

TR is at its maximum

What happens to TR when MR is negative?

TR decreases

What is the relationship between AR and the demand curve?

AR is the price and therefore represents the demand curve

For a linear demand curve, how does MR compare with AR?

MR has the same y-intercept and is twice as steep

What is the relationship between MR, price and PED?

MR = P(1 + 1/PED)

What does PED measure?

The responsiveness of quantity demanded to a change in price

What happens to TR when demand is elastic and price falls?

TR increases

What happens to TR when demand is inelastic and price falls?

TR decreases

What happens to TR and MR when PED = 1?

TR is maximised and MR = 0 (dP offsets dQ, so TR same)

total cost (TC) formula

TFC + TVC

What are total fixed costs (TFC)?

Costs that do not vary with output (only applies SR)

What are total variable costs (TVC)?

Costs that vary with the level of output

average total cost (ATC) formula

total cost ÷ quantity of output

average fixed cost (AFC) formula

total fixed costs ÷ quantity of output

average variable cost (AVC) formula

total variable costs ÷ quantity of output

marginal cost (MC) formula

change in cost ÷ change in quantity

What is marginal cost?

The cost of producing an additional unit of output

What happens to AFC as output increases?

AFC falls

What is the law of diminishing marginal productivity?

As the input of a variable factor increases while another factor is fixed, the additional output from each extra unit of the variable factor eventually falls

Why is diminishing marginal productivity a short-run concept?

It assumes that at least one factor of production is fixed

What is the short run?

The period in which all FoP is fixed except labour

What is the long run?

The period in which all factors of production can vary

What is the relationship between LRAC and short-run average cost curves (SRAC)?

LRAC is the envelope of the SRAC curves

Why can LRAC be below SRAC?

The firm can adjust its capital stock in the long run to suit its output level

What happens when a firm moves away from its output level for which its capital stock is designed?

SRAC > possible LRAC

What are economies of scale?

Producing on a larger scale reduces AC

What are constant returns to scale?

Range where LRAC constant as Q increases

What are technical economies of scale?

• Specialised equip

• Equip that would be expensive/underused in small firms (economies from indivisibilities)

• Container principle: Volume increases faster than length

What are economies from indivisibilities?

Lower AC from capital/prod processes only justified at large scales

Management EoS causes

• Management team does not need to grow as quickly as Q

• Different managers specialise in dpt.s

What are marketing economies of scale?

Marketing CoP rise less quickly than Q

What are financial economies of scale?

Large firms can raise finance on more favourable terms e.g. larger loans at lower IR as seen as lower risk of default

What are purchasing economies of scale?

• Buying raw materials in bulk

• Negotiating lower P

What can cause management diseconomies of scale?

Problems w/:

• Coordination

• Comms

• Bureaucracy

• Motivation

MES

Minimum Efficient Scale: Level of Q after which LRAC stops falling as Q rises

What is productive efficiency?

Minimising LRAC

What are internal economies of scale?

Economies of scale arising from the internal expansion of a firm

What are external economies of scale?

Economies of scale arising from the expansion of the industry

How are external economies of scale shown diagrammatically?

LRAC shift down

Example of industry expansion creating external EoS

More skilled labour → Lower training costs

Normal profit

Min. profit needed to cover TC of being in business, incl OC

How is normal profit treated in economics?

As part of the firm's total costs

What are supernormal profits?

Profits above normal profit

What is a loss?

TR < TC

What is the condition for profit maximisation?

MC = MR, with MC cutting MR from below

What does MC = MR where MC cuts MR from above represent?

Maximising loss

What is the short-run shut-down point?

AR = AVC (continuing creates larger loss than shut down)

Note: Shut down PAST this, i.e. AR < AVC, not only AT this

When does a firm shut down in the short run?

AR < AVC

Why can a firm continue operating while making a short-run loss?

Covers VC and some/no FC

What happens to fixed costs in the short run if a firm shuts down?

They still have to be paid

What is the long-run shut-down condition?

AR < LRAC

Why is the long-run shut-down condition different?

LR: all FoP vary, so firm can make normal profit

overhead cost

CoP not directly involved in prod (can be fixed/variable)

risk-bearing EoS

Diversification of diff G+S/regions

→ Safety net prevents risk of revenue drops/bankruptcy

supernormal + normal profit on diagram