6 - Costs, revenues, and profit

IB 19/21

Total product (TP)

The total output that a firm produces, using its fixed and variable factors in a given time period.

Total Fixed Cost (TFC)

The cost(s) that does not vary with the quantity produced.TFC = The number of fixed factors * the cost of each fixed asset

Marginal Cost (MC)

The additional cost by producing one more unit of a productMC = Change in TC / Change in Q

Total Variable Cost (TVC)

The cost(s) that varies with the quantity produced. TVC = Number of variable factors * the cost of each variable factor

Total Cost (TC)

TC = total fixed costs + total variable costs

Example of fixed cost

- Rent- Insurance

Example of variable cost

- Raw materials- Labour (workers)

Example of marginal cost for a car producer and a pizzaria

Car producer: Cost of producing one extra car
Pizzaria: Cost of producing one extra pizza

Calculation of marginal cost (MC)

Change in total cost / Change in total output

Definition of short run

The period of time where at least one factor of production is fixed. All production takes place in the short run

Definition of long run

The period of time where all factors of production are variable, but the state of technology is fixed. All planning takes place in the long run.

Marginal Product (MP)

The extra output that is produced, on average, by each unit of the variable factor. E.g.: the output (amount of pizzas) one additional worker in a pizzaria produces

Average Product (AP)

The output that is produced, on average, by each unit of the variable factor. E.g.: The amount of pizza's each worker produces in a pizzaria

Calculations of marginal product (MP)

Change in total output / Change in the number of units the variable factor produces

Hypothesis of eventually diminishing marginal returns

As extra units of a variable factor are added to a given quantity of a fixed factor, the output from each additional unit of the variable factor will eventually diminish.

Hypothesis of eventually diminishing average returns

As extra units of a variable factor are added to a given quantity of a fixed factor, the output per unit of the variable factor will eventually diminish.

Example of law of diminishing returns

Jels Pizzaria. If it was only Ali working, the output would increase by employing, Hamsa. The output would further increase by employing me/Amina, and again increase by employing Ahmed. But by also employing Mohsen, the output will not increase as much. Mohsen's marginal product (amount of extra pizza's he could help us sell), would be smaller than Hamsa, Amina, and Ahmed's. We would start to all run into each other and cause more inefficiency than efficiency.

Explicit costs

Any costs to a firm that involve the direct payment of money. E.g., rent and wages- Factors that are purchased from others and not already owned by the firm -

Implicit costs

The earnings that a firm could have had if it had made use of its factors in another use, or if it had hired out or sold them to another firm. - Factors that are already owned by the firm -

Average Fixed Cost (AFC)

Fixed cost per unit of outputAFC = TFC/Q
*note, because TFC is a constant, the AFC will always fall as output increases. E.g. the amount of money that has to go to rent per unit becomes smaller and smaller the more units there are

Average Variable Cost (AVC)

Variable cost per unit of outputAVC = TVC/Q

Average Total Cost (ATC)

Total cost per unit of outputATC = TC/Q

Increasing returns to scale

When long-run average costs are falling as output increases.
A given percentage increase in all factors of production will lead to a greater percentage increase in output, thus reducing long-run average costs.

Constant returns to scale

When long-run average costs are constant as output increases.
A given percentage increase in all factors of production will lead to the same percentage increase in output, thus leaving long-run average costs the same.

Decreasing returns to scale

When long-run average costs are increasing as output increases.
A given percentage increase in all factors of production will lead to a smaller percentage increase in output, thus increasing long-run average.

Economies of scale

Factors that cause a producer's average cost per unit to decrease as output increases

Economies of scale: Specialisation

As firms grow, they're able to have their management specialise in individual areas of expertise, e.g. production, finance, marketing, and thus be more efficient

Economies of scale: Division of labour

As firms get bigger and demand increases, they're often able to break down their production processes and use division of labour to reduce their unit costs. Example: Workers on assembly lines at a conveyor belt

Economies of scale: Bulk buying

As firms get bigger they're often able to negotiate discounts with their suppliers that they could not have received if they were smaller / were buying smaller quantities

Economies of scale: financial economies

Banks tend to charge a lower interest rate to larger firms than smaller firms, since the risk of large firms not being able to pay back loans is less likely than for small firms

Economies of scale: transport economies

Large firms making bulk orders may be charged less for delivery / shipping than small firms. Also, larger firms might be able to have their own transport fleet

Economies of scale: large machines

Some machinery is too large to be owned by small firms, so they have to purchase the service from someone else owning the machine. Large firms can own the machinery themselves, which reduced the unit costs of production.

Economies of scale: promotional economies

Almost all firms try to promote their products by ads, PR, etc. etc. The costs of promotion tend not to increase by the same proportion as output. Meaning that if a firm gets much bigger, they will not start spending a whole lot extra on promotion, therefore the cost of promotion per unit of output decreases.

Diseconomies of scale

The situation in which a firm's long-run average costs rise as the firm increases output. This leads to decreasing returns to scale.
* (No evidence have been found of any firm becoming so large that diseconomies of scale started to outweigh the economies of scale in the long-run)

Diseconomies of scale: Control and communication problems

As firms grow in scale, the management will find it harder to control and coordinate the activities of the firm and this could lead to eventual inefficiency and thus increase the unit costs of production.

Diseconomies of scale: Alienation and loss of identity

As firms grow, workers and managers may begin to feel that they are only a very small part of a very big organisation. This could cause workers and managers to become less hard working and less productive, which could increase the unit costs of production

Internal economies and diseconomies of scale

All of the factors decreasing or increasing the unit costs, that a single firm might encounter

External economies and diseconomies of scale

Factors that come about when an entire industry increases and this has an effect on the unit costs of the individual firms.
Example: Growth of an industry in a given geographical area leads to universities etc. starting up courses that relate to the skills required in the industry.

Total Revenue (TR)

The total amount of money that a firm receives from selling a certain amount of good or service in a given time period. TR = P * Q

Average Revenue (AR)

The revenue that a firm receives per unit of its sales. (the price per unit)AR = TR / Q

Marginal Revenue (MR)

The extra revenue that a firm gains when it sells one more unit of a product in a given time periodAR = Change in TR / Change in Q

Formula of total profit

Total profit = Total revenue - economic costs (both explicit and implicit costs, meaning also the opportunity cost)

Abnormal profit (economic profit)

Where total revenue is greater than total costs, including opportunity cost

Normal profit (zero economic profit)

It is the amount of revenue needed to cover the total costs of production, including the opportunity costs. Normal profit is the exact amount needed to keep a firm running.

Loss (Negative Economic Profit)

A firm makes this profit when total revenue is less than total cost. Explicit costs maybe covered by implicit costs are not covered.

Shut-down price

The level of price that enables a firm to cover its variable costs in the short run, i.e. it is the price where price = AVC. If price does not cover AVC, then the firm will shut down in the short run

Break-even price

The price at which a firm is able to make normal profit in the long-run. That means it will break even, covering all of its costs, including the opportunity cost

Profit-maximising level of output

MR = MC

Other aims of firms than to maximise profits

- Corporate Social Responsibility: adopting ethical code to accommodate the public's interest
- Satisficing: Many workers and managers of firms will prioritise other stuff than to only maximise prift in the firm they are employed, which they typically do not even own, so they will not be affected too much if profit is maximised. They will instead work to satisfy, in order to keep their job, but not more.
- Growth and revenue maximisation