3.3 Revenue, Costs and Profits

Question 1

Types of Revenue

Answer 1

Total Revenue => total amount of money coming into the business through sale of goods and services
Quantity x Price

Average Revenue => demand is equal to AR
Total Revenue / Output

Marginal Revenue -> extra revenue firm earns from selling one more unit of production
Change in Total Revenue / Change in Output

Question 2

Price Elasticity
Perfectly Elastic Demand Curve

Answer 2

Firms are in perfect competition
Firms have no price setting power
Price received by firm for good is constant so MR=AR=D
TR curve is upwards sloping because prices are constant so more goods sold = more revenue

Question 3

Price Elasticity
Downward Sloping Demand Curve

Answer 3

For most goods, the price decreases as output increases => downward sloping demand curve => downward sloping AR curve
Demand curve for firm is the same as the firm’s AR revenue curve => indicates the price that consumers are willing to pay for each quantity sold
Imperfect competition and so have some price setting power

Question 4

Price Elasticity
Marginal Revenue

Answer 4

For goods with a downwards sloping demand curve, the elasticity of the curve is linked to MR
If MR is positive, firm sells product at lower price, TR grows and so demand is elastic until output Q
If MR is negative, TR decreases as price decreases and so demand curve is inelastic after output Q
Explains why TR curve is a U shape, first total revenue rises with output then it begins to decline

Question 5

Type of Costs

Answer 5

Total Costs => Fixed Costs + Variable Costs
Total Fixed Cost => Costs that don’t change with output
Total Variable Cost => Costs changing with output
Average Total Cost => Total Costs / Output
Average Fixed Cost => Total Fixed Costs / Output
Average Variable Cost => Total Variable Cost / Output
Marginal Cost => Change in Total Cost / Change in Output

Question 6

Short and Long Run Costs

Answer 6

Short run is the length of time when at least one factor of production is fixed and cannot be changed
Varies massively with different types of production
Long run is when all factors of production become variable

Question 7

Law of Diminishing Returns / Diminishing Marginal Productivity

Answer 7

If factor of production is fixed, business will be affected if it decides to expand. More workers can be added easily => increasing production
However, long time to expand and increased labour has no effect if there is no increase in machinery
=> if variable factor is increased when other factor is fixed, there will come a point when each extra unit of variable factor will produce less extra output than previous unit
Marginal output decreased in short run => marginal cost of production will rise

Question 8

Cost Curve
Factors Explanation

Answer 8

AFC starts high because fixed costs are being divided by small amount. As output increases, AFC falls
ATC is a U Shaped due to law of diminishing marginal productivity. Costs fall when machinery used more efficiently but efficiency falls as machinery is overused
AVC is U shaped but gets closer to ATC as output increases since AFC gets smaller
MC is U Shaped due to law of diminishing marginal productivity. Initially fall aa machines used more efficiently but rise as production rises

Question 9

Cost Curve
Diagram

Answer 9

Question 10

Cost Curve
Explanation

Answer 10

MC line always cuts AC line at lowest point on AC curve
=> If MC is below AC then AC continues to fall since producing one more costs less than average so average fall
=> If MC is above AC then AC rises, MC can be rising while AC is falling as long as MC is below AC

Question 11

Total Cost
Diagram

Answer 11

Each firm has different TC curve
If AC is constant, line would be a straight diagonal line from beginning at origin
When output is 0, FC = TC since there are no VC
AC can be worked out from TC curve
=> Point A, AC = C/D whilst point B, AC = E/F
AC at B < AC at A since gradient of A is steeper than B
Tangent to TC curve is MC

Question 12

Short Run (SR) and Long Run (LR) Cost
 Explanation

Answer 12

SRAC curves represent different factors of production
Placement of SRAC curves represent quantity of factors of production
At most efficient point of each SRAC curve, the LRAC curve is touched
Any point before the most efficient on the SRAC curves is inefficient use of factors of production
LRAC curve tends to be capital as it can usually only be changed in the LR

Question 13

Short Run and Long Run Cost Curve
Diagram

Answer 13

Until Q1, firm experiences economies of scale so sees falling LRAC
From Q1 to Q2, firm has constant returns to scale where LRAC is constant
Above Q2, firm experiences diseconomies of scale and their LRAC rises

Question 14

Shifts and Movements on LRAC Curve

Answer 14

LRAC curve is boundary representing minimum level of AC attainable at any given level of output
Points below LRAC are unattainable and producing above LRAC is inefficient
Movement along LRAC is due to change in output which changes AC of production due to internal economies/diseconomies of scale
Shift can occur due to external economies/diseconomies of scale, taxes/technology, which affect cost of production for a given level of output

Question 15

Economies and Diseconomies of Scale

Answer 15

EoS are advantages of large scale production that enable large businesses to produce at a lower AC than smaller businesses => firm is able to experience increasing returns to scale where an increase in inputs will lead to a greater percentage increase in outputs

DoS are disadvantages that arise in large businesses that reduce efficiency and cause AC to rise => decreasing returns to scale where outputs increase by a smaller percentage than inputs

Question 16

Economies and Diseconomies of Scale
Diagram

Answer 16

Minimum efficient scale is minimum level of output needed for a business to fully exploit economies of scale
It is the point where LRAC curve first levels off and when constant returns to scale is first met

Question 17

Internal Economies of Scale

Answer 17

Advantage that a firm is able to enjoy because of a growth in the firm, independent of anything happening to other firms or the industry in general

Technical Economies
Financial Economies
Managerial Economies
Risk Bearing Economies
Marketing and Purchasing Economies

Question 18

Internal Economies of Scale
Technical Economies

Answer 18

Arise as a result of what happened to the production process

Specilisation
Balanced Teams of Machines
Increased Dimensions
Indivisibility of Capital
Research and Development

Question 19

Internal Economies of Scale
Technical Economies
Specilisation

Answer 19

Large firms will be able to appoint specialist workers and buy specialist machines which will be able to do their jobs more quickly and better than machines/workers which are not specialised

Question 20

Internal Economies of Scale
Technical Economies
Balanced Teams of Machines

Answer 20

Large firms can afford to buy a number of every kind of machine for each stage of production
By combining these machines, they can ensure they run each machine at its optimal level
Smaller companies may only be able to afford one machine for each stage and if one stage of production runs faster than the other, machines will spend a long time turned off

Question 21

Internal Economies of Scale
Technical Economies
Increased Dimensions

Answer 21

This relates to the fact that if you double the size of the walls you can increase the area by four times, or if you double the size of a container, you increase the amount it can carry by more than double
This all occurs without doubling the cost

Question 22

Internal Economies of Scale
Technical Economies
Indivisibility of Capital

Answer 22

Some processes require huge items of machinery and investment that make it only possible for them to produce on a large scale

Question 23

Internal Economies of Scale
Technical Economies
Research and Development

Answer 23

Often it is only large firms that can afford to carry out large scale R&D, which means they are able to gain a large advantage over their competitors

Question 24

Internal Economies of Scale
Financial Economies

Answer 24

Large firms have greater security because they have more assets and are therefore less likely to be forced out of business overnight
=> it is easier for them to obtain finance and interest rates will be lower due to lower risk
This makes investment more accessible

Question 25

Internal Economies of Scale
Risk Bearing Economies

Answer 25

Large companies are able to operate in a range of different markets, producing different products => if one area of business fails, their whole business will not collapse

Question 26

Internal Economies of Scale
Managerial Economies

Answer 26

Large companies can afford to appoint specialist managers in every field, who are specialised and so have greater knowledge and are able to do their job better
Staff represent an Indivisibility and so small firms cannot employ specialist staff

Question 27

Internal Economies of Scale
Marketing and Purchasing Economies

Answer 27

Buying in Bulk => Large firms able to buy in large numbers so may be able to buy raw materials for cheaper than competitors
Specialisation => Businesses can afford to take on specialist buyers and sellers who could be more efficient due to time and knowledge
Distribution => Able to enjoy preferential rates from transport companies because they offer a lot of business, transport in big batches

Question 28

External Economies of Scale

Answer 28

An advantage which arise from growth of the industry within which the firm operates, independent to the firm itself
Cause LRAC curve to shift downwards

Labour
Support Services

Question 29

External Economies of Scale
Labour

Answer 29

Businesses established in an area with other successful firms from the same industry find that labour tends to come to that area if they want a job in that industry => reduces cost and time taken to recruit
Local education and training providers are more likely to develop courses to prepare people to take up jobs in these businesses
Firms able to hire staff who have been trained by other businesses => cheaper and more efficient

Question 30

External Economies of Scale
Support Services

Answer 30

Businesses who provide products or services for large businesses will naturally move to the area where those businesses are based => reduces transport cost/time delays for the business

Question 31

Diseconomies of Scale Factors

Answer 31

Workers
Geography
Change
Price of Materials
Management

Question 32

Diseconomies of Scale
Workers

Answer 32

In a large business, people can think their efforts go unnoticed and have less chance of promotion => lose motivation and work less hard
Also lose sense of belonging and have less personal commitment and identification with the business

Question 33

Diseconomies of Scale
Geography

Answer 33

A firm may have to transport finished products huge distances and firms may find it harder to control parts of the business which is miles away

Question 34

Diseconomies of Scale
Changes

Answer 34

It takes much longer and is much more difficult for a large firm to respond to change

Question 35

Diseconomies of Scale
Prices of Materials

Answer 35

As business grows so does their demand for raw materials and equipment
Although this can increase bargaining power as they buy in bulk, an increase in demand can cause prices to rise and therefore increase production costs
This could also occur if the whole industry increases and so firms bid up prices

Question 36

Diseconomies of Scale
Management

Answer 36

Coordination and Control => businesses become progressively more difficult to coordinate and keep control of all parts of business. Coordination of a multinational company producing different parts of a car around the world is much more difficult than coordinating and controlling work of a local garage => lead to poor quality work and business decisions which don’t work well together

Communication => can be slow and lose accuracy due to distance and number of people it has to be passed through

Question 37

Condition for Profit Maximisation

Answer 37

Profit is maximised when TR and TC are furthest apart with TR > TC
Also occurs when MC=MR => always true because if producing one more adds more revenue than it does to cost, producing that must increase profit and vice versa
MR and MC may cross at two points => profit maximising point is where MC rises as it crosses the MR line

Question 38

Normal Profit

Answer 38

Return that is sufficient to keep the factors of production committed to the business
Costs include level of profit needed to keep producer in the marker and to cover opportunity cost => if firm covers its costs, it earns normal profit
AC = AR
TC = TR
Break even point

Question 39

Supernormal Profit

Answer 39

If profit is greater than normal profit, it is earning supernormal, abnormal, or monopoly
AR > AC
TR > TC

Question 40

Losses

Answer 40

Where the firm fails to cover its costs
AR < AC
TR < TC

Question 41

Short Run and Long Run Shut Down Points

Answer 41

When making a loss, it is not necessarily the best decision to shut down => dependent on AVC
If AVC>AR then firm should leave industry as producing more increases loss
In LR, firms need to make at least normal profit for them to stay but in SR, they should produce as long as revenue covers VC hence SR shut down where AVC=AR

Question 42

Short Run and Long Run Shut Down Points
Diagram

Answer 42

Business continues to produce in SR
If they are profit maximising, they will produce MR=MC at Q1
Means price is P1, determined by the AR curve at this level of output, and their costs are C1, determined by the AC curve
Making a loss of the shaded area
AVC is only C2 and AR>AVC so they will produce in SR