3.3 - Revenue, costs and profits Flashcards
What is marginal revenue?
What is the formula for MR?
- The extra revenue that the firm earns from selling one more unit of production
- change in TR/ change in Q
What is average revenue?
What is the formula for AR?
- Shows how much revenue there is per unit of output
- TR/output
What is total revenue?
What is the formula for TR?
- The total amount of money coming into the business through sale of goods and services
- no. of units sold x cost per unit
What is the relationship between PED and MR?
- As price falls, elasticity changes from elastic to unitary elastic (midpoint) to inelastic - as Q falls, demand becomes more elastic
- When MR is positive, PED is elastic
- When MR is negative, PED is inelastic
- When MR is 0, PED = unitary elastic
What is marginal cost?
What is the formula for MC?
- The extra cost of producing one extra unit of a good
- Change in TC/ Change in Q
What is a fixed cost?
Give an example.
- Costs that don’t change with output and remain constant
- E.g. rent, machinery, salaries
What is a variable cost?
Give an example.
- Costs that change directly with output
- E.g. raw materials, electricity bills
What is total cost?
What is the formula for TC?
- The cost of producing a given level of output
- Fixed + variable costs
What is average cost?
What is the formula for AC?
- Cost per unit of output
- TC / Q
What is a perfectly elastic demand curve and how does this relate to revenue?
- These firms are in perfect competition - have no price-setting power, and it’s constant (MR=D=AR=P)
- TR curve is upward sloping - prices are constant -> more goods sold = more revenue
- Firms in imperfect competition have a downward sloping demand curve - price setting power
What is diminishing marginal productivity?
- If a variable factor is increased when another factor is fixed, there will come a point when each extra unit of the variable factor will produce less extra output than the previous unit
- Marginal output decreases as more inputs are added in the SR - marginal COP rises
What is diminishing marginal returns? When does it occur?
- Increased specialisation occurs as a firm grows in size -> productivity increases -> MC falls
- Additional labour beyond this point -> productivity falls -> fixed resources e.g. kitchen space, ovens
- Decreasing productivity is known as diminishing marginal returns
- Occurs only in the short-run - at least one FOP is fixed
Why is AC U-shaped?
- Due to the law of diminishing marginal returns (or productivity)
- Costs initially fall as machinery is used more efficiently, but as production continues to expand, efficiency falls as machinery is overused
Why is MC U-shaped?
- Due to the law of diminishing marginal returns
- It will iniatlly fall as machines are used more efficiently but will rise as production continues to rise
Why will the MC curve always cut the AC curve at its lowest point?
- If MC is below AC then AC will continue to fall since producing one more costs less than the average so the average falls
- If MC is above AC, then AC will rise
- Marginal costs can be rising while AC is still falling, as long as MC is still below MC
What is the relationship between the MC and AVC curve?
- When MC is below (MC<AVC) - MC drags AVC down because the cost of producing the next unit is lower than the average
- When MC is above (MC>AVC) - MC pulls AVC up and AVC starts to increase
What is the relationship between short-run and long-run cost curves?
- SRAC curves are u-shaped due to diminishing marginal returns
- LRAC curves are u-shaped due to economies and diseconomies of scale
Describe the LRAC and SRAC curves diagram?
- LRAC is an envelope to SRAC as it’s either equal to or below the relevant SRAC
- A firm may initially be set to produce a certain amount a day + have enough machinery to do so effectively
- They could become popular and need to produce more- in the SR SRAC increases due to diminishing marginal returns (fixed resources)
- In the LR (variable factors) SRAC shifts lower -> economies of scale and eventually constant returns to scale then diseconomies
What causes a movement along the LRAC and what causes a shift along the LRAC curve?
- Movement: due to a change in output - changes average COP due to internal economies/diseconomies of scale
- Shift: due to external economies/diseconomies, taxes, or technology - affects COP for a given level of output
What is economies of scale?
Occurs when an increase in the scale of output results in a lower cost per unit -> generates efficiencies that lower AC
What is diseconomies of scale?
Occurs when an increase in the scale of output results in a higher cost per unit
What is constant returns to scale?
Where firms increase inputs and receive an increase in output by the same percentage
What is the minimum efficient scale?
- The minimum level of output needed for a business to fully exploit economies of scale
- The point where the LRAC curve first levels off and when constant returns to scale is first met
What is an internal economy of scale?
Occur as a result of the growth in the scale of production within the firm - when increased output results in lower cost per unit
What are the different types of internal economies of scale?
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- Managerial
- Risk-bearing
- Purchasing
- Marketing
- Financial
- Technological
What are managerial economies of scale?
- Large firms can appoint specialist managers in every field - greater knowledge + able to do their job better
- Staff represent an indivisibility - small firms cant employ specialist staff
What are purchasing economies of scale?
- When large firms buy raw materials in greater volumes and receive a bulk purchase discount - lowers AC
What are marketing economies of scale?
- Larger firms spread the cost of advertising over a large number of sales - reduces AC
- Can also reuse marketing materials in different geographic regions - lowers AC
What is risk-bearing economies of scale?
- Occurs when a firm is able to spread the risk of failure by increasing its number of products e.g. greater product diversification - less failure lowers AC
What is financial economies of scale?
- Large firms often receive lower interest rates on loans than smaller firms - perceived as less risky -> cheaper loan lowers AC
What is technological economies of scale?
- Occurs as a firm can use its machinery at a higher level of capacity due to increased output -> spreads the cost of machinery over more units + invest in specialist capital -> lowers AC
- E.g. Spread Lettuce Farm in Japan - output is 50,000 a day -> run by robots monitoring, sunlight, watering plants etc
What is an external economy of scale and what are the different types?
- Occurs when there is an increase in the size of the industry in which the firm operates - benefits from lower AC generated by factors outside of the firm
Types:
- Knowledge transfers - when an industry expands, knowledge is transferred between firms - helps firms learn effective new production techniques -> LRAC falls - E.g. In LA’s film industry, the green screen technique was spread by knowledge transfer
- Recruitment costs - when an industry expands, lots of specialist workers will move to that area to find work -> easier to recruit workers -> lower recruitment costs -> LRAC falls - E.g. 60,000+ coders in Silicon Valley -> tech firms’ recruitment costs fall
- Transport links
- Geographic cluster
- Skilled labour
- Favourable legislation
How do geographic clusters lead to external economies of scale?
- As an industry grows, ancillary firms move closer to major manufacturers to cut costs & generate more business - lowers AC
- E.g. car manufacturers in Sunderland rely on 2500+ ancillary firms
How do transport links lead to external economies of scale?
- Improved transport links develop around growing industries in order to help get people to work & to improve transport logistics -> lower AC
- E.g. Bangalore (India’s Silicon Valley) - transport projects have been successful in transforming the movement of people & goods
How does skilled labour lead to external economies of scale?
- An increase in skilled labour can lower the cost of skilled labour -> lowering the AC
- The larger the geographic cluster, the larger the skilled pool of labour
How does favourable legislation lead to external economies of scale?
- Often generates significant reductions in AC as governments support certain industries in order to achieve their wider objectives
What are the causes of diseconomies of scale?
- Management: where managers work more in their own interest - lowers efficiency
- Communication: when a firm with multiple layers of management or geographic locations can’t communicate quickly & efficient
- Geographical: when a firm has widespread bases of operations -> logistical & communication challenges
- Cultural: when a firm expands into foreign markets where workers may have different cultural work norms
What are the 3 main reasons for internal diseconomies of scale? Give a real world example.
- Alienation: workers feel isolated from co-workers (cubicles in office spaces) -> productivity falls -> LRAC rises
- Bureaucracy: more managers = more forms needed to track work etc (admin is $21bn of NHS budget) -> LRAC rises
- Communication -> slows down -> productivity falls -> LRAC rises
What is the disctinction between normal and supernormal profit?
- Normal profit: breakeven, TR=TC
- Supernormal profit: TR>TC
What are short-run shut down points?
- In the SR, if the selling price is higher than AVC, the firm should keep producing (AR>AVC)
- If the selling price (AR) falls to the AVC it should shut down (AR<AVC)
What are long-run shut down points?
- In the LR, ATC=AVC
- LR shutdown - AR=ATC
- If AR>ATC -> profit is made on each unit -> stay in the market
- If the selling price (AR) is equal to or lower than ATC, the firm should shut down (AR<ATC)
When do you shift MC and/or AC?
- Changes in variable costs -> shift MC & AC
- Changes in fixed costs -> shift AC
