3.3 Revenues, Costs And Profits

Question 1

Total revenue (TR) formula

Answer 1

= total amount of money coming into business though sales of goods & services

Total revenue = price x quantity

Question 2

Average revenue (AR) formula

Answer 2

Demand = AR

Average Revenue = Total revenue / quantity (output)

Question 3

Marginal revenue (MR) formula

Answer 3

= extra revenue firm earns from selling 1 more unit of output

Marginal revenue = change in revenue/change in quantity(output)

Question 4

Revenue curve for perfect competition

(diagram)

Answer 4

• firms in perfect competition have perfectly elastic demand curve (horizontal)
  (no price setting power so constant price so AR=MR=D)

Because of perfect info & many buyers/sellers, if firm increased prices, would lose all consumers as they would know.

TR (total revenue) curve upward sloping as prices are constant, increases at same rate so same gradient

Question 5

Revenue table for perfect information

(calculations, example, to explain diagram)

Answer 5

Prices within market same despite changes in quantity (eg. Price = 2)
Total revenue = price x quantity (2x1=2)
So total revenue increases at constant rate so marginal revenue same for each added unit (2)
Average revenue (total revenue / quantity) same for each quantity (2)

Their graph will show horizontal AR=MR=D curve at 2 & constant increasing gradient TR curve

Question 6

Revenue curve for imperfect competition

(diagram)

Answer 6

Firms in imperfect competition have some price setting power so downward sloping AR=D curve

Law of supply & demand operate as different goods/services produced, barriers to export/import, etc. so as price level decreases, quantity increases

Question 7

Revenue table for imperfect competition

(calculations, example, to explain graph)

Answer 7

Average revenue & marginal revenue decrease as quantity increases = both revenue lines (MR curve & AR curve downward sloping)

Marginal revenue decreases 2x average revenue (-2 vs -1) so MR curve 2x steeper than AR curve
Total revenue curve peaks at revenue maximisation point (price = 5) where marginal revenue = 0 then marginal revenue decreases so total revenue line decreases

Total revenue = parabola curve as marginal revenue counties to decrease as quantity increases at slower rate as closer to revenue maximisation point & faster rate as quantity increases after revenue maximisation point

Question 8

PED relationship with revenue (how price elasticity determines whether firms should increase or decrease prices to produce optimal amount of total revenue)

Answer 8

Important for firms to know whether they sell price elastic or price inelastic goods/services, can change price to produce optimal amount of total revenue

Price inelastic demand = firms better off increasing prices
Increase in price (P1 to P2) causes proportionally smaller decrease in quantity demanded (Q1 to Q2)
So total revenue increases (0-P1-A-Q1 to 0-P2-B-Q2)
Total revenue would decrease if price decreases

Price elastic demand = firms better off decreasing prices
Decrease in price (P1 to P2) causes proportionally larger increase in quantity demanded (Q1 to Q2)
So total revenue increases (0-P1-A-Q1 to 0-P2-B-Q2)
Total revenue would decrease if price increases

Question 9

Total cost

(formula + graph)

Answer 9

Total cost = total fixed cost + total variable cost (cost of producing a given level of output)

Total fixed costs (TFC) stays same, unchanged by output (straight horizontal line)

Total variable cost curve (TVC) influenced by diminishing marginal returns, as labour increases, productivity per worker increases so cost of labour spread over greater output (curve steep at first but gradually decreases in gradient)

But once fixed factors of production become over utilised, additional unit of labour added produces less output despite labour unit cost remaining same = increase in gradient as middle of curve (costs increase at greater rate & output increases at slower rate)

TC curve follows same shape as TVC cure as TC = TVC + TFC (and total fixed costs stays the same)
(Same starting value as at 0 output, variable costs are 0, space between TV and TVC curve = TFC

Question 10

Total variable costs formula

Answer 10

Total variable costs = variable cost x quantity

Question 11

Average (total) cost formula

Answer 11

Average (total) cost = total cost / quantity

Question 12

Average fixed costs

(formula & graph)

Answer 12

Average fixed cost = total fixed cost / quantity

Average fixed costs decrease as firms quantity produced (output) increases despite total fixed costs staying the same

Question 13

Average variable cost

(formula & graph)

Answer 13

Average variable cost = total variable cost / quantity

Average variable costs change with output
As demand increases for firm product, firm will need to increase amount of raw materials used to meet demand

Shape explained through law of diminishing marginal returns (as quantity of labour increases, total productivity increases due to specialisation so variable costs decrease. But after retain point, fixed factors of production become over utilised & labour constraints to limited space = output per worker decreases so average variable costs start to increase again

Question 14

Marginal cost formula

Answer 14

Marginal cost = change in cost / change in quantity

Question 15

Derivation of short run cost curves from assumption of diminishing marginal productivity

Answer 15

In short run at least 1 factor of production fixed, but in long run all factors of production variable
Eg. difficult for firms to respond to increases in demand through expansion as large amounts of money & time required to buy land. (assumed this factor is fixed but becomes variable in long run due to time.

Law of diminishing marginal productivity occurs with an increase in quantity of variable factors in short run (eg. labour, land) as fixed variable becomes over utilised, marginal productivity decreases so total productivity eventually decreases, firm will need to expand in long run

Question 16

Example of diminishing marginal productivity relating to short run cost curves (labour)

(with table & graph)

Answer 16

When 1st unit of labour added, marginal productivity increases (from 0 to 3)
When 2nd unit of labour added to fixed factor of production (land), marginal product increases more (workers can specialise on certain tasks = increased productivity)

But when 3rd & 4th unit of labour added, marginal productivity decreases (from 7 to 4) as workers constrained to fixed piece of land in short run, cramped working conditions so decreased productivity per worker

Added units of labour = fixed factors of production (land) becomes over utilised = total productivity decreases (from 15 to 12)

So firm will need to expand in long run

Question 17

Relationship between short run & long run average cost curves

Answer 17

In short run, firms constrained by certain fixed factors of production (eg. land)

(Can expand in long run)

But once firm purchases new factor of production (land), after a certain amount of labour units are added, diminishing marginal productivity /returns sets in again & they are constrained again

To stop this they will purchase extra land again and this will repeat

All these short run curves (SRAC) add up to make a long run curve (LRAC)

Question 18

Economies vs Diseconomies of scale

(with diagram)

Answer 18

Economies of scale = when average costs of firm decrease due to increased output

Diseconomies of scale = when average costs of firm increase due to increased output

(minimum efficient scale where curve first stops falling & levels off = minimum output required by firm to fully exploit economies of scale, within red lines is all output values in which firms fully exploit economies of scale)

Question 19

Internal vs external economies of scale

Answer 19

Internal economies of scale: when just individual firm benefits of increased output

External economies of scale: when entire industry grows, benefiting all firms within industry

Question 20

Internal economies of scale

Answer 20

Financial: bigger firms more likely to get bank loans with lower interest rates as often more reputable so investment is less risky

Technical: larger firms can afford specialist machinery so decrease in firms average cost so increased competitiveness in market
& division of labour to increase efficiency
Law of increased dimensions (increase h/w or warehouse leads to more than proportionate increase in cubic storage space available, more transport & distribution)

Managerial: larger firms can split into different departments & employ specialist managers (Human Resources, finance) increases efficiency & productivity as more knowledge

Marketing: larger firms so more output so marketing costs spread over larger output so firm can spend more money on marketing & has more leverage over advertisement companies in terms of price as more money available

Purchasing: large firms can purchase goods at lower prices as larger firm more likely to bulk buy so value of purchase more valuable to seller so can negotiate & get discounts or larger firms more reputable so seller trusts payments so may offer lower prices

Risk-bearing: larger firms have resources to release range of goods, some in different markets so firms can withstand fall in demand for one product as other goods doing well so dont rely on a few products

Question 21

External economies of scale

Answer 21

As industry grows, firms within industry often locate in same area (Silicon Valley)
= suppliers locate themselves in same place as firms in same market as lots of demand & transport costs decrease, can offer lower prices to firms = lower costs

= attracts labour that specialises in that industry to same area = firms have greater variety of skilled labour to choose from = more productivity

Eg. Tech advancement

Question 22

Diseconomies of scale

Answer 22

Control: as firm grows, layers of hierarchy are likely to increase so harder to control workers so their objectives align with shareholders (principle agent problem) leads to reduction in productivity so increase in average costs

Co-ordination & communication: increased layers of hierarchy so reduced co-ordination. Ideas / information flows difficult to implement across different departments

Motivation: workers in larger firms feel de-motivated as their work doesn’t have substantial impact on firm so their productivity drops so long run average costs of firm increase

Question 23

Condition of profit maximisation

Answer 23

• profit is maximised when TR (total revenue) and TC (total cost) are furthest apart (TR above TC)
• or when MC=MR (marginal cost = marginal revenue) if MR is higher than MC profits increase

Question 24

Explicit vs implicit costs

Answer 24

Explicit costs are easily quantifiable (labour, raw materials)

Implicit costs are not easily quantifiable (opportunity cost)

Important when working out economic profit (total revenue - total costs)

Question 25

Types of economic profit (normal vs supernormal profits vs losses (subnormal profits))

Answer 25

Normal profit: minimum level of profit needed to keep existing factories of production running at their current level (indicates factors of production being used efficiently, resources not better shifted elsewhere) (no economic profit as total revenue - total cost = 0)

Supernormal profit: any level of profit above normal profit, have a positive opportunity cost as using resources most efficiently (positive economic profit)

Losses (subnormal profit): level of profit made not enough to cover opportunity cost / existing factors of production (factors of production better shifted elsewhere) (economic loss)

Question 26

The shutdown condition

Answer 26

In short run, firms need to consider their total revenue, total fixed costs and total variable costs

If the firm shuts down, total variable costs & total revenue would drop to 0 but total fixed costs will stay the same regardless (don’t vary with output)

Loss if firm shuts down = TFC
Loss if firm stays open = TC-TR

So only rational to continue production in short term if total revenue > total variable costs

(But will be forced to shut down in long run as can’t keep missing fixed costs payments eg. rent, loan payments)

(if TR=TVC firms may choose to stay open eg. to keep existing employees employed or try to improve firm finances)

Question 27

Short run shut down-point (monopoly vs perfect competition in market)

(On diagram)

Answer 27

Firm’s short term shut-down point: AVC=AR

Monopoly diagram on left:
Firms average variable costs (AVC-A-Q1-0) greater than total revenue (P1-B-Q1-0)
So by shutting down, firm would save AVC-A-B-P1, minimising their losses
Subnormal profit (ATC-C-B-P1) can only be sustained in short run

Perfect competition diagram on right:

Question 28

Long run shut-down point (monopoly vs perfect competition market)

(+ diagram)

Answer 28

Firms long term shut-down point: ATC=AR

Monopoly diagram on left:
Total revenue (P1-B-Q1-0) greater than average variable costs (AVC-A-Q1-0)
So firm better off continuing production in short run
But as average total costs greater than total revenue can’t continue production in long run & will be forced to close
Subnormal profit (ATC-C-P1-B)