3.3 - Revenues, costs and profits

Question 1

What is the formula of total revenue (TR)

Answer 1

TR = Q x P

Question 2

What is the formula of average revenue (AR)

Answer 2

AR = TR / Quantity of output (Q)
The revenue generated by each individual unit sold

Question 3

What is the formula of marginal revenue (MR)

Answer 3

MR = change in TR / change in Q
Additional revenue generated by selling one more unit of output

Question 4

PED = elastic (greater than 1)
What happens to total revenue if prices increase and decrease

Answer 4

If firm decides to lower price - TR will increase because the percentage increase in quantity sold will be greater than percentage decrease in price

If firm raises price - TR will fall because the percentage decrease in quantity sold will be greater than the percentage increase in price

Question 5

PED = unitary (1)
What happens to total revenue if prices increase and decrease

Answer 5

A change in the firm’s price will have no effect on TR because the percentage increase in quantity sold will offset the percentage decrease in price

Question 6

PED = inelastic (below 1)
What happens to TR if prices increase and decrease

Answer 6

If firm lowers price, TR will fall because the percentage increase in quantity sold will be smaller than the percentage decrease in price

If firm raises price, TR will rise because the percentage decrease in quantity sold will be smaller than the percentage increase in price

Question 7

What is the formula of total cost (TC)

Answer 7

TC = AFC + AVC
AFC = remains constant regardless of the level of production
AVC = varies with the level of production

Question 8

What is the formula of average total cost (ATC)

Answer 8

ATC = TC / Quantity of output

Question 9

What is the formula of marginal cost (MC)

Answer 9

MC = change in TC / change in Q
Additional cost incurred when producing one more unit of output

Question 10

What are the 5 types of economies of scale?

Answer 10

1. Managerial - larger firms can gain from having specialised management teams, experitse, better coordination and more efficient decision making processes. This all leads to increased cost savings and increased efficiency
2. Financial - larger firms have access to more financial options (e.g. lower interest rates on loans and better terms from suppliers) due to their size and financial stability
3. Risk bearing - larger firms are better equipped to handle unexpected market fluctuations and risks (reducing overall costs of risk management)
4. Technical - when a firm can produce goods / services more efficiently as it increases scale of production (e.g. specialisation of labour, better utilisation of machinery and improved production processes)
5. Marketing - larger firms will have more resources to allocate on advertising and marketing efforts, this increases market presence and reduces advertising cost per unit sold

Question 11

What is diminishing marginal productivity?

Answer 11

The assumption that as a firm increases its variable costs (e.g. raw materials or labour) while keeping some inputs fixed (like machinery or factory space), the additional output generated by each additional unit of the variable input will decrease

Question 12

4 factors of diseconomies of scale

Answer 12

1. Managerial diseconomies - complex and less efficient management structure will lead communication breakdown and bureaucracy causing higher costs
2. Coordination and control problems - larger firms often struggle to control among various divisions and departments, leading to higher costs
3. Worker alienation - due to workers not aligning with company’s goals and values, productivity will drop and higher turnover rates
4. Communication changes - with increased size, communications become more challenging leading to miscommunication and errors, resulting in higher costs

Question 13

What is the Minimum Efficient Scale (MES)

Answer 13

The level of production at which a firm achieves the lowest possible long run average cost (LRAC) per unit of output

The point at which economies of scale is fully realised and any further production will lead to diseconomies of scale

Question 14

Why will firms struggle to operate below and above the MES?

Answer 14

Operating below the MES will mean that the firm is less competitive as there will be higher production costs

Operative above the MES will mean that the firm is more inefficient result in higher costs

Question 15

What is profit maximisation?

Answer 15

When a firm selects the level of output where economic profit is the highest

MC = MR

Question 16

What is normal profit?

Answer 16

The minimum level of profit required to keep a firm in that industry (TR = TC)

The firm covers all implicit and explicit costs but provides no extra income above those costs

Question 17

What is supernormal profits?

Answer 17

When a firm’s total revenue (TR) exceeds total costs (TC)

The firm is earning more than enough to cover all costs (including opportunity cost of the resources used)

Question 18

What are losses?

Answer 18

When a firm’s total cost (TC) exceeds total revenue (TR)
A firm could be forced to shut down in the short run if it is unable to cover variable costs (VC)