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

AR curve is firms demand curve
Average revenue curve is the price of the good

Average revenue is the average receipt per unit

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)

MR=0, total revenue is maximised

Question 4

Revenue curve for perfect competition

(diagram)

Answer 4

• firms in perfect competition have perfectly elastic demand curve (horizontal)

Firms are price takers- AR 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

SEE SAVEMYEXAMS

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

MR curve is twice as steep as the AR curve= trend line. Firms to sell extra units of quantity, reduce price of all
units that preceded that, MR falls at faster rate

§ Shows the perfectly elastic demand for their goods. AR= the demand curve, AR is the price of the good, and the
demand curve shows the relationship between price and quantity. Average revenue=marginal revenue=demand

TR= max when MR=0.) MR is decreasing, up until MR is 0 always MORE TOTAL REV BEING GENERATED. As MR is decreasing, rate at which TR is increasing will be slower, up until MR = 0 (NO MORE EXTRA REV TO BE GAINED. TR hits its peak. MR goes negative

Imperfect info:

Few buyers and sellers
Differentiated goods
Price makers
High barriers to entry/exit
Imperfect info

Question 7

Revenue table for imperfect competition

(calculations, example, to explain graph)

Answer 7

SEE SAVEMYEXAMS

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

The total revenue rule states that in order to maximise revenue, firms should increase the price of products that are inelastic in demand and decrease prices on products that are elastic in demand

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). Eg- rents, advertising, capital goods

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

Firms total variable costs increase, both its marginal cost curve and average cost curve shift upwards. When a firms total costs increase, only its average cost curve shifts upwards.

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

The variable factor assumed to be labour and fixed factors = land and capital. By adding more labour initially there are productivity improvements as underutilised fixed factors are used up and specialisation gains take place - leads to an initial rise in marginal product and fall in marginal costs.

Eventually however when more workers are hired they get in the way of one another- FC s of production constraining production therefore labour productivity falls reducing marginal product not increasing marginal costs

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)

Long run- all factors of production are variable where the ROI decisions when increasing output is needed to understand the average cost relationship. The long run average cost curve is shaped due to increasing and decreasing returns to scale as a result of economies and diseconomies of scale. The minimum efficient scale of production occurs where full economies of scale have been exploited. The point of lowest LRAC is the minimum efficient scale. This is where the optimum level of output is since costs are lowest

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. Average costs of production fall as output increases.

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

Question 20

Internal economies of scale

Answer 20

KEY POINT: Total costs are rising but more slowly than output reducing unit costs of production

REALLY FUN MUMS TRY MAKING PIES

Financial: negotiate lower rates of interest on loans for investment as banks more willing to loan to bigger firms. Total costs are rising but more slowly than output reducing unit costs of production

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. Double size of its lorry might increase its capacity by 3 times.). Reduces AC and unit costs of production

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

Marketing: use size and dominance to negotiate bulk deals and discount when marketing. Total costs are rising more slowly than output reducing unit cost of production

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: When a firm becomes larger, they can expand their production range. Therefore, they can spread the cost of uncertainty. If one part is not successful, they have other parts to fall back on

Question 21

External economies of scale

Answer 21

TOTAL COSTS DECREASE- Average cost decrease

As industry grows, firms within industry often locate in same area (Silicon Valley, IT industry attracted lots of specialized workers)
= 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

Improvement in transport infrastructure- improve locality, reduce costs of production, reduce unit cost

Material suppliers move closer to where a business is located- reduce cost of accessing these, reduce total/unit cost

R & D firms move close to where business is located- benefit innovation, reduce costs, increase productivity, reduce unit costs of production

Question 22

Diseconomies of scale

Answer 22

Communication- difficult to monitor, communicate, managing becomes harder- reduces productivity- increase unit cost of production.

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: increased layers of hierarchy so reduced co-ordination. Ideas / information flows difficult to implement across different departments. Reduces productivity- increases unit cost. Time consuming

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

What is the minimum efficient scale?

Answer 23

The minimum efficient scale is the lowest cost point on a long - run average total cost curve.

It represents the lowest possible cost per unit that a firm in the industry can achieve in the long run.

As a firm grows, economies of scale help a firm to reach its minimum efficient scale before diseconomies raise the cost/unit again

DIAGRAM ANALYSIS:

Each subsequent short-run average cost (SRAC) curve represents growth & an increase in size

Output increases with each period of growth
Initially firms experience increasing returns to scale as a result of the economies of scale

At a certain level of output, the firm will reach the minimum efficient scale where it experiences constant returns to scale

If it continues to grow beyond that level of output the firm will experience decreasing returns to scale as diseconomies of scale occur

Question 24

Condition of profit maximisation

Answer 24

• 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

IF MR> MC at a particular level of output then firms should increase output- revenue gained by increasing output is greater than the cost of producing it- increasing output adds to profit

§ If MR<MC at a particular level of output – firms should decrease output- costs more to produce its last unit of output than it receives in revenue

Question 25

Explicit vs implicit costs

Answer 25

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 26

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

Answer 26

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). FLOWCHART:

Supernormal profit: any level of profit above normal profit, have a positive opportunity cost as using resources most efficiently (positive economic profit). OCCURS WHEN TR>TC ALSO WHEN AR>AC/

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) TR<TC AR<AC

Question 27

The shutdown condition

Answer 27

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 28

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

(On diagram)

Answer 28

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 29

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

(+ diagram)

Answer 29

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)

Question 30

What is difference between short run and long run?

Answer 30

Short-RUN- A period of time where at least one factor of production is fixed

Long RUN- A period of time where all factors of production are variable

Question 31

Why do firms shut down?

Answer 31

Firms do not always make a profit & may endure losses for a period

Entrepreneurs often keep firms going in the hope that market conditions will change & demand for their products will increase leading to profitability

This raises the question, ‘when is it the best time for a firm to shut down?’

The shut-down rule provides the answer by considering both the long-run & short-run periods

Question 32

When do firms shut down in the short run?

Answer 32

In the short-run, if the selling price (average revenue) is higher than the average variable cost (AVC), the firm should keep producing (AR > AVC)

If the selling price (AR) falls to the AVC it should shut down (AR = AVC)

A firm should shut down in the short-run if the selling price (AR) is unable to cover the AVC

DIAGRAM ANALYSIS:

The firm produces at the profit maximisation level of output (Q) where MC=MR

At this level, the P = AVC

This means that there is no contribution towards the firm’s fixed costs

The selling price literally only covers the cost of the raw materials used in production

There is no point in continuing production & the firm should shut down

Question 33

When do firms shut down in the long run?

Answer 33

In the long-run, if the selling price (AR) is higher than the average cost (AC) the firm should remain open (AR > AC)

if the selling price (AR) is equal to or lower than the average cost (AC), the firm should shut down (AR = AC)

DIAGRAM ANALYSIS:

The firm produces at the profit maximisation level of output (Q) where MC=MR

A firm should shut down in the long-run if the selling price (AR) is unable to cover the AC

At this level, P < AC

It could continue operating in the short-run as the AR > AVC, but in the long-run they are making a loss & the firm will shut down