3.3) revenues, costs and profits

Question 1

What is total revenue (TR), average revenue (AR) and marginal revenue (MR)?

Answer 1

• Total revenue is the total amount of money received in a time period, from a firm’s sales -> TR = price (P) x quantity (Q)
• Average revenue is the revenue PER unit sold -> AR = TR/Q
• Marginal revenue is the EXTRA revenue received when selling an additional unit ->

Question 2

How does the demand curve determine how revenue relates to output?

Answer 2

• demand curve determines the quantity of a product that can be sold at a certain price
• price = AR = D => same curve shows the relationship between quantity sold and AR
• TR shown by Q x P

Question 3

What is a price taker? What is the condition when there is a perfectly elastic demand curve?

Answer 3

• A firm that has no power to control the price it sells at - accepts market price
• Hence, their demand curve is completely flat - demand is perfectly elastic
• if the price increases, QD will drop to 0 and no reason to drop the price

When perfectly elastic:
- price is the same no matter what output level
- so AR = MR because each extra unit sold brings in the same revenue
- when AR constant, the TR increases proportionally with sales

Question 4

What is a price maker?

Answer 4

• They have some power to set the price they sell at
• They have a downwards-sloping demand curve because to increase sales the firm must reduce the price
• With a downward-sloping demand curve, TR is maximized when PED = -1 (unit elastic) which is at the midpoint of the TR curve where MR = 0

Question 5

What is total cost (TC), total fixed cost (TFC) and total variable cost (TVC)?

Answer 5

• Total cost is all the costs involved in producing a particular level of output => TC = TVC + TFC
• Fixed costs DON’T vary with output and must be paid whether or not anything produced e.g. rent on a shop
• Variable costs DO vary with output - they increase as output does e.g. cost of raw materials - in the long run all costs are variable

Question 6

What is average cost (AC), average fixed cost (AFC) and average variable costs (AVC)?

Answer 6

• Average cost is the cost PER unit produced
• Average fixed cost = TFC / Q - falls as output increases as the total cost is spread across the greater output
• Average variable cost = TVC / Q - AC and AVC both form u-shaped curves in the short run

Question 7

When are costs fixed or variable?

Answer 7

in the short run at least one of the FoP is fixed
- in the short run costs can be fixed or variable

in the long run where all FoP are variable
- all costs are variable

Question 8

What is the marginal cost?

Answer 8

• Marginal cost is the extra cost incurred of as a result of PRODUCING an additional unit of output
• It is only affected by variable costs as fixed costs have to be paid regardless
• MC = change in TC / change in Q

Question 9

Why is the marginal cost curve u-shaped?

Answer 9

• MC initially decreases as output increases, then begins to increase in the short run due to the law of diminishing returns
• MC curves meet AC and AVC at their minimum as it is made up of variable costs

Question 10

What is the law of diminishing marginal returns?

Answer 10

If one variable factor of production is increased while the other factors stay fixed, eventually the marginal returns from the variable factor will begin to decrease
- if you add more of a FoP then MP will increase e.g. as more people are employed they can specialise in carrying out a specific task
- if you keep adding, then the other fixed factors will begin to limit the additional output that you get and MP falls = point of diminishing returns

Question 11

What is marginal product (MP) and how does it relate to marginal cost?

Answer 11

• Marginal product is the additional output produced by adding one more of a unit of a FoP
• As MP falls, MC rises because, ceteris paribus, if you get less additional output from each unit of input then cost per unit of that output will be bigger
• As MP rises, MC falls
• MP curve is the mirror image of the MC curve

Question 12

What are economies of scale?

Answer 12

• The cost advantages of producing at a large scale. The more you produce, the lower the average cost (in the long run)
• Can be internal and external

Question 13

What are the internal economies of scale?

Answer 13

PURCHASING
- larger firms making a lot of goods will need higher quantities of raw materials, so they can often negotiate discounts with their suppliers because as large firms they are the most important (biggest orders)
- discounts = less cost -> allows firms to sell goods for less like McDonald’s
TECHNICAL
- large firms can buy specialist equipment to help reduce average costs -> increased productivity -> decrease LRAC
- implementation of a production line to make goods at a low AC and workers can specialise to become more efficient in their respective tasks
MANAGERIAL
- large firms will be able to hire experts that are experts in different areas of the business -> better decision-making and productivity -> decreased costs e.g. Man U hiring specialist coaches to increase their productivity
MARKETING
- Advertising is at a fixed cost and for a large company so the cost per unit is lower
- Benefit from brand awareness and loyal customers
FINANCIAL
- large firms can can often borrow money at a lower rate of interest - lending to them is seen to be less risky
RISK-BEARING
- bigger firms are able to diversify their investments to prevent them from over-relying on one industry -> minimises cost of failure

Question 14

What are external economies?

Answer 14

involves changes outside a firm -> reduction in LRAC, as the industry output increases e.g. when an industry like tech or fil expands, more workers are attracted to it or there is a transfer in knowledge helping all firms -> recruitment costs are reduced -> cheaper to produce at all quantities
-shown as a shift (downwards) of the LRAC curve, as opposed to a movement along it

Question 15

How do EOS help companies gain monopoly power?

Answer 15

• if the AC falls then it can sell the product for a lower price, undercutting its competition
• leads to firm gaining a bigger market share as it continually undercuts
• eventually can drive out all its competition and gain a monopoly

Question 16

What are diseconomies of scale? And what causes this?

Answer 16

an increase in LRAC as a result of too much expansion, higher prices for consumers

• increased alienation: alienation of employees -> fall in motivation -> fall in productivity -> rise in LRAC – like in call centres where people are stuck in cubicles

Increased Bureaucracy: hire more people, more paperwork etc. -> layers of administration -> fall in productivity -> increased LRAC – NHS spends 21bn in bureaucracy, to the loss of the consumers

A lack of Communication: too many channels of information to get a message through -> reduces productivity -> increases LRAC

Question 17

How do high fixed costs lead to large EOS?

Answer 17

• high fixed costs but low variable costs
• e.g. improved technology is expensive to set up (fixed cost) but reduces the need for labour required to produce each unit
• firms can then take advantage of these EOS and force others to follow or shut down - results to an industry dominated by one or a few firms

Question 18

What determines the shape of the LRAC curve?

Answer 18

• AC falls as output rises - internal EOS
• AC rises as output fall - internal DEOS
• may vary depending on which is having the greater effect on the same level of output

Question 19

What causes the LRAC curve to shift?

Answer 19

• external EOS causes the LRAC curve to shift downwards => implementation of new technology
• external DEOS will cause the LRAC curve to shift upwards => an increase in taxation, like fuel duty, will shift it up

Question 20

What are the different types of returns to scale?

Answer 20

Returns to scale are the effects on output of increasing all factor inputs by the same proportion - long run
- increasing returns to scale: when an increase in all the factor inputs leads to a more than proportional increase in output
- decreasing returns to scale: when an increase in all factor inputs lead to a less than proportional increase in output
- constant returns to scale: when an increase in factor inputs leads to a proportional increase in output

Question 21

How do returns to scale contribute to EOS?

Answer 21

• increasing RTS contribute to EOS => when returns to scale are increasing the LRAC will fall because more output per cost of production per unit
• decreasing RTS contribute to DEOS
• when RTS constant then LRAC will remain constant

Question 22

When is LRAC at its minimum?

Answer 22

• At the Minimum Efficient Scale of production (MES) - the lowest level output at which the minimum possible average cost can be achieved
• It is the first point at which the curve reaches the minimum value; the rest is a range but not the MES

Question 23

What are the two different types of profit and what are their conditions?

Answer 23

Profit = TR - TC (money and opportunity)
- Supernormal profit -> TR > TC
- Normal profit -> TR = TC

Question 24

When does normal profit occur?

Answer 24

• TR = TC -> economic profit of 0
• When the extra revenue (on top of money costs) is equal to the opportunity costs of the FoP that aren’t paid for
• MINIMUM level of profit needed to keep resources in their current use in the long run

Question 25

When does supernormal profit occur?

Answer 25

• TR > TC
• FoP being used in this way generates greater revenue than using them any other way
• if firms in an industry are making supernormal profit then this will create an incentive for other firms to try and enter that industry

Question 26

Why does a firm need at least normal profit to keep operating in the long run? But not in the short run?

Answer 26

• In the LR, its revenue will not be able to cover all of its costs.

Question 27

What are the conditions determining whether a firm should shut down in the short run?

Answer 27

• SR SHUT DOWN POINT -> PRICE = AC
• Even if a firm is making a loss, it will remain in the market if PRICE > AVC because in the LR, the firm will eventually break even and start making profit. Price is greater than variable costs per unit so makes a profit on each unit sold and this can be used to pay off fixed costs and eventually make profits in the LR
• If TR < TVC or AR < AVC, then it will close immediately. Will be worse off if it continues to produce

Question 28

What are the conditions for LR shut down?

Answer 28

• When price = ATC => that is the LR shut down point
• When price > ATC, the firm will stay in the market because it is covering its average total costs
• When price < ATC, the firm will shutdown and leave the market

Question 29

At what point is profit maximised?

Answer 29

• profits are maximised when MR = MC
• When MR > MC, the firm should increase output because rev gained by increasing output is greater than the cost of producing it - so increasing output adds to profit
• When MR < MC, the firm should decrease output because rev gained by increasing output is less than the cost of producing it - so decreasing output adds to profit