3.3 Revenues, costs and profits Flashcards
What is a price maker/setter?
A firm that has sufficient market power to influence the price of the good it is selling and faces a downward sloping demand curve.
What is a price taker?
A firm that has to offer its product at the same price as everyone else.
What is total revenue (TR)?
The total amount of money a firm receives.
How is total revenue (TR) calculated?
TR = P X Q
What is revenue maximisation?
The output at which total revenue is at a maximum (price maker).
Draw a diagram of ‘total revenue’ (TR) for both price taking and making firms:
What is average revenue (AR)?
The price the firm receives per unit sold.
What is average revenue (AR) the same as?
The demand curve.
How is average revenue (AR) calculated?
AR = TR / Q
What is marginal revenue (MR)?
The change in total revenue from selling one more unit of output.
How is marginal revenue (MR) calculated?
MR = ∆TR / ∆Q
Draw a diagram of ‘marginal revenue’ (MR) and average revenue’ (AR) for both price taking and making firms:
What is total cost (TC)?
Refers to producing a given level of output
What is total fixed cost (TFC)?
Costs that do not change directly with output, e.g. rent paid for a factory building.
What is total variable cost (TVC)?
Costs that vary directly with output, e.g. variable prices of raw materials.
How is total cost (TC) calculated?
TC = TFC + TVC
How is total fixed cost (TFC) calculated?
TFC = TC -TVC
How is total variable cost (TVC) calculated?
TVC = TC -TFC
Draw a diagram of ‘total cost’ (TC), ‘total fixed cost’ (TFC) and ‘total variable cost’ (TVC):
What is average cost (AC)?
The cost per unit of output.
Why does average cost (AC) initially fall as more is produced?
The fixed cost is spread over more units of output.
How is average cost (AC) calculated?
AC = TC / Q
What is average fixed cost (AFC)?
The fixed cost per unit of output.
Why does average fixed cost (AFC) cost fall as output increases?
Fixed costs do not change with output, so as more is produced, total fixed cost (TFC) is spread out more.
How is average fixed cost (AFC) calculated?
AFC = TFC / Q
What is average variable cost (AVC)?
The variable cost per unit of output
How is average fixed variable cost (AVC) calculated?
AVC = TVC / Q
What is marginal cost (MC)?
The cost to the firm of making one more unit of output.
How is marginal cost (MC) calculated?
MC = ∆TC / ∆Q
Explain the relationship between average cost (AC) and marginal cost (MC):
When MC is below AC, the cost of producing the next unit is less than the AC of producing a unit. Due to this, an extra unit produced brings down AC.
When MC is above AC, the cost of producing the next unit is more than the AC of producing a unit. Due to this, an extra unit produced brings up AC.
Therefore, MC cuts AC at its minimum point.
Draw a diagram of ‘average cost’ (AC), ‘average variable cost’ (AVC) and ‘marginal cost’ (MC):
What is the law of diminishing returns?
States that as more units of a variable factor are added to a fixed factor, the increase in output (marginal product) eventually falls.
Why is the law of diminishing returns only applicable in the short-run?
Because it assumes that at least one factor of production is fixed.
What is total product (TP)?
The total output of a firm in a given period of time.
What is average product (AP)?
The unit of output produced per unit of a variable factor of production.
How is average product (AP) calculated?
AP = TP / Q
What is marginal product (MP)?
The change in output resulting from employing one more unit of the variable factor.
How is marginal product (MP) calculated?
MP = ∆TP / ∆Q
Draw a diagram of ‘average product’ (AP) and ‘marginal product’ (MP):
How are average product (AP) and marginal product (MP) related to marginal cost (MC) and average variable cost (AVC) diagrammatically?
They are the respective mirror images.
Draw a diagram of ‘short run average cost’ (SRAC) and ‘long run average cost’ (LRAC):
What are internal economies of scale?
Occur when the long run average costs (LRAC) of a firm decrease as firm increases in size.
What are external economies of scale?
Occur when the long run average costs (LRAC) of a firm decrease as the whole industry increases in size.
What are the 6 types of internal economies of scale?
Hint:
(Really Fun Mums Try Making Pies)
Risk-bearing economies - large firms can diversify to spread risk. For example they become less vulnerable to changes in taste as they operate in a variety of markets.
Financial economies - large firms can issue shares on the stock market and care considered lower risk to banks so can have lower interest rates.
Managerial economies - larger firms can increase efficiency by employing highly skilled and experienced managers.
Technical economies - for example, larger facilities can produce greater volumes of output and bigger warehouses are able to store this.
Marketing economies - as a firm increases in size, the cost of advertising is spread across more output and potential customers.
Purchasing (commercial) economies - large firms are able to bulk-buy at lower prices from their suppliers, because they are buying large amounts at a consistent rate.
What is the minimum efficient scale (MES)?
The output at which the long run average costs (LRAC) curve reaches a minimum.
What are constant returns to scale?
Occur when an increase in the scale of production results in an exactly proportional increase in output. Long run average costs (LRAC) curve in horizontal.
What are diseconomies of scale?
Occur when long run average costs (LRAC) increase as output increases.
What are the 4 types of diseconomies of scale?
X-inefficiency - as the size of the firm increases, administration costs may also rise disproportionately. Further, a lack of competition may allow prices to rise.
Poor communication - lines of communication between managers and workers may become complex, leading to delays.
Demotivation - larger businesses can feel impersonal meaning workers may not feel valued. This can lead to a fall in productivity.
Poor co-ordination - large firms can become difficult to manage, especially if they are operating in different countries. Different time zones and languages make effective communication more difficult.
How do external economies of scale cause the long run average costs (LRAC) to shift?
Downwards, without any direct involvement by the firm itself.
Provide 2 examples of external economies of scale:
Transport improvements that benefit firms, e.g. HS2
New methods of production, e.g. robot vacuum cleaners
What are external diseconomies of scale?
Where the long run average costs (LRAC) curve moves upwards, without any direct involvement by the firm itself.
Provide 2 examples of external diseconomies of scale:
There may be higher costs, e.g. if a firm wants offices in a different location.
Congestion can occur, e.g. if the location a firm operates in rapidly grows up, transportation can take longer and cost more.
What is meant by profit?
Profit is the reward for risk taking. It’s the difference between revenue and cost.
What is profit maximisation?
Where a firm cannot increase profit anymore, whether by increasing or decreasing price or output.
Where does profit maximisation occur?
MC = MR
What is normal profit?
This is the minimum necessary to keep the risk-taking resources in their current use. It does not act as a signal for firms to enter or leave the market.
Where does normal profit occur?
AC = AR or TC = TR
What is supernormal profit?
Profit above the minimum required to stay in business.
Where does supernormal profit occur?
AC < AR or TC < TR
What is a loss?
Losses occur when TC > TR. A firm does not automatically shut down when making a loss, if it is covering average variable cost (AVC) it will stay in business in the short-run.
Where is the shutdown point of a firm?
P = AVC
