3.3 Revenues, Costs and Profits

• Average revenue (AR)


  Demand is equal to AR: total revenue divided by output
• Price elasticity
• For most goods, the price decreases as output increases and there is a downward sloping demand curve and therefore a downward sloping AR curve. The demand curve for the firm is the same as the firm's AR revenue curve, as it indicates the price that consumers are willing to pay for each quantity sold. Firms with a downward sloping demand curve are firms that are in imperfect competition and so they have some price setting power.
• Total revenue (TR)


  The total amount of money coming into the business through the sale of goods and services (quantity x price)
• Types of costs
• Some firms experience a perfectly elastic demand curve; these are firms in perfect competition, a concept looked at in the next unit. These firms have no price setting power. In this case, the price received by the firm for the good is constant and so MR=AR=D. Their demand curve is horizontal. The TR curve is upward sloping because prices are constant and so the more goods that are sold, the higher the revenue made.
• Maginal revenue (MR)

  The extra revenue that the firm earns from selling one more unit of production: total revenue from 'N' goods - total revenue from (N-1) goods OR change in total revenue divided by change in output
• For goods with a downward sloping demand curve, the elasticity of the curve is linked to marginal revenue. If marginal revenue is positive, when the firm sells the product at a lower price (or when they increase output), total revenue still grows and so the demand curve is elastic. Up until output Q, the demand curve is elastic. If MR is negative, TR decreases as price decreases (or output increases) and so the demand curve is inelastic. After output Q, the demand curve is inelastic. When MR=0, TR is maximised and the demand curve is unitary elastic; this is at point Q. This explains why the TR curve is a U-shape: at first, total revenue rises with output (when MR is positive) but it then begins to decline (when MR is negative).
• Total variable cost (TVC)


  Costs that change directly with output e.g. (continues in the next source)...
• Total cost (TC)


  The cost of producing a given level of output: fixed + variable costs
• Types of revenue
• Total fixed cost (TFC)


  Costs that do not change with output and remain constant e.g. rent, machinery
• Short run cost curves

  • The average fixed cost curve (AFC) starts high and falls as output increases, the average total cost curve (AC/ATC) is U-Shaped due to the law of diminishing marginal productivity, the average variable cost curve (AVC) is U-Shaped and gets closer to ATC as output increases, the marginal cost (MC) is also U-Shaped
• Examples of Total fixed cost (TFC)


  • Rent
  • Machinery
• Total variable cost (TVC)


  Costs that change directly with output e.g. materials
• Average (total) cost (ATC)

  Total costs divided by output
• Law of Diminishing Returns

  Diminishing marginal productivity
• The marginal cost line will always cut the AC line at the lowest point on the AC curve


  If MC is below AC, then AC will continue to fall; if MC is above AC, then AC will rise
• Rent becomes higher
• Total fixed cost (TFC)


  Costs that do not change with output and remain constant
• Marginal output will decrease as more inputs are added in the short run, leading to a rise in the marginal cost of production
• Average variable cost (AVC)

  Total variable cost divided by output
• Each firm will have a different total cost curve. If average costs are constant, the line would be a straight diagonal line beginning at the origin. When output is 0, fixed costs are equal to total costs since there are no variable costs. Average costs can be worked out from the total cost curve
• Diminishing marginal productivity


  If a factor of production is fixed, adding more of a variable factor will eventually lead to less extra output per additional unit of the variable factor
• Average fixed cost (AFC)

  Total fixed cost divided by output
• Cost calculation formula for Marginal cost (MC)


  The extra cost of producing one extra unit of a good: total cost of producing N goods - total cost of producing (N-1) goods OR change in total cost divided by change in output
• The short run is the length of time when at least one factor of production is fixed and cannot be changed; this varies massively with different types of production. The long run is when all factors of production become variable
• The firm will continue to experience falling LRAC until output Q1, then constant returns to scale until output Q2, and finally diseconomies of scale for any output above Q2
• Movement along the LRAC is due to a change in output which changes the average cost of production due to internal economies/diseconomies of scale
• In the long run, the new SRAC curve will be lower since the firm is able to enjoy economies of scale
• Economies of scale are the advantages of large scale production that enable a large business to produce at a lower average cost than a smaller business
• The tangent to the total cost curve is marginal cost
• The minimum efficient scale is the minimum level of output
• In the short run, a rise in SRAC occurs due to the law of diminishing returns as some factors of production are fixed
• Shifts and movement of the LRAC curve
• Characteristics of average costs

  • Constant when output is 0 since fixed costs are equal to total costs
  • Can be worked out from the total cost curve
  • At point A, average costs are C/D
  • At point B, average costs are E/F
• A shift can occur due to external economies/diseconomies, taxes, or technology, affecting the cost of production for a given level of output
• In the long run, all factors become variable and the SRAC curve can be shifted
• Relationship between short-run and long-run cost curves

  • Short run average cost (SRAC) curves are U-Shaped due to the law of diminishing returns
  • Long run average cost (LRAC) curves are U-Shaped due to economies and diseconomies of scale
• Diseconomies of scale are the disadvantages that arise in large businesses that reduce efficiency and cause average costs to rise