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Edexcel A Level Economics A Your notes

3.3 Revenues, Costs & Profits

Contents
Revenue
Costs
Economies & Diseconomies of Scale
Normal Profits, Supernormal Profits & Losses

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Revenue
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Total, Average & Marginal Revenue
Total revenue is the total value of all sales a firm incurs

Total revenue (TR) = selling price (P) × quantity sold (Q)

Average revenue is the overall revenue per unit

TR
Average revenue (AR) =
Q

Marginal revenue is the extra revenue received from the sale of an additional unit of output

∆ in TR
Marginal revenue (MR) =
∆ in Q

The relationship between TR, AR & MR is different in perfect competition and imperfect competition

Perfect competition
The Relationship Between TR, AR and MR In Perfect Competition Can Be Seen Numerically Below

P (£) Q TR (P ×Q) TR ∆ in TR
AR MR
Q ∆ in Q

8 5 40 8 8

8 6 48 8 8

8 7 56 8 8

8 8 64 8 8

The situation in the table above is illustrated in the diagram below

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An illustration of the relationship between AR, MR and TR

Observations
The firm is a price taker at P1 (£8)
Every unit of output is sold at the same price
A higher price would decrease sales to zero
A lower price would result in all sellers lowering their price
TR increases at a constant rate
MR = AR = Demand

Imperfect competition
The Relationship Between TR, AR & MR For Imperfect Competition Can Be Seen Numerically Below

P (£) Q TR (P ×Q) TR ∆ in TR
AR MR
Q ∆ in Q

8 1 8 8 8

7 2 14 7 6

6 3 18 6 4

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5 4 20 5 2
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4 5 20 4 0

3 6 18 3 -2

2 7 14 2 -4

1 8 8 1 -6

The situation in the table above is illustrated in the diagram below

An illustration of the relationship between AR, MR & TR for imperfect competition

Observations
The firm is a price maker
In order to sell an additional unit of output, the price (AR) must be lowered

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Both AR & MR fall with additional units of sale

When the AR falls, the MR falls by twice as much Your notes
The gradient of the MR curve is twice as steep as the AR curve
TR is maximised when MR = 0
AR is the demand (D) curve
When MR = 0, then the price elasticity of demand (PED) = 1
This is unitary elasticity
PED & 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
This can be illustrated using an average revenue (AR) curve which is the demand curve

An illustration of price elastic demand where a small decrease in price from P1→P2 causes a large
increase in quantity demanded from Q1→ Q2

Observations
When a good/service is price elastic in demand, there is a greater proportional increase in the quantity
demanded to a decrease in price
TR is higher once the price has been decreased
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(P 2 ×Q 2 ) > (P 1 ×Q 1 )

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An illustration of price inelastic demand where a large increase in price from P1→P2 causes a small
decrease in quantity demanded from Q1→ Q2

Observations
When a good/service is price inelastic in demand, there is a smaller than proportional decrease in the
quantity demanded to an increase in price
TR is higher once the price has been increased

(P 2 ×Q 2 ) > (P 1 ×Q 1 )

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Costs
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The Relationships Between Different Types of Costs
Fixed costs are costs that do not change as the level of output changes
These have to be paid whether output is zero or 5000
e.g. building rent, management salaries, insurance, bank loan repayments etc.
Variable costs are costs that vary directly with output
These increase as output increases and vice versa
E.g. raw material costs, wages of workers directly involved in production
Marginal cost is the cost of producing an additional unit of output

Cost calculations
Based on the above definitions, we can calculate several different types of costs

1. Total costs (TC) = total fixed costs (TFC) + total variable costs (TVC)

2. Total variable cost (TVC) = variable cost (VC) × quantity (Q)

total cost (TC)

3. Average total cost (AC) =
quantity (Q)

Total fixed costs (TFC)

4. Average fixed cost (AFC) =
quantity (Q)

Total variable costs (TVC)

5. Average variable cost (AVC) =
quantity (Q)

∆ in total cost (TC)

6. Marginal cost (MC) =
∆ in quantity (Q)

Cost Calculations Using the Above Formulas

Output (Q) TFC TVC TC = TFC + TVC AFC =

TFC
AVC =
TVC
AC =
TC
MC =
∆ TC
Q Q Q ∆Q

0 200 - - - - - -

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1 200 60 260 200 60 260 60

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2 200 100 300 100 50 150 40

3 200 130 330 66.67 43.33 110 30

4 200 170 370 50 42.50 92.50 40

5 200 230 430 40 46 86 60

6 200 320 520 33.34 53.33 86.77 90

7 200 440 640 28.58 62.86 91.44 120

8 200 620 820 25 77.50 102.5 180

Short-run Cost Curves

Concepts That Help to Provide Understanding of How the Cost Curves Are Derived

Concept Explanation

Short-run That period of time in which at least one factor of production is fixed. E.g. it is
difficult to change machinery or the number of factories in the short run, but that
can be achieved in the long run. The variable factor that is usually added to
production is labour as it is easy to hire new workers

Long-run That period of time in which all of the factors of productions are variable. This is
also called the planning stage as firms can plan for increased capacity and
production

Marginal product The change in output that results from adding an additional unit of labour
of labour (MP)

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Law of diminishing In the short run, as more of a variable factor (e.g. labour) is added to fixed factors
marginal (e.g. capital), there will initially be an increase in productivity. However, a point will
Your notes
productivity be reached where adding additional units begins to decrease productivity due to
the relationship between labour and capital

In the short-run, the shapes of the cost curves (AC, AVC and MC) are determined by the law of
diminishing marginal productivity

In the short run, marginal product (MP) increases with the addition of three workers before diminishing
returns for each additional worker begin

Diagram analysis
A small food van selling burgers (product) at a music festival increases productivity up to the addition
of a third worker
After that, workers get in each other's way and there is not enough grill space (capital) and MP no
longer increases
If more workers are hired, then the MP of each additional worker begins to fall
Adding additional workers up to the 7th worker will keep increasing the total product

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With the hiring of the 7th worker, the MP turns negative which will decrease the total product
Connection between diminishing marginal returns and the Your notes
cost curves
As the marginal product increases, marginal costs decrease
There is an inverse relationship
Increasing returns = decreasing costs
Decreasing returns = increasing costs

Diagram analysis
The distance between the AVC and AC = the AFC

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AVC converges towards AC as the AFC continuously decreases with an increase in output
AVC decreases as additional workers are added and each worker produces additional product Your notes
Marginal costs (MC) decrease initially as additional workers are added and the marginal product is
increasing
Diminishing returns begin when the MC starts to increase
MC will cross the AVC and AC curves at their lowest point
As long as the cost of producing the next unit (MC) is lower than the average, it will pull down the
average
When the cost of producing the next unit (MC) is higher than the average, it will pull up the average
Short-run and Long-run Average Costs Curves
Day to day operations of a firm occur in the short-run
In the long-run, they are able to plan to increase the scale of production
E.g by increasing the size of the factory
Larger scale = more output and the firm moves onto a new SRAC curve in which the average unit
costs are lower
In the long-run, a growing firm is likely to keep repeating this process,
Each time a more efficient SRAC is generated
The long-run average cost curve (LRAC) is the line of best fit between the lowest points of the short-
run ATC curves

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Your notes

The LRAC curve is generated by the addition of successive SRAC as the firm expands its scale of
production

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Economies & Diseconomies of Scale

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Economies & Diseconomies of Scale
As a firm increases its scale of output in the long-run, its long-run average total costs (LRATC) will
initially decrease due to the benefits it receives
These benefits are called economies of scale
During this period the firm is enjoying increasing returns to scale
As a firm continues increasing its scale of output in the long-run, its LRATC will start to increase at
some point
The reasons for the increase in the LRATC are called diseconomies of scale
During this period the firm is facing decreasing returns to scale
Types Of Economies and Diseconomies of Scale

Economies of Scale Diseconomies of Scale

Financial Economies Management Diseconomies

Managerial Economies Communication Diseconomies

Marketing Economies Geographical Diseconomies

Purchasing Economies Cultural Diseconomies

Technical Economies

Risk-bearing Economies

Minimum Efficient Scale

The minimum efficient scale is the lowest cost point on a long-run average total cost (LRATC) curve
It represents the lowest possible cost per unit that a firm in the industry can achieve in the long run.

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Your notes

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 and 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

Internal & External Economies of Scale

All of the economies of scale explained above are internal economies of scale
External economies of scale occur when there is an increase in the size of the industry in which the firm
operates
The firm is able to benefit from lower LRATC generated by factors outside of the firm
Sources Of External Economies Of Scale

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Source Explanation
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Geographic As an industry grows, ancillary firms move closer to major manufacturers to cut costs
Cluster and generate more business. This lowers the LRATC e.g. car manufacturers in
Sunderland rely on the service of over 2,500 ancillary firms

Transport Improved transport links develop around growing industries in order to help get
Links people to work and to improve the transport logistics. This lowers the LRATC e.g.
transport links around the M4 Corridor Tech Area between Reading and Bracknell have
experienced significant improvement

Skilled Labour An increase in skilled labour can lower the cost of skilled labour, thereby decreasing
the LRATC. The larger the geographic cluster, the larger the pool of skilled labour

Favourable This often generates significant reductions in LRATC as governments support certain
Legislation industries in order to achieve their wider objectives e.g the animation cluster in Bristol
and Bath is growing due to the tax incentives offered to the industry by the
Government

Examiner Tips and Tricks

Diminishing marginal returns are the reason for the shape of the short-run cost curves. Economies
and diseconomies of scale are the reason for the shape of the long-run cost curves. Students often
get their language confused on this theory. Increasing and decreasing returns to scale only happen
in the long run. Increasing and diminishing marginal returns only happen in the short run.

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Normal Profits, Supernormal Profits & Losses

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Condition for Profit Maximisation
To maximise profit firms should produce up to the level of output where marginal cost (MC) = marginal
revenue (MR)
Calculations To Demonstrate the Profit Maximisation Rule

Output MR (£) MC (£) Addition to Profit

5 50 32 +18

6 50 36 +14

7 50 50 0

8 50 68 -18

Observations
With the 7th unit of output, MC = MR and no additional profit can be extracted by producing another
unit
Up to the 6th unit of output, MC < MR and additional profit can still be extracted by producing an
additional unit
From the 8th unit of output, MC > MR and the firm has gone beyond the profit maximisation level of
output
It is making a marginal loss on each unit produced beyond the point where MC = MR

Normal Profit, Supernormal Profit & Losses

When calculating costs, Economists consider both the explicit and implicit costs of production
Explicit costs are the costs which have to be paid e.g raw materials, wages etc.
Implicit costs are the opportunity costs of production
This is the cost of the next best alternative to employing the firm's resources

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E.g. if an investor puts £1m into producing bicycles and they could have put it in the bank to
receive 5% interest, then the 5% represents an implicit cost
Implicit costs must be considered as entrepreneurs will rationally reallocate resources when Your notes
greater profits can be made elsewhere
Profit = total revenue (TR) - total costs (TC)
Total costs include explicit and implicit costs
Normal profit occurs when TR = TC
This is also called breakeven
Supernormal profit occurs when TR > TC
A loss occurs when TR < TC
Calculations To Demonstrate Profits

Output TR (£) TC (£) Profit (TR - TC)

5 150 70 80

6 180 96 84

7 220 220 0

8 250 270 -20

Observations
Supernormal profit occurs up to the 6th unit of output
Normal profits occur at the 7th unit
From the 8th unit, the firm is making a loss

Short-run & Long-run Shut-down Points

Firms do not always make a profit and may endure losses for a period
Entrepreneurs often keep firms going in the hope that market conditions will change and 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 and short-run periods

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The short-run shut down point

In the short-run, if the selling price (average revenue) is higher than the average variable cost (AVC), Your notes
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 and the firm should shut down

The long-run shut down point

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In the long-run, if the selling price (AR) is higher than the average cost (AC) the firm should remain
open (AR > AC)
Your notes
if the selling price (AR) is equal to or lower than the average cost (AC), the firm should shut down
(AR = AC)

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

Diagram analysis
The firm produces at the profit maximisation level of output (Q) where MC=MR
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 and the firm will shut down

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