TOPIC CONTENT SCOPE AND DEPTH OF EXAMINABLE

CONTENT
6
Explain and illustrate by means of
Effects
of cost & graphs the effects of cost and revenue
revenue on prices and the levels of production.

• Objectives of businesses • Briefly discuss the objectives of a

- SMART business. Use the SMART principle
➢ Specific
➢ Measurable
➢ Acceptable
➢ Realistic
➢ Time specific

- Different objectives • Distinguish between the different types

➢ Survival of objectives in business
➢ Profit maximizing
➢ Revenue maximizing
➢ Sales maximizing
- Short-run costs:
➢ total, average and marginal • Explain the short-run cost of a business.

➢ cost schedules Use cost diagrams and cost graphs in

➢ curves the explanation.

• Long-run costs • Explain the long-run cost of a business.

- revenue calculations Use cost diagrams and cost graphs in
- changes in revenue the explanation
- profits and losses
Note: Application of revenue and costs
analysis should include production and
the pricing of factors.

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 ECONOMICS

PAPER 2

MICROECONOMICS

TOPIC 6: DYNAMICS OF MARKETS: EFFECTS OF COST AND REVENUE:

Candidates should cover the following:

Explain and illustrate by means of Objectives of businesses Application of revenue and costs
graphs the effects of cost and analysis should include production
and the pricing of factors.
revenue on prices and the levels
of production.

Vocabulary list:

Learners must first give a description of the following words in their notebook.

Total Product/ Output Marginal revenue

Fixed Costs Average revenue
(indirect costs/ overhead costs) The long-run
Variable Costs Economies of scale
(direct costs/prime costs) Diseconomies of scale
Total cost: Profit
Marginal costs ECONOMIC PROFIT
Average cost ECONOMIC LOSS
Average fixed cost NORMAL PROFIT
Average variable cost
Total Revenue

REVENUE AND COST ANALYSIS

MC = Marginal Cost

It is the amount by which the total cost increase when one extra unit of a product is produced.

∆Total Cost (TC) ÷ ∆ Output (Q) = MC

MR = Marginal Revenue

Marginal revenue refers to the extra amount of revenue earned when an additional (extra) unit
of a product is sold.

∆TR ÷∆ Q = MR

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 AC = Average Cost

Total Fixed Cost + Total Variable Cost = Total Cost

Total Cost ÷ Total output = AC.

Also called unit cost.

AR = Average Revenue

Average revenue refers to the amount the enterprise earns for every unit sold.

TR ÷ Q = AR

Because TR = PQ,

it follows that AR = PQ ÷ Q

therefore, AR = Price

AVC = Average Variable Cost

Total Variable Cost divided by number of units produced.

Total Variable Cost ÷ Total output = AVC.

P = Price

A value that will purchase a definite quantity, weight, or other measure of a good or service.

Q = Quantity

The extent, size, or sum of countable or measurable discrete events, objects, or phenomenon,
expressed as a numerical value.

Objectives of the business according to the SMART principle.

Specific the idea must be identified and understood and not merely a random idea

Measurable it must be possible to test or measure whether the goal has been reached

Agreed in a small business, the goal is easy to set as the owner is the only one who
has to agree, in a larger business there will be many stakeholders who need to
agree

Realistic the goal must not be out of reach for the business, the business must be
capable of generating the required profit

Time specific there must be a time limit on achieving the goal

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Main objectives of the business:

• Survival
• Profit maximization
• Revenue Maximization
• Sales Maximization

Survival • Initially the objective of the firm will be to merely survive.

• New firms face constraints that could hamper their progress and success.
Profit maximising • Making as much profit as possible.
• Profit is the difference between the revenue and the cost of the business.
Revenue maximising • Some businesses have very high costs
• If they have a very large workforce, large business premises, etc.
Sales maximising • Sales refer to the number of goods or services sold.
• Reaching as many customers as possible can increase the size and
popularity of the business although the profit may fall if lower prices have
to be charged to reach this objective.

Short run and Long run

Short run
• It is that period where at least one input is fixed.
• The enterprise can increase its outputs by increasing its variable factors.

Long run
• It is that period where both fixed factors and variable factors can be changed.

Differentiate between long run costs and short run costs.

Long run cost

• It is the period of time in which the business is able to increase all of its output at will, none of the
factors of production are fixed.
• It is not only limited to increasing variable input.
• The period in which there are no fixed inputs, all the inputs are variable.
• In the long run, firms are all trying to produce at a level that will allow them to experience economies of
scale.

Short run cost

• The period of time during which the business is faced with at least one of its production factors being
fixed.
• One of the inputs are unable to be increased.
• Fixed inputs do not change in the short run, variable inputs change.
• If a firm wants to increase production in the short run, it can do so only by increasing the number of
labourers it employs.

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FIXED FACTORS AND VARIABLE FACTORS:

The main difference between fixed factor and a variable factor is the time it takes to change the input.

Fixed factors:
• These are inputs that take time and planning to increase.
• E.g. size of the factory or building, the type of machines that is used, etc.

Variable factors
• These are inputs that can be changed easily and quickly.
• E.g. electricity, labour, water, etc.

Abbreviations used in graphs:

Abbreviations used in graphs

FC Fixed Cost

VC Variable Cost

TC Total Cost

TFC Total Fixed Cost

TVC Total Variable Cost

MR Marginal Revenue

MC Marginal Cost

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AC Average Cost
ATC Average Total Cost

AC Average Cost
AVC Average Variable Cost

AR Average revenue

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PERFECT MARKETS / PERFECT COMPETITION

COSTS IN THE SHORT RUN

FIXED COST, VARIABLE COST AND TOTAL COST

Output
• Output is the quantity of goods produced during a certain period.

Total Fixed Cost (TFC) / FC

• It is all those costs which stay the same, no matter how many products are produced by the
enterprise.
• It must be paid, irrespective whether 0 or 1 million units are being produced.
• E.g. insurance premiums, rent of the building, property taxes, etc.

Total Variable Cost (TVC) / VC

• It is those cost that change as the number of products being produced (output) changes.
• E.g. the services of a labourer, electricity, telephone bills, water accounts, etc.

Total cost (TC)

• It is when fixed cost and variable cost are added together.
• TC = TFC + TVC

Total
Fixed Total
Cost Variable Cost Total Cost
Output (TFC) (TVC) (TC)
0 3 0 3
1 3 5 8
2 3 8 11
3 3 10 13
4 3 11.5 14.5
5 3 13 16
6 3 15 18
7 3 18 21
8 3 23 26
9 3 31 34
10 3 43 46

Total Fixed Cost (TFC) also called Fixed Cost (FC).

• It is illustrated as a horizontal line on the graph.
• Fixed cost stays the same, regardless of the quantity of outputs produced.

Total Variable cost (TVC)

• The TVC curve starts from 0 because when zero (0) goods are being produced the variable cost is
zero (0)
• As the outputs increase, variable cost will increase.
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Total Cost (TC)
• It is the sum total of Total Fixed Cost plus Total Variable cost.
• The total cost curve starts at the point where Fixed cost starts.
• TC = TFC + TVC

• The variable cost curve always has an S-Shape.

• It has to do with the law of diminishing returns.
• When resources are fully used and every time another worker is added, total costs will increase at an
increasing (faster) rate.
• The curve increases slowly at first, and when it reaches a particular point, the variable cost starts to
increase at a faster rate.

MARGINAL COST (MC)

Describe the term: Marginal cost:

It is the amount by which the total cost increase when one extra unit of a product is produced.

∆ Total Cost (TC)

➢ The formula is: ∆ Output (Q)

Total cost of one unit – the total cost for the previous unit.

Total
Output Total Variable Cost Marginal
(Q) Cost (TVC) (TC) Cost (MC)
0 0 3 -
1 5 8 5
2 8 11 3
3 10 13 2
4 11.5 14.5 1.5
5 13 16 1.5
6 15 18 2
7 18 21 3
8 23 26 5
9 31 34 8
10 43 46 12

• Total cost increase as output increase.

• Marginal cost decrease to a point and starts to increase again.
• When 5 products are produced, Marginal cost (MC) will be R1.50 per unit.
• When 6 products are produced, Marginal cost (MC) will increase to R2.00 per unit.
• The law of diminishing returns sets in when producing more than 5 products.
• It now becomes more expensive to produce each additional unit of a product
• Each time when an extra product is produced, it becomes more expensive to produce each
additional unit of the product.
• However, even though the marginal cost is rising, the firm can still continue producing more units of
a good as long as the marginal revenue is greater than the marginal cost.

Take note: The law of diminishing returns is also referred to as the law of diminishing marginal returns.
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AVERAGE COST CURVES

• It is the cost per unit of production.

• There are TWO types of average cost.

Average Fixed Cost (AFC)

Average Variable Cost (AVC)
Average Cost (AC)

Average
Average Variable Average
Output Fixed Cost cost Cost

AFC + AVC = AC
0
1 3 5 8
2 1.5 4 5.5
3 1 3.33 4.33
4 0.75 2.88 3.63
5 0.6 2.6 3.2
6 0.5 2.5 3
7 0.43 2.57 3
8 0.375 2.88 3.25
9 0.33 3.44 3.8
10 0.3 4.3 4.6

Average Fixed Cost (AFC)

Formula:
Total Fixed Cost
Average Fixed Cost = Total Output

• AFC is the amount of fixed cost allocated to the production of one unit of a product.
• As the outputs increase, the average fixed cost decrease.

Average Variable cost (AVC)

Formula:
Total Variable Cost
Average Variable Cost (AVC) = Total Output

• As the outputs increase, the average variable cost will decrease to a point after which it will start to
increase.

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Average Cost (AC)

Formula:
Total Cost
Average Cost (AC) = Total Output

• It is the sum total when Total Average Fixed Cost and Total Average Variable Cost is added.

IMPERFECT MARKETS / IMPERFECT COMPETITION

COST IN THE SHORT RUN

The demand curve of the Monopoly: D = AR

Total Average
Quantity Price Revenue Revenue

Total rev /quan(output)

0 100 0 0
1 90 90 90
2 80 160 80
3 70 210 70
4 60 240 60
5 50 250 50
6 40 240 40
7 30 210 30
8 20 160 20
9 10 90 10
10

Demand curve = Average Revenue Curve

• Demand curve is the quantity demand at each price – therefore the higher the price the less quantity of
a product is demanded. The demand curve is downward sloping.
• A revenue curve reflects the amount of money a business earns from the sale of goods and services. It
is the price per unit.
• If the business wants to sell extra units then they must cut the price – The Average Revenue curve is
also downward sloping.

NB: The Average Revenue curve is the same as the Demand curve.

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Average cost

Quantity Total Average

Output Price TFC TVC cost AVC cost
0 100 10 0 10
1 90 10 10 20 10 20
2 80 10 18 28 9 14
3 70 10 25 35 8.33 11.67
4 60 10 33 43 8.25 10.75
5 50 10 43 53 8.6 10.6
6 40 10 55 65 9.17 10.83
7 30 10 70 80 10 11.43
8 20 10 90 100 11.3 12.5
9 10 10 115 125 12.8 13.89
10 0 10 145 155 14.5 15.5

Total cost ÷ Output (Q) = AC or ATC.

• As the firm produces more of a product the average cost reduces to a certain point then it increases
again.
• The reason is average cost has a fixed part and a variable part. Adding them together the AC will
decrease to a point and then start to increase.

The law of diminishing returns

• Law of diminishing returns states that as more of a variable input is added to a fixed input, the returns
from the variable input will decrease.

Marginal cost

Quantity /
Output Price Total cost MC
0 100 10
1 90 20 10
2 80 28 8
3 70 35 7
4 60 43 8
5 50 53 10
6 40 65 12
7 30 80 15
8 20 100 20
9 10 125 25
10 0 155 30

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 • Marginal cost is the cost of the resources to produce an additional product. (What does it cost to
produce one additional unit?)
• The cost to produce an additional unit will decrease to a point (5 units) then it will increase again.

COST IN THE LONG RUN

• Long run refers to the time period where both fixed factors and Variable factors change.
• E.g. business enterprises need time to:
o expand their business property.
o install new machinery.
o to develop new production techniques.

• The law of diminishing returns does not influence the business because businesses can make any
changes.
• The long term curve differs from the short term curve.
The most important decisions that enterprises have to take into consideration are the scale of their operations.

REVENUE CALCULATIONS AND CURVES

PERFECT COMPETITION

TOTAL REVENUE, MARGINAL REVENUE, AVERAGE REVENUE / output (quantity)

• Revenue = Flow of money that businesses receive.

• Cost = Payments made by businesses.

To calculate profit /loss: Profit = Total Revenue – Total Cost

TOTAL REVENUE

• Total revenue is the amount of money that a business earns in a particular period of time.
• A business earns money by selling its output.

TR = Q x P

Total Revenue Output Price

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 Quantity Total
/Output Price Revenue
0 4 0
1 4 4
2 4 8
3 4 12
4 4 16
5 4 20
6 4 24

7 4 28
8 4 32
9 4 36
10 4 40

• Total revenue increase as the level of output increase.

AVERAGE REVENUE

Average revenue refers to the amount the enterprise earns for every unit sold. Also referred to as unit cost.

AR = TR
Q

When every product is sold for the same price the average revenue will simply equal the price of the product.

AR = P

Total Average
Quantity Price Revenue Revenue
0 4 0 4
1 4 4 4
2 4 8 4
3 4 12 4
4 4 16 4
5 4 20 4
6 4 24 4
7 4 28 4
8 4 32 4
9 4 36 4
10 4 40 4

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MARGINAL REVENUE

• Marginal revenue refers to the extra amount of income earned when an additional (extra) unit of a
product is sold.

MR = ∆TR
∆Q

Total Marginal
Quantity Price Revenue Revenue
0 4 0 4
1 4 4 4
2 4 8 4
3 4 12 4
4 4 16 4
5 4 20 4
6 4 24 4
7 4 28 4
8 4 32 4
9 4 36 4
10 4 40 4

REVENUE CALCULATIONS AND CURVES

IMPERFECT COMPETITION

• Revenue = Flow of money that businesses receive.

• Cost = Payments made by businesses.
• To calculate profit: Profit = Total Revenue – Total Cost

TOTAL REVENUE

• Total revenue is the amount of money that a business earns in a particular period of time.
• A business earns money by selling its output.

TR = Q x P

Total Revenue Output Price

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 QUANTITY /
Price Total Revenue
Output

0 0
10 8 80
20 7 140
30 6 180
40 5 200
50 4 200
60 3 180
70 2 140

• Total revenue increase as the level of output increase to a certain amount but then it decreases again.

AVERAGE REVENUE

• Average revenue refers to the amount the enterprise earns for every unit sold.

AR = TR
Q

• When every product is sold for the same price the average revenue will simply equal the price of the
product.
AR = P

QUANTITY Total Average

Price
/ Output Revenue Revenue

0 0
10 8 80 8
20 7 140 7
30 6 180 6
40 5 200 5
50 4 200 4
60 3 180 3
70 2 140 2

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MARGINAL REVENUE

• Marginal revenue refers to the extra amount of income earned when an additional (extra) unit of a
product is sold.

MR = ∆TR
∆Q

QUANTITY Total Marginal

Price
/ Output Revenue revenue
0 0
10 8 80 8
20 7 140 6
30 6 180 4
40 5 200 2
50 4 200 0
60 3 180 -2
70 2 140 -4

• The MR decrease with each additional unit of output as the level of output increase.

PROFIT MAXIMIZATION: PERFECT COMPETITION

Point e
• At point e the business produces at maximum profit where marginal income equals marginal cost
(MR = MC).
• This is known as the equilibrium point or profit maximization point.

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Point a:
• At point a the marginal revenue is greater than marginal cost: (MR˃MC). (Marginal revenue lies above
the marginal cost)
• If the business produces at the level of point a, then the business can increase the level of poduction
until the profit maximization point is reached (point e).
• This is because every additional unit of production will add to the total profit of the business.

Point c:
• At point c the marginal revenue is smaller than marginal cost (MR ˂MC). (Marginal revenue lies below
the marginal cost).
• If the business produces at the level of point c, then the business must decrease the level of production
until the profit maximization point is reached (point e).
• This is because every additional unit of production will contribute to the decrease in profits. (Add to the
losses of the business).

Conclusion:
1. MR = MC: Maximum profit
2. MR ˃ MC: Every additional unit produced adds to the profit of the business.
3. MR ˂ MC: Every additional unit produce will contribute to the decrease in profits. (add to the loss of
profits).

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PROFIT MAXIMIZATION: IMPERFECT COMPETITION

Imperfect Competition
Profit maximization

• The monopolist maximize its profits were at the level of output where Marginal Cost is equal to
Marginal Revenue: (MC = MR)

Quantity Price Total Average Total MC MR

/ Output Revenue Revenue cost
0 100 0 10
1 90 90 90 20 10 90
2 80 160 80 28 8 70
3 70 210 70 35 7 50
4 60 240 60 43 8 30
5 50 250 50 53 10 10
6 40 240 40 65 12 -10
7 30 210 30 80 15 -30
8 20 160 20 100 20 -50
9 10 90 10 125 25 -70
10 155 30 -90

PROFIT AND LOSS

Enterprises do business in different types of markets.

Some enterprises are:

PRICE TAKERS: They do not influence the prices for which products sell. They accept the market price.

PRICE MAKERS (SETTERS): (Monopolies): They influence the price of products. They can decide within
limits at what price to sell their products.
E.g. diamond mines.

PRICE LEADERS: (E.g. oligopoly): They are large firms. They initiate price changes and smaller businesses
follow by increasing the prices of their products accordingly.
They lead with prices and other companies follows.
E.g. large supermarkets, travel agencies, etc.

PROFIT AND LOSS

• Profit is the difference between revenue and cost.

• An enterprise makes a profit when the revenue it earns is more than the production cost.

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Different types of profit

Accounting profit
• Also known as total profit.
• It is the difference between total revenue from sales and total costs.
• Accounting profit = Revenue minus explicit costs.
Normal profit
• It is the minimum return required by the owners to continue with the
• business.
• It is the remuneration for entrepreneurship.
• It is included in the total cost of production.
• When revenue is equal to explicit cost plus implicit costs.
Economic profit
• It is the extra profit that the firm makes.
• It is the profit that the business makes in addition to the normal profit.
• It is also known as surplus or excess or extra profit.
• Economic profit = Revenue minus explicit plus implicit costs.

PROFIT AND LOSS IN THE PERFECT MARKET PROFIT AND LOSS IN THE IMPERFECT MARKET

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