3.3 Revenue, costs and profits

Question 1

What is total revenue?

Answer 1

Price x Quantity

Question 2

What is average revenue?

Answer 2

Total Revenue

__________________

Quantity

Question 3

What is marginal revenue?

Answer 3

The revenue gained with each additional unit sold - i.e. the change in total revenue from selling more than one unit

Question 4

How does elasticity affect revenue?

Answer 4

If a firm lowers prices on the elastic part of the AR curve, then total revenue will increase

However, if it lowers prices on the inelastic part of the AR curve, then total revenue will decrease

Question 5

What do the AR and MR curves look like?

Answer 5

The MR is twice as steep as the AR.

Question 6

What is the short-run (in terms of costs)?

Answer 6

A time where at least one factor of production is fixed, e.g. rent

Question 7

What is the long run (in terms of costs)?

Answer 7

A time period where all factors of production are variable

Question 8

What are fixed costs?

Answer 8

These are short-run costs that do not vary with output

Question 9

What are variable costs?

Answer 9

Costs that do vary with output, such as raw material consumption

Question 10

What are total costs?

Answer 10

This is Total Fixed Costs (TFC) + Total Variable Costs (TVC)

Question 11

What is average fixed cost?

Answer 11

total fixed costs

__________________

output

Question 12

What is average variable cost?

Answer 12

total variable costs

______________________

output

Question 13

What is average cost?

Answer 13

average costs per unit of output =

ATC or (AFC+AVC)

_____________________

output

Question 14

What is marginal cost?

Answer 14

The change in total costs when one more unit of output is produced

Question 15

What does the short-run average cost curve look like?

Why?

Answer 15

As you approach Q₁, there are increasing returns to a fixed factor - as greater inputs are added to a fixed factor (such as a shop), output is increasing at a faster and faster way, hence average costs are falling

However, from Q₁, the firm will experience diminishing returns to a fixed factor - as greater inputs are added, they start to add less than the last to total output, which means that average costs begin to rise (for example, from overcrowding of staff)

This can also be called diminishing marginal productivity - after Q₁, the addition of each input produces less output as productivity is hampered

Question 16

What does the marginal cost curve look like? (with AC)

Why?

Answer 16

Initially, marginal costs starts to decrease as the cost of the second good does not include the fixed costs, and you experience increased marginal productivity.

However, marginal costs then increase because of diminishing marginal productivity

As soon as MC intersects AC, AC begins to increase - this is because the cost of producing another good (marginal) is now greater than the average, and so the average cost begins to rise

Question 17

What does the long-run average cost curve look like?

Why?

Answer 17

As a firm increases its scale, economies of scale allow it to move onto lower SRAC curves.

Joining all of the SRAC curves together produces the long run average cost curve (LRAC).

The point where the LRAC is lowest is called the minimum efficient scale (Q₃)

After the MES, the firm experiences disceonomies of scale, which creates higher average costs at higher outputs

Question 18

What are economies of scale?

Answer 18

A fall in long-run average costs as output increases

There are two types:

1. Internal - a fall in costs for an individual firm as its output increases
2. External - when an individual firm expands, the industry benefits and their average costs fall too

Question 19

Give 4 examples of internal economies of scale

Answer 19

1. Purchasing economies - as a firm gets larger, it can afford to purchase its raw materials more cheaply through bulk buying
2. Financial economies - the rate of interest charged to large firms may be lower than that of small firms because small firms are often deemed to be riskier ventures.
3. Risk-bearing economies - the ability of large firms to spread the costs of uncertainty of production over a large level of output and thereby reduce unit cost.
4. Technical Economies - when a firm increases physical capacity and costs rise less than proportionately. For example, studies have shown that when oil firms increase the size of their tankers from 30,000 tons to 90,000 tons, costs do not rise threefold so cost per unit fall.

Question 20

Give 2 examples of external economies of scale

Answer 20

1. Retailers located close to each other are able to benefit from the development of new roads and transport links
2. A group of small businesses is able to share administrative and secretarial facilities and therefore lower long-run costs per unit

Question 21

What is profit?

Answer 21

Profit is the difference between revenue and costs

Question 22

What are the two types of profit?

Answer 22

1. Accounting profit: revenue - costs
2. Economic profit: revenue - economic cost

Economic cost is cost including opportunity cost of producing elsewhere

Question 23

Where is profit maximised?

Answer 23

Where marginal cost = marginal revenue

Question 24

Why is profit maximised at MC = MR?

Answer 24

This is where the difference between total cost and total revenue is greatest, hence profit is greatest

Question 25

What are the three types of profit?

Answer 25

1. Supernormal profit: AR > AC
2. Normal profit: AR = AC
3. Subnormal Profit (economic loss): AC > AR

Question 26

Should a firm shut down immediately if it is making an economic loss? Why/why not?

Answer 26

It depends on whether revenue is larger than the average variable cost:

If it is lower - the firm should shut down immediately.

If it is higher* - the firm should *continue to run in the short-run so it can use its revenue to contribute towards fixed costs. This is because the loss made from shutting down immediately is greater than the loss made by operating in the short-run.

Question 27

Should this firm shut down immediately, or in the long-run?

Answer 27

Immedietely - AR is less than AVC as well as AC , meaning that neither variable costs or fixed costs are being covered and so the firm should shut down straight away