Revenue, Costs & Profits

This is the engine room of Unit 3. Get the revenue and cost curves rock-solid here, because every market-structure diagram in 3.3 is built from them.

Learning objectives — by the end of 3.2 you can…

- calculate and relate total, average and marginal revenue, and link them to PED; - derive the short-run cost curves from diminishing returns and draw them; - explain economies and diseconomies of scale and the LRAC curve; - distinguish normal profit, supernormal profit and losses, and identify shutdown points.

Revenue: total, average & marginal

Spec: 3.2.1

Key Terms

Total revenue (TR) Price × quantity sold.

Average revenue (AR) TR ÷ Q = the price. The AR curve is the demand curve.

Marginal revenue (MR) The change in TR from selling one more unit.

For a price taker (perfect competition), the firm sells all it wants at the market price, so AR = MR = price (a horizontal line). For a price maker facing a downward-sloping demand curve, MR falls faster than AR and lies below it.

The PED–revenue link

- Demand elastic (PED > 1): a price cut raises TR → MR is positive. - Demand inelastic (PED < 1): a price cut lowers TR → MR is negative. - TR is maximised where PED = 1, i.e. where MR = 0.

Worked Example — TR, AR & MR

At $10 a firm sells 100 units → TR = $1,000 (AR = $10). It cuts the price to $9 and sells 120 → TR = $1,080.

ΔTR = $80 over 20 extra units → MR ≈ $4 per unit. Because the price cut raised total revenue, demand over this range is elastic.

Costs & the law of diminishing returns

Spec: 3.2.2

In the short run at least one factor (usually capital) is fixed. The law of diminishing returns says that as more of a variable factor (labour) is added to a fixed factor, the marginal product eventually falls. This is exactly why the cost curves are U-shaped: while marginal product is rising, MC falls; once diminishing returns set in, MC rises.

Cost definitions & relationships

TC = TFC + TVC Total cost = total fixed + total variable cost.

AFC = TFC ÷ Q Average fixed cost — falls continuously as output spreads fixed costs.

AVC = TVC ÷ Q Average variable cost — U-shaped.

AC = TC ÷ Q Average (total) cost — U-shaped; AC = AVC + AFC.

MC = ΔTC ÷ ΔQ Marginal cost — the cost of one more unit.

Two relationships examiners love: MC cuts AVC and AC at their lowest points, and the gap between AC and AVC is AFC (so they converge as output rises).

Economies & diseconomies of scale

Spec: 3.2.3

In the long run all factors are variable, so the firm can change its scale. As it grows, economies of scale can pull long-run average cost (LRAC) down — but grow too big and diseconomies of scale push it back up.

Diseconomies of scale arise from communication problems, coordination problems and X-inefficiency (waste and slack in very large organisations). The minimum efficient scale (MES) is the lowest output at which LRAC is minimised.

Profits & losses

Spec: 3.2.4

Key Terms

Normal profit The minimum reward needed to keep the firm in the industry (it covers opportunity cost). Occurs when AR = AC (TR = TC). It is treated as a cost.

Supernormal profit Profit above normal — when AR > AC (TR > TC).

Loss When AR < AC (TR < TC).

Shutdown points

- Short run: a firm keeps producing as long as it covers its variable costs. It shuts down if AR < AVC — the short-run shutdown point is where AR = AVC (minimum AVC). - Long run: the firm must cover all costs. It shuts down if AR < AC — the long-run shutdown point is where AR = AC (minimum AC).

Watch Out

Because normal profit is a cost, a firm earning normal profit (AR = AC) is doing fine — it's covering everything including the owner's opportunity cost. "Only normal profit" is not a loss.

3.2 Recap — nail these

AR = price (the demand curve); price taker AR = MR; price maker MR < AR; TR max at MR = 0.
Cost curves are U-shaped (diminishing returns); MC cuts AVC & AC at their minima; AFC falls.
Economies of scale lower LRAC to the MES; diseconomies raise it.
Normal profit AR=AC; supernormal AR>AC; loss AR