1.5.1: Cost, Revenue and Profit Theory (HL only)

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    Definitions

     

    1. Short run is the period of time in which one factor of production is fixed. All production takes place in the short run.
    2. Long run is the period of time in which all factors of production are variable. All planning takes place in the long run.
    3. Law of diminishing returns states that the increased output per additional unit of variable factor will ultimately fall. These diminishing returns will always set in if one or more factors of production are fixed.
    4. Economic costs are estimated by adding explicit costs (accounting costs) and implicit costs (the opportunity cost of using factors of production).
    5. Explicit costs are costs to a firm that involve the direct payment of money to purchase factors not already owned by the firm.
    6. Implicit costs are earnings a firm could have had if it had employed its factors in another use or hired out or sold them to another firm.
    7. Economies of scale are a fall in the long run average costs that come about when a firm alters its factors of production in order to increase its scale of output, and lead to the firm experiencing increasing returns to scale.
    8. Diseconomies of scale are an increase in the long run average costs that come about when a firm alters its factors of production in order to increase its scale of output, and lead to the firm experience decreasing returns to scale.
    9. Normal profit/Zero economic profit is the amount of revenue needed to exactly cover all of the economic costs. It is the minimum revenue needed to keep the firm in business.
    10. Economic profit/Abnormal profit is a level of profit that is greater than that required to ensure that a firm will continue to supply its existing product. This occurs when the total revenue is greater than the economic costs.
    11. Shut-down price enables a firm to cover its variable costs in the short-run, and occurs where price equals the average variable costs. If the price does not cover the average variable costs, the firm will shut down in the short run.
    12. Break-even price enables a firm to cover its costs in the long-run, and occurs where price equals average total costs, making normal profit. If the price does not cover the average total costs, the firm will shut down for good.
    13. Profit-maximizing level of output is the level of output where marginal revenue is equal to marginal cost, and marginal cost is rising.
    14. Satisficing refers to acceptance of less than maximum profits in order to pursue other objectives..

    Total, average, marginal product

     

    1. Total product

    • Total output that a firm produces, using its fixed and variable factors in given time period.

     

    2. Average product

    • Output that is produced, on average, by each unit of variable factor.
    • AP = TP

    V

    Where TP is total product and V is the number of units of variable factors employed.

     

    3. Marginal product

    • Extra output that is produced by using an extra unit of the variable factor.
    • MP = △TP

    △V

    Where △TP is the change in total product and △V is the change in number of units of

    variable factors employed.

    Law of diminishing returns

     

    1. Law of diminishing marginal returns

    • As extra units of a variable factor are added to a given quantity of a fixed factor, the output from each additional unit of the variable factor will eventually diminish.

     

    2. Law of diminishing average returns

    • As extra units of a variable factor are added to the given quantity of a fixed factor, the output per unit of the variable factor will eventually diminish.

     

    Economic cost

     

    Economic Cost = Explicit Costs + Implicit Costs

     

    1. Explicit Cost

    • Costs that involve direct payment of money.
    • These factors are purchased from others and not already owned by the firm.
    • Therefore, there’s no opportunity cost involved in buying factors of production from other firms.

     

    2. Implicit Cost

    • Opportunity cost for the firm if they had employed its factors for another use.
    • These factors are already owned by the firm.
    • Therefore, there’s opportunity cost involved due to uncertainty that the firm could’ve had more profit if they used these factors for another use.

     

    Short run-costs

     

    1. Total Costs

    • Complete costs of producing output.

     

    i. Total fixed cost (TFC)

    • Total cost of fixed assets that a firm uses in a given time period.
    • It is the same whether a firm produces one or additional units of output.
    • TFC = Number of fixed assets * Cost of each fixed asset.

     

    ii. Total variable cost (TVC)

    • Total cost of variable assets that a firm uses in a given time period.
    • TVC increases as firm uses more of the variable factor.
    • TVC = Number of variable factors * Cost of each variable factor.

     

    iii. Total cost (TC)

    • Total cost of all fixed and variable factor used to produce a certain output.
    • TC = TFC + TVC

    ALWAYS REMEMBER!!

    TC SHOULD START AT TFC CURVE AS TC IS THE SUM OF TFC AND TVC.

    2. Average Costs

     

    i. Average fixed cost (AFC)

    • Fixed cost per unit of output.
    • AFC = TFC

    q

    Where q is the level of output

    • As output increases → AFC decreases due to TFC always being constant.

     

    ii. Average variable cost (AVC)

    • Variable cost per unit of output.
    • AVC = TVC

    q

    Where q is the level of output.

    • As output increases → AVC decreases then increases due to diminishing average returns.
    • As more variable factors are applied to fixed factors → Output per unit of variable factor decreases → Cost per unit of output increases.

     

    iii. Average total cost (ATC)

    • Total cost per unit of output.
    • ATC = TC

    q

    Where q is the level of output

    • As output increases → ATC decreases then increases.

    Marginal cost

    • Increase in total cost of producing an extra unit of output.
    • MC = △TC

    △q

    Where △TC is the change in total cost and △q is the change in level of output.

    • As output increases → MC decreases then increases due to diminishing marginal returns.
    • As more variable factors are applied to fixed factors → Output per additional unit of variable factor decreases → Extra cost per unit of output increases.

     

    ALWAYS REMEMBER!!

    1. MC CURVE CUTS THE AVC AND AC CURVE AT THEIR LOWEST POINT.
    2. AC CURVE IS ABOVE AVC AS AVC AND AFC ADDS TO THE AC CURVE.

     

    Long run

     

    1. Increasing returns to scale

    • Happens when long-run unit costs fall as output increases.
    • Given % increase in all factors of production → greater % increase in output → Reducing long-run average costs.

     

    2. Constant returns to scale

    • Happens when long-run unit costs are constant as output increases.
    • Given % increase in all factors of production → same % increase in output →

    Leaving long-run average costs with the same.

     

    3. Decreasing returns to scale

    • Happens when long-run unit costs rise as output increases.
    • Given % increase in all factors of production → smaller % increase in output → Increasing long-run average costs.

    Economies of scale

    • Any decreases in the long-run average costs when a firm alters all of its factors of production in order to increase its scale of output.
    • Leads to firms experiencing increasing returns to scale.
    • There are many types of economies of scale, such as:

    ❖      Specialisation

    • In small firms, the managers take on many roles in the business.
    • Some of these roles might not fit for the manager’s working capacity, which leads to higher costs for the firm.
    • As firms grow, they are able to manage their company by having people specialize in different areas of business, such as operations, finance or marketing.
    • This would increase the efficiency of the firm.

    ❖      Division of labor

    • Splitting up the production process into small activities that workers can perform repeatedly and efficiently.
    • As firms get bigger and demand increases → They start to break down production process, division of labor and reduce unit costs.

    ❖      Bulk buying

    • As firms increase in scale → They negotiate discounts with suppliers than they would have if they purchased less materials → Reduced cost of their inputs →

    Reduced unit costs of production

    ❖      Financial economies

    • Large firms can raise money more cheaply than small firms.
    • Banks tend to offer lower interest rates to larger firms since they are less of a risk compared to small firms, and they can repay their loans faster than small firms.

     

    ❖      Transport economies

    • Large firms that does bulk buying may also be charged less for delivery costs than smaller firms.
    • As firms grow, they’re able to have their own transportation system → Reduces cost for the firm as they’re not paying other firms to transport their products.

    ❖      Large machines

    • Small firms use equipment from suppliers who will charge them a price that includes a profit margin for the supplier.
    • Once the firm grows, they can buy their equipment, which reduces the cost of productions in the long run.

    ❖      Promotional economies

    • Almost all firms promote their products through advertising, sales promotion, personal selling, publicity or all of the above.
    • Costs of production tends to not increase by same % as the output → Cost of promotion per unit of output falls.

     

    Diseconomies of scale

    • Any increases in long-run average costs when a firm alters all of its factors of production in order to increase its scale of output.
    • Leads to firm experiencing decreasing returns to scale.
    • There are different types of diseconomies of scale that affects a firm, such as:

    ❖      Control and communication problems

    • As firms grow in scale, the management will find it harder to control and coordinate the activities of the firm → Inefficiency → Increase in unit costs of production.
    • Greater size → Huge increase in need for effective communication as more communication breakdowns occurs → Unit cost increases.

    ❖      Alienation and loss of identity

    • As firms grow, both workers and managers begin to feel like they only have a small part in a large organization → Loss in sense of loyalty and belonging → They will be less productive in their work → Increases unit costs of production.

    Revenue theory

     

    1. Total revenue

    • Total amount of money that a firm receives from selling certain amount of good or service in a given time period.
    • TR = p * q

    Where p is the price of the product sells for and q is the quantity of the product sold in

    the given time period.

     

    2. Average revenue

    • Revenue that a firm receives per unit of its sales.
    • AR = TR = p * q = P

    q         q

    Where q is the quantity of the product sold in the given time period.

    • Average revenue is the same as the price of the product.

     

    3. Marginal revenue

    • Extra revenue that a firm gains when it sells one more unit of a good or service in a given time period.
    • MR = △TR

    △q

    Where △TR is the change in total revenue and △q is the change in quantity of product

    sold in a given time period.

     

     

     

     

    Two situations for revenue theory

     

    1. Revenue when price doesn’t change with output

    • Elasticity of demand is infinite in this situation.
    • When a firm doesn’t have to lower price as output increases and wishes to sell more of its product, then it has a perfectly elastic demand curve.
    • Therefore, demand of the product = Average revenue = Marginal revenue.
    • Only happens in theory.
    • It’s assumed that firms are very small to affect the total industry supply and price in a significant way. Therefore, firm can sell their products the same price it produces it.

    2.Revenue when price falls as output increases

    • Elasticity of demand falls as output increases.
    • Total revenue, average revenue and marginal revenue decreases as output increases.
    • If a firm wants to sell more of its product and they are able to control its price, then they have to lower the price to increase demand of the product.
    • Demand of the product = Average revenue.

    ALWAYS REMEMBER!!

    1. WHEN PED > 1, THE REVENUE FOR THE FIRM IS INCREASING.
    2. WHEN PED = 1, THE REVENUE FOR THE FIRM IS MAXIMIZED.
    3. WHEN PED < 1, THE REVENUE FOR THE FIRM IS DECREASING.

    Profit theory

     

    Total profit = Total revenue – Economic cost (Explicit cost + Implicit cost)

     

    1. Abnormal profit

    • Also known as economic profit.
    • Happens when total revenue > total cost.

    2. Normal profit

    • Also known as zero economic profit.
    • Happens when total revenue = total cost.

    3. Loss

    • Also known as negative economic profit.
    • Happens when total revenue < total cost.

    ALWAYS REMEMBER!!

    1. FOR ABNORMAL PROFIT, THE PRICE CHANGE IS BELOW EQUILIBRIUM.
    2. FOR NORMAL PROFIT, THE PRICE DOESN’T CHANGE.
    3. FOR A LOSS, THE PRICE CHANGE IS ABOVE EQUILIBRIUM.
    4. MC CURVE ALWAYS CUTS THE AC CURVE AT ITS LOWEST POINT.

     

    Shut-down price

    • If the price doesn’t cover average variable cost → Firm will shut down in the short run.
    • If the firm doesn’t cover AVC → the firm should shut down temporarily.
    • If the firm covers AVC but not AFC → the firm might continue or shut down.
    • If the firm covers AVC and a bit of AFC → the firm should continue to operate.
    • Example of this situation is when a coffee shop closes in the summer as they don’t have enough customers to serve to, which leads to the the coffee shop not covering up their average variable costs. However, they can re-open during the summer as demand for coffee would be huge, which leads to the firm covering their AVC and AFC.

     

     

     

    Break-even price

    • Price at which a firm is able to make normal profit in the long run.
    • If the price doesn’t cover average total cost → Firm will shut down for good.

     

    Profit-maximizing level of output

    • When marginal revenue > marginal cost → firms should increase their production.
    • If a firm wants to maximize their profit, they should produce the level of output where marginal cost curve cuts marginal revenue curve from below.

     

    Other aims for owners of a business

     

    1. Revenue maximization

    • Some owners might maximize their sales revenue by producing where MR = 0.
    • This will produce above the profit maximizing level of output.
    • For example, if a company wants to sell cricket bats, they would focus on at what quantity and at what price does the company earn the maximum revenue.

     

    2. Growth maximization

    • Companies focus on gaining larger market share and dominating the market in the long run rather than achieving profit maximization.
    • Can be measured through quantity of sales, sales revenue, employment or the percentage of the market share in an industry.
    • For example, Snapchat is focusing more on dominating t he social networking industry rather than maximizing their profit so they have a more social media presence.

     

    3. Satisficing

    • Occurs when an economic agent aims to perform satisfactorily rather than to a maximum level in order to pursue other strategies and goals.
    • For example, an accountant, working for Nestle, would perform what they are asked for and will do it as their contract says, but they have other goals in their life, such as leisure time with family and friends.

     

     

     

     

     

     

    4. Corporate social responsibility

    • Business includes the public interest in their decision making.
    • Firms tend to focus on making their surroundings better by hiring more workers to raise employment rate, to develop the country and make the society better.
    • For example, Abercrombie and Fitch had to deal with issues related to body types as one employee said they won’t give dresses to people who don’t fit into their beauty standards. This lead to ethical issues and later the company did advertisements with people from different cultures and body types.

      Paper 3 Questions

       

      1. A small firm has been operating for one year. During the year they have:
      • Paid $40,000 in wages and salaries.
      • Paid $100,000 for raw materials.
      • Used their own small factory, which could have been rented out for $90,000.
      • Used $40,000 worth of electricity and services.
      • Received $450,000 in total revenue.

      In addition:

      • The firm uses its own machinery, which has reduced in value by $20,000 because of wear and tear and now has a second hand value of $70,000.
      • The owner of the firm has given up a job with another firm, where he would have been paid $70,000 per year.
      • The owner has invested $60,000 of his own money into the business (the rate of interest during the year has been 5%)

       

      a) Identify the costs of the firm as explicit or implicit.

    1. b) Calculate profits/losses made by the firm from the point of view of:

     

    1. i) an accountant

     

    1. The following table provides data for the total product of good Z and quantity of labor of a firm. Complete the table and graph it.

     

    1. Some figures for the price and quantity demanded for the product X is shown below. Complete the table and graph it.

     

    1. Consider the following data on output and total cost corresponding to each level of output. Complete the data table and graph it.