1.5.

Theory of the Firm

Costs, revenues and profit

Production and Costs

Short run vs Long run

A short run period is one during which certain factors like factory building ,no of
machines etc.. remains fixed i.e. the size of the plant remains constant .but the
others like labour, raw material and power called variable factors can be
increased or decreased. In a short run period the output of a commodity can be
increased or decreased by changing the amount of variable factors only. A short
run period differs from industry to industry and it is an operational period.

So the short run is the time frame in which the quantities of some resources are
fixed. In the short run, a firm can usually change the quantity of labour it uses but
not the quantity of capital.

A long run period is one in which all the factors of production i.e. fixed (plant)
and variable (raw material, labour) can be changed. So the size of the plant can be
increased or decreased by changing the quantities of all factors of production. It
differs from industry to industry.

So the long run is the time frame in which the quantities of all resources can be
changed.

The length of the short run for a firm will be determined by the time it takes to
increase the quantity of the fixed factor, this will vary from industry to industry.
All production takes place in the short run and all planning takes place in the long
run.

1
Short-run production
We describe the relationship between output and the quantity of labour
employed by using three related concepts:
Total product
Marginal product
Average product

Total Product
Total product (TP) is the total quantity of a good produced in a given period. Total
product is an output rate the number of units produced per unit of time (per
hour, per day, week etc).

The total product schedule shows how the quantity of the product that the
producer can produce changes as the quantity of labour employed changes.

Point Quantity of labour Total product (gallons

(workers) per hour)
A 0 0
B 1 1
C 2 3
D 3 6
E 4 8
F 5 9
G 6 9
H 7 8

Task 1: Plot the information above with Q labour on horizontal axis and
total product on the vertical axis
Marginal Product
Marginal product (MP) is the change in total product that results from a one-unit
increase in the quantity of labour employed. It tells us the contribution to total
product of adding one additional worker.

2
Marginal Product = Change in Total Product/Change in the quantity of labour
Task 2: Complete the table below
Point Quantity of Total product Marginal
labour (gallons per Product
(workers) hour)
A 0 0
B 1 1 1
C 2 3 2

D 3 6 3
E 4 8 2
F 5 9 1
G 6 9 0
H 7 8 -1

Increasing marginal returns occur when the marginal product of an

additional worker exceeds the marginal product of the previous worker.
Increasing marginal returns occur when a small number of workers are employed
and arise from increased specialization and division of labour in the production
process.
Decreasing marginal returns occur when the marginal product of an
additional worker is less than the marginal product of the previous worker.
Decreasing marginal returns arise from the fact that more and more workers use
the same equipment and work space. As more workers are employed, there is less
and less that is productive for the additional worker to do.
Decreasing marginal returns are so pervasive that they qualify for the status of a
law: the law of decreasing/diminishing returns which states that:

3
 As a firm uses more of a variable input, with a given quantity of
fixed inputs, the marginal product of the variable input eventually
decreases.

Average Product (AP)

This is the total product per worker employed. It is calculated as:

Average product = Total product/quantity of labour

Task 3: Complete the table below

Point Quantity of labour Total product Average product
(workers) (gallons per (AP)
hour)
A 0 0 -----
B 1 1 1.0
C 2 3 1.5
D 3 6
E 4 8
F 5 9
G 6 9
H 7 8

Relationship between average product and marginal product

Task 4: Illustrate the average product and marginal product on a graph with
marginal/average product on the y-axis and quantity of labour on the x-axis.

Interpretation of the relationship

4
 When marginal product exceeds average product, average product is
increasing.
When marginal product is less than average product, average product is
decreasing.
Notice that average product is largest when average product and marginal
product are equal.

Task 5
(a) Construct the marginal product and average product schedules for the
following production function:

Labour Total Output Marginal product Average product

1 8
2 18
3 29
4 42
5 52
6 60
7 67
8 72
9 75
10 74

(b) Graph the total output and marginal product curves, and identify increasing
and diminishing marginal returns

Costs of Production (economic costs)

Accounting costs + Opportunity costs = Economic costs
Accounting costs are visible and/or directly quantifiable costs such as the cost of
raw material and the labour explicit costs. Economic costs are estimated by
adding onto accounting costs the (imputed) opportunity costs of using factors of

5
production, plus the risk premium of required minimum profit called normal
profit.

Thus Economic Cost of Production is the opportunity cost of production. it is the

value that could have been generated had the resources been employed in their
next best use. This concept of opportunity cost is useful when dealing with
production possibility frontiers.

Explicit costs and Implicit costs

A cost paid in money is an explicit cost and so for a producer it is the costs of
production.
A firm incurs an implicit cost when it uses a factor of production but does not
make a direct money payment for its use. The categories of implicit costs are as
follows:
1. Economic depreciation is the opportunity cost of the firm using capital
that it owns. It is measured as the change in the market value of capital
the market price of the capital at the beginning of a period minus its market
price at the end of the period. For example, suppose that a producer has
assets valued at $250,000 on December 31st 2014. If she can sell the same
assets on 31st December 2015 for $246,000 then her economic depreciation
for 2015 is $4000.
2. Interest is another cost of capital when the firms owner provides the
funds used to buy capital, the opportunity cost is the interest income
forgone by not using them in an alternative way
3. When a firms owner supplies labour, the opportunity cost of the
owners time spent working for the firm is the wage income forgone by not
working in the next best alternative job.
4. A firms owner often supplies entrepreneurship, the factor of production
that organizes the business and bears the risk of running it. The return to

6
 entrepreneurship is normal profit. Normal profit is part of a firms
opportunity cost because it is the cost of a forgone alternative running
another firm.

Example of Explicit and Implicit costs for a producer

Explicit Costs
Cost of raw material inputs $20,000
Wages $22,000
Interest on capital $3,000

Total Explicit Costs $45,000

Implicit costs
Entrepreneurs forgone wages $34,000
Entrepreneurs forgone interest $1,000
Economic depreciation $4,000
Normal Profit $16,000

Total Implicit Costs $55,000

Questions
6: Indicate whether each of the following is an explicit cost or an implicit cost:
(a) A managers salary
(b) Payments to IBM for computers
(c) A salary foregone by the owner of a firm by operating his or her own company
(d) Interest foregone on a loan an owner makes to his or her own company
(e) Medical insurance payments a company makes to its employees
(f) Income foregone while going to college

7
7: Lee is a computer programmer who earned $35000 in 1999. But with the new
millennium, Lee decided to try a new career. He loves water sports, and in 2000
he opened a body board manufacturing business. At the end of the first year of
operation, he submitted the following information to his accountant:

I. He stopped renting out his seaside cottage for $3500 a year and used it as
his factory.
II. He spent $50000 on materials, phone, utilities and the like.
III. He leased machines for $10000 a year.
IV. He paid $15000 in wages.
V. He used $10000 from his savings account at the bank, which pays 5% a
year interest.
VI. He borrowed $40000 at 10% a year from the bank.
VII. He sold $160000 worth of body boards
VIII. Normal profit is $25000 a year.

(a) Calculate Lees explicit costs

(b) Calculate Lees implicit costs.

Costs of Production in the short-run

Costs are defined as those expenses faced by a business in the process of
supplying goods and services to consumers

Types of costs
Fixed costs
Variable costs
Total costs

8
 Total fixed costs
Total variable costs
Average costs
Average fixed costs
Average variable costs
Marginal costs
Accounting costs + Opportunity costs = Economic costs

FIXED COSTS
Fixed costs relate to the fixed factors of production and do not vary directly with
the level of output so these costs are completely independent of output. At zero
output any costs that a firm has must be fixed. They have to be paid regardless of
the firms level of production. It is also known as indirect costs or overheads.

Some firms operate in a situation where the fixed costs represent a large
proportion of the total so it is wise to produce a large output in order to reduce
unit costs. Examples rent of buildings, leasing of capital equipment, the annual
uniform business rate charged by local authorities, the costs of full-time
contracted salaried staff, interest rates on loans, the depreciation of fixed capital
(due to age) and the costs of business insurance. It is a horizontal straight line.

VARIABLE COSTS
These are costs that vary directly with output since more variable units are
required to increase output. Examples are the costs of essential raw materials and
components, the wages of part-time staff or employees paid by the hour, the costs
of electricity and gas (although the cost of utilities is generally considered a semi-
variable/semi-fixed cost). Total variable cost rises as output increases. It is also
known as direct costs. If a firm wants to make more chocolate, for example, it will

9
need more cocoa beans and sugar which are basic raw material (variable) for the
firm

TOTAL COSTS (TC).

This is the total cost to the firm of producing a given number of units. This can be
sub-divided. Total cost = total fixed costs + total variable costs (or TC = TFC +
TVC). A cost is either fixed or variable. There is no third group. If a cost is not
fixed, then, by definition, it must vary with output.

Total fixed costs (TFC)

(TFC) remain constant as output increases.
TFC is the total cost of the fixed assets that a firm uses in a given time period

Total Variable costs (TVC)

It is the total costs of variable assets that a firm uses in a given time period. TVC
increases as the firm uses more of the variable factors

Access -
http://web.sis.edu.hk/Departments/EcoBus/microeconomics_11/media/tc
fcvccircle.html
AVERAGE COSTS (AC).

This is the cost, on average, per unit of output produced. If a firm made 100 bars
of chocolate at a total cost of 10, then the cost, on average, per bar of chocolate
produced, is 10c.
Average cost = Total cost = TC
Output Q Q= output

10
Average cost = average fixed cost + average variable cost (AC = AFC + AVC). This is
derived by simply dividing both sides of the total cost equation by Q. Average cost
is often called average total cost so as to distinguish it from AFC and AVC.

Average costs vary according to the level of output. They fall at first as the
quantity is increased because the fixed costs are being spread across a large
quantity of output. AC may also fall because there are economies of scale to be
reaped. At higher levels of output, it may be more efficient to use large machines
and invest in different technologies. If levels of output continue to increase then it
is possible that there will be diseconomies of scale these will cause average costs
to rise with output, reason may be difficulties of communication in a large
organisation.

The minimum average cost is associated with technical efficiency. When all
resources are being used as efficiently as possible it follows that average costs
will be at a minimum

Average total cost refers to the total costs per unit of a commodity. The average
total costs is equal to the total costs divided by the total output .

ATC = TFC + TVC or ATC = TC

Output (Q) Output

ATC = AFC + AVC

11
 Average fixed costs (AFC)

Average fixed costs refer to the fixed costs per unit of the commodity.
AFC = Total fixed costs (TFC)
Q(output)

Average fixed costs will fall continuously with output because the total fixed costs
are being spread over a higher level of production or the same amount of fixed
costs is distributed over more and more units causing the average cost to fall.
A business can "spread their overhead costs" by increasing output in the short
run. Average fixed cost will never be zero if there are positive total fixed costs.

Average variable cost (AVC)

AVC refers to the variable cost per unit of a commodity.

AVC = Total Variable Costs (TVC)
Output (Q)

AVC depends on the cost of employing variable factors compared to the average
productivity of these factors (usually labour productivity). If additional units of
labour can be hired at a constant cost there will be an inverse relationship
between average product and average variable cost. Therefore, when average
product is maximised, AVC will be minimised.

MARGINAL COSTS (MC)

This is the additional cost incurred by a firm as a result of producing one more
unit of output. It is the extra cost at the margin (i.e. by producing the marginal
unit of output

12
MC = TC (change in total cost )
Q (change in quantity)
MC is independent of the size of fixed cost in the short run; it consists solely of
variable costs.

Access -
http://web.sis.edu.hk/Departments/EcoBus/microeconomics_11/media/tcacmc
circle.html

Task 8: Calculating costs of production complete the table

Output 0 1 2 3 4 5 6 7 8 9 10
(units
Total 100 110 125 145 170 200 235 275 320 370 425
cost
($k)
Fixed
Cost
Variabl
e Costs

Graphing total cost, fixed cost and variable cost

13
Task 9: Calculating costs of production average and marginal

Output (units) 0 1 2 3 4 5 6 7 8 9 10
10 11 12 14 17 20 23 27 32 37 42
Total cost ($000)
0 0 5 5 0 0 5 5 0 0 5
Total variable cost 10 13 17 22 27 32
0 10 25 45 70
($000) 0 5 5 0 0 5
Average variable cost
----
($ per unit)
Average fixed cost ($
----
per unit)
Average cost ($ per
----
unit)
Marginal cost ($000) ----

Graphing average and marginal cost curves

14
Questions
Task 10: Calculating the costs of production
1 2 3 4 5 6 77 8 9
Qty of Total Total Total Total Average Average Average Marginal
labour Product Fixed Variable Cost Fixed Variable Total Cost (MC)
(V) (TP) or cost Cost (TC) cost Cost Cost
output (TFC) (TVC) (AFC) (AVC) (ATC)
(q)

0 0 400 0 400 0 0 0 0
1 10 400 200 600 40 20 60 20
2 25 400 400 800 16 16 32 13.33
3 45 400 600 1000 8.89 13.33 22.22 10
4 70 400 800 1200 5.71 11.43 17.14 8
5 90 400 1000 1400 4.44 11.11 15.55 10
6 105 400 1200 1600 3.81 11.43 15.24 13.33
7 115 400 1400 1800 3.48 12.17 15.65 13.33
8 120 400 1600 2000 3.33 13.33 16.66 40

The law of diminishing marginal returns

The law of diminishing returns states that as one input variable is increased,
there is a point at which the marginal increase in output begins to decrease,

15
holding all other inputs constant. At the point where the law sets in, the
effectiveness of each additional unit of input decreases.

Access -
http://web.sis.edu.hk/Departments/EcoBus/microeconomics_11/media/lawdim
rtns.html

The shape of short run costs (MC, ATC and AVC) is determined by the law of
diminishing returns. Since short-run costs are determined by the productivity of
the variable resource in the short-run (labor), diminishing returns assures that at
first, since a firm can expect to get MORE output for additional units of labor (as
fixed capital is used more efficiently) ATC declines as output increases. But
beyond a certain point, diminishing returns sets in and the additional output
attributable to more units of the variable resource declines. Inevitably, a firm will
experience higher and higher average costs as its output continues to grow, since
its only able to vary the amount of labor used, not capital.

This theory supports the shape of the marginal and average cost curves. Both of
these curves will be u-shaped as eventually diminishing returns will lead to costs
increasing. Initially increasing returns mean that both AC and MC will fall, but
once diminishing returns set in both curves start to rise again. The MC and AC
curves are shown in Figures 2 and 3, although we will return to these in more
detail in the next section.

Figure 1 Marginal cost curve

16
 Figure 2 Average cost curve

The marginal cost curve will

intersect the average cost
curve at its minimum point.

The actual position of the AC

curve will vary with a
number of factors.

Costs of factor
inputs (labour,
materials, services etc).
The cheaper the inputs the lower the average cost will be at any given
output.

Productivity - productivity can be defined as output per unit input. The

more productive the firm, the more output it gets from its inputs and the
lower the average cost at any output.

Productivity is measured in a number of ways:

Marginal product (MP) - the change in total output resulting from the
adding of one extra unit of a variable factor, often labour.

Average product (AP) - total output / units of variable factor being used.

The choice of factor inputs will be driven by their costs, productivity and effect on
product cost. An efficient firm will make its choices so as to minimize its average
cost at the production rate being worked. Look at the following example.

17
Example
Student Computers make DVD drives. Its average cost curve is shown in figure 3
below.

Figure 3 Average cost curve for Student Computers on 1st May 2002

The following then takes place:

Business rates increase (fixed costs (FC))

Insurance premiums rise (FC)
Wage rates (variable costs (VC)) and salaries (FC) increase

This will change the cost curves. The curve will move upwards due to the increase
in fixed costs. The average cost of production at the present output will rise from
C1 to C2. Unless something is done about it, the profits will fall.

Figure 4 Average cost curves for Student Computers on date 1

18
In response to these changes the research and development department
introduces new materials that are cheaper to buy than the old ones. They also
introduce new working practices and procedures that increase productivity
considerably. The savings are shared between the firm and its employees. This all
reduces variable costs and the AC curve falls again. Now the production average
cost, at C3, is lower than before.

Figure 5 Average cost curves for Student Computers on date 2

The firm has responded to rises in certain costs by taking steps to reduce others.

19
Costs of Production in the long run

The Long Run: The long run is defined as the variable-plant period. A firm can
adjust the number of all its inputs: land, labor and capital. One way of thinking
about the difference between the short-run and the longrun is imagining the
long-run as several different short-runs spread out over a larger range of output.
The graph below will illustrate this concept for you.

When we examine the long-run ATC more closely, it becomes apparent that there
are in fact lots of little short-run ATC curves along the length of the long-run
curve. Each of the gray lines in the graph above represents a short-run period in
which this firm opened a new factory.

Source: http://welkerswikinomics.com/blog/tag/long-run-average-total-cost/

20
There are three distinct phases of this firms long-run ATC:

1. Economies of Scale - Economies of scale are the cost advantages that a

business can exploit by expanding their scale of production in the long run.
The effect of economies of scale is to reduce the long run average (unit)
costs of production over a range of output. These lower costs represent an
improvement in productive efficiency and can feed through to consumers in
lower prices. But economies of scale also give a business a competitive
advantage in the marketplace.
2. Constant returns to scale a condition in which, when a firm increases its
plant size and labour employed by the same percentage, its output
increases by the same percentage and its average total cost remains
constant.
3. Diseconomies of scale a condition in which, when a firm increases ist
plant size and labour employed by the same percentage, its output
increases by a smaller percentage and its average total cost increases.

Economies of Scale

Internal economies of scale (IEoS)

Internal economies of scale arise from the growth of the firm itself. Examples
include:

1. Technical economies of scale:

a. Large-scale businesses can afford to invest in expensive and specialist capital
machinery that reduces their average costs. For example, a national chain
supermarket might invest in technology that improves stock control and helps to
control costs. It would not, however, be viable or cost-efficient for a small corner
shop to buy this technology. Capital equipment capable of producing
thousands/millions of units of a product will only lead to economies of scale if
there is sufficient market demand for the good or service. Otherwise the supplier
will end up with excess capacity and higher unit costs
b. Specialization of the workforce: Within larger firms there splitting complex
production processes into separate tasks in order to boost productivity. The
division of labour in mass production of motor vehicles and in manufacturing
electronic products is an example
c. The law of increased dimensions. This is linked to the cubic law where doubling
the height and width of a tanker or building leads to a more than proportionate
increase in the cubic capacity an important scale economy in distribution and
transport industries and also in travel and leisure sectors

21
2. Marketing economies of scale and monopsony power: A large firm can
spread its advertising and marketing budget over a much larger output and it can
purchase its factor inputs in bulk at negotiated discounted prices if it has
monopsony (buying) power in the market. A good example would be the ability of
the electricity generators to negotiate lower prices when negotiating coal and gas
supply contracts. The major food retailers also have monopsony power when
purchasing supplies from farmers and wine growers.

3: Managerial economies of scale: This is a form of division of labour. Large-

scale manufacturers employ specialists to supervise production systems. Better
management; investment in human resources and the use of specialist
equipment, such as networked computers that improve communication raise
productivity and reduce unit costs.

4: Financial economies of scale: Larger firms are usually rated by the financial
markets to be more credit worthy and have access to credit facilities, with
favourable rates of borrowing. In contrast, smaller firms often face higher rates of
interest on their overdrafts and loans. Businesses quoted on the stock market (or
capital market) can normally raise fresh money (extra financial capital) more
cheaply through the issue of equities. They are also likely to pay a lower rate of
interest on new company bonds issued through the capital markets.

5. Network economies of scale: There is growing interest in the concept of a

network economy of scale. Some networks and services have huge potential for
economies of scale. That is, as they are more widely used (or adopted), they
become more valuable to the business that provides them. The classic examples
are the expansion of a common language, a common currency. We can identify
networks economies in areas such as online auctions, air transport networks. The
marginal cost of adding one more user to the network is close to zero, but the
resulting benefits may be huge because each new user to the network can then
interact, trade with all of the existing members or parts of the network. The rapid
expansion of e-commerce is a great example of the exploitation of network
economies of scale.

External economies of scale (EEoS)

External economies of scale occur outside of a firm, within an industry. Thus,
when an industry's scope of operations expand due to for example the creation of
a better transportation network, resulting in a subsequent decrease in cost for a
company working within that industry, external economies of scale are said to
have been achieved. Another good example is the development of research and
development facilities in local universities that several businesses in an area can
benefit from. Likewise, the relocation of component suppliers and other support

22
businesses close to the main centre of manufacturing are also an external cost
saving.

Diseconomies of scale
A firm may eventually experience a rise in LRAC caused by diseconomies of scale.
Diseconomies are the result of decreasing returns to scale. The potential
diseconomies of scale a firm may experience relate to:
1. Control monitoring the productivity and the quality of output from
thousands of employees in big corporations is imperfect and costly this
links to the concept of the principal-agent problem how best can
managers assess the performance of their workforce when each of the
stakeholders may have a different objective or motivation?
2. Co-ordination - it can be difficult to co-ordinate complicated production
processes across several plants in different locations and different
countries. Achieving efficient flows of information in large businesses is
expensive as is the cost of managing supply contracts with hundreds of
different suppliers at different points of an industrys supply chain
3. Co-operation - workers in large firms may feel a sense of alienation and
subsequent loss of morale. If they do not consider themselves to be an
integral part of the business, their productivity may fall leading to wastage
of factor inputs and higher costs

Avoiding diseconomies of scale

1. Developments in human resource management are an attempt to avoid
diseconomies of scale. HRM is a horrible phrase to describe improvements
to procedures involving recruitment, training, promotion, retention and
support of faculty and staff. This becomes critical to a business when the
skilled workers it needs are in short supply. Recruitment and retention of
the most productive and effective employees makes a sizeable difference to
corporate performance in the long run (as does the flexibility to fire those
at the opposite extreme!)
2. Likewise, performance related pay schemes can provide incentives for the
workforce leading to an improvement in industrial relations
3. Increasingly companies are engaging in out-sourcing of manufacturing and
distribution as they seek to supply to ever-distant markets.

23
Questions

11: The table below sets out the quantity of labour (L), total product, and the
various costs incurred at Bills factory. Calculate the values of A, B, C, D, E, F, G, H
and I

L TP TVC TC AFC AVC ATC MC

1 100 350 850 C: 5 3.50 D: 8.50 E: 3.5
2 240 700 B: 1200 2.08 2.92 5.00 F: 2.50
3 380 A: 1050 1550 1.32 2.76 4.08 G: 2.50
4 440 1400 1900 1.14 3.18 4.32 H: 5.83
5 470 1750 2250 1.06 3.72 4.79 I: 11.67

12: Suppose the firm in Q1 can buy an additional machine that causes its
minimum short-run average total cost to become $10. Does this expansion
involve economies or diseconomies of scale? Sketch this situation in a diagram.

13: Plot the following data on quantity of production and long-run average total
cost for a firm. Show the areas of economies and diseconomies of scale and
constant returns to scale. What is the minimum efficient scale? Explain.
Quantity Long Run ATC
1 33
2 27
3 25
4 25
5 30
6 38
7 50

14: Suppose the average total cost curves for a firm for three different amounts of
capital are as follows:
Quantity ATC1 ATC2 ATC3
1 40 50 60
2 30 35 40
3 20 25 30
4 30 15 25
5 40 30 20
6 50 40 30
(a) Plot the three average total cost curves in the same diagram
(b) Determine the long-run average total cost curve and show it in the same
diagram as in part (a).
Revenues

24
Revenue is the income a firm obtains from the sales of its goods or services. Three
terms must be understood:

Total revenue (TR) - all the revenue earned by the business. Total revenue
= price x quantity demanded.
Average revenue (AR) - total revenue divided by number sold.
Marginal revenue (MR) - the increase in total revenue as the result of one
more sale. This is not necessarily the same as the price. It is only the same
as price, if price remains constant.
Revenue curves vary depending on whether price is constant at all levels of
output (as in the case of a firm which is a price-taker), or falls as output increases
(as in the case of a firm who is a price-setter). Look at Figures 1 and 2 below to
see the difference this makes to the shape of the average / marginal revenue and
total revenue curves:

Figure 1 Revenue curves - constant price (price-taker)

Figure 2 Revenue curves - falling price (price-setter)

25
You have to be able to calculate revenue, in any form, from data, then draw and
interpret curves. Time for an example, and for you to do some work again!
Output 0 1 2 3 4 5 6 7 8 9 10
(units)
Total 0 100 180 240 280 300 300 280 240 180 100
revenue
($ 000)

Plot this with output on the horizontal axis and revenue on the vertical axis. Look
at it and then we will do some more calculations.

Task 15: Calculate the average revenue and marginal revenue

Output (units) 0 1 2 3 4 5 6 7 8 9 10
10 18 24 28 30 30 28 24 18 10
Total revenue ($000) 0
0 0 0 0 0 0 0 0 0 0
Marginal revenue - 10
80 60 40 20 0 -20 -40 -60 -80
($000) - 0
10
Average revenue ($) 0 90 80 70 60 50 40 30 20 10
0

26
Graphing average revenue and marginal revenue

Observation of the graph shows:

Both AR and MR fall as output increases.
AR and MR start at the same point on the Y-axis, at the same level of
revenue.
MR can and does become negative.
Using the first graph as well, when MR is zero, TR is at its maximum. Output
is 5.5 units.

27
Profit (supernormal, normal and subnormal)

Profit measures the return to risk when committing scarce resources to a

particular market or industry. Entrepreneurs take risks for which they require an
adequate expected rate of return. The higher the market risk and the longer they
expect to have to wait to earn a positive return, the greater will be the minimum
required return that an entrepreneur is likely to demand.

Normal profit - is the minimum level of profit required to keep the factors
of production in their current use in the long run. Normal profits reflect the
opportunity cost of using funds to finance a business. Normal profits are
therefore included in the AC curve, thus, if the firm covers its ATC (where
AR meets AC) then it is making normal profits.

Sub-normal profit - is any profit less than normal profit (where price <
average total cost)

Abnormal profit - is any profit achieved in excess of normal profit - also

known as supernormal profit. When firms are making abnormal profits,
there is an incentive for other producers to enter the market to try to
acquire some of this profit. Abnormal profit persists in the long run in
imperfectly competitive markets such as oligopoly and monopoly where
firms can successfully block the entry of new firms.

Task 16: Calculate profit

Output 0 1 2 3 4 5 6 7 8 9 10
(units)

Total cost 100 110 125 145 170 200 235 275 320 370 425
($ 000)

Total 0 100 180 240 280 300 300 280 240 180 100
revenue ($
000)

Profit ($ -100 10 55 95 110 100 95 5 80 -190 -

000) 325

Questions

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Task 17: Calculating profit

Total Revenue $150,000

Explicit Costs
Cost of raw material inputs $20,000
Wages $22,000
Interest on capital $3,000

Total Explicit Costs $45,000

Implicit costs
Entrepreneurs forgone wages $34,000
Entrepreneurs forgone interest $1,000
Economic depreciation $4,000
Normal Profit $16,000

Total Implicit Costs $55,000

(a) Taking the perspective of an economist, identify the type of profit earned
and its level
There is a net profit and it is an abnormal profit
(b) Calculate the level of profit an accountant would value it at
Profit= 150000-45000= $ 105000
(c) Assume 10000 units are produced
AR= $15
ATC= $10
Profit= $5 X 10000 = $50000

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18: Consider the following cost data for a perfectly competitive firm in the short
run

Output (Q) Total Fixed Total Total Cost Total Profit

Cost (TFC) Variable (TC) Revenue
Cost (TVC) (TR)

1 100 120 220 150 -70

2 100 200 300 300 0
3 100 290 390 450 60
4 100 430 530 600 70
5 100 590 690 750 60

If the market price is $150, how many units of output will the firm produce in
order to maximise profit in the short run? Specify the amount of economic profit
or loss. At what level of output does the firm break even? Break even= zero profit
OR Total Cost= Total Revenueo

19: Sonya used to sell real estate and earn $25000 a year, but she now sells
greetings cards. Normal profit for the retailers of greetings cards is $14000. Over
the past year, Sonya bought $10000 worth of cards from manufacturers of cards.
She sold these cards for $58000. Sonya rents a shop for $5000 a year and spends
$1000 on utilities and office expenses. Sonya owns a cash register, which she
bought for $2000 from her savings accounts. At the end of the year, Sonya was
offered $1600 for her cash register machine. Calculate Sonyas:

(a) Explicit costs= 10000+ 5000+ 1000= $16000

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(b) Implicit costs= 25000+14000+(2000-1600) = $39400
(c) Economic profit= = 58000- 55000= $3000
Supernormal profit: continue with the business

Goals of Firms

Primary Goal: Profit Maximization

An assumption in classical economics is firms seek to maximize profits.

Profit = Total Revenue Total Costs Therefore, profit maximization occurs
at the biggest gap between Total revenue and total costs.
A firm can maximize profits if it produces at an output where Marginal
revenue (MR) = Marginal cost (MC)

*Discuss alternative goals of firms in the business so that its more inclusive
(more juice and higher marks lolllll)

***Diagram of Profit Maximization

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To understand this principle, look at the above diagram. If the firm produces less
than Q1, MR is greater than MC. Therefore, for this extra output, the firm is
gaining more revenue than it is paying in costs. Total revenue will increase. Close
to Q1, MR is only just greater than MC, therefore, there is only a small increase in
profit. But, profit is still rising.
However, after Q1, the marginal cost of the output is greater than the marginal
revenue. This means the firm will see a fall in its profit level.

Usually, in economics we assume firms are concerned with maximizing profit.

Higher profit means:
Higher dividends for shareholders.
More profit can be used to finance research and development.
Higher profit makes the firm less vulnerable to takeover.
Higher profit enables higher salaries for workers

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Alternative Aims of Firms

However, in the real world, firms may pursue other objectives apart from profit
maximization.
1. Profit Satisficing
In many firms there is separation of ownership and control. Those who
own the company (shareholders) often do not get involved in the day to day
running of the company.
This is a problem because although the owners may want to maximize
profits, the managers have much less incentive to maximize profits because
they do not get the same rewards, (share dividends)
Therefore managers may create a minimum level of profit to keep the
shareholders happy, but then maximize other objectives, such as enjoying
work, getting on with other workers. (e.g. not sacking them) This is the
problem of separation between owners and managers.
This principal agent problem can be overcome, to some extent, by giving
mangers share options and performance related pay although in some
industries it is difficult to measure performance.

2. Sales Maximization.
Firms often seek to increase their market share even if it means less profit. This
could occur for various reasons:
a) Increased market share increases monopoly power and may enable the
firm to put up prices and make more profit in the long run.
b) Managers prefer to work for bigger companies as it leads to greater
prestige and higher salaries.
c) Increasing market share may force rivals out of business. E.g.
supermarkets have lead to the demise of many local shops. Some firms may
actually engage in predatory pricing which involves making a loss to force a
rival out of business.

3. Growth Maximization.
This is similar to sales maximization and may involve mergers and takeovers.
With this objective, the firm may be willing to make lower levels of profit in order
to increase in size and gain more market share.

4. Long Run Profit Maximization.

In some cases, firms may sacrifice profits in the short term to increase profits in
the long run. For example, by investing heavily in new capacity, firms may make a
loss in the short run, but enable higher profits in the future.

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5. Social/ Environmental concerns.
A firm may incur extra expense to choose products, which dont harm the
environment or products not tested on animals.
Alternatively, firms may be concerned about local community / charitable
concerns.
Many companies who have adopted such strategies have been quite
successful. This has encouraged more firms to consider these over
objectives, but a cynic may argue they see it as another opportunity to
increase profits rather than a genuine sacrificing of profits in order to
promote other objectives.

6. Co-operatives
Co-operatives may have completely different objectives to a typical PLC. A co-
operative is run to maximize the welfare of all stakeholders especially workers.
Any profit the co-operative makes will be shared amongst all members.

See -
http://web.sis.edu.hk/Departments/EcoBus/microeconomics_11/media/al
ternativegoals.html

Source: http://www.economicshelp.org/microessays/costs/objectives-
firms/

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