Costs, Revenue and Profits

The Theory of Firms

How firms behave in
different market structures
like:
Perfect Competition,
Monopoly,
Monopolistic Competition
and
Oligopoly.
 Fixed factors and variable factors
Variable factors are the
inputs a manager can adjust
to alter production in the
short run, E.g, labour and
materials
Fixed factors are the inputs
that a manager cannot adjust
to alter production in the
short run. e.g., capital or land.
 Short run and Long run

The short run is that period of

time in which at least one factor
of production is fixed. All
production takes place in the
short run.
How long is the short run?.......
It is determined by the time it
takes to increase the quantity of
the fixed factor.
 Short run and Long run

Long run is that period of

time in which all factors of
production are variable, but the
state of technology is fixed. All
planning takes place in the long
run.
If a firm plans ahead to change
its fixed factors then all factors of
production are variable.
 Total, Average and Marginal product

Total product:
Total product (TP) is the total output that a
firm produces, using its fixed and variable
factors in a given period.
 Total, Average and Marginal product

Average product:
Average product(AP) is the output that is
produced, on average, by each unit of the
variable factor.

TP
AP = ____
V
 Total, Average and Marginal product

Marginal product:
Marginal product (MP) is the extra output that
is produced by using an extra unit of the
variable factor (V).
TP
MP ______
V
 TP, AP and MP
1 2 3 4
Quantity of Total product Average Marginal
Labour (V) (TP) product (AP) product (MP)
0 0
1 10 10 10
2 25 12.5 15
3 45 15 20
4 70 17.5 25
5 90 18 20
6 105 17.5 15
7 115 16.43 10
8 120 15 5
Output
Total
Total product curve

(Variable factor)
Average and marginal product curves
 Production function

Land Labour
Out
put
Production
Process

Enterpris
Capital
e
 Short run and long run

The short run is The long run is

defined as that time that period of
period where at time when all
least one factor of inputs can be
production is fixed. changed.
 The Law of Diminishing Returns
The law of diminishing
returns states that in all
productive processes,
adding more of one
factor of production,
(variable factor) while
holding all others
constant will at some
point yield lower per-
unit returns.
 Theory explained
Consider a factory that employs laborers to produce its
product. If all other factors of production remain
constant, at some point each additional laborer will
provide less output than the previous laborer. At this
point, each additional employee provides less and less
return. If new employees are constantly added, the
plant will eventually become so crowded that additional
workers actually decrease the efficiency of the other
workers, decreasing the production of the factory.
Read more: http://www.investopedia.com/terms/l/lawofdiminishingmarginalreturn.asp#ixzz292UDwHY4
Economic cost:The economic cost of producing a good is the opportunity cost of the firms production.

Explicit Cost Implicit cost

The costs that have a The cost of using the firms
money value like raw own resources. This is the
materials, energy, rent, earnings that a firm could
interest and wages and have have had if it had employed
to be purchased from its factors in another
outside the firm. use/hired/sold out.(Normal
(Accounting costs) profit)
(Accountants view) (Economists view)
 Short run costs

Total
cost

TFC TVC TC
 TFC is the total costs of the fixed assets.
TFC It is a constant amount.

TVC is the total costs of the variable assets.

TVC TVC increases as more variable factors are used.

Total costs of all fixed and variable factors.

TC TC=TFC+TVC
 DRAWING EXERCISE:
Using data given, draw TC,TVC and TFC Curves
Quantity TFC TVC TC
0 400 0 400
1 400 200 600
2 400 400 800
3 400 600 1000
4 400 800 1200
5 400 1000 1400
6 400 1200 1600
7 400 1400 1800
 Average
costs

AFC AVC ATC

 AFC is the fixed cost per unit of output.
AFC AFC=TFC divided by output

AVC is the variable cost per unit of output.

AVC AVC=TVC divided buy output.

ATC is the total cost per unit of output.

ATC ATC= TC divided by output.
 MARGINAL COST

Marginal Cost is the increase in the

total cost of producing an extra unit of
output. MC= TC divided by output
 DRAWING EXERCISE:
Using data given, draw TC,TVC and TFC Curves
Qty TFC TVC TC AC MC
0 400 0 400
1 400 200 600
2 400 400 800
3 400 600 1000
4 400 800 1200
5 400 1000 1400
6 400 1200 1600
7 400 1400 1800
AFC,AVC,ATC and MC Curves
 Relationship between ATC, AVC and MC
Curves
MC curves cuts the
AVC and ATC curves at
their lowest points.
Vertical gap between
ATC and AVC gets
smaller as output
grows.
AFC falls as output
increases.
 The long run
Definition:
The long run is that period of
time in which all factors of
production are variable, but
the state of technology is
fixed.
The long run is the planning stage.
Free to change all the factors of
production.
But constrained by the current level of
technology.
 Envelope Curve
When demand
increase, firms alter
all the factors of
production, and
move to an another
SRAC.
LRAC is made up of
infinite number of Attainable
such SRACs.
LRAC is the boundary Unattainable
between unit costs
that are attainable
and unattainable.
Increasing, Constant and Decreasing Returns

When long-run costs are

falling, as output increases
Increasing Returns.
When long-run costs are
constant, as output increases
Constant Returns.
When long-run costs are
increasing, as output increases

Decreasing Returns.
 Minimum Efficient Scale
The minimum efficient scale is defined as the
lowest production point at which long-run
total average costs (LRATC) are minimized.
Lowest (minimum)cost point.
Productively highly efficient point.
Economies of scale and diseconomies of scale
in balance.
 Why long-run costs increase or
decrease as output increase?
Economies of Scale:
The increase in efficiency of
production as the number of
goods being produced increases.
Diseconomies of Scale:
Rather than experiencing
continued decreasing costs per
increase in output, firms see an
increase in marginal cost when
output is increased.
 ECONOMIES OF SCALE
1. Specialisation:
As firms grows, they specialise in individual
areas of expertise, production, finance,
marketing.
 ECONOMIES OF SCALE
2. Division of labour:
As production increase, firms break-up the
production process, and use division of labour
and reduce the unit costs.
 ECONOMIES OF SCALE
3. Bulk buying:
Negotiate discounts with suppliers and reduce
the unit costs.
 ECONOMIES OF SCALE
4. Financial economies:
Banks charge lower interest rate to larger
firms because they are less risky and less likely
to fail to repay.
 ECONOMIES OF SCALE
5. Transport economies:
Delivery cost is less. Can have own transport
fleet.
 ECONOMIES OF SCALE
6. Large machines:
Big producer can own big machines and save
the money spent on hiring machines oft and
on.
 ECONOMIES OF SCALE
7. Promotional economies:
Advertising, sales promotion, personal selling,
publicityeverything is possible for a big firm.
 Diseconomies of scale
Increase in long-run average costs when firms
alters all of its factors of production in order
to increase its scale of output.
 Diseconomies of scale
Control and communication problems:
Difficulties in control and coordination
eventually leads to inefficiency.
Communication breakdowns.
 Diseconomies of scale
Alienation and loss of identity:
In bigger organizations, workers and
managers will feel themselves as a tiny part
of the organization and start lose of
belongingness.
 External economies of scale
The external factors (outside the
control of a particular company),
creates positive externalities
that reduce the firm's costs.
Eg; growth of industry leads to
local universities to start up
courses relate to the skill
required in the industry.
 External diseconomies of scale
External factors beyond the control of a company
increases its total costs, as output in the rest of the
industry increases.

Eg: competition among firms makes the raw materials,

capital and qualified labour quite expensive.
 Final Notes
Short-run cost curves are U shaped because
of diminishing returns.(Diminishing average
returns and diminishing marginal returns)
Long-run cost curves are U shaped (in theory)
because of economies and diseconomies of
scale.
But in reality, actual LRAC is
 Revenue Theory

Revenue is the income that a firm receives

from selling its products, goods and service
over a certain period of time.
 Measurement of
Revenue

Total Average Marginal

Revenue(TR) Revenue(AR) Revenue(MR)
 Total Revenue(TR)
TR is the total amount of money that a firm
receives from selling its goods and services in
a given time period.

TR= p x q
 Average Revenue(AR)
AR is the revenue that a firm receives per
unit of its sale.
TR
AR= ----- = P
q
 Marginal Revenue(MR)
MR is the extra revenue that a firm gains
when it sells one more unit of a product in a
given time period
TR
MR= -----------
q
 Total Revenue and Output
TR when price does not
change.(Horizontal demand
curve)
The firm does not have to
lower the price to sell more
output.
If PED=perfectly elastic, then
P=AR=MR=D
TR curve is upward sloping.
 Total Revenue and Output
TR when price change as output increase.
(downward sloping demand curve)
Firm has to lower price to sell more.
PED falls as output increases.
Relationship between TR, AR, MR and PED.

TR rises at first but will eventually

falls as output increases.
When PED is elastic, to increase
revenue, lower the price.
When PED is inelastic, to increase
revenue, raise the price.
When PED is unity, to increase
revenue, leave the price
unchanged.
 Profit Theory
Generally,
Profit =TR-TC.
But for an economist,
Profit= TR-Economic Cost(Explicit + Implicit
Cost)
Normal Profit and Abnormal Profit
TR<TCLoss (Negative
economic profit)

TR=TCNormal Profit (Zero

economic profit)

TR > TCAbnormal
Profit(Economic Profit)
 TR and TC
Firm A Firm B Firm C
Total Revenue 200 000 200 000 200 000
TFC 40 000 40 000 40 000
TVC 80 000 100 000 120 000
Implicit Cost 60 000 60 000 60 000
Total Cost 180 000 200 000 220 000

Firm A: TR>TC Abnormal Profit

Firm B: TR=TC Normal Profit
Firm C: TR<TC Loss
 Whether to produce or not?

Firm A Firm B Firm C

TR 80 000 120 000 150 000

TFC(including opp.cost) 100 000 100 000 100 000

TVC 100 000 120 000 140 000

TC 200 000 220 000 240 000

Loss 120 000 100 000 90 000

Firm A: Loss = FC+20 000 VC

Firm B: Loss = FC
Firm C: Loss = <FC
 Shut down Price

SHUT DOWN PRICE IS THE LEVEL OF PRICE

THAT ENABLES A FIRM TO COVER ITS
VARIABLE COSTS IN THE SHORT RUN (P=AVC).
IF PRICE DOES NOT COVER AVC, THEN THE
FIRM WILL SHUT DOWN IN THE SHORT RUN.
 Shut down price
At price P, firm is
able to cover
variable cost in the
short run.
Shut down price is P. P1 =ATC

P=AVC P=AVC
Below this price,
firm will shut down
in the short-run.
 Break-even price
The break even price is
the price at which a
firm is able to make
normal profit in the
long run. P1 =ATC
At this price the firm is
P=AVC
able to cover all of its
cost.
P=ATC
Below price P1, firm
will shut down in the
long run.
 Profit Maximizing level of output
The level of output that the firm
achieves the maximum profit.
MC=MR
M is the profit minimization
output.
M1 is the profit maximization
output.
MC curve cuts the MR curve
from below.
Till M, MC>MR
Between M and M1, MC<MR
Beyond M1, MC>MR
 Profit Maximizing level of output
Normal Demand Curve
situation:
Profit maximization
output is the level of
output where MC cuts
MR from below.
Price is Pm, because
consumers are willing
to pay this much.
 Measuring abnormal profit
MC curve cuts the AC
curve at the lowest
point.
Profit per unit is AR-AC.
Total abnormal profit=
ab x OQn
 Abnormal Profit, Normal Profit & Loss
Whether a firm earns AR<AC

abnormal profit, normal

profit or loss is AR=AC
depended on the
position of the AC AR>AC
curves.
If average cost is: AC1,
abnormal profit
AC*, normal profit
AC2,loss.
 Objectives of Firms
Revenue maximization:
Success=Revenue
 Objectives of Firms
Growth maximization:
Growth is more important than profit.
It leads to large market share and dominance
in the long run.
 Objectives of Firms
Satisficing Profit:
A decision-making strategy that aims for a
satisfactory or adequate result
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.
Therefore managers may create a minimum level of
profit to keep the shareholders happy but then max
other objectives such as enjoying work, getting on
with other workers
 Objectives of Firms
Corporate Social Responsibility (CSR):
Public interest considered in decision making.
Encourage workforce and local community.
Reducing negative effect on environment.
Community service.
Advantages of CSR
Attract and keep better work
force.
Reputation.
Brand loyalty.
Reduce the need of government
involvement.
Ethical business & Ethical
consumerism