Chapter 22

Firms, costs, revenue and objectives

 Learning objectives
By the end of this chapter you will be able to:
define total cost, average total cost. fixed cost, variable cost,
average fixed cost and average variable cost
calculate total cost, average total cost, fixed cost, variable cost,
average fixed cost and average variable cost draw and interpret
diagrams that show how changes in output can affect costs of
production
define total revenue and average revenue
describe how sales affect revenue
- discuss the objectives of firms including survival. social welfare,
profit maximisation and growth
 22.1 Calculating the costs of production

• Total and average total cost

Total cost (TC), as its name implies is the total
cost of producing a given output. The more
the output is produced, the higher the total
cost of production. Producing more units
requires the use of more resources.
 Average total cost (ATC)
• Average total cost (ATC) is also referred to as
average cost (AC), or unit cost, and is given as
total cost divided by output. Table 22.1 shows
the relationship between output. total cost
and average cost.
Table 22.1: Total and average cost
 Fixed costs
•
Table 22.1 indicates that there is a cost even when
output is zero. In the short run, some factors of
production are in fixed supply. When a firm changes its
output. the costs of these factors remain unchanged —
they are fixed costs (FC). For instance. if a firm raised its
output. the interest it pays on past loans would remain
unchanged If it closed down during a holiday period, it
may still have to pay for security and rent for buildings.
Fig. 22.1: Total fixed cost
 Average fixed cost
Average fixed cost (AFC) is total fixed cost
divided by output. As total fixed cost is
constant, a higher output will reduce average
fixed cost. Table 22.2 and Figure 22.2 show
how the average fixed cost falls as output
increases.
Table 22.2: Average fixed cost
Fig. 22.2: Average fixed cost
 Variable costs
•
Variable costs (VC), also sometimes called direct costs, are the
costs of the variable factors. They vary directly as output
changes .Production and sale of more cars will involve an
increased expenditure on component parts. ,electricity, wages
and transport for a car firm .As output increases, total variable
cost rises. It usually tends to rise slowly at first and then rise
more rapidly. This is because productivity often rises at first
and then begins to decline after a certain output. Figure 22 3
shows the change of total variable cost (TVC) with output.
Fig. 22.3: Total variable cost
 Average variable cost
Average variable cost (AVC) is total variable cost
divided by output .As output increases in the
short run, average variable cost tends to fall and
then rise. This is for the same reason which
accounts for an increase in total variable cost at
different rates with increase in output .Table 22.3
and Figure 22 4 show the change in average
variable cost with output
Table 223: Average variable cost
Fig. 22.4: Average variable cost
 Answer
• Fixed costs = rent, business rates, insurance,
and depreciation.
• Variable costs = flour, yeast, overtime pay and
energy costs.
 Fixed and variable costs
•
In practice, it is not always easy to decide whether a
cost is fixed or variable. This is particularly true of
payments to workers. It is clear that overtime
payments and the wages of temporary workers are
variable costs as they vary directly with output. The
basic wage or salary paid to workers, however, may be
regarded as a fixed cost since it has to be paid
irrespective of the amount of output.
 The sum of total fixed cost and total
variable cost equals total cost.
• For instance. if fixed costs are 5800 and
variable costs are $4200 a week, the total cost
of production would be $10000 a week. Figure
22.5 shows how total cost is made up of fixed
and variable costs.
Fig. 22.5: The composition of total cost
Fig. 22.6: Long-term total cost
 Average total cost
In the short run, average cost consists of average
fixed cost and average variable cost. The shape of
the short run average cost curve is usually U-shaped.
The long run average cost curve is also usually U-
shaped. This can be explained as follows. As a firm
alters its scale of production, it first experiences
economies of scale and then, after reaching a certain
output. it may encounter diseconomies of scale.
Answer
 22.2 Calculating revenue
The money received by firms from selling their
products is referred to as revenue. Total
revenue Is. as Its name suggests. the total
amount of money received by firms through
the sale of their products Average revenue is
found by dividing total revenue by the
quantity sold and is the same as price.
 22.2 Calculating revenue
In very competitive markets each firms output
may have no effect on price. In this case, total
revenue rises consistently as more quantity is
sold Table 22.4 shows the change of total
revenue with sales.
Table 22.4: Average and total revenue of a perfectly competitive firm
Fig. 227: The average and total revenue curves of a perfectly competitive firm
Table 22.5: Average and total revenue in a monopoly market
Fig. 22.8: The average and total revenue curves of a monopoly firm
 22.3 Objectives of firms
•
Firms may pursue a range of objectives
including survival, growth, social welfare,
profit satisficing and profit maximisation
 Survival
•
When firms are started, their initial objective may
be just to survive in what may be a very
competitive market. A firm may be content to just
cover its costs until it can become better known
During difficult times when demand is falling, even
large firms may have survival as their key objective
They will try to stay in the market in the hope that
conditions will improve.
 Growth
•
Some firms may pursue the objective of growth
Increasing the size of the firm may bring a number of
advantages High and expanding sales tend to enable
firms to take advantage of a number of internal
economies of scale and so. for instance, to raise finance
more easily and to buy raw materials at a discounted
rate Those who run firms, the managers. directors and
chief executives. may have the growth of the firm as
their key objective because their pay and status may be
more closely linked to the size of the firm they run
 Growth
• Those in charge of large firms are usual’y paid
more than those running smaller firms and also
tend to be held in higher esteem. They may also
have greater job security as the larger the firm they
run, the more difficult it will be for any other firm
to take it over and replace them with their own
managerial team If growth is achieved by merging
with other firms. competition will be reduced and
the firm will gain a larger market share.
 Social welfare
•
State-owned enterprises may be given by the
government the objective of improving social
welfare. They may. for instance, charge a
relatively low price for their products to ensure
they are affordable to even the poor. They are
more likely than private sector firms to base their
production decisions on social costs and benefits
 Social welfare
• In recent years some private sector firms have
also been showing a greater concern about
the environmental and social effects of their
actions. A number of firms have sought to
clean up their production processes and
ensure that they source their raw materials
from firms that do not employ child labour
 Profit maximisation
•
Traditional theory. however. suggests that firms seek to maximise
profits This means that they try to earn the largest profit possible
over a period of time Whilst some of the other objectives may appear
to conflict with profit maximisation. pursuit of them may actually
increase profits in the longer term For instance, growth may involve
reducing the number of competitors This would reduce the price
elasticity of demand for its product and so its ability to raise price and
revenue In addition. increasing the scale of operation may reduce
average costs. Both of these outcomes would increase profits.
 When profit maximization is achieved
•
Profit is made when the revenue earned by a firm is greater
than the costs incurred by it. Profit maximisation is an
objective pursued by most private sector firms
Total profit is the positive difference between total revenue
and total cost Profit per unit (sometimes referred to as the
profit margin) is the positive difference
between average revenue (revenue per unit) and average
total cost (unit cost). Profit is maximised when the positive
gap between revenue and cost is greatest
Table 22.6 shows that profit would be maximised at 40
units of output
Table 22.6 The relationship between total revenue, total cost and total profit
Table 22.7: The relationship between average revenue, average cost and total profit
Table 22.8: Total revenue, total cost and total profit
• If information is given on output. costs and revenue.
it is possible to work out revenue as shown in Table
22 9. This is because it is known that
• profit = revenue — cost
So.
• revenue = profit + cost. Similarly, from information
on output. revenue and profit cost can be calculated.
cost = revenue - profit
Table 22.9: The relationship between total profit, total revenue and total cost
Answer
Answer
 Effects of changes in profit
• Profits provide an incentive for entrepreneurs to undertake
production An increase in profit will encourage more firms
to enter a competitive market. It will also provide firms
with more finance to update their capital equipment and
expand their business
A profitable firm will also find it easier to obtain external
finance. Shareholders are more likely to want to buy shares
in profitable firms and banks are usually willing to give
them loans These firms may also find it easier to recruit top
managers and directors. attracted by their success.
 Ways of increasing profit
• The two fundamental ways of increasing profit are to
• reduce costs of production, and
• raise revenue
There are a number of ways of reducing costs of
production. One is by reducing any wastages and
inefficiency. Another is by increasing the productivity of
factors of production. In the short run the second
strategy may actually raise costs. but in the long run it
may lower average costs and raise revenue by
improving quality.
 Answer
A Total revenue could rise and profits fall, if costs
rise by more than total revenue.
B i A fall in stock levels will reduce costs. Less
staff time and less space will be required for
storage of products. These resources could
then be put to alternative uses or the number
of workers employed and the building space
used could be reduced.
 Answer
Ii A firm could seek to increase demand for its
products by advertising. This might be on
television, in newspapers or through direct
mailing. For instance, a successful advertising
campaign is one that increases revenue by
more than the cost of the campaign.
 Answer
A Next’s total cost in 2016 was $4.1 bn − $0.821 bn
= $3.279 bn.
B Next’s profit in 2015 was $4 bn − $3.2 bn = $0.8
bn.
C Good sites for a retailer are in city centres, where
there are many potential buyers and hence an
increased potential revenue. Good window
displays should attract more customers into the
shops and turn potential into actual revenue.
 Multiple choice questions
I Which of me following is a fixed cost to a
manufacturing flrm9
A Insurance on buildings
B Overtime payments to workers
C The cost of energy
D The cost of raw materials
 Multiple choice questions
• 2 A firm produces 50 units of output The total
variable cost of mis output is S200 and me
total fixed cost is 5300. What is the average
total cost of production?
AS2
BS4
CS6
D 510
 Multiple choice questions
• 3 A firm sells 100 units at a price of 54 per
product. From this information, calculate the
firms total revenue (TR) and average revenue
(AR).
Total revenue ($) Average revenue (S)
A 100 4
B 100 25
C 400 4
D 400 25
 Multiple choice questions
• 4 A firm achieves profit maximisation What
does this mean?
A It cannot increase its profit by changing its
output
B It makes more profit than the other firms in
the industry
C It maximises its total revenue
D It produces at the lowest possible cost
 Answer
• 1A
• In the short run, insurance on buildings will not
change with firm’s output, as the size of the
building will not alter. B, C and D are all variable
costs.
• 2D
• The total cost is $500 ($200 + $300). Average
total cost is total cost divided by output. In this
case, $500 50 = $10.
 Answer
• 3C
• Total revenue is price multiplied by quantity
sold i.e. $4 × 100 = $400. Price is the
equivalent of average revenue, so in this case
average revenue is $4.
• 4A
• Profit is maximised when profit is at its
highest.
 Four-part question
A Giving an example. define ‘anabie cast (2)
B Explain two causes of an increase in a firms
profit (4)
C Analyse. using diagrams how a rise in output
affects total fixed cost and average fixed cost (6)
D Discuss whether or not firms try to maxiniise
profits (8)
 Answer
A A variable cost is a cost that changes when
output changes. As output increases the cost
of raw materials, for example, would increase.
 Answer
B A firm’s profit would increase if its revenue rose
while its costs remained unchanged. For example,
an increase in income would be likely to increase
demand for luxury handbags. This would be likely
to increase the revenue and profit received by the
handbag producers. A firm’s profit would also
increase if its revenue remained unchanged while
its costs fall. Its costs may decline as a result, for
instance, of a rise in labour productivity or a fall in
the price of raw materials.
 Answer
C A rise in output would have no effect on total
fixed cost. This is because fixed costs are those
costs that are not directly related to output.
They do not change as output changes in the
short run. For example, if a handbag producer
makes more handbags, the cost of insuring its
factory is unlikely to alter. Figure 1 shows that
total fixed cost remains unchanged as output
increases.
Answer
 Answer
In contrast, average fixed cost falls with
output. This is because the unchanged total
fixed cost is spread over more units. The more
output that is produced, the lower the
average fixed cost of production. Figure 2
shows how average fixed cost falls
continuously with output.
Answer
 Answer
D It is usually assumed that firms in the private
sector try to maximise profit. Profit is the
reward to entrepreneurs and provides the
incentive to take the risk of making a loss.
Profit also provides the funds for further
investment.
 Answer
Firms in the public sector may follow a
different objective. A state-owned enterprise
(SOE) may have a number of objectives. These
are likely to be linked to social welfare. For
example, a SOE may try to reduce the external
costs arising from pollution by investing in
cleaner technology. It may also seek to
improve worker welfare by providing good
working conditions.
 Answer
Private sector firms may also try to improve
working conditions. Firms have a number of
stakeholders, including shareholders, workers
and consumers. A firm may try to satisfy the
interests of all these groups. At any one time,
it may be focusing on one particular group but
it has to remember that it always has to keep
its shareholders happy.
 Answer
At certain times, a firm may not be able to
think about making a profit. The economy may
be in recession with demand for most
products falling. In this situation, a firm may
put its efforts into survival. It may, for
instance, have to search for a favourable loan
to cover any losses and for lower-priced raw
materials.
 Answer
A firm may also, at least for a period of time,
favour growth over profit maximisation. It may
seek to become larger to increase its market
power and to raise the salary and status of its
managers. In the long run, all the objectives
that private sector firms might pursue are likely
to lead to profit maximisation. Becoming larger
may involve a firm eliminating competitors and
gaining more monopoly power.
 Answer
This may enable its ability to raise its price without losing
many sales and so may raise its revenue. Growing in size
may also enable the firm to take greater advantage of
economies of scale and so lower its costs of production.
Keeping all the stakeholders happy may also increase profit.
For instance, better working conditions and higher pay for
workers may increase labour productivity, which could
lower costs of production and increase demand because of
higher quality. Achieving higher environmental standards
may also increase demand and firms that are seeking to
survive are likely to want to maximise profit in the long run.