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.

TPAP = ____ 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.

TP• MP ______ V

TP, AP and MP1 2 3 4

Quantity of Labour (V)

Total product (TP)

Average product (AP)

Marginal 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

Total product curve

(Variable factor)

Tota

l O

utpu

t

Average and marginal product curves

Production function

Land Labour

Capital Enterprise

Production Process

Output

Short run and long run

The short run is defined as that time

period where at least one factor of production is fixed.

• The long run is that period of time when all inputs can be 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• The costs that have a

money value like raw materials, energy, rent, interest and wages and have to be purchased from outside the firm.(Accounting costs)

• (Accountant’s view)

Implicit cost• The cost of using the firm’s

own resources. This is the earnings that a firm could have had if it had employed its factors in another use/hired/sold out.(Normal profit)

• (Economist’s view)

Short run costs

Total cost

TFC TVC TC

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

TVC •TVC is the total costs of the variable assets.•TVC increases as more variable factors are used.

TC •Total costs of all fixed and variable factors.•TC=TFC+TVC

DRAWING EXERCISE: Using data given, draw TC,TVC and TFC Curves

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

AVC •AVC is the variable cost per unit of output.•AVC=TVC divided buy output.

ATC •ATC is the total cost per unit of output.•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

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 such SRACs.

• LRAC is the boundary between unit costs that are attainable and unattainable.

Attainable

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 decreasing, 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,

publicity…everything 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 Revenue(TR)

Average Revenue(AR)

Marginal 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<TC…Loss (Negative economic profit)

• TR=TC…Normal Profit (Zero economic profit)

• TR > TC…Abnormal 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 ProfitFirm B: TR=TC Normal ProfitFirm C: TR<TC Loss

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 VCFirm B: Loss = FCFirm C: Loss = <FC

Whether to produce or not?

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.• P=AVC• Below this price,

firm will shut down in the short-run.

P1 =ATC

P=AVC

Break-even price

P1 =ATC

P=AVC

•The break even price is the price at which a firm is able to make normal profit in the long run.•At this price the firm is 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 abnormal profit, normal profit or loss is depended on the position of the AC curves.

• If average cost is: AC1, abnormal profit

• AC*, normal profit• AC2,loss.

AR>AC

AR=AC

AR<AC

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