Introduction: Why Revenue and Profit Matter

Welcome to one of the most fundamental chapters in firm theory! Don't worry if this seems tricky at first; we are essentially learning how a business counts its money and decides if it is successful. This section (3.1.3.5) builds directly on your knowledge of costs, forming the complete picture of a firm’s financial health.

Understanding Revenue and Profit is crucial because these figures determine a firm's survival, ability to invest, and long-term objectives in the market.

1. Total Revenue (TR)

What is Total Revenue?

Total Revenue (TR) is simply the entire amount of money a firm receives from selling its goods or services over a specific period.

It’s the income generated *before* any costs are subtracted.

Analogy: If you run a small lemonade stand, TR is all the cash in your till at the end of the day.

The Formula for Total Revenue

The calculation is straightforward:

\(TR = \text{Price (P)} \times \text{Quantity Sold (Q)}\)

Quick Calculation Example:
A baker sells 50 loaves of bread (Q) at $3 per loaf (P).
\(TR = 3 \times 50 = \$150\)

Key Takeaway for TR: Total Revenue shows the volume and value of sales combined. A firm wants to maximise TR, but not at the expense of profit!

2. Average Revenue (AR) and the Demand Curve

What is Average Revenue?

Average Revenue (AR) is the revenue generated per unit of output sold. It tells us, on average, how much money the firm receives for each item it sells.

The Formula for Average Revenue

To find the average, you divide the total by the quantity:

\(AR = \frac{\text{Total Revenue (TR)}}{\text{Quantity Sold (Q)}}\)

Since \(TR = P \times Q\), we can substitute this into the AR formula:

\(AR = \frac{P \times Q}{Q}\)

The Q's cancel out, meaning:

\(AR = P\) (Price)

This is a critical relationship! Average Revenue is mathematically identical to the price of the good sold.

The AR Curve is the Firm's Demand Curve

This is one of the most important concepts in firm theory:

The Average Revenue (AR) curve is always the same as the firm's demand curve.

Why? Because the demand curve shows the relationship between the price (P) and the quantity (Q) that consumers are willing and able to buy. Since AR is equal to P, the graphical line showing the possible prices (AR) at various quantities (Q) must, by definition, represent the demand curve facing the firm.

Did you know?
In a graph, if the AR curve is downward sloping (meaning the firm must lower its price to sell more, typical for imperfect competition), it is simply confirming the Law of Demand: as price falls, quantity demanded increases.

Key Takeaway for AR: Think of AR as the "P" column in your price/quantity table. Therefore, the AR curve tells you exactly what the market demand looks like for that firm’s product.

3. Profit: The Ultimate Goal

Defining Profit

For most firms, the primary objective is to maximise profit (although objectives like survival and growth also exist, as per syllabus 3.1.4.2).

Profit is the reward for the entrepreneur taking risks. It is the amount left over after all costs have been paid for.

The Formula for Profit

Profit is calculated by taking the difference between Total Revenue and Total Costs.

\(Profit = \text{Total Revenue (TR)} - \text{Total Costs (TC)}\)

Note: You should already be familiar with Total Costs (TC), which include fixed costs and variable costs (3.1.3.3).

The Difference Between Normal and Abnormal Profit

In Economics, we make an important distinction between different types of profit (as specified in 3.3.2.5):

  1. Normal Profit

    This is the minimum level of profit required to keep the factors of production (land, labour, capital, enterprise) in their current use in the long run. It is considered an economic cost (specifically, the opportunity cost of the entrepreneur's time and capital).

    If a firm earns normal profit, it means: \(TR = TC\).

    Analogy: Normal profit is like your basic salary. If you don't earn at least this amount, you will leave your job (or industry) and find a better opportunity.

  2. Abnormal Profit (also called Supernormal Profit or Economic Profit)

    This is any profit earned over and above normal profit. It is a genuine surplus.

    If a firm earns abnormal profit, it means: \(TR > TC\).

    Abnormal profit acts as a signal for other firms to enter the industry, attracted by the high returns (this links to market structures).

  3. Losses (or Subnormal Profit)

    If a firm cannot even cover its total costs, it is making a loss.

    If a firm makes a loss, it means: \(TR < TC\).

    A firm making a loss will usually exit the market in the long run.

Common Mistake to Avoid: Total Costs (TC) used in economic profit calculation already includes normal profit. So, if TR = TC, the accountant might say the firm made a profit, but the economist says it only made normal profit.

Step-by-Step Calculation Summary

You must be able to calculate TR, AR, and Profit. Here is a quick review table:

Output (Q) Price (P) / AR Total Cost (TC) TR (P x Q) Profit (TR - TC)
10 \$8 \$60 \$80 \$20 (Abnormal Profit)
15 \$7 \$105 \$105 \$0 (Normal Profit)
20 \$6 \$150 \$120 -\$30 (Loss)

Key Takeaway for Profit: Profit is the fundamental measure of success. Always remember that the Total Costs (TC) figure already incorporates the minimum needed to stay in business (normal profit).

Quick Review Box

Key Formulas to Memorise:

\(TR = P \times Q\)
\(AR = \frac{TR}{Q} = P\)
\(Profit = TR - TC\)

Essential Links:
  • Average Revenue (AR) is the same as Price (P).
  • The AR Curve is the Demand Curve for the firm.
  • Normal Profit is earned when TR = TC.