Welcome to Revenue, Costs, and Profits!

Hello future Economist! This chapter is absolutely crucial because it forms the bedrock of understanding Business Behaviour. Why do firms make the decisions they do? Why do they charge certain prices? How big should they grow?
The answers lie in how they manage their money flow: Revenue (money in), Costs (money out), and the resulting Profit (what's left).
Don't worry if the formulas look scary—we will break them down into simple steps and use real-world analogies to make them stick! Let's dive in!

Section 1: Understanding Revenue (Money In)

Revenue is the money a firm receives from selling its goods or services over a period of time. There are three key measures we need to understand.

1. Total Revenue (TR)

This is the total income earned from selling a specific quantity of output.

Formula:
$$TR = P \times Q$$ Where:
\(P\) = Price per unit
\(Q\) = Quantity sold

2. Average Revenue (AR)

This is the revenue earned per unit of output sold.

Formula:
$$AR = \frac{TR}{Q}$$

Key Insight: Since \(TR = P \times Q\), dividing by \(Q\) means \(AR\) is always equal to the Price (P).
\(AR = P\)

Crucial Connection: The Average Revenue (AR) curve is exactly the same as the firm's Demand curve. If a customer is willing to pay \$5 for a product, then the firm earns \$5 in AR from that sale.

3. Marginal Revenue (MR)

This is the additional revenue generated by selling one more unit of output. This is one of the most important concepts in decision-making for firms.

Formula:
$$MR = \frac{\text{Change in TR}}{\text{Change in Q}}$$

Why is MR usually less than P (or AR)?

In most market structures (except perfect competition), if a firm wants to sell more products, it usually has to lower the price for all units sold, not just the extra unit.
Example: A bakery sells 10 cakes at \$20 each (TR = \$200). To sell 11 cakes, they must drop the price to \$19 for *all* 11 cakes (New TR = \$209).
The 11th cake sold for \$19, but the MR is only \$9 (\$209 - \$200) because they lost \$1 on each of the first 10 cakes!

Quick Review: The Revenue Trio
  • TR: Total money from sales (\(P \times Q\)).
  • AR: Price per unit (equals the Demand Curve).
  • MR: Revenue from the last unit sold (often falls faster than AR).

Section 2: Understanding Costs (Money Out) – The Short Run

For firms to decide how much to produce, they must analyse their costs. When economists talk about costs, we first divide time into two periods: the Short Run and the Long Run.

Short Run Definition

The Short Run is a time period where at least one factor of production (usually capital or land) is fixed. You cannot instantly build a new factory.

1. Total Costs (TC, FC, VC)

a) Total Fixed Costs (TFC or FC)

These costs do not change as output changes. They must be paid even if the firm produces nothing. Example: Rent on the factory building, insurance premiums, interest on loans.

b) Total Variable Costs (TVC or VC)

These costs change directly with the level of output. If you produce more, these costs rise. Example: Raw materials, hourly wages for production workers, energy consumed during production.

c) Total Costs (TC)

The sum of all costs.

Formula:
$$TC = FC + VC$$

2. Average Costs (AFC, AVC, ATC)

These measures tell us the cost per unit of output. They are vital for setting prices and determining efficiency.

a) Average Fixed Cost (AFC)

The fixed cost spread across each unit. As output increases, AFC must fall (since the numerator, FC, is constant). $$AFC = \frac{FC}{Q}$$

b) Average Variable Cost (AVC)

The variable cost per unit. This typically falls initially due to specialisation, then rises rapidly. $$AVC = \frac{VC}{Q}$$

c) Average Total Cost (ATC)

The total cost per unit. This is often the most important cost measure for pricing. $$ATC = \frac{TC}{Q} \quad \text{or} \quad ATC = AFC + AVC$$

3. Marginal Cost (MC)

Similar to MR, MC measures the additional cost incurred when producing one more unit of output.

Formula:
$$MC = \frac{\text{Change in TC}}{\text{Change in Q}}$$

Analogy: Imagine your average test score (ATC). If your next test score (MC) is higher than your average, your average will go up. If your next score (MC) is lower, your average will go down.
This explains why the MC curve always cuts the AVC and ATC curves at their absolute minimum points.

The Law of Diminishing Returns

This law explains the characteristic 'U' shape of the AVC, ATC, and MC curves in the Short Run.
Definition: If you continuously add units of one variable factor (like labour) to a fixed factor (like capital/factory size), eventually the marginal product (extra output from the extra worker) will begin to fall.

When marginal product falls, the cost of producing an extra unit (MC) must rise. This is why MC curves eventually slope upwards, pulling the average cost curves up with them.

Memory Aid for Short-Run Costs

All Curves Together Meet Minimums: The Average Costs (AVC, ATC) are cut by the Marginal Cost (MC) curve at their Minimum points.

FC (Fixed Cost) is the one that never changes its total, only its average (AFC).

Section 3: Costs in the Long Run and Economies of Scale

Long Run Definition

The Long Run is a time period sufficient for a firm to vary all its factors of production. A firm can expand its factory, build new machines, or close down entirely.

1. The Long Run Average Cost (LRAC) Curve

The LRAC curve shows the lowest possible average cost of producing any level of output when the firm is able to choose the optimal combination of inputs (the best size of factory/scale).

It is sometimes called the "envelope curve" because it effectively wraps around the minimum points of many possible Short Run Average Cost (SRAC) curves.

2. Economies and Diseconomies of Scale

As a firm increases its size (its scale of operations), its costs might change. This movement along the LRAC curve is driven by scale effects.

a) Economies of Scale (EOS)

If average cost falls as the firm increases its output (or size), the firm is experiencing Economies of Scale. The firm is becoming more efficient.

Types of Internal EOS (Advantages due to firm's own growth):

i. Technical Economies: Using specialised, high-capacity machinery (e.g., a massive oil tanker is cheaper per barrel of oil moved than many small boats). Applying the principle of division of labour.

ii. Purchasing (Bulk-buying) Economies: Large firms receive massive discounts when buying raw materials in bulk.

iii. Managerial Economies: Large firms can afford to hire specialised managers (HR, Marketing, Finance), leading to better organisation and decision-making.

iv. Financial Economies: Large firms can borrow money from banks more cheaply and easily because they are seen as less risky.

v. Risk-bearing Economies: Large firms can diversify their product lines or markets, meaning a failure in one area won't destroy the whole company.

Did you know? The Minimum Efficient Scale (MES) is the lowest level of output at which all internal economies of scale have been fully exploited. The LRAC curve is flat or at its lowest point here.

b) Diseconomies of Scale (DOS)

If average cost rises as the firm increases its output, the firm is experiencing Diseconomies of Scale. The firm has become too large and is inefficient.

Causes of DOS:

  • Communication Problems: Information gets distorted or delayed as it travels through many layers of management.
  • Coordination and Control Issues: It becomes difficult for senior management to monitor vast global operations effectively.
  • Motivational Issues: Workers in very large firms may feel alienated, reducing productivity and increasing cost per unit.

3. External Economies and Diseconomies of Scale

These effects relate to cost changes due to the size of the entire industry or concentration of firms, not the size of an individual firm.

  • External Economies: Average costs fall for all firms in an area because of industry growth (e.g., development of specialist infrastructure, shared pool of skilled labour, creation of supplier networks).
  • External Diseconomies: Average costs rise for all firms due to industry growth (e.g., traffic congestion causing transport delays, bidding up the price of local land or labour).

Section 4: Defining and Maximising Profit

1. Accounting vs. Economic Costs

To properly define profit, economists include costs that accountants often ignore: Implicit Costs.

  • Explicit Costs (Accounting Costs): Direct, out-of-pocket expenses (wages, rent, raw materials).
  • Implicit Costs (Opportunity Costs): The cost of using factors of production already owned by the firm—what the entrepreneur or firm owner gives up by operating this business rather than the next best alternative (e.g., the salary the owner could have earned working elsewhere).

2. Types of Profit

a) Normal Profit

Normal Profit is the amount of profit needed to keep the factors of production (especially the entrepreneur) in their current use. It covers all explicit and implicit costs.
If a firm earns normal profit, its Economic Profit is zero.
It is considered a cost of production.

b) Supernormal Profit (Abnormal Profit)

This occurs when Total Revenue is greater than Total Cost (where Total Cost includes both explicit and implicit costs, i.e., Normal Profit). This is profit earned above the minimum required to keep the firm running.

c) Subnormal Profit (Loss)

This occurs when the firm's Total Revenue is less than its Total Cost. The firm is not even covering its opportunity costs, meaning it is earning less than Normal Profit.

Shutdown Rule (A Quick Thought)

Even if a firm makes a loss (Subnormal Profit), it might continue to operate in the Short Run, provided its revenue covers its Variable Costs (VC). If revenue cannot cover variable costs, the firm should shut down immediately because it is losing more money by operating than by closing.

3. The Profit Maximisation Rule

The core goal for most firms is to maximise profit. Economists define the profit-maximising output level where:

$$\mathbf{MC = MR}$$

Step-by-Step Explanation of \(MC = MR\):
  1. If \(MR > MC\): The revenue gained from selling the last unit (\(MR\)) is greater than the cost of producing it (\(MC\)). The firm should increase output, as this extra unit adds to total profit.
  2. If \(MC > MR\): The cost of producing the last unit (\(MC\)) is greater than the revenue gained from selling it (\(MR\)). The firm should decrease output, as this last unit reduced total profit.
  3. At \(MC = MR\): The firm has found the output level where the marginal gain equals the marginal cost. Profit is maximised at this point.

This rule is universal and applies to virtually every market structure. Understanding why \(MC=MR\) is the maximum profit condition is fundamental to advanced microeconomics.

Chapter Conclusion: You have successfully navigated the three core pillars of business analysis! Remember, firms use these marginal concepts (MR and MC) to make small, profitable decisions, while average concepts (AR and ATC) help them understand their overall efficiency and pricing strategy. Keep practising those relationships!