EDEXCEL A LEVEL ECONOMICS NOTES - 3.3 Revenues, Costs and Profits.

3.3.1 Revenue

a) Formulae to calculate and understand the relationship between:

o total revenue: Total receipt from the sale of all goods and services.

o average revenue: Total revenue/quantity = (Price x Quantity) / Quantity: Price (corresponding to the demand curve).

o marginal revenue: Additional revenue gained from producing an additional unit of output.

b) Price elasticity of demand and its relationship to revenue concepts (calculation required)

• Elastic Demand (PED > 1)Price ↓ → TR ↑Price ↑ → TR ↓Firms should lower prices to increase revenue as there will be a significant increase in demand due to its responsiveness.
• Inelastic Demand (PED < 1)Price ↓ → TR ↓Price ↑ → TR ↑Firms should raise prices to increase revenue as demand will not fall by a significant amount.
• Unitary Elastic Demand (PED = 1)Any price change leaves total revenue unchanged.

3.3.2 - COSTS

o total cost 

• All the expenses incurred by a business. 

Formula: Total fixed costs + total variable costs

o total fixed cost 

• Costs that do not vary with the level of output. For example, rent and salaries. 

o total variable cost 

• Costs do vary with the level of output. For example, delivery costs, raw material cost, and commissions. 

o average (total) cost 

Formula: Total Cost/Quantity

o average fixed cost 

Formula: Total fixed cost/Quantity

o average variable cost 

Formula: Total variable cost/Quantity

o marginal cost

The cost of producing an additional unit of output.

PRACTICE PAST PAPER QUESTION

SHORT RUN COST CURVE

• Assume all factors of production are fixed, except labour. 
• In the short run, firms can easily hire and fire workers, whereas buying a new piece of land or building takes a longer time. Hence, land and capital is fixed in the short run. 

• When firms initially hire workers there is plenty of office space and desks so workers can easily specialise in their own tasks. This results in high levels of productivity and hence average costs fall initially (before Q1). 
• Beyond Q1, average costs begin to rise as workers' productivity falls due to the limited capacity in the office/building (computers, desks, space, etc). Multiple workers may be working on one desk or overlapping in tasks, which results in inefficiency.

This is called diminishing marginal productivity of adding a variable factor (labour) to a fixed factor (land and capital), as average costs eventually rise due to a slowdown in productivity.

LONG RUN

In the long run, all factors of production are variable. This means a business can change the amount of capital, land, and labour. 

• LRAC (Long-Run Average Cost) comprises multiple SRACs (Short-Run Average Cost curves).
• SRAC represents average costs at a fixed level of land and capital.
• As the firm expands in the long run, it acquires more land and capital, reaching new levels.
• Each level of land/capital corresponds to a new SRAC.
• LRAC is composed of these SRACs as the firm scales up.
• It's assumed that the firm operates at the lowest point of the SRAC in each period.
• Q: Minimum efficient scale --> minimised costs.

Section 3.3.3 - Economies and Diseconomies of scale

Economies of scale

EOS: Large scale production which leads to lower long-run average costs. 

Internal: Cost benefits to the individual firm when it grows

Types of Economies of scale

Technical Economies of Scale: These occur when a firm can produce more efficiently due to advancements in technology. 

Managerial Economies of Scale: Larger firms often benefit from better management and organization. 

Financial Economies of Scale: Larger firms may have better access to large funds from banks and can secure loans at lower interest rates. 

Marketing Economies of Scale: Larger firms can spread their marketing and advertising costs over a larger volume of production.

Purchasing Economies of Scale: As firms increase their production, they can negotiate bulk purchase discounts with suppliers.

Risk-Bearing Economies of Scale: Larger firms can often better manage risks associated with market fluctuations or unexpected events because they have a more diversified product or service portfolio.

External EOS

Definition: External economies of scale refer to the cost advantages that multiple firms in a particular industry or region can benefit collectively as they all grow and expand their operations. 

• Skilled workers
• Specialised suppliers
• Infrastructure 

Analysis points for EOS

• Lower costs in the long run → productive efficiency increases → lower prices in the long (link to Allocative efficiency points learnt in tuition) 
• Lower costs → productive efficiency increases → higher profits → invest in technology/training (Dynamic efficiency points learnt in tuition) 
• Growth in size → raises barriers to entry → reduces contestability of market as the threat of new entrants is limited because it is expensive to enter and duplicate the technologies and buildings the large incumbent firm have → enables firms to profit maximise and charge higher prices without the concern of a new firm entering and undercutting them. However, this can harm consumer choice in the long run as there will be fewer competitors. 

3.3.4 Normal profits, supernormal profits and losses

Profit: Total revenue minus total costs.

Normal profit: The minimum profit required to cover opportunity costs and retain the entrepreneur and factors of production in the industry (break even).

Supernormal profit: Profit exceeding the minimum needed to cover opportunity costs and retain the entrepreneur and factors of production in the industry (earning positive profits).

Shut down price

Firms who make a loss will need to shut down at some point, however whether they shutdown in the short run or long run will depend on if they can cover their average variable costs. (Please remember AR is also the price)

• Cannot cover Variable costs → close down immediately (AR<AVC)
• Can cover variable costs, but not fixed costs → close down in long run as they are still making an overall loss.