Costs, revenues, and profit

Transcription

1 26 Costs, revenues, and profit By the end of this chapter, you shoud be abe to: HL define, expain and distinguish between the concepts of the short run and the ong run in the context of production HL define, expain, iustrate, and cacuate tota, average, and margina product HL define and expain the aw of diminishing returns HL define and expain the meaning of economic costs HL distinguish between expicit costs and impicit costs HL define, expain, iustrate, cacuate, and give exampes of short run costs HL define, expain, iustrate, and give exampes of ong run costs HL define, describe, and give exampes of economies and diseconomies of scae HL expain the reationship between ong run costs and returns to scae HL define, expain, iustrate, and cacuate tota, average, and margina revenue HL expain and iustrate the reationship between average revenue, margina revenue, tota revenue, and price easticity of demand HL define and expain the measurement of profit HL distinguish between norma and abnorma profit HL define and distinguish between the shut down price in the short and the ong run HL define, expain, and iustrate the concepts of break-even and profit maximisation HL describe aternative goas of firms. In the next six chapters, we address the topic known as The Theory of the Firm. We ook at the different types of behaviour of firms in reation to the markets in which they operate and the nature of competition in different markets. In this first chapter, we cover the fundamenta concepts necessary to carry out an anaysis of the four different theoretica market structures that exist. These fundamenta concepts are costs, revenues, and profits. Cost theory The short run and the ong run When a firm is producing, some of its factors of production wi be fixed in the short run, i.e. the firm wi not be abe to quicky increase the quantity of them that it has. Often the fixed factor is some eement of capita or and, but this is not aways the case. It coud be a type of highy skied abour, such as a speciaist machine worker. Therefore, if a firm wishes to increase output in the short run, it may ony do so by appying more units of its variabe factors to the fixed factors that it possesses, whie it pans ahead to change the number of fixed factors that it has. Definitions The short run is that period of time in which at east one factor of production is fixed. A production takes pace in the short run. The ong run is that period of time in which a factors of production are variabe, but the state of technoogy is fixed. A panning takes pace in the ong run. 77

2 The ength of the short run for a firm wi be determined by the time it takes to increase the quantity of the fixed factor. This wi vary from industry to industry. For exampe, a sma firm invoved in gardening may find that its fixed factor is the number of awn mowers that it has avaiabe and that it takes a week to order and get deivery of a new awn mower. Thus its short run is one week. On the other hand, a nationa eectricity provider is constrained by its fixed factor, the number of eectricity generating pants that it has. Buiding a new eectricity generating pant may take up to two years (more if a nucear pant is buit) and so its short run is a ot onger. If a firm pans ahead to change its fixed factors then a factors of production are variabe as the pans are being made. The firm is panning in the ong run. However, as soon as the fixed factors are changed the firm is once again in the short run; it simpy has a different number of fixed factors. Once again, the ony way that output can be increased is to appy more units of the variabe factors to the new quantity of the fixed factors. As we said earier, a production takes pace in the short run and a panning takes pace in the ong run. Tota, average and margina product Tota product (TP) is the tota output that a firm produces, using its fixed and variabe factors in a given time period. As we have aready said, output in the short run can ony be increased by appying more units of the variabe factors to the fixed factors. product (AP) is the output that is produced, on average, by each unit of the variabe factor. AP 5 TP, where TP is the tota output V produced and V is the number of units of the variabe factor empoyed. Margina product (MP) is the extra output that is produced by using an extra unit of the variabe factor. MP 5 TP, where TP is the V change in tota output and V is the change in the number of units of the variabe factor empoyed. Take an exampe. A firm has four machines (fixed factors) and increases its output by using more operators to work the machines. Production figures for each week are given in Tabe Student workpoint 6.1 Be knowedgeabe Improve your knowedge of the short run and the ong run by considering the foowing scenario. A sma firm sets up a pant making teddy bears. The firm has a sma production unit, two teddy bear making machines and two operators. There is one manager, who owns the firm, and carries out a nonproduction activities. There is aso an unimited amount of the materias needed to make the teddy bears. Answer the foowing questions. 1 What are the fixed factors? 2 What is the variabe factor? There is an increase in the demand for teddy bears and the firm decides to satisfy this demand with the existing factors. 3 What wi the firm do? The increase in demand persists and so the firm now decides to expand the production unit, bring in two extra machines and empoy two more workers. 4 The panning takes pace in which time period? 5 What time period is the firm in once the changes to the pant have taken pace and the firm is producing again? 6 What are the fixed factors now? The foowing short section provides you with some important definitions and equations. They may initiay seem puzzing, but wi become cearer when used in an exampe. As we add an additiona unit of abour, more output (TP) is produced Quantity of abour (V) Tota product (TP) Tabe 6.1 Tota, average, and margina product per week product (AP) Assessment advice: In HL paper 3, you may be asked to cacuate tota, average, and margina product from a set of data and/or diagrams. Margina product (MP) The extra units of output that are produced when each unit of abour is added 78 79

3 Now we can pot these curves. Tota product Quantity of variabe factor (abour) Figure 6.1 The tota product curve TP Tota product AP MP Quantity of variabe factor (abour) Figure 6.2 and margina product curves hour, making the margina product 34 burgers. Note that the margina product fe when Niki was added to the workforce. Why was this? We, it was efficient to add extra peope up to three workers, but because the space in the shop, the counter tops, and the gri, are a fixed, it became ess efficient when there were more peope. They started to get in each other s way and so coud not increase the output of burgers by as great an amount as when the previous worker was added. Whether we measure it from the amount added by the extra variabe factor (margina product) or the amount added per unit of the variabe factor (average product), ogic tes us that inefficiency must eventuay begin to occur. The aw of diminishing returns From the tabe, we can deduce the foowing definitions. Definitions The hypothesis of eventuay diminishing margina returns As extra units of a variabe factor are added to a given quantity of a fixed factor, the output from each additiona unit of the variabe factor wi eventuay diminish. The hypothesis of eventuay diminishing average returns As extra units of a variabe factor are added to a given quantity of a fixed factor, the output per unit of the variabe factor wi eventuay diminish. Economic cost The economic cost of producing a good is the opportunity cost of the firm s production. Remember that opportunity cost is the next best aternative foregone when an economic decision is made. In this case it is the opportunity cost of the factors of production (resources) that have been used in producing the good or service. In order to work out the economic cost of production we separate the factors used by a firm into two categories: 1 Factors that are purchased from others and not aready owned by the firm The opportunity cost of factors of production not owned by the firm is simpy the price that is paid for them and the aternative things that coud have been bought. For exampe, if a firm hires a worker for $1, a week then the opportunity cost to the firm is the cost of that worker s wage and the other things on which the $1, coud have been spent. Any costs of this sort are known as expicit costs. Expicit costs are any costs to a firm that invove the direct payment of money. 8 The two hypotheses ook at the same reationship from different anges. The whoe concept is reay a matter of common sense. Consider an exampe. A young entrepreneur named Ben sets up a new business, which is a sma hamburger stand on a busy street corner. The stand consists of a very sma shop, containing a refrigerator, a gri, and some countertops for preparing the burgers. There are aso the impements for making burgers. These are a the fixed factors. When he starts out, Ben works aone and prepares everything himsef. He makes the burgers, cuts the onion, ettuce, and tomatoes, heats the buns, and ses the hamburgers to the customers. He can make 2 burgers per hour. Ben finds demand to be high and he cannot make enough burgers, so he hires his friend, Caroine, to hep. They divide up the jobs and manage to produce 5 burgers each hour. The hamburgers become even more popuar and Ben and Caroine agree that they need another worker, so Nick joins them. They divide up the work again, with each speciaising in a task, and produce 9 burgers each hour. Demand continues to rise, so they bring in Niki. With the four working together, they produce 124 burgers per hour. When Ben worked aone, his output was 2 burgers per hour. When Caroine joined him, the tota output was 5 burgers per hour. This means that Caroine s margina product was 3 burgers. When Nick joined, the tota number of burgers per hour rose to 9, so Nick s margina product was 4 burgers. When Niki joined (we are adding units of a variabe factor), the tota output of burgers rose to 124 per 2 Factors that are aready owned by the firm If a firm has factors that it aready owns then it wi not have to pay out money when it uses them. However, there wi sti be an opportunity cost invoved in their use which needs to be accounted for. Any costs of this sort are known as impicit costs. Impicit costs are the earnings that a firm coud have had if it had empoyed its factors in another use or if it had hired out or sod them to another firm. Impicit costs are best understood through exampes: a The owner of a firm may be abe to earn $1 per year in her next best aternative job, as a tax accountant. This opportunity cost shoud be incuded in the firm s economic costs. Indeed, some woud argue that it is the most important cost that a firm needs to cover since, if it is not met, the entrepreneur woud presumaby cose down the firm and take the job as a tax accountant. The very existence of the firm depends upon covering this cost. 81

4 b A firm owns buidings that it uses to produce its goods. The buidings coud be rented out to other firms for $15 per month. The opportunity cost to the firm of using the buidings itsef is the rent that is foregone and the things that coud have been purchased with that money. As we can see from above, if economists count these costs and accountants do not, then economists and accountants woud report different profit eves for the same firms. Student workpoint 6.2 Be a thinker identify the different costs and revenues and cacuate the answer. A sma firm has been operating for one year. During the year they have: paid $4 in wages and saaries paid $1 for raw materias used their own sma factory, which coud have been rented out for $9 used $4 worth of eectricity and services received $45 in tota revenue In addition: the owner of the firm has given up a job with another firm, where he woud have been paid $7 per year The owner has invested $6 of his own money into the business (the rate of interest during the year has been 5%) In ight of the facts above: 1 Identify the costs of the firm as expicit or impicit. 2 Cacuate and expain the profits/osses made by the firm from the point of view of: a an accountant b an economist Quantity of abour (V) Tota product (TP) or Output (q) Tota fixed cost (TFC) Tota variabe cost (TVC) Tota cost (TC) fixed cost (AFC) variabe cost (AVC) tota cost (ATC) , , , 1, ,2 1, ,4 1, ,6 2, Margina cost () the firm uses its own machinery, which has reduced in vaue by $2 because of wear and tear and now has a second hand vaue of $7 Short-run costs Firms have many different costs when producing whatever good or service they provide. We need to be abe to understand the different types of costs that firms face and to understand where those costs originate. We can start by ooking at the exampe from Tabe 6.1, and adding some costs. We wi assume that the cost of a machine per week is $1 (there are four machines) and that the cost of a worker is $2 per week. The outcome of this on the costs of a firm are shown in Tabe 6.2. Using the figures above, we can expain the different ways of measuring costs. We tend to separate costs into two groups: Tabe 6.2 Tota, average, and margina costs per week b c Tota variabe cost (TVC): TVC is the tota cost of the variabe assets that a firm uses in a given time period. TVC increases as the firm uses more of the variabe factor. TVC is equa to the number of variabe factors times the cost of each variabe factor. So in the current exampe, TVC is $2 when one worker is being empoyed and $1,2 when six workers are being used. Tota cost (TC): TC is the tota cost of a the fixed and variabe factors used to produce a certain output. It is equa to TFC pus TVC. So in the current exampe the tota cost of producing 15 units of output per week is $1,6. It is the fixed cost of $4 pus the variabe cost of $1,2. The different tota cost curves are shown in Figure TC TVC TFC Figure 6.3 Tota cost, tota variabe cost, and tota fixed cost 1 Tota costs: Tota costs are the compete costs of producing output. We use three measures: 2 costs: These are costs per unit of output. We use three measures: 82 a Tota fixed cost (TFC): TFC is the tota cost of the fixed assets that a firm uses in a given time period. Since the number of fixed assets is, by definition, fixed, TFC is a constant amount. It is the same whether the firm produces one unit or one hundred units. TFC is equa to the number of fixed assets times the cost of each fixed asset. In the exampe in Tabe 6.2, TFC per week is $4 (four machines costing $1 each) at every eve of output. a fixed cost (AFC): AFC is the fixed cost per unit of output. It is cacuated by the equation AFC 5 TFC q, where q is the eve of output. Because TFC is a constant, AFC aways fas as output increases. In the current exampe, AFC is $4 per unit when output is 1 units and fas to $3.33 per unit when output increases to 12 units. 83

5 b variabe cost (AVC): AVC is the variabe cost per unit of output. It is cacuated by the equation AVC 5 TVC q, where q is the eve of output. AVC tends to fa as output increases, and then to start to rise again as the output continues to increase. This is expained by the hypothesis of eventuay diminishing average returns. As more of the variabe factors are appied to the fixed factors, the output per unit of the variabe factor eventuay fas, and so the cost per unit of output eventuay begins to rise. In the current exampe AVC is $2 per unit when output is 1 units, fas to $11.11 per unit when output rises to 9 units and then increases to $13.33 when output continues to rise to 12 units. We have seen how to cacuate the different types of average and margina costs and draw the curves that represent the data. When economists draw costs curves to iustrate a genera position, they draw them as shown in Figure 6.5: AVC ATC c tota cost (ATC): ATC is the tota cost per unit of output. It is equa to AFC pus AVC. It is cacuated by the equation ATC 5 TC q, where q is the eve of output. As with AVC, ATC tends to fa as output increases, and then to start to rise again as the output continues to increase. In the current exampe ATC is $6 per unit when output is 1 units, fas to $15.24 per unit when output rises to 15 units and then increases to $16.67 when output continues to rise to 12 units. 3 Margina cost (): is the increase in tota cost of producing an extra unit of output. It is cacuated by the equation: 5 TC, where TC is the change in tota cost and q is the q change in the eve of output. tends to fa as output increases, and then to start to rise again as the output continues to increase. This is expained by the hypothesis of eventuay diminishing margina returns. As more of the variabe factors are appied to the fixed factors, the extra output from each additiona unit of the variabe factor added eventuay fas, and so the extra cost per unit of output eventuay begins to rise. In the current exampe is $2 when output rises from to 1 units, fas to $8. when output rises from 45 to 7 units and then increases to $4. when output continues to rise and goes up from 115 to 12 units. The average and margina cost curves from our exampe are shown in Figure 6.4. It is important to recognise the reationship between the ATC, AVC, and curves. Quite simpy, the curve cuts the AVC and ATC curves at their owest points. This is a mathematica reationship. AFC fas as output increases and, since it is the difference between ATC and AVC, the vertica gap between ATC and AVC gets smaer as output grows ATC AVC AFC Figure 6.4 Short-run AFC, AVC, ATC, and curves Figure 6.5 A genera diagram showing short-run ATC, AVC, and Assessment advice: In HL paper 3, you may be asked to cacuate tota, average and margina costs from a set of data and/or diagrams. The ong run We have aready said that the ong run is the panning stage. When panning in the ong run, an entrepreneur is free to adjust the quantity of a of the factors of production that are used and is ony restrained by the current eve of technoogy. This means that in the ong-run, we ook at what happens to costs when a of the factors of production are increased in order to increase output. What we find is rather different in theory to practice. In theory, the ong-run average cost curve (LRAC) is an enveope curve, i.e. it enveops an infinite number of short-run average cost (SRAC) curves. This reationship is shown beow in Figure 6.6. C3 C * C2 C1 SRAC1 SRAC2 SRAC3 SRAC4 q 1 q 2 q 3 q 4 LRAC (ENVELOPE CURVE) Definition The ong run is that period of time in which a factors of production are variabe, but the state of technoogy is fixed. A panning takes pace in the ong run. Figure 6.6 The LRAC curve and short run average cost curves 84 85

6 Let us assume that the firm in Figure 6.6 is producing an output of q 1 at a cost per unit of C 3. They are operating on the short-run average cost curve SRAC 1. (Remember that a production takes pace in the short run.) C 3 is the owest possibe cost of producing the output, since it is a point on the SRAC curve that is tangent to the LRAC curve. Thus this singe point from SRAC 1 is aso a singe point on the LRAC curve. If demand is increased and the firm now wishes to produce q 2, it can do so in the short run by simpy empoying more variabe factors and moving aong SRAC 1 unti q 2 is being produced at a cost per unit of C*. This is a ower cost per unit than before, but the firm wi know that they coud produce this output even more cheapy if they were abe to ater a of their factors of production, i.e. if they were in the ong run. Thus they wi pan ahead to change a of the factors and wi eventuay move to SRAC 2. Now they wi be producing an output of q 2 at a cost per unit of C 2. They are operating on SRAC 2, where C 2 is the owest possibe cost of producing the desired output, q 2, since it is again a point on the SRAC curve that is tangentia to the LRAC curve. This singe point on SRAC 2 is another singe point on the LRAC curve. The whoe LRAC curve is made up of an infinite number of singe points from SRAC curves. These curves woud represent a of the possibe combinations of fixed and variabe factors that coud be used to produce different eves of output for this firm. There are a number of different economies of scae that may benefit a firm as it increases the scae of its output. a Speciaisation: In sma firms there are few, if any, managers and they have to take on many different roes, often roes for which they are not the best candidates. This may ead to higher unit costs. As firms grow they are abe to have their management speciaise in individua areas of expertise, such as production, finance, or marketing, and thus be more efficient. b Division of abour: This is breaking a production process down into sma activities that workers can perform repeatedy and efficienty. As firms get bigger and demand increases, they are often abe to start to break down their production processes, use division of abour, and reduce their unit costs. A good exampe of this woud be workers on assemby ines, where they each have a position by a conveyor bet and add parts to a product as it moves down the conveyor bet. Cars and teevision sets, among other things, have been produced by this sort of method. c Buk buying: As firms increase in scae they are often abe to negotiate discounts with their suppiers that they woud not have received when they were smaer. The cost of their inputs is then reduced, which wi reduce their unit costs of production. The LRAC curve is the boundary between unit cost eves that are attainabe by the firm and unit cost eves that are unattainabe. If possibe, the firm woud wish to produce different output eves at points on the LRAC curve in order to minimizes their cost per unit of output. This may not, of course, aways be possibe in the short run. d Financia economies: Large firms can raise financia capita (money) more cheapy than sma firms. Banks tend to charge a ower interest rate to arger firms, since the arger firms are considered to be ess of a risk than the smaer firms, and are ess ikey to fai to repay their oans. When ong-run unit costs are faing as output increases, we say that the firm is experiencing increasing returns to scae. This means that a given percentage increase in a factors of production wi ead to a greater percentage increase in output, thus reducing ong-run average costs. e Transport economies: Large firms making buk orders may be charged ess for deivery costs than smaer firms. Aso, as firms grow they may be abe to have their own transport feet, which wi then cost ess because they wi not be paying other firms, who wi incude a profit margin, to transport their products. 86 When ong-run average costs are constant as output increases, we say that the firm is experiencing constant returns to scae. This means that a given percentage increase in a factors of production wi ead to the same percentage increase in output, thus eaving ong-run average costs the same. When ong-run average cost is rising as output increases, we say that the firm is experiencing decreasing returns to scae. This means that a given percentage increase in a factors of production wi ead to a smaer percentage increase in output, thus increasing ong-run average costs. We need to consider why the ong-run costs may increase or decrease as output increases. There are two factors to be considered: 1 Economies of scae: Economies of scae are any decreases in ong-run average costs that come about when a firm aters a of its factors of production in order to increase its scae of output. Economies of scae ead to the firm experiencing increasing returns to scae. Increasing returns to scae LRAC Constant returns to scae Decreasing returns to scae Figure 6.7 Increasing, constant, and decreasing returns to scae f Large machines: Some machinery is too arge to be owned and used by a sma producer, for exampe a combine harvester for a sma farmer. In this case, sma farmers have to hire the use of the equipment from suppiers who wi then charge a price that incudes a profit margin for the suppier. However, once a farm can increase to a certain size it becomes feasibe to have its own combine harvester, reducing the unit costs of production. g Promotiona economies: Amost a firms attempt to promote their products by using advertising, or saes promotion, or persona seing, or pubicity, or a combination of the above. The costs of promotion tend not to increase by the same proportion as output. If a firm doubes its output, it is unikey that it wi doube its expenditure on promotion methods, such as saes promotion and advertising. Thus the cost of promotion per unit of output fas. This situation aso appies to other fixed costs, such as insurance costs or the costs of providing security for the production unit. 87

7 2 Diseconomies of scae: Diseconomies of scae are any increases in ong-run average costs that come about when a firm aters a of its factors of production in order to increase its scae of output. Diseconomies of scae ead to the firm experiencing decreasing returns to scae. There are a number of different diseconomies of scae that may affict a firm as it increases the scae of its output: a Contro and communication probems: As firms grow in scae, the management wi find it harder to contro and coordinate the activities of the firm and this is said to ead, eventuay, to inefficiency and increases in the unit costs of production. In the same way, greater size eads to a huge increase in the need for effective communication and it is suggested that there wi be more communication breakdowns as firms increase in size, eventuay causing unit cost increases. b Aienation and oss of identity: As firms grow, it is suggested that both workers and managers may begin to fee that they are ony a very sma part of a very big organisation. They begin to think that what they do does not matter and they start to ose a sense of beonging and oyaty. If this happens, then it is ikey that the workers and managers wi begin to work ess hard and become ess productive, and this wi tend to force up the unit costs of production. A of the above economies and diseconomies of scae reate to the unit cost decreases or increases that might be encountered by a singe firm. They are known as interna economies and diseconomies of scae. There is another group of economies and diseconomies that come about when the size of the whoe industry increases and this has an effect on the unit costs of the individua firms. They are known as externa economies and diseconomies of scae. An exampe of externa economies of scae might be where the growth of an industry in a certain geographica area eads to oca universities and coeges starting up courses that reate to the skis required in the industry. The graduates of these courses woud be ready trained for the firms in the industry, at no direct cost to the firms, and so woud make the firms more efficient, reducing unit costs. An exampe of this coud be coeges offering metaurgy courses in an area ike Sheffied in the UK where one of the main industries is the arge-scae production of cutery. An exampe of externa diseconomies of scae might be where the rapid growth of an industry eads to more competition among individua firms to acquire raw materias, capita and quaified abour. Such competition may force up the prices of the factors so forcing up the unit costs of the firms in the industry. Fina note on cost theory You shoud aways remember that: Student workpoint 6.3 Be a thinker On page 8 we ooked at a burger stand run by a young entrepreneur caed Ben. If demand for the burgers continues to be strong, and Ben is facing diminishing margina returns, what shoud be his strategy in terms of the ong run? Long-run cost curves are U-shaped, in theory, because of the existence of economies and diseconomies of scae. In reaity, economists have not yet found evidence of a firm becoming so arge that the diseconomies of scae start to outweigh the economies of scae in the ong run. Actua ong-run cost curves may be drawn as shown in Figure 6.8. Revenue theory Revenue is the income that a firm receives from seing its products, goods, and services, over a certain time period. Measurement of revenue Revenue may be measured in three ways: 1 Tota revenue (TR) TR is the tota amount of money that a firm receives from seing a certain amount of a good or service in a given time period. It is cacuated by using the formua: TR 5 p 3 q where p is the price that the good or service ses for and q is the quantity of the good or service sod in the time period being considered. If a firm ses 4 pizzas per week, at a price of $6 per pizza, then: TR 5 $ $2,4 per week. 2 revenue (AR) AR is the revenue that a firm receives per unit of its saes. It is cacuated using the formua: AR 5 TR q 5 p 3 q q 5 P As we can see, since TR is (p 3 q), q is common to the top and bottom of the formua and so AR is the same as p. Thus, if the firm ses 4 pizzas at a price of $6 per pizza, then: AR 5 $2,4 5 $6(the same as the price per unit) 4 3 Margina revenue (MR) MR is the extra revenue that a firm gains when it ses one more unit of a product in a given time period. It is cacuated by using the formua: MR 5 TR, where means the change in. q Thus, if our pizza firm owered the price of a pizza to $5 and found that their weeky saes rose to 5 pizzas, then: MR 5 $25 2 $24 5 $ $1 The extra revenue gained from seing an extra unit is $1. LRAC Figure 6.8 A ong-run average cost curve in reaity Theory of Knowedge Deductive and inductive ogic Empirica evidence suggests that firms benefit from economies of scae up to a certain eve of output. Economies of scae reduce ong-run unit costs. Ceteris paribus, firms wi find that their profit per unit of output rises if they increase the amount of factors of production up to a certain eve of output. 1 Distinguish between deductive reasoning and inductive reasoning. 2 Is the exampe above a piece of deductive reasoning or inductive reasoning? 3 Do you think that most economic reasoning is deductive or inductive? Why? 88 Short-run cost curves are U-shaped because of the hypothesis of diminishing returns. The existence of eventuay diminishing average returns expains the shape of the short-run average variabe cost curve and the existence of eventuay diminishing margina returns expains the shape of the short-run margina cost curve. 89

8 Revenue curves and output We now need to consider what happens to a firm s revenue as output increases. We sha consider two different situations. 1 Revenue when price does not change with output (when easticity of demand is infinite) If a firm does not have to ower price as output increases and it wishes to se more of its product, then it faces a perfecty eastic demand curve. This situation ony happens in theory, but it is very usefu to economists when they are buiding their modes of how markets work and they start with the theoretica market form of perfect competition (see Chapter 7). A firm that has a perfecty eastic demand curve might have the revenue figures shown in Tabe 6.3. Price ($) Quantity demanded Tota Margina PED Price ($) Quantity demanded Tota Margina Tabe 6.3 Possibe revenue figures for a firm with a perfecty eastic demand curve Tabe 6.4 Output, revenue, and PED figures for a firm with a norma demand curve 9 We can assume that the firm is very sma in terms of the size of the whoe industry, and that they can increase their output without affecting tota industry suppy, and thus price, in any significant way. Therefore the firm can se a that it produces at the same price. If we graph the revenues, we wi get the curves shown in Figure 6.9(a) and (b). In these graphs, we can see that, when price easticity of demand is perfecty eastic, then price, average revenue, margina revenue, and demand are a the same. In this case, they are a $5. Tota revenue increases at a constant rate as output increases, since each extra sae adds $5 to tota revenue. Margina revenue is constant at $5. 2 Revenue when price fas as output increases (when the demand curve is downward soping, i.e. when easticity of demand fas as output increases) When we ook at what happens to TR, AR, and MR as price fas when output decreases we get a very different set of curves from the ones above. If a firm wishes to se more of its output and it can contro the price at which it ses, then it wi have to ower the price if it wants to increase demand. In simper terms, it wi face a downward-soping demand curve. An exampe of this, and the revenue figures reating to it, is shown in Tabe 6.4. Price ($) TR ($) 5 (a) AR & MR when PED = infinity D=AR=MR 5 1 Output 35 (b) TR when PED = infinity TR 7 Output Figure 6.9 Curves for PED 5 infinity As we woud expect, AR is equa to price and so it fas as output increases, since the price has to be owered in order to se more products. This is shown ceary in Figure 6.1, where the demand curve is now abeed D 5 AR. MR aso fas as output increases, but at a greater rate than AR. In fact, as we can see in Figure 6.1, the MR curve is twice as steepy soping as the AR curve and aso goes beow the x-axis. This is a reationship that hods for a downward-soping AR curves and the MR curves that reate to them. MR is beow AR because in order to se more products the firm has to ower the price of a products sod, osing revenue on the ones that coud have been sod at a higher price in order to get the revenue from the extra saes. For exampe, in Tabe 6.4, when price is dropped from $4 to $35, the quantity demanded increases from 4 units to 6. Before the price drop, the TR was $16 ($4 3 4). After the price drop, TR becomes $21 ($35 3 6). The MR is $25 ( TR q ). Price ($) TR is maximum PED = 1 TR PED > 1 PED < 1 D = AR MR = MR Quantity (units) Figure 6.1 The reationship between D, AR, MR, TR, and PED for a norma demand curve 91

9 There are two events affecting the TR. First, two extra units of the product are sod at a price of $35 and so TR rises by $7. However, in order to do this, the price of the 4 units that coud have been sod for $4 has been dropped to $35 and so there is a oss of revenue of $2 (4 3 $5). The overa effect is an increase in revenue of $7 2 $2 5 $5. For a norma, downward-soping demand curve, TR rises at first but wi eventuay start to fa as output increases. This is because the extra revenue gained from dropping price and seing more units is outweighed by the oss in revenue from the units that were being sod at a higher price and now have to be sod at the ower price. For exampe, in Tabe 6.4, when price is dropped from $15 to $1, the quantity demanded increases from 14 units to 16. Before the price drop, the TR was $21 ($ ). After the price drop, TR becomes $16 ($1 3 16). The MR is 2$25 ( TR q ). The negative MR means that TR wi fa. MR is negative because, when the price is owered, two extra units of the product are sod at a price of $1 each, but the price of the 14 units that coud have been sod for $15 has been dropped to $1, and so there is a oss of revenue of $7 (14 3 $5). The overa effect is a fa in tota revenue of $2 2 $7 5 2$5. Therefore to the eft of the point where PED = 1 on the demand curve, PED wi be greater than 1. Figure 6.11 A ogic tree expaining the varying vaues of PED on a demand curve The basic rues are: When PED is equa to 1 TR is maximised Therefore PED is equa to 1, where MR =. Therefore to the right of the point where PED = 1 on the demand curve, PED wi be ess than 1. When MR = PED fas as price fas on a demand curve 1 When PED is eastic any firm wishing to increase revenue shoud ower its price. 2 When PED is ineastic any firm wishing to increase revenue shoud raise its price. 3 When PED is unity then any firm wishing to increase revenue shoud eave the price unchanged, since revenue is aready maximised. There are some very important reationships between price easticity of demand, MR, AR, and TR that we can identify from Figure 6.1. They are most easiy expained by a ogic tree, using information aready discovered in the study of price easticity and revenue. This knowedge of the reationship between the vaue of PED for a demand curve and TR is very usefu for firms when they are trying to assess the impact that a change in the price of their product wi have upon the tota revenue that they receive. If the firm raises price and demand is ineastic then the firm wi find that tota revenue wi increase, because the increase in price wi see a reativey smaer fa in the quantity demanded. However, if the firm raises price and demand is ineastic then the firm wi find that tota revenue wi decrease, because the increase in price wi cause a reativey arger fa in the quantity demanded. So, if a firm knows whether their demand is eastic or ineastic, they wi know what pricing poicy to adopt to increase their revenue. Student workpoint 6.4 Be a thinker sove the probems and iustrate the outcomes Here are some figures for the price and quantity demanded of a product: Price ($) Quantity demanded Tota Margina 116 PED

10 1 Copy out the tabe and fi in the missing vaues in the other coumns. 2 On a piece of graph paper, draw a vertica axis, abeed Price ($), going from 212 to 16. Then add a horizonta axis, abeed Quantity Demanded, going from to 1. 3 Pot the demand curve on the graph (i.e. pot price against quantity demanded). Labe the curve D. Pot the Revenue curve. What do you notice? Now add 5 AR. 4 Pot the Tota Revenue curve. 5 Pot the Margina Revenue curve, remembering to pot it at the haf-way marks on the horizonta axis. Assessment advice: the use of diagrams In workpoint 6.4, you drew an important diagram showing the reationship between demand, average revenue, margina revenue, tota revenue, and PED. It shoud ook much ike Figure 6.1. It is very hepfu if you are confident in your understanding of these reationships and if you can draw the diagram showing the reationships without any figures. This is worth practising! However, you aso have to be abe to use and interpret the data and you may be asked, on HL paper 3, to cacuate tota average and margina revenue from a set of data and/or diagrams. 6 Using the PED figures that you have cacuated, try to identify: the eastic region of the demand curve the ineastic region of the demand curve the point where PED Compete the foowing sentences: In the eastic region of the demand curve, as price fas, tota revenue. In the ineastic region of the demand curve, as price fas, tota revenue. Tota revenue is maximized where PED is equa to and where the margina revenue is. Thus, the opportunity cost is the most important one for the firm to cover. It is the difference between surviva and non-surviva. In Nermin s case, said the economist, I know that she expects to make $8 per year, since she coud earn the same amount if she cosed down the firm and went back to her od job as a marketing manager. That means that she is satisfied with what she has made this year, but no more. The conversation above expains how economists measure profit. Tota profit 5 Tota revenue 2 economic cost (expicit and impicit costs) From this point forward we wi assume that we are now economists and that when we say tota cost we are incuding expicit costs and impicit costs. If tota revenue is equa to tota cost we say that a firm is making norma profit (or zero economic profit). If tota revenue is greater than tota cost then we say that the firm is making abnorma profit (aso known as economic profit). If tota revenue is ess than tota cost then we say that the firm is making a oss (or negative economic profit). In Tabe 6.5 we can see these three situations. Firm A Firm B Firm C Tota revenue Tota fixed cost Tota variabe cost Impicit cost Profit theory Tota cost An economist and an accountant were taking about the accounts of a company. The accountant said that the owner of the firm, Nermin, woud be very happy because the profit for the year was $8. The economist, however, ooked at the same set of figures and said that the owner woud be satisfied, but ony just. Why is that? said the accountant. Profit is tota revenue minus tota cost and when I work that out the profit figure is very heathy. Yes, said the economist, I agree with your definition of profit, but what you need to understand is that we do not take the same view on how to cacuate costs. As an economist I woud say that profit is tota revenue minus economic cost. Economic cost incudes expicit costs (costs that invove the direct payment of money) and impicit costs (earnings that the firm coud have had if it empoyed its factors of production in other ways). In Nermin s case there is ony one impicit cost that I woud incude that you do not incude, but it is the most important cost that the firm faces. Which cost is that? asked the accountant. Tabe 6.5 Revenue and cost information for one year for firms A, B and C Firm A is making an abnorma profit (economic profit) of $2. This means that the revenue earned by the firm is not ony covering a the economic costs but is in fact $2 more. This wi make the entrepreneur happy as she was expecting to cover her impicit costs, incuding opportunity costs, of $6 but exceeds her expectations by $2. Firm B is making norma profit (zero economic profit). The revenue earned by the firm exacty covers a of the economic costs. The entrepreneur wi be satisfied. Firm C is making osses. Athough an accountant woud say that the firm is making a profit of $4 ($2 - $16 ), the entrepreneur wi not be happy since fixed and variabe costs (expicit costs) are covered, but impicit costs are not being covered. The entrepreneur wi cose the firm down and move on to his or her next best occupation. 94 I incude the opportunity cost of the owner of the firm, the entrepreneur, said the economist. If an owner does not manage to cover his or her opportunity cost in the ong run then they wi cose the firm down and move on to their next best aternative occupation. For the remainder of this companion we wi use the terms abnorma profit, norma profit, and oss, but you must remember that these are the same as economic profit, zero economic profit, and negative economic profit. 95

11 We now need to consider three different scenarios: 1 the shut-down price 2 the break-even price 3 the profit-maximising eve of output. The shut-down price It is not unusua to see firms continue to operate, in the short run, even if they are making a oss. It is aso not unusua to see firms shut down for a short period of time and then open up again. Let us ook at these two situations. If it wants to, a firm may cose down, temporariy, in the short run and produce nothing. If it does this, then it wi ony ose its tota fixed costs, the costs that are unavoidabe, such as rent or interest repayments on oans. To make things easier, we wi now incude opportunity cost as a fixed cost and not show it on its own, so it is aso not being covered. This may be better than producing and not getting enough revenue to cover the variabe costs, thus osing the fixed costs and the part of the variabe costs that have not been covered. This can be best expained by using an exampe. Suppose that there are three firms, a producing comics, and a making osses at the moment. The firms are caed Archie, Batcat, and Charie. Their monthy revenue and cost figures are given in Tabe 6.6. Archie Batcat Charie Tota Tota fixed cost (inc opportunity cost) ($) Tota variabe cost ($) Tota cost Loss ($) Tabe 6.6 Revenue and cost figures for Archie, Batcat, and Charie Archie woud be better not producing at a in the short run and cosing down temporariy. This is because the revenue gained has faied to cover a of the variabe costs, so Archie oses the $2 of variabe costs that are not covered by the tota revenue and a of the $1 of fixed costs. So by producing, Archie has ost $12, whereas it woud ony ose $1 of fixed costs if it did not produce. Batcat oses $1 whether it produces or not. The revenue gained means that the variabe costs are just covered, so they wi ose the fixed costs, $1, whether they produce or not. In this situation, it is ikey that Batcat wi continue to produce in order to maintain the continuity of production, thus peasing customers, and to maintain the empoyment of workers and the usage of inputs, thus peasing the workforce and the suppiers. However, a three firms are making osses in the short run and they cannot do this for ever. Whether they produce or not in the short run, the firms need to pan ahead in the ong run in order to change their combinations of factors and to devise a situation where they are abe to cover a of their costs and make norma profits. If they cannot do this then they wi have to cose down permanenty. From this exampe, we can derive a definition for the shut-down price. In Figure 6.12, the shut-down price is P. At this price, the firm is abe to cover its variabe costs in the short run, because P 5 avc, and so is ony osing its fixed costs. At any price beow P, the firm wi shut down in the short run. Athough this may seem ike theory, there are in fact many rea exampes of this behaviour. In Vienna, Austria, there is an ice cream store that shuts down each October, because the demand for its products is ow over the winter and so the revenue earned woud not be enough to cover even its variabe costs. In Apri each year, it opens up again, when demand is beginning to rise and it makes impressive profits unti the end of September. The act of temporariy cosing down, because it cannot cover its variabe costs, is a good exampe of a firm that is not reaching its shut-down price in the short run. The break-even price The break-even price is the price at which a firm is abe to make norma profit in the ong run. This means that it wi break even, covering a of its costs, incuding the opportunity cost. The break-even price is the eve of price that enabes a firm to cover a of its costs in the ong run, i.e. it is the price where price 5 average tota costs. If price does not cover average tota costs in the ong run, then the firm wi shut down for good. In Figure 6.12, the break-even price is P 1. At this price, the firm is abe to cover its tota costs, because P 1 5 atc, and so a costs are covered. The profit-maximising eve of output Economists usuay assume that the main aim of a firm is to maximise profits. If this is the case, then firms need to know what eve of output they have to produce in order to achieve maximum profits. If a firm finds that at its present eve of output the cost of producing another unit () is ess than the revenue that the unit woud bring in (MR), it is cear that the firm coud increase its profits by producing more. Wherever the firm finds that MR, it shoud increase production. We can see the margina cost and margina revenue situation for a firm with a perfecty eastic demand curve in Figure Price/ Definition The shut-down price is the eve of price that enabes a firm to cover its variabe costs in the short run, i.e. it is the price where price 5 average variabe costs. If price does not cover average variabe costs, then the firm wi shut down in the short run. P 1 = ATC P = AVC Figure 6.12 A genera diagram showing short run ATC, AVC, and Price/ Price/ P P (a) q1 q2 (b) D=AR=MR Output ($) ATC AVC D=AR=MR 96 Charie oses $9 by producing, since their tota revenue covers their variabe costs and aso contributes $1 towards their fixed costs. If they did not produce then Charie woud ose their fixed costs of $1. So Charie wi produce in the short run. As we can see in Figure 6.13(a), the curve cuts the MR curve at two points. The first point where 5 MR, q 1, is the point of profit minimisation (oss maximisation). The firm has made a oss on every unit produced up to this eve of output, because is greater than q2 Output ($) Figure 6.13 Revenue and costs for a firm with a perfecty eastic demand curve 97

12 MR. From q 1 to q 2, the firm makes a profit on every extra unit produced, because the MR is greater than the. As ong as the profit made between q 1 and q 2 is greater than the oss made on the first q 1 units, then the firm wi be making abnorma profits. Any unit that is produced beyond q 2 wi make a oss, because woud again be above MR. So if the firm produces more than q 2, the eve of abnorma profit wi begin to fa. It is at q 2 where profits are maximised. Because profit minimisation is not what a firm woud want, to avoid confusion the eft hand part of the curve is normay omitted in diagrams. This means that ony the profit maximising output, q 2, is shown, as in Figure 6.13(b). As a genera rue, we can say that: If a firm wishes to maximise its profits, it shoud produce at the eve of output where Margina Cost () cuts Margina Revenue (MR) from beow. The profit-maximising output for a norma demand and MR curve is shown in Figure Profit is maximised by producing where 5 MR, at a eve of output of q. To find the price, we ook at what consumers are wiing to pay for this quantity. This is shown on the demand curve. It is found by going from q up to the demand curve and then across to the y-axis. In order to show a measurabe amount of profit on a diagram, i.e. a simpe shape ike a rectange, the average cost curve (AC) is added to the diagram. You must remember to make sure that the curve cuts the AC curve at the owest point on the AC. This is shown in Figure The profit-maximising output is q and the price is p. The profit per unit of producing q is the difference between AR and AC. Thus the profit per unit is a 2 b. Since q units are produced, the tota abnorma profit is the shaded area, ab 3 Q. Whether an abnorma profit is made wi depend upon the position of the AC curve. The AC curve is a student s best friend! This is because it can be moved around to show what we want, i.e. abnorma profit, norma profit, or osses. This is shown in Figure If the average cost is at AC, then the diagram shows an abnorma profit of pabc. If the average cost is represented by AC 1, then norma profit is being made, because p 5 c 1 and so there is no abnorma profit rectange. If average cost is shown by AC 2, then a oss is being made and it is represented by the rectange pc 2 da. Price/ Figure 6.14 The profit-maximising eve of output for a norma demand curve Price/ P Price/ q P C Abnorma profit q c2 c1=p c a b Figure 6.16 Using AC to show different profit and oss situations q d a b MR MR Output AC Output D=AR D=AR Figure 6.15 Showing an area of profit using the AC curve AC2 AC1 AC D=AR MR Fina note on profit theory In reaity firms may not aways have the main aim of maximising profits. Not everyone has studied economics! Other aims foowed by entrepreneurs may be: Revenue maximisation: entrepreneurs often measure success by the amount of revenue that they make. If this is the case then they may attempt to maximise their saes revenue by producing where the margina revenue is zero. They wi actuay produce above the profit maximising eve of output. (See Figure 6.8). Growth maximisation: companies may set their target to achieve growth in the short run, rather than profits, in order to gain a arge market share and then dominate the market in the ong run. Growth may be measured in a number of ways, such as the quantity of saes, saes revenue, empoyment or the percentage of market share. Satisficing: there are now economic theories that doubt whether entrepreneurs ever, in reaity, attempt to maximise profits. They caim that what entrepreneurs actuay do is to satisfice. Satisficing is where an economic agent aims to perform satisfactoriy rather than to a maximum eve, in order to be abe to pursue other goas. For exampe, if peope own firms they wi work hard enough to make a reasonabe iving (cover their opportunity costs), but wi not reay push themseves further, preferring to foow other goas, such as the pursuit of eisure. In many cases firms are run by peope who do not actuay own them. An exampe of this woud be a firm owned by sharehoders who are not invoved in running the company and are therefore managed by empoyed non-owners. In this case the managers do not have a great dea to gain if the firm makes maximum profits. It is ikey that the managers wi make enough profit to keep the owners of the firm happy, thereby keeping their jobs, but no more. They wi satisfice. Corporate socia responsibiity (CSR): this is where a business incudes the pubic interest in its decision making. It adopts an ethica code that accepts responsibiity for the impact of its activities on areas such as the workforce, consumers, the oca community, and the environment. Different businesses may adopt different approaches to CSR. Some may concentrate on encouraging deveopment in the workforce and the oca community through educationa projects and fair trade projects. Some may concentrate on reducing their negative effect on the environment by cutting emissions and the use of sustainabe resources. Some may make the provision of aid to ess deveoped communities a priority. In some cases businesses may adopt a of the above approaches to some extent. 98 Assessment Advice In HL paper 3 you may be asked to cacuate different profit eves from a set of data and/or diagrams. You may aso be asked to cacuate the shut down price and the break-even price from a set of data. There are a number of advantages to adopting a CSR approach such as attracting and keeping a better workforce, buiding up reputation and deveoping brand oyaty for being an ethica business. If companies adopt appropriate corporate socia responsibiity poicies and are active in addressing socia and environmenta issues it can aso reduce the need for government intervention in business 99