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Theory of the Firm :
Revenue and Cost Functions Foundation MicroeconomicsPart 1 of 3
MARK CLEARYFOUNDATION MICROECONOMICS
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Key Concepts• Costs: Fixed, Variable, Total, Average,
Marginal• Price taker, price maker• Profit • Profit maximisation
Theory of the FirmCosts: charges incurred for the use of resources.
Short Run: at least one factor of production is fixed
Long Run: all factors of production are variable.
Fixed Costs: costs that are independent of the level of activity of the firm, has to be paid for regardless of whether or not it is used.
E.g. Rent , Business rates
Fixed Costs
0 50 100 150 200 250 300 350 400 450-100
100
300
500
700
900
1100
1300
1500 Fixed Costs
Output
Cos
ts £
000
CostsVariable Costs: Rise with outputNo output = No V.C.E.g. raw materials, wages, transportTotal Costs: the summation of all
the firms costs. TC = TVC + TFC
Variable Costs
CostsVariable Total
Output Fixed Cost Cost Cost
(units) (£000) (£000) (£000)
0 600 0 600
40 600 150 750
80 600 300 900
130 600 450 1050
190 600 600 1200
260 600 750 1350
310 600 900 1500
345 600 1050 1650
380 600 1200 1800
390 600 1350 1950
410 600 1500 2100
Total Costs
Cost
£
q
TC
TVC
FC
Costs• Average Total Cost: the firm’s average cost per unit
produced. ATC = TC/Q
• Average Variable Cost: AVC = TVC/Q
• Average Fixed Cost: AFC = TFC/Q
• Marginal Cost: rTC/rQ
Cost
Average fixed cost
Marginal Cost
Average Total Cost
Average variableCost
Cost Functions
Quantity
Variable Total ATC AVC AFC MC
OutputFixed Cost Cost Cost
(units) £0 £0 £0 0 600 0 600 600
40 600 150 750 18.8 3.8 15 3.880 600 300 900 11.3 3.8 7.5 3.8
130 600 450 1050 8.1 3.5 4.6 3.0190 600 600 1200 6.3 3.2 3.2 2.5260 600 750 1350 5.2 2.9 2.3 2.1310 600 900 1500 4.8 2.9 1.9 3.0345 600 1050 1650 4.8 3 1.7 4.3380 600 1200 1800 4.7 3.2 1.6 4.3390 600 1350 1950 5 3.5 1.5 15.0410 600 1500 2100 5.1 3.7 1.5 7.5
Theory of the Firm 1:
Revenue and Cost Functions End of Part 1
RevenueTotal Revenue: total received from the sale of
output; TR = Price x Quantity that is TR = P x QProfit: the difference between income and
expenses; π = Total Revenue – Total CostsMarginal Revenue: the additional income gained
by selling one addition unit MR= rTR / rQAverage Revenue: the firm’s average revenue per
unit sold; AR = TR/Q
Price Maker revenue curves:
Total revenue
£
£q
q
Average revenue and marginal revenue
D = ARMR
Price taker revenue curves:
Total revenue
£
£q
q
P
Average revenue and marginal revenue
TR
D = AR = MR
Theory of the Firm 1:
Revenue and Cost Functions End of Part 2
Theory of a Firm: Profit Profit: the difference between income and expenses; π = TR - TC
Normal Profit: covering all costs, without making a surplus; thus effective π = 0
Supernormal Profit: cover all costs and make a surplus; π > 0
Loss: Not able to cover costs; π < 0
£
Output
Total Cost
Total Revenue
Profit
Q*
Theory of a Firm: Profit
Profit Maximisation
Profit Maximisation: the price and output levels that would yield the greatest profits. Occurs when; Marginal cost = Marginal Revenue
If;
MR > MC; can make more profit by producing more; thus raise output
MR < MC; making a loss on additional units sold; thus reduce profit
MR = MC; any change from this point will cause a reduction in profit; stay at this level of output
Profit Maximisation
MR
MC
Costs/Revenues
Quantity
Key Concepts• Costs: Fixed, Variable, Total, Average,
Marginal• Price taker price maker• Profit• Profit maximisation
KEY CONCEPTS• Economies of Scale• Diseconomies of Scale• Impact of technology on firms
Theory of a Firm: Economies of ScaleEconomies of Scale: cost advantages obtained due to business
expansion. If a firm is experiencing an increase in economies of scale; as output increases average costs per unit decrease.
Diseconomies of Scale: as output increases, average costs per unit increases
OutputO
Co
sts
LRACEconomiesof scale
Constantcosts
Diseconomiesof scale
A typical long-run average cost curveA typical long-run average cost curve
Economies of Scale
Factors that can lead to Economies of Scale
• Indivisibilities - large scale production uses more efficient techniques
– central office and other functions– minimum efficient size of production lines– Research and Development
• Specialisation - division of labour, especially production lines; specialised departments - accounts, personnel, production etc.
Economies of Scale• Expansion of Capacity
• More scope to meet unexpected contingencies - better experience.
• Inventories are smaller % of production
• Creation of transport and distribution networks
Economies of Scale• Financial
• Loans, market power, bulk buying of raw materials, advertising
• Improve contracts with suppliers• Selling and Marketing
• Improved capital and experience for advertising
• Creation of brand images, improved brand awareness
Economies of Scale• Sunk costs - once plant is installed, the opportunity cost of its
continued use may be very low. This gives ‘larger’ existing producers a cost advantage over new entrants.
• Central management organisation is of the nature of a one-off cost
• Spreading of risk - multi-product firms,
• may be able to force down labour costs
Diseconomies of Scale
• Ineffective Management
• Poor Communication
• Lack of effective knowledge and lack of building on experience