What are the different types of revenue, what is the relationship between them and what are the formulas to calculate them?

• Total revenue (TR) is the total amount of money that a firm earns from the sale of its goods/services. Total revenue = price (average revenue) x quantity.
• Average revenue (AR) is the price per unit. AR is total revenue/total output.
• Marginal revenue (MR) is the additional revenue from the sale of an additional unit. MR = (change in total revenue)/(change in output). MR is also the gradient of the TR curve.

What is the relationship between price elasticity of demand and revenue concepts?

When demand is relatively price inelastic, an increase in the price of a good or service will likely result in an increase in total revenue, as the contraction in quantity demanded is less than proportionate to the increase in price. When demand is relatively price inelastic, a fall in the price of a good or service will likely result in a fall in total revenue, as the extension in quantity demanded is less than proportionate to the fall in price. 

When demand is relatively price elastic, an increase in the price of a good or service will likely result in a fall in total revenue, as the contraction in quantity demanded is more than proportionate to the increase in price. When demand is relatively price elastic, a fall in the price of a good or service will likely result in an increase in total revenue, as the extension in quantity demanded is more than proportionate to the fall in price. 

When price elasticity of demand is unitary, any change in price will have no effect on total revenue as a change in price will have a proportionate effect on quantity demanded.

A calculation can be used to show the relationship between price elasticity of demand and total revenue.

For example, a firm sells a good at a price of £2 at a quantity demanded of 10 with PED = -10. The price of the good falls to £1. The change in price from £2 to £1 is -50%. PED = (% change in quantity demanded) / (% change in price), this can be rearranged to (% change in quantity demanded) = PED x (% change in price). Thus the percentage change in quantity demanded = -10 x -50%, = 500%. So there has been a 500% increase in quantity demanded from 10 units to 60 units following the price change. So at the new price of £1 and the new quantity demanded of 60 units, total revenue is now £1 x 60 = £60. This is greater than the original total revenue of £2 x 10 = £20, showing that a fall in the price of a good or service that has an elastic price elasticity of demand is likely to result in an increase in total revenue.

Producers in perfect competition have a perfectly elastic AR curve meaning that they are price-takers. Price is constant so MR=AR=D. The TR curve is upward-sloping as the price is constant.

Most firms are in imperfect competition and have some price-setting power. Hence there is a downward-sloping AR curve as shown below. TR is maximised in the diagram below at quantity Q where MR = 0.

What are the different types of costs and what formulas can be used to calculate them?

• Total Cost (TC) is the sum of all the costs of producing a given output (fixed + variable costs). TC = total fixed costs + total variable costs.
• Total Fixed Cost (TFC) is the sum of all of the costs that don’t change as output changes (e.g. rent). TFC = average fixed cost x quantity.
• Total Variable Cost (TVC) is the sum of all of the costs that change as output changes (e.g. raw materials). TVC = average variable cost x quantity.
• Average Total Cost (ATC) is the total cost divided by the output of a firm. Hence ATC = total cost/output.
• Average Fixed Cost (AFC) is the total fixed cost divided by the output of a firm. Hence AFC = total fixed cost/output.
• Average Variable Cost (AVC) is the total variable cost divided by the output of a firm. Hence AVC = total variable cost/output.
• Marginal Cost (MC) is the additional cost of an additional unit. MC = (change in total cost/change in output).

How can short-run cost curves be derived from the assumption of diminishing marginal productivity?

When a firm initially adds workers, the marginal product per worker will rise as more workers are required. However, eventually, an optimum is reached as more and more workers are added, and marginal product per worker will begin to fall after this point as workers get in the way of each other, as there is limited machinery in the short run. This is the law of diminishing marginal productivity. Thus, diminishing marginal productivity can be defined as when an additional variable input is added when some inputs are fixed in nature, there will be an eventual fall in marginal product.

Short-run cost curves can be derived from the assumption of diminishing marginal productivity. For example, diminishing marginal productivity influences the shape of the ATC (Average Total Cost) curve. This is because, ATC initially falls as efficiency is initially likely to improve with the addition of an additional variable input such as labour, however, eventually marginal product begins to fall resulting in a fall in efficiency and an increase in ATC. The AVC (Average Variable Cost) curve approaches the ATC curve at high levels of output. This is because, at higher levels of output, the average fixed cost falls, resulting in the AVC curve approaching the ATC curve. Moreover, the AFC (Average Fixed Cost) curve is likely to be high to start with when the firm is producing at low quantities. This is because the total fixed cost is spread over a relatively small quantity. At larger quantities, AFC is likely to be lower as the total fixed cost is spread over a large quantity. Diminishing marginal productivity also influences the shape of the MC (Marginal Cost) curve. Marginal cost initially falls as variable inputs are added as a result of efficiency improvements, however, at larger quantities, marginal cost is likely to rise as the marginal product of additional variable inputs falls. The MC curve always intersects the lowest point on the AVC and ATC curves. The ATC, AVC, AFC and MC curves are shown in the diagram below.

What is the relationship between short-run and long-run average cost curves?

The law of diminishing marginal productivity influences the shape of the SRAC curve, whereas economies of scale, constant returns to scale and diseconomies of scale influence the shape of the LRAC curve. The LRAC (Long-Run Average Cost) curve acts as a boundary that encloses all the SRAC (Short-Run Average Cost) curves, as demonstrated below. 

In the short run, if a firm has to produce more, they can usually do so but this is likely to lead to a movement to the right along the SRAC curve. After a certain point, SRAC will begin to rise as the firm moves further along the SRAC curve due to the law of diminishing marginal productivity.

Firms can operate on different SRAC curves in the long run.

What are the types of economies and diseconomies of scale?

Economies of scale are the unit cost advantages that can occur by increasing the scale of production leading to a fall in long-run average cost. Economies of scale can be classified into internal and external economies of scale. These are discussed later on in this article.

Diseconomies of scale occur where the expansion of a business leads to an increase in long-run average cost due to inefficiencies or complexities that arise in larger operations. Examples of diseconomies of scale may include:

1. Loss of control as the business grows. This is because it will become progressively harder to keep control over all the parts of the business.
2. Workers in a larger business may feel like they are looked over or ignored and may become demotivated leading to a fall in productivity. 
3. Firms may struggle to control areas of the business which are geographically far away.

Constant returns to scale happen when the output increases in proportion with all the inputs.

What is the minimum efficient scale?

The minimum efficient scale is the lowest point on the LRAC curve where a firm fully exploits its economies of scale. 

What is the distinction between internal and external economies of scale?

Internal economies of scale are advantages that a firm can gain as a result of its expansion. Examples of internal economies of scale include:

1. Risk-bearing economies. Larger firms have more collateral and can take on more risk.
2. Financial economies. Larger firms are normally less risky as they have more collateral and hence have more access to loans and financial services than smaller firms.
3. Purchasing economies. Larger firms have more bargaining power with suppliers and can usually get a discounted price from their suppliers.
4. Managerial economies. Larger firms can employ more experienced labour and managers, improving the productivity of the firm.
5. Marketing economies. Larger firms can afford larger marketing budgets, improving advertising and the reach of the firm.
6. Technical economies. Larger businesses can invest in better technology which can improve efficiency.

External economies of scale are the advantages a firm can gain because of its location or the growth and development of the industry it operates in. Examples of external economies of scale include:

1. Improvement in transport infrastructure within the firm's region may make it cheaper to transport resources.
2. Improvement in local education such as the establishment of a local university or school may give firms easier access to highly skilled labour.
3. Location attracts more firms which may lead to a pool of labour of workers that have high levels of skills.

What conditions are necessary for profit maximisation?

Profit maximisation is achieved when MC=MR. Profit is also maximised when the TR curve reaches its highest point above the TC curve.

What is normal profit, supernormal profit and losses?

Normal profit occurs when AC=AR or TC=TR. It is the level of profit that allows a firm to cover all its costs.

Supernormal (or abnormal profit) occurs when AR>AC or TR>TC. It occurs when a firm earns more revenue than is necessary to cover its costs. 

Losses (subnormal profit) occur when AC>AR or TC>TR. It occurs when a business earns less revenue than it requires to cover all its costs.

What are short-run and long-run shut-down points?

When a firm makes a loss, the firm may not always shut down. The firm is only likely to shut down once it reaches its shut-down point in the short run or the long run.

In the short run, a firm should continue production if AR>AVC. Thus, in the diagram above, P>C1, so the firm which has this cost and revenue diagram should continue production in the short-run as their AR (P) is greater than their average variable cost (C1) at quantity Q. This is because the firm is generating enough revenue to pay for the variable cost. The excess can be used to reduce the TFC which would have been incurred in full if the firm had left the market and shut down. If AVC>AR in the short run, then the firm should shut down in the short run.

In the long run, the firm must make at least a normal profit to survive, so the shut-down in the long-run when AC>AR. In the diagram above, the firm would shut down in the long run as its AC (C) is greater than its AR (P).