1. Background to Supply – Costs, Revenue and Profit
23rd of October

2. Costs, revenue and profit
Topics to be covered:
Revenue, output and revenue
The meaning of cost
Elasticity and revenue
Production in the short-run: the law of diminishing returns
Profit maximisation
short-run
Short-run production function
Costs in the short-run
long-run
Production in the long run
Shut-down point
Relationship between sales revenue and output

3. Meaning of Cost
Cost is the money spent by a firm to produce goods or services
Example: labour cost, material cost, machinery cost
Opportunity costs
Often cost is measured in terms of opportunity cost
“Opportunity cost” is the cost of any activity measured in terms of the next best alternative (opportunity) foregone.
Example: producing 10 small cars instead of 6 large cars with same amount of input (opportunity cost of producing 1 small car is 0.6 of a large car).

4. Measuring opportunity cost
What factors of production the firm uses
Cost (sacrifice) involved in using them
Explicit cost and implicit cost
Explicit costs: Costs involved with the production of goods or services that require a direct payment of money to a third party, e.g., electricity bill, labour cost.
Implicit costs: Costs which do not involve a direct payment of money to a third party, but nevertheless involve a sacrifice of some alternative e.g., cost of machinery, building etc. not owned by the firm.

6. Measuring opportunity cost
If there is no alternative use of an input and if it has not scrap value, the opportunity cost of using it is zero.
Costs not considered as opportunity cost:
Historic costs – original purchase price of an asset
Fixed costs – not important in short-run decision making (referred to as sunk cost).
‘Bygones’ principle: the sunk (fixed) costs should be ignored when deciding whether to produce or sell more or less of a product. Only variable cost should be considered.
Replacement cost ( something needs to pay in the future)

7. Production in the Short run
Production functions
factors of production
labour
land and raw materials
capital
entrepreneurship
the cost of producing any level of output will depend on the amounts of inputs used and the price that the firm pay for them. 2

8. Production in the Short run
Short-run : short-run is a time period during which the cost of at least one factor of production is fixed.
Long-run: all costs are variable
The actual length of short-run will differ from firm to firm. It is not a fixed period of time.
The law of diminishing return: decrease in marginal production as the amount of a single factor of production is incrementally increased. 2

9. The short-run production function
Production function: relationship between input and output
Total physical product (TPP): total output produced in a given period of time.
Average physical product (APP): output per unit of variable factor
marginal physical product (MPP): extra output produced by employing one more variable factor
the graphical relationship between TPP, APP and MPP

10. Wheat production per year from a particular farm
Number of
workers 1 2 3 4 5 6 7 8
TPP 3 10 24 36 40 42
Tonnes of wheat produced per year
Number of farm workers

11. Wheat production per year from a particular farm
Number of
workers 1 2 3 4 5 6 7 8
TPP 3 10 24 36 40 42
Tonnes of wheat produced per year
Number of farm workers

12. Wheat production per year from a particular farm
TPP
Tonnes of wheat per year
Number of
farm workers (L)
Tonnes of wheat per year
Number of
farm workers (L)
MPP

13. Wheat production per year from a particular farm
TPP
Tonnes of wheat per year b
Diminishing returns
set in here.
Number of
farm workers (L)
Tonnes of wheat per year
APP
Number of
farm workers (L)
MPP

14. Wheat production per year from a particular farm
Maximum
output
TPP
Tonnes of wheat per year b
Number of
farm workers (L) b
Tonnes of wheat per year
APP
Number of
farm workers (L)
MPP

15. Q If the marginal physical product (MPP) is above the average physical product (APP):
the MPP must be falling.
the MPP must be rising.
the APP must be falling.
the APP must be rising.
the APP could be either rising or falling depending on whether the MPP is rising or falling.
C. If the marginal cost is below the average cost, then additional units will cost less to produce than the average and will thus pull the average down.

16. Fixed costs and variable costs Total costs
Costs in the Short run
Fixed costs and variable costs
Total costs
total fixed cost (TFC): total fixed cost does not vary with output.
total variable cost (TVC)
Variable cost per unit of output X Number output produced
total cost (TC = TFC + TVC) 9

17. TC TVC TFC Total costs for firm X Output (Q) 1 2 3 4 5 6 7 TFC (£) 121 2 3 4 5 6 7
TFC
(£) 12
TVC
(£) 10 16 21 28 40 60 91 TC
(£) 12 22 28 33 40 52 72
103 TC
TVC
TFC

18. Costs in the Short run Average cost Marginal cost = TC/ Q
average fixed cost (TFC/Q)
average variable cost (TVC/Q)
average (total) cost (TC/Q) = AFC + AVC
Marginal cost = TC/ Q

19. Total, average and marginal cost for Firm X

20. Average and marginal costsMC AC
AVC
AFC
Costs (£) z y x
Output (Q)

21. Production in the Long run
All factors are variable in long run
Planning in the long-run involves decisions on :
Scale of its production
economies of scale – when increasing the scale of production leads to lower cost per unit of output.
constant returns to scale: percentage increase in input will lead to the same percentage increase in output.
increasing returns to scale: output grows at a higher rate than the growth in input
decreasing returns to scale: Output grows at a lower rate. 4

22. Alternative long-run average cost curves
Constant costs
Costs
LRAC O
Output

23. A typical long-run average cost curve
LRAC
Costs O
Output

24. A typical long-run average cost curve
LRAC
Economies
of scale
Constant
costs
Diseconomies
of scale
Costs O
Output

25. Deriving long-run average cost curves: factories of fixed size
SRAC4
SRAC5
SRAC1
SRAC2
SRAC3
5 factories
4 factories
1 factory
Costs
2 factories
3 factories O
Output

26. Deriving long-run average cost curves: factories of fixed size
SRAC1
SRAC5
SRAC2
SRAC4
SRAC3
LRAC
Costs O
Output

27. Deriving a long-run average cost curve: choice of factory size
Costs
Examples of short-run
average cost curves O
Output

28. Deriving a long-run average cost curve: choice of factory size
LRAC
Costs O
Output

29. Exam Questions
The costs that are influenced by output in the short run are
Select one:
A. total fixed costs only.
B. total costs only.
C. total variable costs only.
D. both total variable costs and total costs.  E. Start up costs

30. Question 2 Economies of scale exist when
A. doubling the amount of labour more than doubles the amount of output.
B. any of the conditions under A or C occur.
C. doubling the amount of capital more than
doubles total output.
D. increasing the scale of production leads to a lower cost per unit output. 
E. any of the conditions under B or C occur

31. Question 3
If the total product of two workers is 80 and the total product of three workers is 90, then the average product of the third worker is ________ and the marginal product of the third worker is ________.
Select one:
A. 30; 10 
B. 10; 3.33
C. 3.33; 10
D. 10; 30
E. 160; 270

32. Revenue Defining total, average and marginal revenue
Total revenue (TR): firm’s total earnings from the sale of particular amount of output (Q) in a period of time. TR = Price (P) × Q
Average revenue(AR): average amount the firm earns per unit sold. AR = TR / Q
Marginal revenue (MR): The extra revenue gained by selling one or more unit per time period. MR = TR / Q 13

33. Revenue
Price taker: A firm that is too small to be able to influence market price.
A “price taking firm” faces horizontal demand curve at the market price
Average revenue curve for a single firm therefore lies along exactly the same line of its demand curve.
Marginal revenue curve will be the same as the average revenue curve
For a price taking firm D=AR=MR

34. Deriving a firm’s AR and MR: price-taking firm
AR, MR (£)
D = AR
= MR Pe D O O
Q (millions)
Q (hundreds)
(a) The market
(b) The firm

35. Total revenue for a price-taking firmTR
Quantity
(units)
Price = AR
= MR (£) TR
(£)
200
400
600
800
1000
1200 5
1000
2000
3000
4000
5000
6000
TR (£)
Quantity

36. Revenue curve for price chooser
Price maker (price chooser) : Firm has a relatively large share of the market.
Firm has the ability to influence the price charged for its good or service.
A price maker firm faces a downward-sloping demand curve
In order to sell more, it must lower the price
A price rise will reduce sale
What happens to AR, MR and TR? 14

37. AR and MR curves for a firm facing a downward-sloping demand curveQ
(units)
P =AR
(£) TR
(£) MR
(£) 1 2 3 4 5 6 7 8 7 6 5 4 3 2 8 14 18 20 6 4 2 -2 -4
AR, MR (£) AR
Quantity MR

38. TR curve for a firm facing a downward-sloping D curve
Quantity
(units)
P = AR
(£) TR
(£)
TR (£) 1 2 3 4 5 6 7 8 7 6 5 4 3 2 8 14 18 20
Quantity

39. Marginal revenue and price elasticity of demand
If demand is price elastic, a decrease in price will lead to a proportionally larger increase in quantity demanded and hence and increase in revenue;
Positive marginal revenue
If demand is price inelastic, a decrease in price will lead to a proportionally smaller increase in quantity demanded and hence and decrease in revenue;
Negative marginal revenue 14

40. AR and MR curves for a firm facing a downward-sloping demand curve
Elastic
Elasticity = -1
Inelastic
AR, MR (£) AR
Quantity MR

41. Shifts in revenue curve
A change in any other determinants of demand, such as, tastes, income or the price of other goods, will shift the demand curve.
These changes will cause shift in all three revenue curves
Revenue curve shifts upward to reflect an increase in revenue and shifts downwards to reflect decrease in revenue. 14

42. Cost and revenue :profit maximisation
Firms strive through in maximizing profit
Managers are interested to know the output level at which profit is maximized
Two approaches to determine profit maximisation level of output:
Total approach = total revenue – total cost
Marginal approach = marginal revenue – marginal cost

43. Revenue, cost and profit for Firm X

44. Finding maximum profit using total curvesTC d e TR
TR, TC, TP (£) f
Quantity TP

45. Profit Maximisation Using total curves
maximising the difference between TR & TC
the total profit curve
Using marginal and average curves
stage 1: profit is maximised at the quantity where MR = MC 15

46. Finding the profit-maximising output using marginal curvesMC
Costs and revenue (£)
Profit-maximising
output e
Quantity MR

47. Profit Maximisation Using total curves
maximising the difference between TR & TC
the total profit curve
Using marginal and average curves
stage 1: profit is maximised at the quantity where MR = MC
stage 2: using AR and AC curves to measure the size of the profit (and the product’s price) 15

48. Measuring the maximum profit using average curvesMC
Total profit =
£1.50 x 3 = £4.50
Profits maximised at the output where MC = MR AC a
Costs and revenue (£)
6.00
4.50
T O T A L P R O F I T b AR
Quantity MR

49. Profit Maximisation long-run profit maximisation
Long-run profits will be maximised at the output where MR equals the long-run MC.
Meaning of ‘profit’
The minimum return that the owners must make on their capital in order to prevent close down.
Normal profit: the opportunity cost of being in business
Economic profit: the excess of profit over normal profit
Loss-minimising output : Output where MR=MC 16

50. Loss-minimising outputMC
Loss-minimising output AC AR MR AC
LOSS Q
Costs and revenue (£) AR O
Quantity

51. Shut down or not Short-run shut-down point: Long-run
In the short-run fixed costs have to be paid even if the firm is producing nothing.
short-run shut-down point: P = AVC
Long-run
All costs are variable
Firms need to cover both fixed and variable costs
P = LRAC 16

52. The short-run shut-down pointAC
The short-run shut-down point
The firm will shut down in the short run if it cannot cover variable costs.
AVC
If AVC is higher or AR lower than that shown, the firm will shut down. AR
P =
AVC
Costs and revenue (£) Q O
Quantity

53. Research! Pick any country
Find the following information about the country
Demographic Information
Population, Nationality, Ethnic Groups, Languages, Religions
Economic Information
GDP, Currency and dollar exchange rate, GDP Growth rate, GDP Per capita, Unemployment rate, Inflation rate
State where you got the information from.