Firms’ costs, revenue and objectives
- Fixed Costs (FC): Costs that do not change with the level of output. These must be paid even if production is zero (e.g., rent for factory premises, salaries of permanent staff). Because they are fixed in total, as output increases, the cost per unit decreases.
- Variable Costs (VC): Costs that vary directly with the level of output. If output is zero, variable costs are zero. Examples include raw materials and direct labour wages. As output increases, total variable costs increase.
Therefore, the fundamental relationship is:
TC = FC + VC
To understand efficiency, we look at average costs (cost per unit):
- Average Fixed Cost (AFC): AFC = \frac{FC}{Q}
- Average Variable Cost (AVC): AVC = \frac{VC}{Q}
- Average Total Cost (ATC): ATC = \frac{TC}{Q} or ATC = AFC + AVC
Where Q is the quantity of output produced.
Why this matters: The shape of the ATC curve is U-shaped. Initially, ATC falls due to economies of scale (spreading fixed costs over more units and specialization). Eventually, ATC rises due to diseconomies of scale (management difficulties, communication breakdowns in large firms).
Total Revenue (TR) is the total income generated from sales. It is calculated as:
TR = P \times Q
Where P is the price per unit and Q is the quantity sold.
Average Revenue (AR) is the revenue per unit sold. For a firm selling at a single price, AR = P. Therefore:
AR = \frac{TR}{Q} = P
The Influence of Sales on Revenue (Learning Objective 6):
Revenue is not just about quantity; it depends on price elasticity of demand.
- If demand is elastic, a decrease in price leads to a proportionately larger increase in quantity demanded, causing Total Revenue to rise.
- If demand is inelastic, a decrease in price leads to a proportionately smaller increase in quantity demanded, causing Total Revenue to fall.
This means firms must understand how changes in price affect the quantity sold to maximize revenue.
Step 1: Calculate Total Cost (TC)
TC = FC + VC = 2000 + 600 = 2600
Step 2: Calculate Average Total Cost (ATC)
ATC = \frac{TC}{Q} = \frac{2600}{200} = 13
The average cost per unit is 13.</p> <p><strong>Step 3: Calculate Average Fixed Cost (AFC)</strong><br><span class="formula-block">AFC = \frac{FC}{Q} = \frac{2000}{200} = 10</span><br>Note that AFC decreases as output increases. If output doubled to 400 units, AFC would fall to5.
Step 4: Calculate Average Variable Cost (AVC)
AVC = \frac{VC}{Q} = \frac{600}{200} = 3
Check: ATC = AFC + AVC \rightarrow 13 = 10 + 3. This confirms the calculation.
Step 1: Calculate Total Cost for 5 units
TC_5 = ATC \times Q = 20 \times 5 = 100
Step 2: Calculate Total Cost for 6 units
TC_6 = TC_5 + MC_6 = 100 + 26 = 126
Step 3: Calculate Average Cost for 6 units
ATC_6 = \frac{TC_6}{6} = \frac{126}{6} = 21
The average cost rises from 20 to21 because the marginal cost of the new unit ($26) was higher than the previous average.
The Correction: While Total Fixed Cost stays the same regardless of output, Average Fixed Cost continuously falls as output increases. This is because the same total fixed cost is spread over more units. For example, if FC is 100, AFC is10 at 10 units but only $2 at 50 units.
The Correction: The Marginal Cost (MC) curve intersects the Average Total Cost (ATC) curve at its minimum point. When MC < ATC, ATC is falling. When MC > ATC, ATC is rising. The lowest point on the ATC curve is where efficiency is maximized in terms of cost per unit.
Why examiners accept this: Examiners look for the link between price elasticity of demand and total revenue. Simply stating 'demand increases' is insufficient; you must explain the mechanism.
Correct Usage Example: 'If a firm lowers its price and demand is elastic, the percentage increase in quantity demanded will be greater than the percentage decrease in price. Consequently, Total Revenue (P x Q) will rise.'
Key Phrase to Include: 'The proportionate change in quantity demanded is greater than the proportionate change in price.'
Why examiners accept this: Examiners want to see that you understand firms have multiple goals beyond just profit. They accept specific examples of non-profit objectives.
Correct Usage Example: 'A firm may pursue growth (increasing market share) to achieve economies of scale. Alternatively, a public sector firm may prioritize social welfare by providing essential services at below-market prices, even if this reduces profit.'
- An increase in demand for the product (e.g., due to successful advertising or an increase in consumer income), leading to a higher quantity sold at the same price.
- A decrease in price if the demand is elastic, causing a proportionately larger increase in quantity sold, which raises total revenue.