Cost, revenue, and profit

Last updated: Mar 13, 2021

Costs

Production involves the purchase or hiring of scarce factor inputs - known as production costs. Some costs are fixed and do not change with output. Fixed costs include some labour and administration costs, rents, insurance, and depreciation of fixed assets. Other costs are variable and do change with output - these commonly include raw materials and most labour costs.

Revenue

A firm's revenue is the income it derives from selling a given quantity of a good or service at a particular price.

There are two revenue cases depending on the market that the firm operates in:

  1. Firstly, where price is set by the market - and where the firm is a price taker. Price taking occurs when the firm is operating in a 'perfectly competitive' market. In this case, the price is determined through the interaction of demand and supply in the market. Each firm then 'takes' this price, and is not able to diverge.
  2. Secondly, when the firm can set its own price, and become a price maker. Firms can set their own price when the market has some imperfections, such as where barriers to entry exist, or where there is information failure.

Entrepreneur's risk

New entrepreneur's face a fundamental business risk which arises as a result of the time lag between costs being incurred, and revenue being earned. The entrepreneur bears this risk until revenue is sufficient to cover costs. This means the entrepreneur must inject their own capital (or equity) into the business, or raise capital from capital markets.

Measuring costs and revenue

Costs and revenue can be measured in terms of ‘total’ quantities, average values, and marginal values, which measure the cost or revenue associated with producing (or selling) an additional unit.

While considering total and average values is important, economics is distinguished from other economic and financial disciplines by its interest in marginal values. Indeed, the ‘marginal revolution’ in economics involved the attempt to understand economic decision making by looking at very small changes in costs, revenue and utility.

Profit maximisation

The goal of profit maximisation is assumed to be the main driver of business activity - this assumption is central to neoclassical economics. Profits are the reward to enterprise – the factor of production providing enterprise is the entrepreneur. The other factors and their rewards are:

  • Capital – capital owners receive an interest
  • Labour – suppliers of labour receive a wage
  • Land – landowners receive rent

Profit maximisation is best looked at through marginal analysis.

Marginal revenue (MR) = Marginal cost (MC)

The condition for profit maximisation is for a firm to produce up to the point where marginal revenue equals marginal cost.

Normal profits

Normal profits occur when entrepreneurs achieve a reward that is just sufficient to keep them supplying their enterprise. Normal profits are seen as efficient in that an entrepreneur will supply their enterprise for this reward, and although a greater reward would be beneficial, in terms of economic theory a reward above normal profit is not required to enable scarce resources to be used.

Example

the tile maker example

Consider a firm making porcelain floor tiles, with the following costs per unit:

  • Raw materials $3
  • Labour costs $5
  • Finishing and packaging $1
  • Interest $1
  • Normal profit $5

To the economist, total costs are those required to supply a given quantity of goods to market. In the above example we will assume that the entrepreneur will not continue in business at a return below $5 – hence all the rewards to factors can be seen as costs to the firm.

In this case, the cost per tile is $15, and if the selling price is $15 then normal profits are made. Hence, when total revenue (TR) equals total cost (TC) normal profit is being made.

So, if the tile makers producers 4000 tiles a day, daily revenue is $60,000 and daily costs are $60,000.

Cost schedule

Cost schedule for the tiles example

Graph for average and marginal cost

Cost graph showing average and marginal cost

The marginal cost (MC) curve cuts the average cost (AC, or ATC) curve at its lowest point.

The pattern is for average costs to be relatively high at low levels of output – because the impact of fixed costs, such as rents and interest payments, is high and drags up the average. However, as more variable factors are added to increase output, the significance of the fixed costs begins to diminish, and average costs fall. However, economic theory predicts that the returns to adding extra variable units of production will begin to diminish – the so-called law of diminishing returns. This drags up average costs and pushes the firm above its productively most efficient level.

Diminishing returns

Graph showing diminishing returns

Diminishing returns sets in when marginal cost begins to rise - in this case, at an output of 3000. The upward increase in marginal costs then drags up the average cost. In this example, the firm is productively efficient at 4000 units as this is the lowest average cost (at $15 per unit).

This can be seen more effectively in a graph for average costs. It is also true that average costs will be at their lowest when average cost equals marginal cost (per unit).

The case above is a special case where the seller can only charge one price and is a ‘price taker’ – a market described as perfectly competitive.

In this case, the best position for the firm is to make only normal profits, as any other output results in a loss. (with the exception of 3000 units – but when we have two identical profit levels we always move to the last case – this is because we never really discover the figure until we have arrived at it. So, if this was a real firm it would only stop production if profits fell – in this case it would not produce above 4000 units).

Revenue schedule for the price taker

In this case, the firm is assumed to be a price 'taker' and cannot set the price itself - hence the price remains at $15 whatever the quantity sold. The price is set by the interaction of demand and supply in the whole market. This type of market is said to be perfectly competitive.

Revenue schedule for the tiles example

Revenue graph for the price taker

Revenue graph for the tiles example

Profit schedule for the price taker

Profit schedule for the tiles example

Here we can see that the 'best' outcome for the price taker is to avoid making losses, and only to derive normal profits.

Graph for the price taker

Schedules for price taker

Super-normal profits

The second case involves the price making firm where the ability to set price enables the firm to make profits in excess of normal profits. If the entrepreneur earns a reward greater than normal profit it is defined as super-normal (or excess) profits. In this case the reward is exceeding the entrepreneur’s opportunity cost. This can only be achieved if the firm has some power to fix its own price. This will happen when the firm operates in a less than perfectly competitive market, such as a monopolistically competitive market or a pure monopoly.

Example

Assuming the firm can set its own price at $18, sales will be 3000 units per day, and revenue will be $54,000. Total costs will be $45,000, which enable the firm to make excess profits of $9,000. The complete schedules and graph are show below:

Revenue schedule for the price maker

Revenue schedule for the tiles example

Revenue graph for the price maker

Revenue schedule for the tiles price maker example

Profit schedule for the price maker

Profit schedule for the tiles example

Graph for the price maker

Graph for the tiles example

Other points to note:

  • For the price making firm, profit maximisation occurs at a price of $18 per unit, and output of 3,000 units.
  • When average revenue (price) falls, marginal revenue falls at twice the rate.
  • Profits are maximised when marginal cost equals marginal revenue.

Efficiency

There are two fundamental types of efficiency to consider with respect to the firm.

  1. Firstly, productive efficiency occurs when average costs are at a minimum. Average costs are also ‘unit costs’ given that they are arrived at by diving total costs for a given quantity by the quantity.
  2. Secondly, allocative efficiency occurs when the marginal cost of production (which is the value of scarce resources used) equals the price of the product (which equates to the marginal benefit derived by consumers.)

Efficiency for the price taker

When considering the price taking firm, in the long run the firm will produce at output Q, which is both an allocatively and productively efficient output.

In the above case, and with a price of $15 per tile, at 4000 units, marginal cost also equals $15. Hence 4000 units sold is also allocatively efficient.

This output is also productively efficient as the average cost is the lowest or the production range - at $15.

This can be seen graphically:

Efficiency for the price taker

Efficiency for the price maker

In the real world most firms can set their own price – they are a price maker. If we look at the figures for the same firm as a price maker is can vary its price between $20 and $13 – selling more at the lower price. This significantly alters the calculation of profit maximisation, and hence the level of efficiency existing a profit maximisation.
With the new figures, although costs have remained the same, revenue has changed. Now, profits are maximised at a lower output, at 3000 units. But, at 3000, while average costs are at $15 (and still the lowest), price at $18 is higher than marginal cost at $13, and there is a loss of allocative efficiency.

This can also be shown graphically.

Efficiency for the price maker

Perfect competition

What is perfect competition?

Perfect competition
Monopoly

Should monopolies be regulated?

Monopoly
Price discrimination

Why do firms price disciminate?

Price discrimination

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