3.2 and 3.3 Business objectives, revenues, costs and profits

Revenue is the money a firm receives from selling its output. Three measures matter, and they connect directly to price elasticity of demand (PED).

AR is the same as price, so the AR curve is the firm's demand curve. When a firm must cut price to sell more, MR falls faster than AR, because the lower price applies to every unit sold, not just the extra one. That is why MR sits below AR and is steeper (twice as steep on a straight-line demand curve).

Try it: move along the demand curve

Demand is AR = 40 − 2Q. Drag the slider and watch total revenue peak exactly where MR reaches zero.

Link to PED

• Where MR is positive, demand is price elastic (PED > 1): cutting price raises total revenue.
• Where MR = 0, demand is unit elastic (PED = 1) and total revenue is at its maximum.
• Where MR is negative, demand is price inelastic (PED < 1): cutting price lowers total revenue.

In the short run at least one factor of production is fixed (usually capital). In the long run all factors are variable.

Fixed costs (rent, insurance, loan repayments) do not change with output. Variable costs (raw materials, hourly wages, energy used in production) do.

Why the curves are U-shaped: the law of diminishing marginal productivity

With a fixed factor such as one factory, adding more workers first raises output by more and more, as specialisation kicks in, so MC falls. Eventually workers crowd the machinery and each extra worker adds less than the one before. Marginal product falls, so MC rises. That gives MC its U (or tick) shape.

Build the short-run cost diagram

Each short-run average cost curve (SRAC) belongs to one fixed level of capital. In the long run the firm can choose any scale, so the long-run average cost curve (LRAC) is drawn as the lower envelope of all the SRAC curves: it shows the lowest cost of producing each output when every factor can change.

Economies of scale are falls in long-run average cost as output rises. They explain the downward-sloping part of the LRAC. Diseconomies of scale push LRAC back up.

Internal economies (arise inside the firm)

• Technical: large machinery and production lines only pay off at high output; the "increased dimensions" effect (double a container's dimensions and its volume more than doubles).
• Purchasing: bulk-buy discounts from suppliers.
• Managerial: specialist managers become affordable.
• Financial: big firms borrow at lower interest rates.
• Marketing: advertising costs are spread over more units.
• Risk-bearing: diversified products and markets cut the impact of any one failure.

External economies (arise from the size of the whole industry)

Supplier clusters, a pool of skilled labour, shared infrastructure and specialist colleges all lower costs for every firm in the area. Silicon Valley and the City of London are common examples.

Diseconomies of scale

Internal: communication breaks down through long chains of command, coordination gets harder, workers feel remote and motivation falls (the principal-agent problem gets worse), and control weakens. External: congestion, and rising rents and wages as many firms compete for the same land and labour.

Minimum efficient scale

The minimum efficient scale (MES) is the lowest output at which the firm reaches the bottom of its LRAC. If MES is a large share of market demand, only a few firms can be efficient, which helps explain natural monopoly and oligopoly.

• Normal profit: the minimum reward needed to keep the entrepreneur in this business, an opportunity cost included in AC. Occurs where AR = AC.
• Supernormal (abnormal) profit: profit above normal, where AR > AC. In competitive markets it attracts new entrants.
• Loss: AR < AC.

Find the profit-maximising output

Profit is maximised where MC = MR. Below that output, an extra unit adds more revenue than cost, so producing it raises profit. Beyond it, each extra unit adds more to cost than to revenue. Use the slider on the last step to shift demand and see supernormal profit turn into a loss.

Shut-down points

Short run: the firm still has to pay fixed costs whether it produces or not. It should keep producing while AR ≥ AVC, because it covers all variable costs and contributes something towards fixed costs. It shuts down if AR < AVC. Long run: all costs are variable, so the firm exits if AR < AC.

Firms do not always aim to maximise profit. The objective a firm follows changes its price, output and behaviour, and each has its own condition.

Managers may pursue revenue or sales because their pay and status rise with firm size, while shareholders want profit. This separation of ownership and control is the principal-agent problem (spec 3.1.1).

Firms also pursue other goals such as growth, market share and corporate social responsibility, and may change objective depending on market conditions, ownership (private or public) and stakeholders.

Question: "Evaluate the view that a firm should always aim to maximise profit." Click through how one analytical paragraph is built.

1. Point. A firm should maximise profit by producing where MC = MR.
2. Explain. Up to this output each extra unit adds more to revenue than to cost, so profit is rising.
3. Extend. Beyond it, MC exceeds MR, so extra units reduce profit. So the firm stops at MC = MR.
4. Diagram / data. Refer to your diagram: price read off AR, cost read off AC, shaded area is supernormal profit.
5. Link to the question. High profit lets the firm reinvest and reward shareholders, so it supports the view.
6. Evaluate. But managers with different incentives may choose revenue or sales maximisation, and firms facing scrutiny may satisfice. The answer depends on ownership and the market.

More on this in the chain of reasoning technique page.

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