Chapter 34
Types of cost,
revenue and profit,
short-run and longrun production
LEARNING INTENTIONS
In this chapter you will learn how to:
•
explain the short-run production function, including: fixed and
variable factors of production; total product, average product
and marginal product; the law of diminishing returns (law of
variable proportions)
•
calculate total product, average product and marginal product
•
explain the short-run cost function, including: fixed costs (FC)
and variable costs (VC); total, average and marginal costs
(TC, AC, MC); the shape of short-run average cost and
marginal cost curves
•
calculate fixed costs and variable costs, and total, average and
marginal costs
•
explain the long-run production function, including no fixed
factors of production and returns to scale
•
explain the long-run cost function, including the shape of the
long-run average cost curve and the minimum efficient scale
•
analyse the relationship between economies of scale and
decreasing average costs
•
explain internal economies of scale and external economies of
scale
•
explain internal diseconomies of scale and external
diseconomies of scale
•
define the meaning of total, average and marginal revenue
•
calculate total, average and marginal revenue
•
define the meaning of normal, subnormal and supernormal
profit
•
calculate supernormal and subnormal profit.
ECONOMICS IN CONTEXT
Does bigger mean better? Economies of scale in container
shipping
Container ships have tripled in size since container vessels were
first introduced on deep-sea routes between Europe, the USA and
Asia in the 1950s. The container ship the OOCL Hong Kong has a
carrying capacity of over 21 000 TEU’s (twenty-foot equivalent
units; one standard 45-foot container is 2 TEU). The OOCL Hong
Kong is 400m long and weighs over 190 000 metric tons
deadweight. Even bigger ships are under construction. OOCL and
rivals such as Maersk and CMA CGM are committed to building
these huge ships for one main reason – economies of scale.
Figure 34.1: The OOCL Hong Kong was the world’s largest
container ship at the time of its launch in 2019
Economies of scale mean lower shipping costs per container. This
generates benefits further down the supply chain. It means, for
example, that global manufacturers find it most economical to
locate production in countries with low labour costs. This means
that the lower costs of production offset the costs of transportation.
Economies of scale have had a major impact on the supply chain.
To give an idea of the impact, it is estimated that the cost of
shipping one item of clothing from Asia to Europe in a container
can be as little as $0.25.
It is often forgotten that shipping is a major polluter of the air as
well as the sea. For example, one container ship may emit as much
pollution as 50 million cars. The emissions consist of carbon
dioxide and poisonous oxides. The ships also pollute the sea with
waste and oil spillage.
Shipping companies argue that bigger container ships mean fewer
container ships and that the latest vessels are cleaner and more
efficient than those they are replacing. There is external pressure
on shipping companies far beyond the benefits of economies of
scale. These include threats to globalisation due to increased trade
protection and the urgent need to combat climate change.
Discuss in a pair or a group:
•
What can economists contribute to the debate on economies
of scale?
•
Make a list of the possibilities and think about where you
might be able to obtain information.
34.1 Introduction to production
The demand for the four factors of production (land, labour, capital,
enterprise) comes from producers who wish to use them to make
various goods or products. The producer is normally a firm whose
demand for factors of production is derived from the needs of operating
factories. Let us look at a clothing manufacturer as an example.
As a consequence of globalisation, many items of clothing are now
produced in Southeast Asia, North Africa and Central Europe. This
includes clothing and footwear for the mass retail market as well as
designer brands such as Nike, Calvin Klein and Ralph Lauren. These
brands are no longer produced on any large scale in the home country of
their designer.
Clothing producers need factors of production in order to make goods
for sale in markets that are mainly in high-income countries. Their task
is to combine factors of production in an effective way to be efficient,
competitive and profitable in the world market. The most important
decision they have to make concerns the relative mixture of labour and
capital. Therefore the task for the firm is to find the least cost or most
efficient combination of labour and capital for the production of a given
quantity of output. Clothing is a typical example of a business where
labour and capital are in direct competition with each other. If labour
costs are relatively cheap, as in lower middle-income countries, then the
production process is likely to take place using much more labour than
capital. In most high-income economies, the reverse is true. High-tech
machines can be used to replace labour, largely because it is more cost
effective to do so. So, in this case, the same amount of output is
produced using more capital and far less labour than if it were taking
place in a lower middle-income country.
Figure 34.2: A clothing manufacturer in Bangladesh
Firms therefore have to choose between alternative production methods.
In the example of the clothing manufacturer, Figure 34.3 shows three
different methods of production, each of which combines different
levels of labour and capital to make items of clothing. Line A shows a
method whereby labour and capital are used in equal proportions; line B
shows a production method that uses twice as much capital as labour;
line C shows the output resulting from twice as much labour as capital
being used. On these lines, points x, y and z show the respective
amounts of labour and capital that are needed to produce 100 units of
clothing. Joining these points gives an isoquant, a curve that joins
points that give a particular level of output. The isoquant can be
extended for other combinations of labour and capital not shown on
Figure 34.3.
Figure 34.3: Alternative methods of production
34.2 Short-run production function
In terms of factors of production, labour is the usual variable factor of
production in the short run; all others are fixed. Table 34.1 shows how
the quantity of clothing produced depends on the number of workers
employed. For example, if there are no workers in the factory, there is
no output or no total product; with one worker, total product is 100
units. When there are two workers, the total product is 180 units and so
on.
Number of
workers
0
Total product
Marginal
product
0
Average
product
0
100
1
100
100
80
2
180
90
60
3
240
80
40
4
280
70
15
5
306
51
11
6
306
51
Table 34.1: Short-run production data
Figure 34.4 is a graph of the first two columns of data in Table 34.1.
The graph shows the relationship between the quantity of factor inputs
(labour/workers) and the total product or output of clothing. This graph
is called the production function. The third column of Table 34.1
shows the marginal product, the increase in total product that occurs
from an additional unit of input (labour, in this case). The data in the
third column show that, when the number of workers goes from one to
two, output increases by 80 units; when it goes from two to three
workers, the marginal product is 60 units. As the number of workers
increases, the marginal product declines. This concept is known as a
diminishing return and is often referred to as the law of diminishing
returns. The law of diminishing returns is clearly evidenced in many
organisations. Adding more workers can be a short-term way of
increasing output, but there comes a point where the marginal product
falls and it might even become negative.
Figure 34.4: A production function
The final column of Table 34.1 shows another important measure
average product. Average product is calculated by dividing the total
product by the number of workers employed. It is a simple measure of
labour productivity, that is, how much output is produced by each
worker.
TIP
Learners often confuse product and productivity. This is a common
error. You should remember that product is about output;
productivity is about output per worker.
KEY CONCEPT LINK
The margin and decision-making: The law of diminishing
returns is a relevant illustration of firms making choices at the
margin in the short run.
ACTIVITY 34.1
1
Using the data from Table 34.1, draw a graph to show:
a
the marginal product of labour
b
the average product of labour.
Compare your graph with another learner’s. Discuss any
differences.
Now working in pairs:
2
What do you notice about the shapes of the two curves and
what do the shapes indicate?
3
Explain how a knowledge of marginal and average product
may be useful for a clothing firm planning how much to
produce.
34.3 Short-run cost function
The term 'firm' was defined in Section 1.1 and referred to in earlier
chapters. More specifically, a firm has particular objectives such as
profit maximisation, the avoidance of risk-taking and achieving longterm growth. At its simplest level, the firm may be a sole trader with a
small factory, a food stall or a local convenience shop. A firm is also
used to describe national or multinational companies with many
factories and offices, such as Apple. In economic theory, all firms are
headed by an entrepreneur.
A firm and its entrepreneur must consider all the costs of the factors of
production involved in the final output. These are the private costs
directly incurred by the owners. Production may create external costs
for others but these are not taken into account by the firm (see Section
33.2). The firm is simply the economic organisation that transforms
factor inputs such as raw materials with capital equipment, labour and
enterprise to produce goods and services for the market.
Fixed costs and variable costs
There are two types of short-run costs:
•
Fixed costs (FC) are the costs that are independent of output. Total
fixed costs when drawn on a diagram take the form of a horizontal
straight line as shown in Figure 34.5. At zero output, any costs that
a firm has must be fixed. Some firms, where capacity is fixed or
where the product is perishable as in the case of a hotel, operate in
markets where fixed costs represents a large proportion of the total
costs. It would be advisable to produce a large output in order to
reduce unit costs or to sell all available capacity to make the firm
more likely to cover total costs.
•
Variable costs (VC) include all the costs that are directly related to
the level of output, the usual ones being labour and raw material or
component costs. In other words, variable costs are incurred
directly in the production process.
Figure 34.5: Total cost curves
Total, average and marginal costs
There are five types of short-run costs:
•
total cost (TC)
•
average fixed cost (AFC)
•
average variable cost (AVC)
•
average total cost (ATC)
•
marginal cost (MC).
Total cost (TC) = total fixed cost (TFC) + total variable cost (TVC)
total
fixed
cost
Average fixed cost (AFC) =
output
total
variable
cost
Average variable cost (AVC) =
output
total
cost
Average total cost (ATC) = output
change in total cost
Marginal cost (MC) =
change in output
Marginal cost is the addition to the total cost when making one extra
unit of output. These costs are shown in Figure 34.6.
Figure 34.6: Average and marginal cost curves
The most important cost curve for the firm is the average total cost
(ATC), which shows the cost per unit of output. For most firms, the
decision to increase output will raise total cost; marginal cost will be
positive as extra inputs are used. Firms will only be keen to increase
output when the expected sales revenue outweighs the extra cost of
production. Rising marginal cost is also an indicator of the law of
diminishing returns (see Section 34.2). As more of the variable factors
are added to the fixed ones, the contribution of each extra worker to the
total output will begin to fall. The diminishing marginal returns cause
the marginal and average variable cost to rise, as shown in Figure 34.6.
The shape of the short-run average cost and
marginal cost curves
The shape of the short-run ATC is the result of the interaction between
the average fixed cost and the average variable cost: AFC + AVC =
ATC. As the firm’s output rises, the average fixed cost will fall because
the total fixed cost is being spread over increased output. At the same
time, average variable cost will be rising because of diminishing returns
to the variable factor. Eventually, this will outweigh the effect of falling
AFC, causing ATC to rise. The result is the classic ‘U’ shape to the ATC
curve because of the law of diminishing returns (shown in Figure 34.7).
On the diagram, the MC crosses AVC and ATC at their lowest points
(see Figure 34.6). It means that the most efficient output for the firm is
where the average total or unit cost is lowest. This is known as the
optimum output. Optimum output is where the firm is productively
efficient in the short run. The most efficient output is not necessarily the
most profitable, since profit maximisation may only be possible in the
long run. For a firm wishing to maximise its profits, its chosen output
will depend on the relationship between its revenue and its costs.
Figure 34.7: Short-run ATC and MC cost curves
ACTIVITY 34.2
Figure 34.8 shows the cost structure of a firm.
Figure 34.8: Cost structure of a firm
1
For each cost item, say whether it is likely to be fixed or
variable in the short run.
2
Use this information to say what type of industry this cost
structure might represent. Justify your answer.
TIP
Decision making by firms is very dependent upon marginal cost in
relation to the revenue that is received from producing one more unit
of output. Maximum output is where marginal cost equals marginal
revenue. A common error is to refer to total costs and total revenue,
not marginal costs and marginal revenue.
34.4 Long-run production function
The short run is a period of time in economics when at least one of the
factors of production is fixed. The factor that tends to be easiest to
change is labour, as explained above. The factor that takes longest to
change is capital.
Learners often ask the question, ‘How long is the short run?’ This is not
an easy question to answer, as it tends to differ for different industries.
In the clothing industry, it is likely to be no more than a few weeks, the
time that is taken to install new machines and to get these up and
running to produce clothing. In other industries, it will be much longer.
A country building a new hydroelectric power station will take much
longer to plan, install and make the power station operational. Ten years
may well be a realistic estimate in this case. This time is still referred to
as the short run since capital is fixed over this time. So, the short run is
not defined in terms of a specific period of time; it refers to the time
when not all factors of production are variable.
All factors of production are variable in the long run. This gives the firm
much greater scope to vary the respective mix of its factor inputs so that
it is producing at the most efficient level. For example, if capital
becomes relatively cheaper than labour or if a new production process is
invented and this is likely to increase productivity, firms can then
reorganise the way in which they produce. Firms must know the cost of
the factors of production they use and consider this in relation to the
additional product from using one more unit of a factor of production.
In the case of labour, it is easy to know the costs; it is more difficult to
estimate costs for other factors of production. The best combination of
factors can be arrived at as their price varies. Firms should aim to be in
a position where:
marginal product factor A marginal product factor B
=
price of factor A
price of factor B
marginal product factor C
=
price of factor C
and so on for all factors of production they use. For firms to be able to
do this, all factors of production must be variable.
It is possible to derive the long-run production function for a firm by
constructing an isoquant map using the principles of a production
function shown in Figure 34.3. The map shows the different
combinations of labour and capital that can be used to produce various
levels of output. The isoquant map is shown in Figure 34.9a. It consists
of a collection of isoquants for output levels of 100, 200, 300, 400 and
500 units of production. From this, it is possible to read off the
respective combinations of labour and capital that could produce these
output levels.
TIP
Remember that Figure 34.9a is looking at output from a physical
standpoint, not a cost standpoint. A common error is to regard
isoquants as cost curves.
Returns to scale
Figure 34.9a also shows that as production increases from 100 to 200,
relatively less capital and labour is required per unit of output. This is
referred to as increasing returns to scale. As production expands
further, increasing amounts of capital and labour are needed to produce
100 more units of output and so move up to the next isoquant. This is
indicated by the increasing width of the gap between the isoquants
indicating decreasing returns to scale.
Figure 34.9: Long-run production function: a Isoquant map b Isoquants
and isocosts
In the long run, labour and capital can be varied; the actual mix will
depend upon their prices. Figure 34.9b shows lines of constant relative
costs for the factors of production, known as isocosts. Each of the
isocosts shown has an identical slope. In deciding how to produce, the
firm will be looking for the most economically efficient or least-cost
process. This is obtained by bringing together the isoquants and
isocosts, so linking the physical and economic sides of the production
process. The point where the isocost is tangential to an isoquant
represents the best combination of factors for the firm to employ. The
expansion path or long-run production function of the firm can be
shown by joining together all of the various tangential points and is
therefore useful from a longer-term planning perspective.
It is important to recognise that the above analysis is what might happen
in theory. In practice:
•
It is often very difficult for firms to determine their isoquants –
they do not have the data or the staff know-how to be able to do
this.
•
It is also assumed that in the long run it is possible to switch
factors of production. This may not always be as easy as the theory
might indicate.
•
Some employers may be reluctant to switch labour and capital –
they may feel that they have a social obligation to their workforce
and will therefore not alter their production plans with a change in
relative factor prices.
ACTIVITY 34.3
Table 34.2 shows the short-run and long-run factor input for a firm
that has just two factors of production: capital and labour.
Short run
Capital Labour
Long run
Output Capital Labour
2
1
1
1
2
2
2
2
2
3
3
3
2
4
4
4
2
5
5
5
2
6
6
6
Table 34.2: Short- and long-run factor inputs
1
Insert your own output data in the table to show:
a
diminishing marginal returns
b
increasing returns to scale
c
decreasing returns to scale.
Output
34.5 Long-run cost function
In the long run, the firm can alter all of its inputs, using greater
quantities of any of the factors of production. It is now operating on
what is known as a larger scale. All of the factors of production are
variable in the long run. In the very long run, technological change can
alter the way the entire production process is organised, including the
nature of the products themselves. In a society with rapid technological
progress, this will shrink the time period between the short run and the
long run. In turn, this will shift the firm’s product curves upwards and
its cost curves downwards since firms are more efficient as a
consequence of new technologies. There are examples in consumer
electronics where whole processes and products have become obsolete
in a matter of months, let alone years. For example, mobile phones
evolved into smartphones and are likely to continue to change in the
future. An even bigger challenge is to reduce the use of fossil fuels in
transport systems. The switch to electric cars, buses and other vehicles
is vital if global CO2 emissions are to be drastically cut.
It is possible that a firm can find a way of lowering its cost structure
over time. One way might be by increasing the amount of capital used
relative to labour, with a consequent increase in factor productivity. The
use of robots in car assembly plants and computer-aided production
methods are good examples of how costs can be reduced.
Shape of the long-run average cost curve
The long-run average cost (LRAC) curve shows the least cost
combination of producing any given quantity of output. This is shown
in Figure 34.10. The LRAC curve is a flatter U-shaped curve compared
to the SRAC and is indicative of a firm experiencing falling long-run
costs over time. Falling long-run average costs allow a firm to lower its
price without sacrificing profit. Products such as laptops, digital
cameras, iPhones and games consoles are examples where costs and
therefore prices have fallen through competition and changing
technology.
Figure 34.10: The long-run average cost curve
The shape of the LRAC is derived from a series of short-run situations,
as shown in Figure 34.10. As output increases, so too does the scale of
the firm’s operations. The LRAC is sometimes referred to as the
‘envelope curve’ as it envelops a series of SRAC curves. The SRAC
curves just touch or are tangential to the LRAC as output increases. The
LRAC curve is therefore the lowest possible average cost for each level
of output where the factors of production are all variable. However, this
does not mean that the firm is producing at the minimum point on each
of its SRAC curves.
The concept of the minimum efficient scale
A firm that is producing at its optimum output in the short run and the
lowest average cost in the long run has maximised its efficiency. This is
known as the minimum efficient scale since it is the lowest level of
output where average costs are minimised. In industries where the
minimum efficient scale is low there will be a large number of firms.
Where the minimum efficient scale is high, competition will tend to be
between a few large players. The minimum efficient point of production
in Figure 34.10 is at Q.
34.6 Internal and external economies and
diseconomies of scale
The shape of the LRAC is also used to explain economies of scale. A
firm experiences economies of scale if costs per unit of output fall as the
scale of production increases. This is shown by the downward sloping
section of the LRAC curve in Figure 34.10. If a firm gets increasing
returns from using its factors of production, then it can produce more
goods with smaller quantities of the factors of production. This means
the firm is producing at a lower average cost. Specialisation and the
division of labour (see Section 3.3) are an obvious source of economies
of scale as workers become increasingly efficient in the tasks that they
carry out. A production line in a food processing factory is a good
example of where a group of workers contribute one part of the food
production process.
The shape of the LRAC slopes upwards after the minimum point. The
reason for this is that beyond a certain size, a firm’s costs per unit of
output may increase as the scale of output continues to increase. This
situation is one of diseconomies of scale.
Figure 34.11: A food production line
TIP
You should notice how ‘scale’ is used to explain the production and
cost concepts when looking at the long run. This is because in the
long run all factors of production are variable and so the scale of
output can be increased. A common mistake is to confuse this with
diminishing returns, which is a short-run concept and applies when
just one factor of production is variable.
Economies of scale and decreasing average costs
Economies of scale occur when average costs decrease as the firm
increases its output by increasing its size or scale of operations.
Economies of scale can only accrue to a firm in the long run. Internal
economies of scale are the benefits gained by a firm as a result of its
own decision to produce on a larger scale. They occur because the
firm’s output is rising proportionally faster than the inputs, which means
that the firm is getting increasing returns to scale. If the increase in
output is proportional to the increase in inputs, the firm will get constant
returns to scale and the LRAC will be horizontal. If the output is less
than proportional, the firm will see diminishing returns to scale or
diseconomies of scale. Diseconomies of scale are represented in Figure
34.10 by any point on the LRAC curve beyond the minimum point.
The advantage for a firm in benefiting from economies of scale is a
reduction in the long-run average cost as the scale of output increases.
This can occur in various ways:
•
Technical economies refer to the advantages gained directly in the
production process through more efficient production methods.
Some production techniques only become viable beyond a certain
level of output. Vehicle production is the result of various
assembly lines. The number of finished vehicles per hour is limited
by the speed of the slowest sub-process. Firms producing on a
larger scale can increase the number of slow-moving lines to keep
pace with the fastest, so that no resources are standing idle and the
flow of finished products is higher.
•
Purchasing economies: As firms increase in scale, they increase
their purchasing power with suppliers. Through bulk buying, they
are able to purchase supplies more cheaply, so reducing average
costs. One of the best examples of this is the US retail giant
Walmart, which uses its huge purchasing power to buy goods for
its stores at the lowest prices. All major retailers behave in this
way.
Purchasing economies can also be made where a retailer reduces
the number of items it sells. This allows the firm to concentrate on
selling a more limited range of goods which can be bought in bulk
at discounted prices.
•
Marketing economies: Large-scale firms are able to promote their
products and pay lower rates for advertising on television, in
newspapers and on social media because they are able to purchase
large amounts of air time and space. This broad type of economies
of scale includes savings in logistics costs (the cost of moving
goods from where they are produced to where they are finally
sold). Transport and warehousing costs can be reduced where
customers require these services on a large scale.
Another example is how large-scale firms can make savings
through their IT systems. Examples include search engines and
corporate websites where customers can buy a wide range of items
such as insurance, hotel accommodation and airline tickets. The
cost savings through efficient IT systems also contributes to the
success of huge on-line retailers such as Alibaba and Amazon.
•
Managerial economies: In large-scale firms, managerial economies
come about as a result of specialisation. Experts can be hired to
manage operations, finance, human resources, sales, IT systems
and so on. For small firms, these functions often have to be carried
out by a multi-task manager. Cost savings are expected to accrue
where specialists are employed.
•
Financial economies: Large-scale firms usually have better and
cheaper access to borrowed funds than smaller firms. This is
because the perceived risk to the lender is lower.
KEY CONCEPT LINK
Time: The benefits from economies of scale can give firms a longrun competitive advantage in the market.
External economies of scale
External economies of scale are particular benefits received by all the
firms in an industry as a direct consequence of the growth of that
industry. External economies of scale may be one reason for the trend
towards the concentration of rival firms in the same geographical area.
Figure 34.12 shows how external economies of scale can reduce longrun average costs for all firms in an industry. The advantages may
include the availability of a pool of skilled labour or a convenient
supply of components and services from specialist producers that have
grown up to provide for all firms in that area. All firms may further
benefit from greater access to knowledge and research; better transport
infrastructure can come from the general expansion of firms and can
result in lower logistics costs for all firms. Silicon Valley in California is
a typical example as is Guzhen, China’s ‘lighting capital’. Another
example is Cambridge, UK, where there is a concentration of biotech
and electronics firms, many of which have research and development
links with the University of Cambridge.
Figure 34.12: External economies of scale and the long-run average
cost curve
Diseconomies of scale
It should be made clear that there are limits to economies of scale. As
indicated in Figure 34.10, a firm can expand its scale of output too
much, with the result that average costs start to rise; efficiency is
therefore compromised. This is indicative of diseconomies of scale. The
most likely source of diseconomies of scale lies in the problems of
management co-ordination of large complex organisations and the effect
that size and poor communications have on the morale of the workforce.
This is one important reason why, after a period of growth, a firm may
decide to split its business into two standalone companies. Another
example of diseconomies of scale is where workers may feel a lack of
motivation due to the repetitive nature of the work they are carrying out.
Workers might also feel that they are just a small insignificant part of a
big organisation where senior managers do not appear to have a duty of
care to employees. Although not particularly visible, these are
underlying reasons for an increase in costs as the firm expands its scale
of operations.
In the same way as internal diseconomies of scale are possible, the
excessive concentration of economic activities in a narrow geographical
location can also have disadvantages. External diseconomies may be
seen in the form of:
•
traffic congestion which increases distribution costs
•
land shortages and therefore rising fixed costs
•
shortages of skilled labour and therefore rising variable costs.
ACTIVITY 34.4
Have economies of scale grounded the A380?
Figure 34.13: The interior of an Airbus A380
The Airbus A380 is a double-deck, wide-body jet manufactured by
the Anglo-French Airbus Corporation. It is the world’s largest
passenger aircraft with a maximum capacity of 853 passengers in a
single class configuration or 525 passengers in the more
conventional three-class configuration. The aircraft’s four engines
are quieter and at the time it started service, were more fuel
efficient compared to the aircraft it is replacing, notably the ageing
‘Jumbo Jet’ Boeing 747s. There seemed to be a clear opportunity
for airlines to benefit from economies of scale, particularly on
busy routes where this aircraft could replace two smaller ones.
Facing a near-empty order book and with extensive sales of
Boeing’s 787 Dreamliner (maximum capacity 336 passengers)
showing no sign of slowing, Airbus announced in February 2019
that it was to cease production of the A380.
The A380 was designed to carry large numbers of passengers
based on a ‘hub and spokes’ model; smaller aircraft would then be
used to distribute passengers from the hub to other destinations as
required.
The problem is that the airline business has changed since
Singapore Airlines had its inaugural A380 flight in 2007. The
global recession has put a lot of pressure on airlines to be more
efficient, particularly in their use of fuel, and for manufacturers to
be more innovative in aircraft design. The new generation of long
haul aircraft like the Dreamliner and the Airbus 350 has taken over
the market. It might appear that economies of scale have killed off
the A380.
1
Explain the likely types of economies of scale that might be
gained by airlines that operate A380s.
2
How might these airlines and their customers benefit from
economies of scale?
3
In a group, discuss whether economics has grounded the
A380? Make a podcast of your discussion using a recording
device such as a smartphone. One member of the group
should introduce the topic under discussion.
REFLECTION
How would you explain to another learner the many applications
of the concept of economies of scale? What evidence would you
need to investigate whether a firm is benefiting from economies of
scale?
34.7 Total, average and marginal revenue
Revenue is the payment firms receive when they sell the goods and
services that they have produced. Revenue is sometimes referred to as
sales. Revenue is usually expressed over a time period such as a month
or year.
There are three revenue concepts:
•
Total revenue (TR) represents the sales of a firm and is obtained
by multiplying the price of a good (P) by the number of units sold
(Q):
TR = P × Q
•
Average revenue (AR) is the revenue per unit of output sold:
TR
AR =
Q
•
Marginal revenue (MR) is the additional revenue arising from the
sale of an additional unit of output:
ΔTR
MR =
ΔQ
In analysing a firm’s revenue, it is important to know the type of market
in which the firm is operating. In a fully competitive market the firm has
no control over the price of its goods. The firm is a price taker. The
firm’s demand curve will be horizontal and its revenue will depend
entirely on the amount of goods sold. The market demand curve though
will be downward sloping as shown in Figure 34.14.
Figure 34.14: Price for a price-taking firm: a Market b Firm
In any other type of market the firm will face a downward sloping
demand curve. The firm is a price maker. If the firm chooses to
increase output, price will fall; if it decides to reduce output, price is
expected to increase. As output changes so does price and revenue. The
extent of the change in revenue will depend on the price elasticity of
demand. The firm’s demand curve is its average revenue curve.
Marginal revenue will always be below average revenue since the firm
can only sell more goods by reducing price. This is shown in Figure
34.15.
Figure 34.15: AR and MR for a firm with a downward sloping demand
curve
34.8 Normal, subnormal and supernormal
profit
Very simply, profit is what is left over when total costs are deducted
from total revenue. The economist’s view is rather wider than the view
of an accountant since the accountant’s approach does not fully
recognise the full private costs of economic activity. As well as money
paid out to factors of production, there must be an allowance for
anything owned by the entrepreneur and used in the production process,
such as any loans, that may have been made available to the business.
This factor cost must be estimated and included with other costs. The
concept of opportunity cost is relevant. The entrepreneur may have
capital that could have been used elsewhere at no risk and this would
have earned an income. So, this cost needs to be taken into account.
An entrepreneur, therefore, will expect a minimum level of profit to
reflect what could have been earned elsewhere with the resources that
are available. In economics, this is known as normal profit. It is the
entrepreneur’s reward as a cost of production because without it,
nothing would be produced by the firm. It is therefore the minimum
return that a firm must receive to remain in business. Crucially, normal
profit is included in the total costs of a firm:
Profit = Total revenue – total costs, including normal profit
Any profit over and above normal profit is known as supernormal
profit:
Supernormal profit = Total profit – normal profit
Where supernormal profits are being earned this is a signal for more
firms to enter a market. Subnormal profit is when the profit that is
earned by a firm is less than normal profit. Its significance is that if a
firm is making subnormal profit then it may decide to withdraw from a
market in the long run.
TIP
Learners often forget that normal profit is an item in the total costs of
a firm. If a firm is not earning normal profits in the long run, then it
should exit the industry.
THINK LIKE AN ECONOMIST
Who benefits from your daily cappuccino?
Figure 34.16: Coffee shops are popular places to work and
socialise
Sales of coffee in specialist shops such as Costa, Starbucks and
others continue to grow in many countries. Drinking coffee in such
outlets has become a social experience. Coffee shops also offer a
workspace with free wi-fi. Some customers may spend two to
three hours drinking a coffee. This may be good value for the
customer, but is less so for the retailer. Table 34.3 shows the cost
structure of a large cappuccino with a retail price of £2.60 in the
UK.
Price (£)
Coffee
0.09
Milk
0.09
Cup, lid and stirrer
0.19
Staff costs
0.63
Overheads
0.76
Profit
0.32
Sales tax (VAT)
0.52
Table 34.3: Cost structure of a large cappuccino in the UK
It is not well known that the cost of the coffee is less than 4% of
the retail price and that when the cost of milk is added, the
cappuccino costs less than the cost of the disposable cup, lid and
stirrer.
1
In a group, suppose you decide to lease a premises to open
your own coffee shop. Use the information above to consider
whether you as the owners are likely to benefit. Or will the
owners of the premises benefit? Consider also how the coffee
growers might benefit? Make a list of all the possible
beneficiaries. Then try to put the beneficiaries in rank order.