Costs, Revenues, and Profits (Part 2)
Revenue Theory
Revenue is quite simply the income a firm receives from selling its products. Revenue is NOT profit. The
difference is that profit takes cost into account, and revenue does not.
Three Types of Revenue
1. Total Revenue (TR)
2. Average Revenue (AR)
3. Marginal Revenue (MR)
Total Revenue – Total amount of money a firm receives from selling its products. TR is calculated
through multiplying price with quantity sold. If my company sells four teddy bears and they cost $5
each, then the total revenue is $20 (4x5).
Average Revenue – The average revenue that a firm receives per unit of sale. It is calculated through
dividing TR by quantity sold. However, (PxQ)/Q = P, so average revenue is always equal to price.
Marginal Revenue (MR) – This one is a little more complicated. MR is the extra revenue a firm gains by
selling one more unit of product. Marginal revenue is different from average revenue because it CAN
involve a price change. However, if price does not change, MR is equal to AR. In pure price competition,
price cannot change; therefore the MR curve is equal to the AR curve. If price does change by selling an
extra unit, then MR is not equal to AR. For example, if you have the option of selling 9 units at $10 or 10
units at 11$, you must use the MR formula:
MR =
∆𝑇𝑅
,
∆𝑞
where TR is total revenue, and q is quantity. Example: Miller’s (first) lunches cost him $5, and
he buys 500 of them. The price of (first) lunches drops to $4, and Miller buys 700 of them. Therefore,
the marginal revenue is:
MR =
∆𝑇𝑅
∆𝑞
MR =
(700×4)−(500×5)
700−500
300
MR = 200 = $1.50
Revenue, Curves, and Output
There are 2 total revenue models:
1. Revenue when price does not change with output (elasticity of demand is infinite)
 When elasticity of demand is infinite, this means that consumers are
infinitely sensitive to a price. This means that if the price of a product
changes, consumers will not demand any of it at all. In theory, this only
occurs in perfect competition. As stated before, when price does not
change with output, average revenue is equal to marginal revenue. This
can be explained by using the formulas for each mentioned earlier.

Graphically, one can see that when the PED (price elasticity of demand)
is infinite, then price does not change with quantity.
2. Revenue when price changes with output (when demand curve is downward sloping)
 This is the case with every model except pure price competition. In
these models, when price decreases, the quantity demanded increases.
This is just simply the law of demand. Therefore, average revenue is not
equal to marginal revenue. To find marginal revenue, you use the
formula mentioned earlier.

Graphically, one can see that quantity changes with price, and therefore
marginal revenue does not always equal average revenue:
Profit Theory
Most of us know that profit is equal to revenue minus costs. Money you make, minus the money
it cost you, right? Wrong. Cost does not just include explicit costs (things that cost money). Cost also
includes implicit costs. Implicit cost is the cost of one’s time or effort. Wikipedia defines it as “the
opportunity cost equal to what a firm must give up in order to use factors which it neither purchases nor
hires”. Such factors might include time or effort spent on other things. Granted, I might make profit
from working at McDonalds, but an implicit cost might be not working as a Heart Surgeon (assuming I
am qualified). In other words, a McDonald’s profit might not be impressive because the related
opportunity cost is massive.
The Shut-Down Price
Hopefully, you have already learned about fixed and variable cost. Recall that
variable costs are costs that change as the quantity supplied changes. Fixed costs are costs
that remain constant, independent of quantity produced. Economically speaking, the shortterm shutdown point is reached when a firm’s total revenue is not high than its total
variable costs. Essentially, if you look at it from another angle, “in the short run a firm
should continue to operate if price exceeds average variable costs”. This concept is easier
understood when you can visualize an example:
Miller’s Hotdog Stand – Miller is a confident young entrepreneur with a love of hotdogs.
He decides to open his own hotdog stand. At his current level of production, his firm faces
variable costs of $6000 a month – these include the number of employees he hires and the
number of hotdog buns he buys. At any point, he can decide to suspend his workers or
cancel his bun orders. His fixed costs amount to $7000; in the short-run he cannot change
the fact he will always have to pay $7000 a month. According to our definition above, Miller
will shut down his business temporarily when his revenue is not higher than his variable
costs. Let’s explore why. If Miller predicts he will take in $5000 of monthly revenue, then he
will reach the shutdown point and temporarily suspend workers/cancel his bun shipment.
Why? Let’s do some math:
If Miller continues production, his total cost would be $13,000 (variable cost of $6000 plus
fixed cost of $7000). His profit would therefore be a loss of $8000 ($5000 of revenue minus
$13,000 total cost).
If Miller shuts down his business, his variable costs become $0. However, he still has to pay
his fixed costs of $7000. Because his business is not producing, he makes no revenue. His
profit is then a loss of $7000 ($0 of revenue minus $7000 total cost).
Clearly, Miller is better off shutting down his business this month; this is because his total
revenue will not exceed his total variable costs. Doing so, he saves $1000.
The Profit-Maximizing Level of Output
This is one of the more complex concepts in the chapter that requires knowledge of
graphical cost and revenue curves you have hopefully learned previously. For the sake of
simplicity, assume the firm we are looking at has a standard downward sloping demand
curve. This firm can choose to produce at any output it wants. Miller, for example, can make
any number of hotdogs he wants. He could make 6, or he could make 6,000. However,
Miller, like any entrepreneur, wants to maximize his profit. Therefore, he will follow the
golden rule of profit-maximization: produce at an output where marginal revenue is
equal to marginal cost. On an IB exam you will most likely have to explain this
graphically: let’s investigate it one step at a time.
First let us review all of the curves:
Demand Curve – This is always equal to average revenue. It shows us how much
consumers are willing to pay at different levels of output.
Marginal Revenue Curve (MR)– This shows us the extra revenue made on each unit after
a price change. Marginal revenue will always be below the demand curve. This is because in
order to sell another unit, the price on ALL units must be lowered. Robert Schenk (PhD,
University of Wisconsin-Madison, 1977) explains it like this:
“According to the picture, people will not buy more than 100 units at a price of $10.00. To sell more, price must
drop. Suppose that to sell the 101st unit, the price must drop to $9.95. What will the marginal revenue of the 101st
unit be? Or, in other words, by how much will total revenue increase when the 101st unit is sold? There is a
temptation to answer this question by replying, "$9.95." A little arithmetic shows that this answer is incorrect. Total
revenue when 100 are sold is $1000. When 101 are sold, total revenue is (101) x ($9.95) = $1004.95. The marginal
revenue of the 101st unit is only $4.95.
To see why the marginal revenue is less than price, one must understand the importance of the downward-sloping
demand curve. To sell another unit, sellers must lower price on all units. They received an extra $9.95 for the 101st
unit, but they lost $.05 on the 100 that they were previously selling. So the net increase in revenue was the $9.95
minus the $5.00, or $4.95. “
Read more: http://ingrimayne.com/econ/elasticity/RevEtDemand.html
Marginal Cost Curve (MC) - The curve that shows the increase in total cost as a result of
producing one extra unit.
Average Total Cost Cuve (ATC) - The total cost of producing one unit
How To Determine Profit
The chapter splits this up into "The break-even price", the "profit maximizing level of
output", and finally a section on abnormal profits/losses. I feel that these concepts are
explained easier when you put them all together. You will most likely be using them all
together on an IB exam. Before the process is explained, let’s review the three different
profit scenarios:
Normal Profit: This occurs when the profit-maximizing price is equal to the average cost.
Normal profit is defined as the amount of profit needed to stay in business. Essentially, if a
firm is making normal profit, then it is taking in enough money to continue. One might
question, “If a firm’s revenue only covers its costs, how do people get paid/make profit?” In
response to this question, one must understand that salaries are a cost of labor, and
therefore included in average total cost. Therefore, if average revenue (price) is equal to
average total cost, then all costs are covered, including the price of labor.
Supernormal Profit: This is simply defined as a profit that is higher than what is needed to
stay in business. Anything higher than normal profit is supernormal profit. This occurs
when average revenue (price) is higher than average total cost.
Losses: Conversely, losses are anything less than normal profit. If average revenue (price)
is lower than average total cost, a firm is experiencing losses.
These are the steps to find which of these is occurring:
Step 1. Find the output (quantity) at which the MR curve intersects the MC curve.
Step 2. Find the price at this output (using the demand curve)
Step 3. Identify the average total cost at this output (using the ATC curve)
Step 4. Evaluate, at this output, whether either:
 price > average cost
 average cost > price
 price = average cost
Now let’s review this graphically:
B
A
Given this diagram, let’s go through the steps to determine what profit this firm faces.
Step 1. The MC curve intersects the MR curve at point A. At this point, the output is at
quantity Q*. This becomes the profit-maximizing output.
Step 2. The demand curve shows us that, at the Q* level of output, consumers are
willing to pay P* dollars.
Step 3. At the Q* level of output, the ATC shows us that the average total cost will be
at B dollars.
Step 4. Because P*> B, consumers are willing to pay more than the average total
cost. This means that the firm is experiencing supernormal profit. This is measured
as the distance between P* and B. Therefore, if P* was $40 and B was 20$, the firm is
facing supernormal profit of (P*-B), or ($40-$20), which equals $20. If P* and B were
equal, then the firm would face normal profit. If P* was less than B, the firm would
face losses.
Quick Quiz
1. Miller sells 9 haircuts at $8. He lowers the price to $7 and sells 11. What is his marginal
revenue for each extra unit after the price change?
a.
b.
c.
d.
$2.50
$3.00
$3.50
$4.00
2. Implicit costs are determined using:
a.
b.
c.
d.
Employment
Marginal Cost
Opportunity Cost
Supply and Demand
3. Miller’s total revenue is expected to be $5000. His total costs are $12,000; $7000 of these
are fixed. Theoretically, will Miller’s profit change if he shuts down?
a. Yes
b. No
4. The output that will maximize profit is determined by the:
a.
b.
c.
d.
Demand Curve
The ATC curve
Supply Curve
MC and MR curves
5. The price that will maximize profit is determined by the:
a.
b.
c.
d.
Demand Curve
The ATC curve
Supply Curve
MC and MR curves
6. ATC factors in which of the following:
a.
b.
c.
d.
The manager’s salary
The calculated intrinsic value of opportunity cost
Transportation costs
A and C
7. True or False: fixed costs can only be changed in the long-run.
a. True
b. False
8. Which of these curves is not used (indirectly or directly) when determining profit?
a.
b.
c.
d.
Marginal Revenue curve
Average fixed cost curve
Supply curve
Demand curve
Essay Question #1 – Using an example, explain why the MR curve will always fall below the
demand curve.
Essay Question #2 – Using a detailed graphic, portray economic losses for a firm with a
standard, down-sloping demand curve.