IB Economics

Costs, Revenues
and profit
(HL ONLY)

Ford has commenced production

on the all-new 2009 Ford Fiesta
at the Cologne assembly plant in
Germany, with other Ford
factories around the globe
gearing up to produce the
automaker’s latest small car
offering.
 What are COSTS?
• COSTS OF PRODUCTION: These are the
costs to the individual firm that it incurs as
a result of production;
– Total costs
– Fixed costs
– Variable costs
 The Theory of Production
Key Terms 1
• Total Costs
– Fixed costs + variable costs
• Fixed Costs
– Costs of production that do not vary as output changes
• Variable Costs
– Costs of production which vary with output
• Short Run
– Period of time during which fixed costs and the scale of
production remain constant
• Long Run
– Period of time during which all factors become variable and the
scale of production can change
• Marginal Product
– The output added by the extra worker or unit of a factor
 Adding more of the
VARIABLE FACTOR when there are FIXED factors
(In SR)

2
 Adding more of the
VARIABLE FACTOR when there are FIXED factors
(In SR)
1

Class Task
using table
1.1 add in
the MPP
curve

AP
The relationship between APP and MPP (In SR)
Table 1.1.1

1
 The relationship between
AVERAGE, MARGINAL & TOTAL Physical Product
(in SR)
APP & 3 TPP
MPP

Class Task
using table
1.1.1 to add TP
detail

AP
1
Number of workers
MP
 The Theory of Production
Key Terms 2
• Increasing marginal returns
– Where the addition of an extra variable factor adds more to output that
the previous variable factor
• Average product
– The total product divided by the number of workers
• Law of diminishing marginal returns
– Where increasing amounts of a variable factor are added to a fixed
factor and the amount added to total product by each additional unit of
the variable factor eventually decreases
• Optimal output
– The ideal combination of fixed and variable factors to produce the
lowest average cost
• Productive efficiency
– When a firm operates at minimum average total cost, producing the
maximum possible output from inputs into the production process
• Depreciation
– In relation to fixed assets, all fall in the value of an asset during its
working life
 FIXED, VARIABLE & SEMI-VARIABLE
(in SR)

Total
Costs

Class Task
complete the
diagram to
include FC,
VC and TC

Output
 The Theory of Production
Key Terms 3
• Semi-variable costs
– Costs which have both a fixed and variable element e.g. landline
telephone usage
• Average fixed costs
– TFC/Q
• Average total costs
– TC/Q
• Marginal costs
– The cost of the extra unit of output
 Costs in more detail (SR)
Table 1.2
 Increasing and decreasing SHORT RUN COSTS

Class Task
Use table 1.2
MC to complete
the diagram
Costs

AC

2 Output
 MC, AC, AVC & AFC (in SR)

Costs £’s

Class Task
Use table 1.2
to complete
the diagram

Quantity
 Questions for thought

1) How does a weak £GBP affect

costs for UK businesses?

2) Are all firms affected by rising

fuel costs in the same way?

3) How can firms protect

themselves from the
fluctuations in commodity and
currency prices?

http://news.bbc.co.uk/2/hi/business/8062844.stm | 22nd May 2009

Task – The shape of costs
 Production in the LR
• In the LR all factors become variable and hence firms
can overcome diminishing returns by increasing the
SCALE of production.
• However as the firm continues to increase output then
diminishing returns will creep in again and the firm must
look to increase it’s scale once more.
• Each size of operation forms a SRAC (or SRATC) curve
each with it’s own optimal size of operation.
• In practice firms may choose or be unable to move to a
new SRAC and may over work a fixed factor e.g. existing
factory size is too small but the owners do not have the
funds to build a new one or the increase in output is only
expected to be temporary
• All planning takes place in the long run
 Relationship between SR & LR AC

Costs £’s

SRAC1 Class Task

SRAC2 complete the
diagram to
show a
series of
SRAC and
the eventual
LRAC

Quantity
 Which factory size would you choose if your
firm needed to produce 100 units?
Costs £’s

SRAC1
SRAC2 What about
175 units?
SRAC3
What will
influence your
decision?

100 175 Quantity

 The Theory of Production (LR)
Key Terms 4
• Increasing returns to scale
– Where an increase in factor inputs leads to a more proportionate
increase in outputs
• Decreasing returns to scale
– Where an increase in factor inputs leads to a less than
proportionate increase in factor outputs
• Constant returns to scale
– Where an increase in factor inputs leads to a proportionate
increase in factor outputs.
• Minimum efficient scale (MES)
– This corresponds to the point at which average costs reach their
lowest point for the first time, i.e. the lowest number of units a
firm needs to produce to fully utilise all available economies of
scale
Costs £’s
What shape & why?

Costs £’s
LRAC1

LRAC2

MES Quantity MES Quantity

Costs £’s

Costs £’s
LRAC4

LRAC3

Quantity MES Quantity

The Minimum Efficient Scale (MES)
• The MES corresponds to the

Costs £’s
lowest point on the LRAC (or LRAC4
LRATC)
• MES defined as the first
point at which all possible
economies of scale are fully
utilized
• There is unlikely to be one
MES
point rather a range of Quantity

outputs which are all

productively efficient
• During the range firms are
said to be experiencing
constant returns to scale
 Economies of Scale
• Defined: Are any decrease in LRAC that come
about when a firm alters all of its factors of
production - Increasing returns to scale
– Specialisation
– Division of labour
– Bulk buying
– Financial economies
– Transport economies
– Large machines
– Promotional economies
 Diseconomies of scale
• Define: Any increase in LRAC when a firm
alters all of its factors of production –
decreasing returns to scale
– Control and management problems
– Alienation and loss of identity
• In reality there is little evidence to suggest
that firms actually suffer from
diseconomies of scale
 External Factors
• Economies of scale
– Local universities specialise due to high
concentration of firms
• Diseconomies of scale
– Increase in size of industry pushes up the
price of raw materials
 Revenue Theory
• Total revenue
 TR=PQ
• Average revenue
 AR=TR/Q
• Marginal revenue
 MR=∆TR / ∆Q
 Revenue Curves and Output
1. AR remains constant as Q increases
 PED = ∞
 AR (D) horizontal
 Firms are price takers
1. AR falls as Q increases
 PED < ∞
 AR (D) downward sloping
 Firms have some influence over P&Q
 Price makers
 When PED = ∞
TR
TR

35

Where P=5

Q
1 7
 The relationship between D, AR, MR, TR & PED for a
downward sloping linear demand curve
P
Class Task
Use table 7.4
to complete
the diagram

Q
 Review of Revenue
• When PED > 1 firms revenue increases if
P falls
• When PED < 1 firms revenue increases if
P increases
• When PED = 1 firms revenue stays the
same as P changes, revenue is already
maximised
 Profit Theory
• The economist versus the accountant
– Accountant: Profit = TR – TC
– Economist: Profit = TR – TC but;
• Where TC = FC + VC + Opportunity Cost
– An accountant may deduce that a firm is making a
profit whereas an economist may conclude that they
are making a loss
– 3 scenarios to consider;
• The shut down price
• The break even price
• The profit maximising level of output
 The Shut Down Price
• Firms often continue to produce even if they are making
a loss
– During the six months to September 2009, the company (BA)
suffered a £292m ($485m) loss. BBC, 9th Nov 2009
• Firms may even shut down for a period and then re-open
later on
– 1,700 jobs to go as Corus mothballs plant BBC, 4th Dec 2009
– Jobs axed at Ford, Nearly a hundred jobs are being cut at Ford’s
plant in Dagenham as a result of the economic downturn The
company has introduced 14 "non production days" until the
new year in its stamping departments. It'll mean 520 staff
could have to work 3 day weeks. BBC Nov 2008
– An ice cream shop shuts for winter and then reopens when the
weather improves
Why are they still in business?
 The Shut Down Price
• The shut down price is the level of price
that enables a firm to cover its variable
costs in the SR, i.e. it is the price where
P=AVC. If price does not cover AVC, then
the firm will shut down in the SR
 The Shut Down Price (ATC, AVC and MC)

Price and Cost

Class Task
complete the
diagram

Q (Units)
 Breaking Even
• In the long run firms are able to cover ATC
• Remember ATC includes OC and is
different for an economists and an
accountant
• If the price does not cover all costs in the
LR the firm will shut down and stay shut
Where does the firm opperate?
• Assumption: Firms seek to
maximise profit
• A firm will continue to produce until
MC=MR why?

Price and Cost ($)

• What if the MC curve crossed the
MR curve twice?
• A firm should produce at the level of Output
Q where MC cuts MR from below
• Remember that the MC cuts the AC
at its lowest point

Output
Price and Cost

Class Task
complete the
diagram to
show a firm
maximising
profits in the
production of
television sets

Q (Units)
Price and Cost

Class Task
Compare firms
making a
profit, making
a loss and
breaking even
(normal profit):
HINT shift the
AC

Q (Units)
 Alternatives to Profit Max
• Revenue Maximisation (MR=0)
• Sales (Volume) Maximisation (AR=AC)
• Employment
• Environment
• Satisficing
Ideas Board 1