Cost and Revenue Concepts (A-Level H2 & IB HL Economics)

Curated by Kelvin Hong, founder of The Economics Tutor. Part of our Free Economics Notes series.

Understanding the concepts of cost and revenue is fundamental to analysing firm behaviour, production decisions, and market outcomes. Firms, whether small businesses or multinational corporations, constantly make decisions about how much to produce, what price to charge, and how to organise their production processes. These decisions are intrinsically linked to their cost structures and revenue potential.

1. Short Run vs. Long Run in Production

The distinction between the short run and the long run in economics is crucial for understanding how firms can adjust their output levels and what types of costs they incur. It’s not defined by a specific calendar period (e.g., 6 months or 1 year) but by the flexibility a firm has to change its inputs.

• Short Run:
  • Definition: A time period in which a firm has at least one fixed input and at least one variable input. Fixed inputs cannot be changed in the short run, while variable inputs can be adjusted to alter output levels.
  • Implication: In the short run, a firm cannot alter the scale of its operations. For example, it cannot overnight build a new, larger factory, install significantly heavier machinery, or substantially expand its land area. Output increases or decreases must primarily come from adjusting the utilisation of variable inputs.
  • Examples: A firm can increase its output by hiring more workers (a variable input), increasing the hours worked by existing employees, or purchasing more raw materials (variable inputs). However, the size of its factory, the number of its machines, or the total land available for production are fixed.
• Long Run:
  • Definition: A time period in which all inputs of a firm are variable. There are no fixed inputs in the long run.
  • Implication: In the long run, a firm has the flexibility to change its scale of operations. It can build new factories, purchase new types of machinery, expand its land, or even exit an industry entirely.
  • Examples: In the long run, a shirt manufacturer can increase its output by building more factories, acquiring larger or more advanced machinery, or even training its entire workforce with new skills. All factors of production, including capital and land, are now adjustable.

2. Costs and Revenue Terms

Understanding key cost and revenue terms is essential for analysing a firm’s financial performance and decision-making.

2.1 Cost Concepts

• Total Costs (TC): The sum of all costs incurred by a firm in producing a given level of output.
  • Total Fixed Costs (TFC): Costs that do not vary with the level of output in the short run. They are incurred even if zero units are produced. (e.g., rent on factory building, insurance premiums, depreciation of machinery). The TFC curve is a horizontal line.
  • Total Variable Costs (TVC): Costs that change with the level of output. They are zero when output is zero and increase as output increases (e.g., raw materials, wages for production line workers, electricity for machinery). The TVC curve typically starts at zero and rises, often initially at a decreasing rate, then at an increasing rate.
  • Formula: TC=TFC+TVC
• Marginal Cost (MC): The additional cost incurred from producing one more unit of output. It represents the change in total cost resulting from a one-unit change in output.
  • Formula: MC=ΔQΔTC or ΔQΔTVC (since TFC does not change with output, ΔTC=ΔTVC)
• Average Costs (AC): The cost per unit of output.
  • Average Fixed Cost (AFC): Total fixed cost divided by total output. As output increases, AFC continuously falls.
    • Formula: AFC=QTFC
  • Average Variable Cost (AVC): Total variable cost divided by total output.
    • Formula: AVC=QTVC
  • Average Total Cost (ATC) or simply Average Cost (AC): Total cost divided by total output.
    • Formula: ATC=QTC=AFC+AVC

2.2 Revenue Concepts

• Total Revenue (TR): The total sum of money received by a firm from selling a certain number of units of its output over a given period.
  • Formula: TR=Price(P)×Quantity(Q)
• Marginal Revenue (MR): The additional revenue derived from the sale of one additional unit of a good. It represents the change in total revenue resulting from a one-unit change in output.
  • Formula: MR=ΔQΔTR
• Average Revenue (AR): The total revenue divided by the total output sold. It represents the revenue per unit sold.
  • Formula: AR=QTR=QP×Q=P
  • Therefore, the average revenue curve is effectively the firm’s demand curve.

Knowing the curves is one thing; shading the right rectangle under exam pressure is another. Part 1 covers supernormal profit, Part 2 covers losses.

Mr Kelvin Hong shows how to locate profit-maximising output where marginal cost meets marginal revenue, read the corresponding price off the average revenue curve, and shade the supernormal profit box correctly. He works through each market structure except perfect competition.

Before deciding whether a loss-making firm should stay open, you need to be able to draw the loss.

Mr Kelvin Hong shows how to illustrate subnormal profit on the firm’s diagram — where the average cost curve sits relative to average revenue, and how to shade the loss box. This is the diagram the shutdown rule below is applied to.

3. Relationship between Average and Marginal Costs/Revenues

Understanding the relationship between marginal and average curves is crucial for firm decision-making, particularly concerning output levels.

3.1 Relationship between Average and Marginal Costs

• When MC < ATC (or AVC): Producing an additional unit lowers the average cost. This means that the cost of the additional unit is pulling the average down. The ATC (or AVC) curve will be falling.
• When MC > ATC (or AVC): Producing an additional unit raises the average cost. The cost of the additional unit is pulling the average up. The ATC (or AVC) curve will be rising.
• When MC = ATC (or AVC): The marginal cost curve intersects the average total cost (and average variable cost) curve at its minimum point. At this point, the additional cost of producing one more unit is exactly equal to the average cost, so the average cost is neither rising nor falling. This is a critical point for understanding efficient scale.

Graphical Representation:

• The MC curve is typically U-shaped.
• ATC and AVC curves are also U-shaped.
• The MC curve intersects both the AVC and ATC curves at their respective minimum points.
• The gap between ATC and AVC narrows as output increases because AFC (the difference between ATC and AVC) continuously falls.

3.2 Relationship between Average and Marginal Revenues

• Perfect Competition: In a perfectly competitive market, individual firms are price takers. They can sell all they want at the prevailing market price.
  • Therefore, P = AR = MR. The demand curve for the individual firm is perfectly elastic (horizontal).
• Imperfect Competition (Monopoly, Oligopoly, Monopolistic Competition): In these market structures, firms face a downward-sloping demand curve. To sell more units, they must lower their price.
  • Therefore, AR (Price) > MR.
  • The MR curve will lie below the AR (demand) curve and will fall at a faster rate.
  • When the AR (demand) curve is a straight line, the MR curve will be twice as steep and have the same y-intercept.
  • When MR = 0, TR is maximised.
  • When MR is negative, TR is falling.

Graphical Representation:

• For a perfectly competitive firm, P, AR, and MR are all represented by the same horizontal line.
• For an imperfectly competitive firm, the AR curve slopes downwards, and the MR curve slopes downwards at a steeper rate, always lying below the AR curve (for positive quantities).

4. Law of Diminishing Marginal Returns

The Law of Diminishing Marginal Returns (also known as the Law of Diminishing Returns) is a fundamental principle in short-run production theory.

Definition: The Law of Diminishing Marginal Returns states that as additional units of a variable input (e.g., labor) are added to a fixed input (e.g., land or capital), the additional output (marginal product) generated by each additional unit of the variable input will eventually decrease, assuming all other factors remain constant (ceteris paribus).

How It Works (Process):

1. Initial Stages (Increasing Returns): When the first few units of a variable input are added to a fixed input, the marginal product (additional output) may actually increase. This is because the fixed input is initially underutilised, and adding more variable input allows for greater specialisation and more efficient use of the fixed resources.
   • Example: One worker in a large factory might be inefficient. A second worker might specialise, greatly increasing overall output.
2. Point of Diminishing Returns: Beyond a certain point, as more and more units of the variable input are added to the fixed input, the positive impact on total output continues, but the rate at which total output increases begins to slow down. This is the point where the marginal product starts to fall.
3. Eventually Decreasing Returns: Eventually, the marginal product of the variable input will decrease. Each additional unit of the variable input contributes less and less to the total output. This occurs because the fixed input becomes increasingly congested or over-utilised relative to the variable input.
   • Example: Adding too many workers to a fixed number of machines or a limited workspace can lead to congestion, reduced efficiency, and workers getting in each other’s way, causing each additional worker to contribute less to total output.

Relationship to Costs: The Law of Diminishing Marginal Returns is directly linked to the shape of a firm’s short-run cost curves:

• When the marginal product is increasing, the marginal cost is falling.
• When the marginal product is decreasing (diminishing returns set in), the marginal cost is rising.
• This explains why the MC, AVC, and ATC curves eventually become upward-sloping and U-shaped in the short run.

Assumptions:

• Constant Technology: The law assumes that the level of technology remains unchanged.
• Homogeneous Units of Variable Input: Each additional unit of the variable input (e.g., each worker) is assumed to be of the same quality and skill level.
• One Variable Input, At Least One Fixed Input: The law strictly applies in the short run, where there’s a distinction between fixed and variable factors.

Real-World Observations: The Law of Diminishing Marginal Returns is a widely observed phenomenon in various sectors:

• Agriculture: Adding more and more fertiliser (variable input) to a fixed plot of land (fixed input) will eventually yield smaller increases in crop output. Beyond a certain point, too much fertiliser might even damage the soil or plants.
• Manufacturing: In a factory with a fixed number of machines, adding more and more workers to operate those machines will eventually lead to overcrowding, idle time waiting for machines, and reduced individual worker productivity.
• Services: Adding more call centre agents to a fixed number of phone lines or computer terminals might initially increase calls handled, but eventually, congestion on systems or a lack of available equipment will cause each additional agent to handle fewer calls.

Evaluation:

• Highlighting Limitations: The law highlights the limitations of expanding production in the short run when some factors are fixed. It explains why firms face rising marginal costs beyond a certain output level.
• Guiding Production Decisions: It helps firms understand the optimal intensity of variable input use given their fixed capital.
• Assumptions May Not Always Be Realistic: The assumption of constant technology and input quality may not always hold true in dynamic industries. Innovation (a change in technology) can temporarily counteract or shift the point at which diminishing returns set in.

In summary, understanding the concepts of short run vs. long run, total, marginal, and average costs and revenues, and the fundamental Law of Diminishing Marginal Returns provides the essential analytical tools for comprehending how firms make production and pricing decisions to achieve their objectives in different market structures.

The relationships between these curves are not obvious, and they are easy to forget under exam pressure. This one is designed to stick.

Mr Kelvin Hong sets the cost curve rules to music — where marginal cost cuts average cost, how the curves relate to one another, and the profit-maximising condition. For H2 A-Level and IB Higher Level students only.

---