Business Economics Edexcel Version Revision

8/20/2019 Business Economics Edexcel Version Revision

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Business Economics & Economic Efficiency (6EC03 – Unit 3)

Costs and Revenues

Costs

There are two types of cost

a) Total Fixed costs: These costs do not vary with output. Fixed costs can only apply when

at least one factor of production (land, labour, capital and entrepreneurship) is fixed. This

will only be the case in the short run. For example, an out-of-town supermarket has a

fixed supply of available land in the short term. n the future, the supermarket may be

able to buy more land ad!acent to the site, showin" that in the lon" run all factors of

production are variable.

b) Total a!ia"le costs: These costs do vary with output and can occur both in the short-run and lon"-run. #n example may be in firm$s electricity which will increase as the

firm is open for lon"er hours and more days.

Taken to"ether fixed costs and variable costs are known as total costs.

t is essential that you learn the formulae below as they will help when answerin" supported

choice %uestions.

Firms are interested in their total costs but are more interested in avera"e costs. This is the

cost per unit of production and "ives a much more accurate picture of the firm$s position, and

allows them to work out how productively efficiently they are.

Efficiency

a) #!oductive efficiency occurs at the bottom of the avera"e cost curve. t is the lowest

unit cost, in other words the firm is producin" as much as it can usin" the least inputs.

b) $llocative efficiency occurs when a firm produces a mix of "oods usin" scarce

resources in such a way as to meet the demands of consumers. Firms will char"e a

price e%ual to the mar"inal cost of manufacturin" the "ood.

$ve!a%e costs

$ve!a%e fixed cost (#F&) is calculated by Fixed costs

output

'.". a firm$s fixed costs are *** and output is **.

Therefore #F& + *** + * per unit of output

**

#s output increases the #vera"e Fixed costs will always continue to fall, because the fixed

cost is bein" spread across a "reater output. f we assume fixed costs are *** and increasethe output we can see


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#F& *** + **

*

#F& *** + *

**

#F& *** +

***

$ve!a%e va!ia"le cost (#&) is calculated by ariable &osts

output

'.". a firm$s total variable cost is **** and it produces ** units.

Therefore #& + **** + / per unit of output

**

Therefore based on this the #vera"e Total &ost (#T&) is e%ual to the #F& and #& in other

words * 0 / + 1/.

a!%inal cost (2&) can be defined as the chan"e in total cost as a result of an additional unit

of output produced.

2ar"inal cost + chan"e in total cost or 3T&

chan"e in output 34

5utput Total cost 2ar"inal cost (3T&)

34

* **

16 16

/7 1

1 86 8

#s can be seen as output increases from 9ero to one the total cost rises by 16. This is the

mar"inal cost.

2ar"inal cost always "oes throu"h the minimum point of the avera"e variable cost and

avera"e total cost curves (as in Fi"ure below).


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Fi%u!e one' o!t*!un ave!a%e costs

t is worth notin" that the "ap

between the avera"e total and

avera"e variable cost is always"ettin" smaller. This is a result of the

avera"e fixed cost always "ettin"

smaller.

The avera"e total cost and avera"e

variable cost curves slope

downwards because of increasin"

returns to a fixed factor. n other

words as "reater %uantities of a

fertiliser are added to a fixed factor

such as a field, the firm will increase output at a faster rate and therefore avera"e costs willfall. owever beyond the lowest point of the #T& and #& the firm be"ins to experience

diminishin" returns to a fixed factor, and therefore as additional factors of production are

added to the field i.e. the fixed factor they start to overcrowd each other and therefore the

avera"e total cost and avera"e variable cost start to increase.

Economies & +iseconomies of cale

n the lon" run all costs are variable and therefore the ; shaped avera"e cost can be explained

by economies and diseconomies of scale.

Fi%u!e t,o' Economies and +iseconomies of scale

Economies of cale

-nte!nal Economies of cale

nternal economies of scale can be defined as a fall in lon"-run avera"e cost associated withan increase in output for an individual firm.


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'xamples of economies of scale include:

. Managerial economies: #s a firm expands it is in a position to employ specialist

mana"ers in finance, sales, operations etc and therefore increase productivity and

lower lon"-run avera"e costs.

. Risk bearing economies: #s the firm expands it is better able to develop a ran"e of

products and a wider customer base to spread risk and minimise the impact of any

downturn.

1. Marketing economies: #s a firm expands its product ran"e, it is able to use any

central brand marketin" to advertise the product ran"e at little extra cost and

therefore spread this across a wider ran"e of "oods and lower lon"-run avera"e

cost.

For example if


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>etailers located close to each other are able to benefit from the development of new roads

and transport links and so lower all the firms$ lon"-run avera"e costs.

# "roup of small businesses are able to share administrative and secretarial facilities and

therefore lower lon"-run costs per unit.

+iseconomies of scale

# firm may experience diseconomies of scale if it "rows too lar"e and moves beyond its

minimum efficient scale. ?iseconomies of scale may result from a breakdown in

communication or other mana"erial difficulties and will result in lon"-run avera"e costs

increasin" as output increases. This may occur when a firm mer"es with another or when a

firm "rows internally and mana"ement lacks the experience necessary to maintain mana"erial

focus and control.

Revenue

Total >evenue

Total revenue is the same as the turnover of the firm. t can be calculated as:

@rice x 4uantity

Firms are also interested in the avera"e revenue, or revenue per unit. This can be calculated:

#> + Total >evenue

4uantity

'%ually important, especially when calculatin" profit maximisation, is mar"inal revenue.

This is the revenue associated with each additional unit sold i.e. the chan"e in total revenue

from one more unit sold.

5utput Total revenue 2ar"inal

revenue

* //

8/ * 71 A

=oth avera"e revenue and mar"inal revenue tend to be downward slopin" as in fi"ure four

(unless the firm is operatin" under conditions of perfect competition) and reflects the

downward slopin" demand curve and the need for firms to lower prices to increase sales.


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Fi%u!e fou!' $ve!a%e & a!%inal Revenue

Therefore the avera"e revenue curve is

also the firms demand curve. This can

be calculated by:

Total revenue + @ x 4

4

Bhere %uantity can be cancelled out so

@ x 4

4 therefore #> can be said

to be e%ual to @

otives of te fi!m

Firms are assumed to be profit maximisers, but sometimes they may opt to satisfy different

ob!ectives such as revenue maximisation and sales maximisation.

#!ofit maximisation

@rofit maximisation occurs at the output level where super-normal profits are their "reatest

(or losses are at their lowest). This occurs where mar"inal cost is e%ual to mar"inal revenue,

but althou"h this is a necessary condition it is not sufficient. 2ar"inal cost must also berisin".

Fi%u!e five' #!ofit aximisation

#t an output of one the mar"inal

profit, in other words the profit

from one more unit sold is 9ero.

The difference between this

output and the next time we

have a mar"inal profit of 9ero

(five units sold) is that at an

output of five the firm ismaximisin" its profits. This is

because we can see each unit

sold between one and five is

addin" to total profit. The

fi"ures from fi"ure five are

converted into a table below.


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5utput 2ar"inal

>evenue

2ar"inal

&ost

2ar"inal

@rofit

Total @rofit

* * * *

* 1 6 61 * 1 A

* 1 6 *

/ * * * *

6 * - 6

Bhen the fifth unit is sold mar"inal cost + mar"inal revenue and as a result of us knowin"

that mar"inal cost is risin" then the next unit sold (sixth) will cause mar"inal cost to rise

above mar"inal revenue. n other words the sixth unit sold results in a mar"inal loss of and

therefore a fall in total profit from the peak of * to 6.

Therefore firms will seek to e%uate mar"inal cost with mar"inal revenue to maximise profits.

owever some firms will consider other ob!ectives.

Revenue maximisation

Fi%u!e six' Revenue aximisation ,e!e R.0

>evenue maximisation occurs when a firm seeks to make as much revenue as is possible.

Firms are therefore willin" to sell products until the last unit sold adds nothin" to total

revenue, knowin" that the next unit sold will reduce revenue. This can be illustrated usin" a

dia"ram as illustrated in fi"ure six.


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#s is clear from the dia"ram as the firm

expands output the mar"inal revenue

declines (remember mar"inal revenue is

the addition to total revenue from onemore unit sold). owever, whilst it is

positive it continues to add to total

revenueC it is only when it passes 9ero

and becomes ne"ative that total revenue

starts to decline.

ales maximisation


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n addition to the motives of the firm

discussed so far firms can decide to adopt

a number of strate"ies desi"ned to "ain

market share.

a) #!edato!y #!icin%

@ricin" at a level low enou"h to

drive out firms currently in the

industry by reducin" profitability

b) /imit #!icin%

@ricin" at a level low enou"h to limit profits to appear to discoura"e new entrants

from !oinin" the industry.

on*1!icin% st!ate%ies

#s an alternative to limit pricin" and predatory pricin" firms may embark on non-price

competition. This is particularly relevant when firms sell "oods which cannot be discounted

heavily or where some form of collusion takes place.

This non-price competition includes

• #dvertisin"

•

=randin"• @acka"in"

• #fter careEcustomer serviceEwarranties

• @roduct development innovation

Beaviou!al motives of te fi!m

Firms and their mana"ers are "enerally expected to behave rationally and therefore profit

maximise. owever there may be occasions when mana"ers or owners will follow other

"oals.

For example they may decide to maximise their own personal welfare or e"o by "rowin" the

business or takin" over a rival firm or ensurin" they maximise their short-term bonus whilst

possibly takin" si"nificant risks with the future viability of the business.

2ana"ers may decide to profit satisfice, in other words achieve the minimum level of profit

re%uired by the owners but then devote time to achievin" other "oals such as spendin" time

on the "olf course. This type of behaviour sees profit not as a "oal to be pursued but rather a

minimum tar"et that needs to be obtained before other "oals can be pursued.

Fi!ms


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The basic entity sellin" "oods and services in an economy can be referred to as a firm. Bhile

a collection of firms operatin" in the same line of business can be referred to as the ndustry.

2y do fi!ms %!o,

Firms "row for a variety of reasons. They may decide to "row lar"er to

. Increase sales throu"h lar"er brand reco"nition and increased number of retail

outlets.

. Benefit from increased profits. Firms aim to profit maximise by expandin" the firm

they may be able to do this.

1. Increase market share and become the dominant firm in a particular industry.

. Increase economies of scale. =y "ettin" bi""er they can exploit their increased si9e

and lower lon"-run avera"e cost (G>#&). #lso by drivin" down lon"-run avera"ecosts the firm can "et closer to the productively efficient point on the G>#& curve

i.e. the minimum point on the G>#&.

/. Gain sufficient power to prevent potential takeovers by lar"er predator businesses.

4o, do fi!ms %!o,

Firms can "row by expandin" the scale of their operations and "ainin" market share. This is

known as internal "rowth. They can also "row throu"h takeovers of which there are a number

of different types.

. Horizontal : a mer"er between two firms at the same sta"e of production.

'.". =ritish #irways beria or Gloyds T


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. =arriers to entry: These barriers to "rowth or even entry into an industry can take

the form of:

a) Ge"al barriers e.". the need to have a permit to operate such as accountancy and

law firms or the need to have a licence from the "overnment as in the case of a

commercial radio station

b) 5vert barriers imposed by those currently operational in the industry. This could

be throu"h brandin", a new advertisin" campai"n to re-establish brand

reco"nition or lowerin" prices to !ust above avera"e cost to make it unprofitable

to enter the industry (Gimit pricin"). f prices are lowered below avera"e cost to

prevent incumbents from expandin" (predatory pricin") then this can be

considered anti-competitive. f this can be proven firms can be fined.

c)


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2y do some fi!ms "!ea5 u1 (deme!%e)


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Hnowled"e @erfect mperfect mperfect mperfect

=arriers to

entryEexit

Kone Gow i"h i"h

@rice settin"

powers

@rice taker @rice setter to a

limited extent

. Therefore the firm is makin" super-normal profits as indicated on the dia"ram.

From the dia"ram we can see that the firm is operatin" in the short-run. @erfectly competitivefirms cannot maintain super-normal profits in the lon"-run, because rival firms will see that


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these super-normal profits are bein" made (because of perfect knowled"e) and enter the

industry (no barriers to entry) and therefore the market supply curve shifts to the ri"ht and the

price falls (


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Fixed costs + /* ***

Goss + /* ***

Fixed costs + /* ***

@rice per unit + 1*

(#vera"e >evenue)

∴ Total >evenue (@x4)i.e.1* x * *** + 1** ***

ariable &ost per unit (#&) + 7

Total ariable costs i.e. #& x 4

7 x * *** + 7* ***

The total cost is made up of Fixed

&osts and ariable &osts

i.e. /* *** 0 7* *** + * ***

Total >evenue + 1** *** L Totalcost + * ***

Thus the loss by stayin" open is

890 000 which makes a

contribution towards fixed costs.

Therefore by remainin" open the firm is able to reduce the loss it makes down to * ***

and makes a contribution of * *** towards fixed costs.

The supply curve of a perfectly competitive firm operatin" in the short-run is therefore the

mar"inal cost above the avera"e variable cost, as at this level of output when the mar"inal

revenue crosses the mar"inal cost the firm will remain open as it makes a contribution toward

fixed costs. (Fi"ure )

Fi%u!e :' u11ly cu!ve fo! a 1e!fectly com1etitive fi!m


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The firm will be indifferent as to whether it stays open at the shut-down point, it will operate

at 4, 4 or 41 in other words when the mar"inal cost is above the avera"e variable cost and

shut down if it cannot cover avera"e variable costs.

ono1oly

2onopoly is the least competitive market structure. 5nly firm operates and as a

conse%uence it is able to set prices and output and maximise profits.

Ca!acte!istics

Kumber of firms: 5ne

Type of @roduct: ;ni%ue

Hnowled"e: mperfect knowled"e. @otential rival firms will not

know the incumbent firms pricin" and outputstrate"y.

=arriers to

entryEexit

i"h

@rice settin"

powers

@rice setter

#s a result of hi"h barriers to entry monopolists can set hi"h prices to maximise profits

without fear that another firm could enter the industry. t is for this reason that many

"overnments will intervene to prevent the development of monopolies and ensure that

competition is maintained in some form. 2onopolies are also often accused of bein" la9y,

less inclined to innovate and develop new products because they have no need to maintain an

ed"e over competitors.

Fi%u!e 3' u1e!*no!mal 1!ofits in ono1oly

2onopolists will operate on the

elastic part of their demand curve and

seek to maximise profits and thereforereducin" consumer surplus.

2onopolists will also not operate at

the allocatively efficient point

(@+2&) or the productively efficient

point (i.e. the lowest point on the

avera"e cost curve) unlike a perfectly

competitive firm.

Com1a!in% a mono1oly ,it 1e!fect com1etition


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2onopoly @erfect &ompetition

@rofit

maximisers

Mes Mes

#llocativelyefficient

Ko Mes

@roductivel

y efficient

Ko Mes

@rice @rices are hi"her under monopoly

compared to perfect competition

@rices are lower under perfect

competition compared to monopoly

4uantity 4uantity is lower under monopoly

compared to perfect competition

4uantity is hi"her under perfect

competition compared to monopoly

$dvanta%es & disadvanta%es of mono1oly

+isadvanta%es of ono1oly #o,e! $dvanta%es of ono1oly #o,e!


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2onopolies may lead to a misallocation of

resources by settin" prices above mar"inal

cost, so that price is above the opportunity

cost of providin" the "ood i.e. @rice N

2ar"inal cost

2onopolists can avoid undesirable

duplication of services.

#!ice +isc!imination

2onopolists can use hi"h barriers to entry to en"a"e in price discrimination. This occurs

when a firm sells the same product to two different markets with differin" elasticities at

different prices. This allows the monopolist to increase profits and reduce consumer surplus.

To embark on price discrimination a firm must fulfil three conditions.

• @ossess hi"h barriers to entry and a de"ree of monopoly power

• dentify two separate markets with differin" elasticities

• Heep these markets separate at a cost that is lower than the "ain in profits. This is to

prevent resale (arbitra"e) between the two markets.

There are three types of price discrimination.

Fi!st de%!ee 1!ice disc!imination

This type of price discrimination is primarily theoretical because it re%uires the seller of a

"ood or service to know the absolute maximum price that every consumer is willin" to pay.=y knowin" the maximum price each person is willin" to pay, the seller is able to absorb the

entire market surplus, thus takin" the entire consumer surplus from the consumer and

transformin" it into revenues.

First de"ree price discrimination is not undesirable as the market is still entirely efficient and

there is no deadwei"ht loss to society. owever, it is the complete opposite of a perfectly

competitive market. n a perfectly competitive market, the consumers receive the bulk of the

surplus. n a market with first de"ree price discrimination, the seller captures the entire

consumer surplus.

The closest example of this type of price discrimination is seen in a biddin" process such asthat on e=ay where a consumer can offer to pay as hi"h a price as they are willin" to pay.

econd de%!ee 1!ice disc!imination

This type of price discrimination is based on the amount sold, with bulk buyin" a typical

example of this. This is often seen in industrial processes where a firm can be rewarded for

the %uantity of a product that it buys.

Ti!d de%!ee 1!ice disc!imination


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This can be based on re"ional, a"e or time differences. 'xamples of this type of price

discrimination include the sale of child and adult railway tickets and the sale of peak and off-

peak telephone, electricity and "as.

Third de"ree price discrimination is the most common type of price discrimination and is

illustrated below in fi"ure .

n fi"ure the firm splits the market into elastic and inelastic demand, sellin" the output at

different prices to the two markets and keepin" these separate.

Fi%u!e 9' Ti!d de%!ee 1!ice disc!imination

atu!al ono1oly

# natural monopoly exists when an industry can only support one firm, this is typical of an

industry which has very hi"h sunk costs and re%uires very lar"e levels of output to exploit

economies of scale.

The introduction of competition, perhaps by some "overnment a"ency, will not be possible in

the lon"-run as the neither firm that is competin" is able to obtain sufficient market share to

ensure that it is best able to exploit economies of scale.

Katural monopolies exist in the supply of water, "as and electricity where there are very hi"h

start-up and infrastructure costs. The costs of establishin" a competin" firm will outwei"h

any economic or social benefit that may materialise. This can be illustrated in Fi"ure /,

where it is clear that the firm operates at the profit maximisin" point at an output of million.


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• =randin"

• @roduct %ualityEinnovation

• @acka"in"

• Free "ifts

•


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# monopolistically competitive firm will exhibit many of the characteristics of firms

operatin" under conditions of perfect competition, however they will be able to set price to a

limited extent durin" the short-run because the products they produce are not exactly the

same and firms will therefore have some brand loyalty. ence this market structure combines

element of perfect competition and monopoly. 'xamples include restaurants, hairdressers andflorists.

Kumber of firms: 2any small firms

Type of @roduct:


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Fi%u!e 6' u1e!*no!mal 1!ofits in so!t*!un mono1olistic com1etition

owever in the same way that a

perfectly competitive firm cannot

maintain super-normal profits in the

lon"-run, a monopolisticallycompetitive firm cannot maintain

super-normal profits in the lon"-run by

virtue of the low barriers to entry

which will allow firms to enter the

market and compete profits away. t is

for that reason that the lon"-run

position for a monopolistically

competitive firm is in the e%uilibrium

as depicted in Fi"ure 8

Fi%u!e =' /on%*!un e7uili"!ium in mono1olistic com1etition

Contesta"le a!5ets

# contestable market exists when a market is said to have low sunk costs and therefore low

barriers to entry and exit. This will mean new firms can %uickly enter an industry when theysee super-normal profits bein" made and exploit these before leavin" the industry. This is

referred to as Phit and run$ profits.

n recent years as a result of the ability to lease planes the airline industry has become more

contestable with the "rowth of low cost airlines as rivals to the more established national

carriers.

ono1sony

# monopsony occurs when many sellers face only one buyer. For example if an individual

wishes to work in emer"ency medicine in the ;nited Hin"dom then the sole buyer of suchemployees is the Kational ealth


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sin"le buyer L for example in the supermarket industry the ma!or retailers may !oin to"ether

to exploit the sellers and ensure that the supermarkets are able to "et the best possible price

for them.

This sort of power may allow a firm to exploit its suppliers in the knowled"e that the supplier

has few options beyond sellin" to the sole buyer. This can mean cheaper prices are passed onto the consumer, but this may be at the expense of the supplier of the "oods.

Com1etition #olicy

The competition commission conducts in%uiries into mer"ers between firms in response to

re%uests from the 5ffice of Fair Tradin" (5FT). ;sually this will take place if the mer"er of

two firms will result in a market share "reater than / per cent or meets the Pturnover test$ of

a combined turnover of 8* million or more. This market share may allow a firm to exhibit

the characteristics of a monopoly and dominate the market.


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excessive profits, althou"h often these profits are used to invest in areas that are outside the

re"ulators remit and therefore will "enerate even "reater profits in the future. There have been

su""estions in the past that the re"ulator and the re"ulated industry have built up a close

relationship which means that the re"ulator has been less strict on the firms it is re"ulatin".

This close relationship is referred to as regulator% capture&

>ate of return

This method of re"ulation was used ori"inally in the ;nited

Documents

Business Economics Edexcel Version Revision