Revenue Curves, Types of Profits.

Revenue curves of the businessAs a business we need to know the most

profitable output we can produce.

To find out how we can be the most profitable we need to understand more about the relationship between the revenue and cost curves of the business

Revenue = Income producers receive from selling goods and services on the market

ProfitProfit depends on

The price the goods are sold forHow much is soldCost of production

Profit = Revenue- Costs

Income from sales

Includes rent wages interest and other costs of production

Normal Profit for a business is where:

Total Cost =Total Revenue

TC=TR

Entrepreneurs include a return for risk in their costs of production this is why at TC=TR we call it normal profit even though there doesn’t appear to be any at all.

Revenue Curves Total Revenue (TR) = Price X Quantity of units soldCalculate the TR for a farmer that sells sheep at $40 each

and sells 300 sheep.TR= 40 x 300

= $12,000

Average Revenue (AR) is the average contribution of each unit sold to TR. AR will be the same as price and is represented by the demand curve

AR= TR/QWhat's the AR for the above situation?12,000/300 = 40 = Price per sheep

Marginal Revenue (MR) is the additional revenue the firm receives from the sale of one more unit of output. Its calculated by the change in TRMR= TR2-TR1

Comparing Equilibrium situations for Monopoly and perfect

Competition

Perfect Competition Deriving the demand curve

60

50

40

30

20

10

0

60

50

40

30

20

10

0

Pric

e

Pric

e

1 2 3 4 5 6 10 20 30 40 50 60Quantity (million)

Output (000)

S

D

P

Q

D

Market Demand curve for the perfectly competitive firm

Because the perfectly competitive firm is a price-taker it faces a horizontal demand curve. The price is determined by demand and supply in the market.

Example revenue curves for perfectly competitive firm

Price ($)

Quantity Total Revenue

Average Revenue

Marginal Revenue

60 1 60 60 60

60 2 120 60 60

60 3 180 60 60

60 4 240 60 60

60 5 300 60 60

1 2 3 4 5

200

160

120

80

40

0

TR

AR/MR/D

As a price taker, a perfectly competitive firm faces a price of $60 regardless of the amount they sell. This firm cannot affect this price in any way.

The demand curve is horizontal. This means the firm can sell unlimited quantities at the same price (AR=MR).

Cost Structures for perfect competitorsThe two most important curves to remember

are theMarginal cost curves “the big tick”Average cost curves “the fruit bowl”

The marginal cost curve always cuts the AC curve at its lowest point.

Perfectly competitive firm

MC

AC

MR/AR/D

Profit maximising equilibrium output is where MR=MC

Q

P

Perfectly Competitive Market

Q1 Q2 Q3

At Q1 MR > MCTherefore the firm should increase output to gain more profit on the additional units of output sold

At Q3 MC>MR, therefore the firm should decrease output to avoid making a loss on the additional units of output sold

Perfect CompetitionDiagrammatic representation

Cost/Revenue

Output/Sales

The industry price is determined by the demand and supply of the industry as a whole. The firm is a very small supplier within the industry and has no control over price. They will sell each extra unit for the same price. Price therefore = MR and AR

P = MR = AR

MCThe MC is the cost of producing additional (marginal) units of output. It falls at first (due to the law of diminishing returns) then rises as output rises.

AC

The average cost curve is the standard ‘U’ – shaped curve. MC cuts the AC curve at its lowest point because of the mathematical relationship between marginal and average values.

Q1

Given the assumption of profit maximisation, the firm produces at an output where MC = MR (Q1). This output level is a fraction of the total industry supply.

At this output the firm is making normal profit. This is a long run equilibrium position.

Perfect CompetitionDiagrammatic representation

Cost/Revenue

Output/Sales

P = MR = AR

MC

AC

Q1

Now assume a firm makes some form of modification to its product or gains some form of cost advantage (say a new production method). What would happen?

AC1

MC1

AC1supernormal profit

Q2

Because the model assumes perfect knowledge, the firm gains the advantage for only a short time before others copy the idea or are attracted to the industry by the existence of abnormal profit. If new firms enter the industry, supply will increase, price will fall and the firm will be left making normal profit once again.

P1 = MR1 = AR1

The lower AC and MC would imply that the firm is now earning abnormal profit (AR>AC) represented by the grey area.

Average and Marginal costs could be expected to be lower but price, in the short run, remains the same.

Making Subnormal Profits If, in the short run firms are making subnormal profits in a

perfectly competitive industry then in the long run some firms will exit the industry. As firms exit the industry the market supply will decrease and consequently the market price will increase. An increase in the market price will mean an increase in average revenue for the remaining firms. In the long run subnormal profits will be replaced by normal profits and only normal profits will be made in the long-runMaking Supernormal Profits

If firms are making short-run supernormal profits in a perfectly competitive industry then in the long- run new firms, attracted by the prospect of supernormal profits will enter the industry. As new firms enter the industry the market supply will increase resulting in a fall in the market price. A fall in the price will mean a fall in average revenue for the firms. Supernormal profits will be reduced and in the long-run only normal profits will be made.

Making Normal ProfitsPerfectly competitive firms making normal profits in the short-run will continue to do so in the. There is no incentive for firms to either exit or enter the industry. Market supply does not change neither does the price nor average revenue. Normal profits will continue.

Characteristics of a MonopolistA monopolist firm is the only supplier of a good or

service in a market. •The revenue curves for a monopoly are different from those of a perfect competitor. •The monopolist is able to restrict output so that a high price can be charged, this means in order to sell more product the monopolist must drop its price.

• Sound similar to the LAW OF DEMAND?•As price decreases quantity demanded increases

•This must mean the monopolist must have a downwards sloping demand curve! •AR=D

Revenues for a monopolist Price Quantity Total

RevenueAverage Revenue

Marginal Revenue

30 1 30 30 30

25 2 50 25 20

20 3 60 20 10

15 4 60 15 0

10 5 50 10 -10

5 6 30 5 -20

Revenue Curves for the Monopolist

The AR curve is the firms demand curveBoth the AR and MR are downwards sloping,

but AR < MRWhen TR is increasing, MR is positiveWhen TR is decreasing, MR is negativeWhen TR is at its maximum MR=O

Comparing Demand Curves

Perfect Competitor Monopolist

Demand Curve

Degree of influence over price

Relationship between AR and MR

Horizontal Downwards sloping

Price Taker Only producer, Price setter

AR=MR MR<AR

Profit Maximising Equilibrium for the Monopolist

To identify the profit maximising equilibrium position for the monopolist firm.

1. Find where MR=MC, from this position draw a dashed line directly down to horizontal axis, (Qe)

2. Continue this dashed line vertically till you reach the AR curve, then take this line to the vertical axis (Pe)

To identify AC at profit max level. Find where the line goes vertically up from Qe and reaches the AC curve take this then to the vertical (price axis) point cTotal supernormal profit Pe, a, b, c

Types of ProfitSubnormal profitTR<TC

Subnormal profit may be sustainable in the short-run if you are covering variable costs

Supernormal ProfitTR>TCSupernormal profit

will attract other businesses into the industry in the Long-run. Thus can only be achieved in the Short Run

Differing profit situations for the monopolist

Profit SituationsThese are assessed in the same way as perfect

competitors- at the profit maximising level of output If

AR < AC Subnormal Profits

AR=AC Normal Profits

AR > AC Supernormal Profits

What happens in the SR and LR for a Monopoly?

In the short run, a monopoly must stay in the industry no matter what the profits position , as at least on factor is fixed.

In the Long Run

Earning a supernormal profit – this situation will continue as strong barriers to entry prevent any other firms entering the market

Earning a normal profit – a firm will continue to operate, as it is earning just enough profit to be worthwhile

Earning a subnormal profit – a firm will leave the market as better returns can be gained else where

Barriers to entryBarriers to entry- strategies available that

will stop new firms from entering a market

This means, existing firms will be able to keep earning supernormal profits in the long run. Examples of barriers to entry Patents – give the firm intellectual property rights over a

new invention Predatory pricing – policies to cut prices to a level that

would force any new entrants to operate at a loss

Cost Advantages- resulting from economies of scale (allowing them to undercut price)

Spending on R&D (research and development) Producing a good with no close substitutes Advertising and marketing – competitors find it expensive

to break into the market

Monopoly VS Perfect Competition

Compared to a perfectly competitive firm a monopoly will

Deliberately restrict output Set a price higher than MCBe able to earn supernormal profits in the LR. Not achieve the efficient level of output where

AR=MR

Monopoly VS Perfect Competition

However there are some situations where the monopolist can provide some advantages to society

Supernormal profits can be used to pay for R&D which could lead to further efficiencies

If the monopolist is earning sufficient economies of scale a firm could charge a price below that of a competitive firm.

Loss of Allocative EfficiencyWork book page 73 In a perfectly competitive market, price is set by

demand and supply at market equilibrium, so the market is allocatively efficient

Curves of a monopolist Demand curve is downwards sloping MR< AR The monopoly restricts output to the profit maximising

level where MR=MC

Where MR=MC, the monopolist charges a higher price and lower output than the market equilibrium where MC (S) = AR (D)

The allocative efficient level of output is where AR=MC

Deadweight loss will exist. . Deadweight loss (DWL) = Represents a loss of allocative

efficiency that is lost to the market

Loss of Allocative Efficiency

Government Policies and Monopolies Because monopolists operate at a non allocative efficient

point governments may choose to intervene in the following ways Price Controls

-Force the monopoly to operate at a price where AR=MR (called marginal cost pricing )

If costs are too high the firm may be forced into a subnormal profit. As a result the government may need to subsidise the firm

- Force the monopoly to operate where AR=AC (called average cost pricing)

The firm will then be making a normal profit and it will be operating at a close to the allocatively efficient point.

Remove all artificial barriers to entry for a firm – e.g legal barriers

Encourage/legislate competition – forcing monopolies to share facilities

Force any parts of a monopoly that can be broken up to be sold