2. Costs
• In buying factor inputs (or factors of production), a
firm will incur costs.
• The cost of
– Labour (wages)
– Land (rent)
– Capital (interest)
– Enterprise (normal profit)
• Some of these costs are classified as:
– Fixed costs – costs that are not related directly to
production, eg land and fixed capital. Rent, rates, insurance
costs, admin costs are seen as fixed because they do not
change in relation to output
– Variable Costs – costs directly related to variations in output
eg wages and the cost of variable capital such as raw
materials primarily.
3. Costs
• Total Cost - the sum of all costs incurred in
production
• TC = FC + VC
• Average (Total) Cost – the cost per unit of output
• A(T)C = TC / Output
• A(T)C = AFC + AVC
• Marginal Cost – the cost of one more or one fewer
units of production
• MCn = TCn – TCn-1
4. Costs
• Short run – Diminishing marginal returns
results from adding successive quantities of
variable factors to a fixed factor
• Long run – Increases in capacity can lead to
economies or diseconomies of scale
6. Revenue
• Total revenue – the total amount received from
selling a given output
• TR = P x Q
• Average Revenue – the average amount received
from selling each unit
• AR = TR / Q
• AR is price
• Marginal revenue – the amount received from
selling one extra unit
of output
• MR = TRn – TR n-1
8. Profit
• The reward for enterprise
• Relating price to costs helps a firm to assess
profitability in production
• Profits help in the process of directing resources to
alternative uses in free markets.
• Profit measures the return to risk when committing
scarce resources to a market or industry. Entrepreneurs
take risks for which they require an adequate rate of
return. The higher the market risk and the longer they
expect to have to wait to earn a positive return, the
greater will be the minimum required return that an
entrepreneur is likely to demand.
9. Profit
• The standard assumption in economics is that
private sector businesses are profit-seeking /
profit maximisers. In reality pure profit
maximisation is a highly unlikely assumption to
hold and that a wide range of alternative
objectives are likely.
10. Normal profit
• Normal Profit – the minimum amount (transfer
earning or opportunity cost) required to keep a firm
in its current line of production.
• For instance normal profits need to reflect the
opportunity cost of using funds to finance a
business. £200,000 of savings invested into a
business could have earned a low-risk rate of return
by being saved in a bank account – that the rate of
interest would the minimum rate of return needed
or normal profit.
• Thus normal profit is the COST of enterprise and is
part of average cost just like rent, interest and wages.
11. Supernormal profit
• Supernormal (abnormal) profit occurs when profit
made is over and above normal profit
– Thus supernormal can be taxed away without altering
resource allocation.
– Supernormal profits are an incentive for other producers to
enter a market to try to acquire some of this profit.
– Thus supernormal profit only persists in the long run in
imperfectly competitive markets such as oligopoly and
monopoly where firms have the market power to
successfully block the entry of new firms.
– Thus supernormal profits may indicate the existence of
welfare losses
• Supernormal profit = TR – TC
12. Subnormal profit
• Sub-normal profit exists when profit below normal
profit
– Firms may not exit the market even if sub-normal
profits made if they are able to cover variable
costs
– Cost of exit may be high
– Sub-normal profit may be temporary (or perceived
as such!)
– Subnormal profit = TR < TC or price (average
revenue) < average cost
14. The function of profit in a market economy
• Finance for investment using retained especially when the alternatives
such as issuing new shares (equity) or bonds may not be attractive
depending on the state of the financial markets especially in the aftermath
of the credit crunch.
• Market entry: Rising profits send signals to other producers within a
market. When existing firms are earning supernormal profits, this signals
that profitable entry may be possible. In contestable markets, we may see a
rise in market supply and lower prices. In a monopoly, the dominant firm
may be able to protect their position through barriers to entry.
• Signals about the health of the economy as the profits made by businesses
throughout the economy provide important signals about the health of the
macroeconomy. Rising profits might reflect improvements in supply-side
performance (e.g. higher productivity or lower costs through innovation).
Strong profits are also the result of high levels of demand from domestic
and overseas markets. In contrast, a string of profit warnings from
businesses could be a lead indicator of a macroeconomic downturn.
15. Key revision points on profit
• By the time of the Unit 3 exam candidates should be able to:
– understand the links between market structure and profits
and the key role played by barriers to entry and exit
– understand how government intervention can affect profits
e.g. price regulation and policies that affect costs of
production
– be able to show how changes in AR/MR and changes in
MC/AVC/AC can affect the profit maximising equilibrium for a
business
– understand how macroeconomic variables affect profitability
e.g. the recession and changes in the exchange rate
– be able to explain and show how pricing strategies such as
price discrimination impact on revenues and profits
