Chapter 7

Profit, cost and revenue

 Learning objectives
7.1 explain why it is important to distinguish between
economic and accounting profit
7.2 explain the difference between a firm’s short-run
and long-run cost of production
7.3 understand total, average and marginal revenue,
their curves and their relationships with each other
7.4 explain the role of the equi-marginal principle in
deciding how much a rational firm will produce, and
understand the differences between profit maximising,
breaking even and shutting down
 7.1 Profit
Account profit, economic profit and normal profit
•Accounting profit = total revenue – total explicit cost
•Economic profit (or supernormal profit) = total revenue –
total explicit cost – total implicit cost
•Normal profit refers to the amount of money needed to
cover the entrepreneur’s implicit costs of running their
business.
Economic profit vs accounting profit
 7.2 A firm’s costs of production
Types of inputs
•In order to produce output, an entrepreneur will need
to acquire and combine productive resources (or
‘inputs’ or ‘factors of production’).
•These resources are: labour (workers), capital (tools,
equipment, machines, buildings), intermediate inputs
(raw materials), & space (land).
 The meanings of ‘short-run’
and ‘long-run’
• Short-run: a situation in which the firm cannot
change the quantity of at least one of the inputs
used in the production process.
• Long-run: a situation in which the firm is able to
change the quantities of all of the inputs used in
the production process.
Short-run vs long-run inputs
and costs
 Short-run costs
• Fixed costs: some costs associated with inputs do not vary
as the firm changes the level of production.
• Variable costs: correspond to inputs that vary with the level
of production. Any cost that firm can change during the
time period under study is a variable cost.

Figure 7.3
Costs and cost curves
 Costs
• Total cost (TC) = fixed cost (FC) + variable cost (VC)
• Marginal cost (MC): the additional costs
corresponding to an additional unit of output
produced.
• To derive marginal cost using a graph, we should
start with the total cost (TC) curve.
• MC is the change in TC resulting from each unit
increase in output.
Marginal cost and the marginal
cost curve

Figure 7.4
Marginal and average cost curves

Figure 7.5
 How changing input prices affect
cost curves
• Average variable cost (AVC) = TVC / output
• AVC increases with output as the law of diminishing returns
sets in strongly.
• Relationship between average and marginal cost curves: MC
intersects with AC curves at their lowest points.

Figure 7.6
 Economies of scale
• As a firm increases its scale, it is possible that
good things can occur in terms of costs.
– There could be improvements in the
productivity of its inputs.
– It may be able to take advantage of lower
input prices compared to when it was smaller
in scale.
Long-run ATC curve with
economies of scale
 Diseconomies of scale
• A firm could become so large in scale that it starts
to experience increases in its average total costs.
• There are two types of factors at work here:
– The negative impact on input productivity
– Increasing scale relates to higher input prices.
Long-run ATC curve with
diseconomies of scale
 7.3 A firm’s revenue
• Total revenue (TR) is the amount of money generated by
selling some quantity of output (Q) at some price (P): TR =
PxQ
• Average revenue (AR) is the amount of money generated
per unit by selling some quantity of output. AR = TR / Q
• Marginal revenue (MR) is the amount of money
generated from the sale of an additional small increment
of output. MR = ΔTR / ΔQ
 Total, average and marginal
revenue curves
• If price (AR) falls then marginal revenue will fall twice as
much.
• Graphically, this means that the flatter [or steeper] the AR
curve is, the flatter [or steeper] the MR will also be.
 7.4 Choosing the optimal amount
to produce
The equi-marginal principle
•The optimal output is where the revenue from
the next increment sold (marginal revenue) is just
equal to the cost of producing that increment
(marginal cost) (i.e. optimal Q is where MR = MC
for that ‘last’ additional increment of Q
produced).
Equi-marginal principle determines
optimal output
 Summary of conditions for an
entrepreneur’s decision-making
The end