Cost Concepts Fixed Costs – costs that are independent of level of output (eg. rent on land, advertising fee, interest on loan, salaries) Variable Costs – costs that are directly linked to the quantity of output (eg. raw materials, electricity, shipping, wages) Average Costs – cost per unit of output (product) Marginal Costs – cost of one additional unit of output

Italian Taste… make a list of their fixed and variable costs

Three Types of Costs Cost Total Cost Variable Cost Fixed Cost Output

Production Costs Output Fixed Cost Variable Cost Total Cost Average Cost Marginal Cost 40 ---- 5 20 10 7 15 90 50

Cost Curves Price £ MC AC MC crosses AC at min. AC Quantity For the average to be falling, the next unit (marginal) must be less than the average – so MC must be less than AC while AC is falling, and greater than AC when AC is rising.

Long Run vs. Short Run AC Short Run: time period in which at least one factor of production is fixed Long Run: time period in which all factors of production can be varied Cost £ SRAC1 LRAC Economies of Scale: - decreases in LRAC from increased scale of production SRAC2 SRAC3 Quantity

Let’s talk about revenue… How do we calculate total revenue? How do we calculate revenue per unit? How do we calculate average revenue? What happens to price as firms try to sell more units? What happens to total revenue as firms try to sell more units? Can you draw a curve for any of these ideas?

Revenue Curves?

Revenue Curves D = AR because it represents all the prices at which consumers are willing to buy different quantities (at 40 units, the price will be £10, so this is also the average revenue if 40 units are sold) MR drops 2x as fast as AR, because as output is increased and price is dropped, all the people who might have paid a higher price now pay the lower price, so the “extra revenue from one extra unit” is less than the actual revenue received for that unit. Price £ AR = D Quantity MR

How does total revenue relate to this diagram…

How does total revenue relate to this diagram… Price AR MR + - TR Q Rev Max Quantity

A firm will “maximise” profit where: MC = MR Profit Maximisation A firm will “maximise” profit where: MC = MR ***MEMORISE THIS*** Because… if adding one extra unit of production adds more to revenue than to cost, it will increase total profit and should be produced If adding one extra unit of production adds less to revenue than it does to cost, it will reduce profit and should not be produced Firms will produce up until the point where MC=MR

MC = MR Price £ MC Quantity MR

Profit Concepts Normal Profit: profit required to keep a firm in business (they will close / ‘exit the industry’ if not making ‘normal profit’ in the long run) Since ‘normal profit’ is required, economists include it in the cost curves of the company So ‘normal profit’ is achieved where AR = AC

Profit Concepts Supernormal Profit: profit over and above ‘normal profit’ AR › AC Loss: normal profit is not being earned AR ‹ AC

Shut-down Point Firms may not want to or be able to go out of business if they start making a loss… Why?

Shut-down Point Firms may wish to stop producing, whilst remaining in business Or they may wish to continue producing, even if they are making a loss The point at which they decide to stop producing is called the ‘shut down point’ Where AR = AVC If AR › AVC, the firm will keep producing If AR ‹ AVC, the firm will ‘shut down’

Productivity Concepts - Returns Output expands when more units of variable factors (labour, raw materials) are added to fixed factors (land and equipment) Returns – a measure of how an increase in inputs affects the total output - a comparison of percentages Increasing Returns Output 20% Input 10% Decreasing or Diminishing Returns Output 10% Input 20%

Efficiency Concepts to Assess Performance of Firms Productive Efficiency: firm operates at the lowest possible average cost (bottom of AC curve) Allocative Efficiency: firm sets price equal to marginal cost (scarce resources are allocated where they are most valued by consumers) Dynamic Efficiency: optimisation from changing production techniques (new technology, building on expertise) – can lower SRAC and LRAC X Inefficiency: bureaucracy & complacency of firm with too much market power → higher costs

Concentration Ratios Used to measure “market concentration” – what percentage of the market is dominated by “x” number of firms? Eg. “5-firm concentration ratio by sales” measure the total market share of the largest five firms in the industry using their sales numbers