Revenue curves of the business As 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

Profit Profit depends on The price the goods are sold for How much is sold Cost 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 sold Calculate 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/Q What'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 TR MR= TR2-TR1

Perfect Competition Deriving the demand curve Price Quantity (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 ($) QuantityTotal Revenue Average Revenue Marginal Revenue 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 competitors The two most important curves to remember are the Marginal 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 Q1Q2 Q3 At Q1 MR > MC Therefore 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 Competition Diagrammatic 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 MC The 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 Competition Diagrammatic 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 AC1 supernormal 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-run Making 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 Profits Perfectly 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 Monopolist A 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 PriceQuantityTotal Revenue Average Revenue Marginal Revenue

Revenue Curves for the Monopolist The AR curve is the firms demand curve Both the AR and MR are downwards sloping, but AR < MR When TR is increasing, MR is positive When TR is decreasing, MR is negative When TR is at its maximum MR=O

Comparing Demand Curves Perfect CompetitorMonopolist Demand Curve Degree of influence over price Relationship between AR and MR HorizontalDownwards sloping Price TakerOnly 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 c Total supernormal profit Pe, a, b, c

Types of Profit Subnormal profit TR<TC Subnormal profit may be sustainable in the short-run if you are covering variable costs Supernormal Profit  TR>TC  Supernormal 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 Situations These are assessed in the same way as perfect competitors- at the profit maximising level of output If AR < ACSubnormal Profits AR=ACNormal 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 entry Barriers 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 MC Be 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 Efficiency Work 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