LCEconomicswww.thebusinessguys.ie©
RevenueandProfits
Wehaveseenthecoststhateachfirmfaces.Costsarethemoneygoing
outofthefirm.Nowwewilllookatthemoneycomingintothefirmand
alsoseewhattheowner(entrepreneur)cankeepforhimself.
Therearemanydifferenttypesofrevenue.
TotalRevenue(TR):Thisisthetotalamountofpaymentreceivedbythe
firmforprovidingitsgoodsandservices.
MathemaMcally
TR=PxQ
AverageRevenue(AR):isrevenueperunitofoutput.
MathemaMcally
TR
AR=
Q
PxQ
∴AR=
Q
∴AR= P
TheARcurveisthedemandcurvefacedbythefirm.Whenyouare
drawingafirm’sdemandcurve,youarealsodrawingitsAverageRevenue
curve.Theyareoneandthesame.
MarginalRevenue(MR):istheextrarevenuereceivedbythefirmfor
producingoneextraunitofoutput.
MathemaMcally
MR=TR2-TR1
Profit(π):TotalRevenue-TotalCosts
Profitisaresidualpayment.Itistherewardtotheentrepreneurfor
seJngupthebusiness.I.e.TheentrepreneurgetswhatisleKover.
JonathanTraynor
LCEconomicswww.thebusinessguys.ie©
DecidingwhatQuanCtytoProduce
Commercialbusinessesaresetupbytheentrepreneurinordertomakea
profitandthemoreprofitthebeQer.
Ineconomics,wesaythatfirmsareprofitmaximisers.Theentrepreneur
wantstomakethemostmoneyhecan.
Inordertodothishelooksattwoideasthatwehavealreadydiscussed.
MarginalRevenueandMarginalCost
Marginalrevenueistheextrarevenuereceivedbythefirmforproducing
oneextraunitofoutput.
MarginalCostisthecost,facedbythefirm,ofproducingoneextraunit
ofoutput.
Ifwegobacktotheexampleofthecomputerfactory,MarginalRevenue
istheamountofmoneythefirmgetsformakingandsellingonemore
computer.MarginalCostiscostofmakingthatoneextracomputer.
Seethegraphbelow.
MarginalRevenueandMarginalCost
Revenue/
Cost
MR1
MC
MR2
MR3/MC3
MC2
MC1
MR
1
2
3
4
JonathanTraynor2
QuanCty
LCEconomicswww.thebusinessguys.ie©
NOTE:TheMarginalRevenueCurvehasnodefiniteshapebutisusuallya
downwardslopingstraightline.
Ifthefirmisproducingonegood,theextramoneythatthefirmgetsfor
thisgood(MR1)isgreaterthanthecostofmakingthatgood(MC1).
Therefore,thefirmearnsmoremoneymakingthatgoodthanitcosts
themtomakeitandassuchitchoosestomakethisgood.
Havingdecidedtoproducethefirstgood,thefirmlooksattheMarginal
RevenueandtheMarginalCostofproducingthesecondgood.Theextra
revenueearnedforproducingthesecondgood(MR2)isgreaterthanthe
costofitsproducMon(MC2)andassuchtheyproducethatgood.
Ifthefirmproducesanothergood(good3),theextrarevenueearned
(MR3)isexactlyequaltothecostofmakingthisgood(MC3).Thefirmwill
makethisgoodandnowallpossibleprofithasbeenexhausted.
Ifthefirmproducesanothergood(good4),thecostofproducingthis
good(MC)isgreaterthantherevenuereceivedbythefirmforits
producMon(MR).Therefore,theproducMonofgood4wouldcostthefirm
moretoproducethanitwouldreceiveinrevenueandassuchthefirm
wouldchoosenottoproducethisgoodasitwouldmakealossonthis
good.
Revenue/
Cost
MarginalRevenueandMarginalCost
ProfitMaximisingCondiMon
MC=MR
(andMCisrisingfasteraKer
thatpointandcuts
MRfrombelow)
!
MC
!
Profit
Loss
QPM
MR
QuanCty
JonathanTraynor3
LCEconomicswww.thebusinessguys.ie©
FromthediagramoverleafwegetthefollowingproperiMes.
1) IfthefirmiscurrentlyoperaMngatapointwhereMR>MCthefirm
willincreaseprofitsbyincreasingoutput.
2) IfthefirmiscurrentlyoperaMngatapointwhereMR<MCthefirm
willincreaseprofitsbyreducingoutput.
3) ThequanMtyofoutput(theamountofstuffthatthefirmshould
make)thatthefirmshouldproduceinordertogetthemostamount
ofprofitpossibleisthequanMtywhere
MC=MR
(andMCisrisingfasteraKerthatpointandcutsMRfrombelow)
Profits
Nowthatweknowtheamountofoutputthatthefirmwillproduce(the
levelofoutputwhereMC=MRandMCisrisingfasteraKerthatpoint
andcutsMRfrombelow),wecantellwhatsortofprofitstheywillearn
bycomparingthefirmsAverageRevenue(AR)andtheirAverageCost
(AC)curves.
1) SupernormalProfits(SNP):SNPareearnedwhenthefirmis
producingwhereAR>AC.Thisisprofitthatisearnedinexcessofthe
minimumamountnecessarytokeepthefirminbusinessintheLong
Run(NormalProfit).Theyrepresent’saninefficiencyinthemarketas
theconsumerispayingmoreforthegoodthanisnecessary.
2) Loss:alossismadeifthefirmproduceswhereAR<AC.
3) NormalProfits:Normalprofitsareearnedwhenthefirmisproducing
whereAC=AR.AfirmmustearnatleastNormalProfitsifitistostay
inbusinessinthelongrun.
JonathanTraynor4
Mr(Traynor©(((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((((St.(Michaels(College
LCEconomicswww.thebusinessguys.ie©
Equilibrium6Posi1on6of6a6Monopoly
SupernormalProfitwithDownwardSlopingDemandCurve
MC
!
AC
!
P1
S(N(P
C1
D/AR
E
MR
Q1
1) Equilibrium:6Occurs(at(point(E(where(MC(=(MR(and(MC(is(rising(and(
1) Equilibrium:OccursatpointEwhereMC=MRandMCis
cuts(MR(from(below.(
risingandcutsMRfrombelow.
2) Price6Charged6&6Output6Produced:6The(firm(produces(output(Q
2) PriceCharged&OutputProduced:Thefirmproduces1(
and(sells(it(at(price(P1(on(the(market(
outputQ1andsellsitatpriceP1onthemarket
3) Cost6of6produc1on:6The(cost(of(producing(each(unit(of(output(is(C1.(
3) CostofproducCon:Thecostofproducingeachunitof
4) Super6Normal6Profits:6This(firm(is(earning(SNP’s(–(represented(by(
outputisC1.
the(shaded(area(above.(They(are(earning(SNP’s(because(AR(>(AC(
4) SuperNormalProfits:ThisfirmisearningSNP’s–
and(they(can(conLnue(to(earn(SNP’s(in(the(longrun(because(
representedbytheshadedareaabove.Theyareearning
barriers(to(entry(exist.(
SNP’sbecauseAR>AC.
5) Waste6of6Scarce6Resources:6Because(the(firm(is(not(producing(at(
5) WasteofScarceResources:Becausethefirmisnot
the(lowest(point(of(the(AC(curve(it(is(wasLng(scarce(resources.(
producingatthelowestpointoftheACcurveitiswasMng
scarceresources.Also,thefirmisearningagreaterreward
NOTE:(When(asked(a(quesLon(about(the(equilibrium(posiLon(in(
thanisnecessarytokeepthefirmintheindustryinthe
Monopoly,(just(reproduce(this(page(exactly(as(it(is.
longrun(SNP).
JonathanTraynor5
QuanLty
Now'that'we'know'the'Longrun'equilibrium'posi,on'of'a'Perfectly'
Compe,,ve'firm,'we'will'look'at'how'the'firm'arrives'at'this'posi,on.
LCEconomicswww.thebusinessguys.ie©
SuperNormalProfitwithPerfectlyElasCcDemandCurve
Shortrun'Equilibrium'Posi:on'of'a'Perfectly'Compe::ve'Firm
P/C
MC
!
AC
!
E
PMARKET
C1
D/AR/MR
S'N'P
Q1
1) From'the'assump,ons'we'know'that'a'Perfectly'Compe,,ve'firm'is'
Equilibrium:OccursatpointEwhereMC=MRandMCis
1) a'Profit'Maximiser.'Therefore'they'produce'at'the'profit'maximizing'
risingandcutsMRfrombelow.
output'where''
2) PriceCharged&OutputProduced:Thefirmproduces
MC'='MR'(and'MC'is'rising)
outputQ1andsellsitatpricePMARKETonthemarket.
8
3) CostofproducCon:Thecostofproducingeachunitof
outputisC1.
4) SuperNormalProfits:ThisfirmisearningSNP’s–
representedbytheshadedareaabove.Theyareearning
SNP’sbecauseAR>AC.
5) WasteofScarceResources:Becausethefirmisnot
producingatthelowestpointoftheACcurveitiswasMng
scarceresources.Also,thefirmisearningagreaterreward
thanisnecessarytokeepthefirmintheindustryinthe
longrun(SNP).
JonathanTraynor6
Q
LCEconomicswww.thebusinessguys.ie©
LosswithDownwardSlopingDemandCurve
Price
MC
AC
C1
P1
LOSS
E
D=AR
MR
Q
QuanCty
1) Equilibrium:OccursatpointEwhereMC=MRandMCis
risingandcutsMRfrombelow.
2) PriceCharged&OutputProduced:Thefirmproduces
outputQ1andsellsitatpriceP1onthemarket.
3) CostofproducCon:Thecostofproducingeachunitof
outputisC1.
4) Loss:Thisfirmissufferingaloss–representedbythe
shadedareaabove.Theyaresufferingalossbecause
AR<AC.
5) WasteofScarceResources:Becausethefirmisnot
producingatthelowestpointoftheACcurveitiswasMng
scarceresources.Also,thefirmisusingscarceresources
andwiththesescarceresourcesisproducingoutput
valuedlessthantheresourcesusedtoproducethese
inputs.Thefirm(loss)ismakingsocietypoorer.
JonathanTraynor7
LCEconomicswww.thebusinessguys.ie©
LossWithaPerfectlyElasCcDemandCurve
MC
C1
P1
LOSS
E
AC
D=MR=AR
Q
QuanCty
1) Equilibrium:OccursatpointEwhereMC=MRandMCis
risingandcutsMRfrombelow.
2) PriceCharged&OutputProduced:Thefirmproducesoutput
Q1andsellsitatpriceP1onthemarket.
3) CostofproducCon:Thecostofproducingeachunitofoutput
isC1.
4) Loss:Thisfirmissufferingaloss–representedbytheshaded
areaabove.TheyaresufferingalossbecauseAR<AC.
5) WasteofScarceResources:Becausethefirmisnotproducing
atthelowestpointoftheACcurveitiswasMngscarce
resources.Also,thefirmisusingscarceresourcesandwith
thesescarceresourcesisproducingoutputvaluedlessthan
theresourcesusedtoproducetheseinputs.Thefirm(loss)is
makingsocietypoorer.
JonathanTraynor8
firm)to)diminish.)Due)to)the)assump,on)of)“Free)Entry”,)the)SNP)earned)
by)each)firm)will)con,nue)to)fall)un,l)each)firm)in)the)industry)is)earning)
LCEconomicswww.thebusinessguys.ie©
Normal)Profits.)That)is,)the)SNP)will)eventually)fall)to)zero.)See)graph)
below.NormalProfitswithaDownwardSlopingDemandCurve
Price
AC
!
!
P1
MC
B
MR
D/AR
E
Q1
Quan,ty
1)Equilibrium/ProfitMaximisaCon:occursatpointE
1) From)the)assump,ons,)we)know)that)Imperfectly)Compe,,ve)firms)
whereMC=MR(MCisrisingandcutsMRfrom
are)Profits)Maximisers)and)as)such)produce)the)quan,ty)of)output)
below).
where)MC)=)MR)and)MC)is)rising.)Point)E.
2)PriceandQuanCty:Thelevelofoutputproducedis
2) Therefore,)the)firm)produces)quan,ty)Q
Q1andthepricethefirmsellsthisoutputatisP
1)and)charges)price)P1.1.
3)Costs:TheaveragecostofproducMonisshownat
3) At)this)quan,ty,)the)Average)Revenue)Curve)equals)the)Average)Cost)
pointB.
Curve)(AR)=)AC))and)as)such,)the)firm)is)earning)Normal)Profits.)))))
4)Profit:ThisfirmisearningnormalprofitsbecauseAR
Point)B.
=AC.
If)we)look)closer)at)where)the)Average)Revenue)Curve)meets)the)Average)
5)Efficiency:Thefirmisnotproducingatthelowest
Cost)Curve,)we)see)that)the)Average)Revenue)Curve)is)a)tangent)to)the)
pointofACcurvethisindicatesthatthefirmiswasMng
Average)Cost)Curve.)When)describing)this)situa,on)we)say)that)the)
scarceresources.
Average)Revenue)Curve)is)tangen,al)to)the)Average)Cost)Curve.
7
JonathanTraynor9
LCEconomicswww.thebusinessguys.ie©
Mr'Traynor©'''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''''St.'Michaels'College
NormalProfitwithaPerfectlyElasCcDemandCurve
The'Longrun'Equilibrium'Posi:on'of'a'Perfectly'Compe::ve'Firm
P
!
MC
!
PM
AC
D/AR/MR
E
Q1
In'the'Longrun
1)Equilibrium/ProfitMaximisaCon:occursatpointE
1)whereMC=MR(MCisrisingandcutsMRfrom
The'firm'produces'where'MC'='MR.'From'the'assump,ons'we'
know'that'Perfectly'Compe,,ve'firms'are'profit'maximisers'and'as'
below).
such'produce'at'the'profit'maximizing'level'of'output'where
2)PriceandQuanCty:Thelevelofoutputproducedis
Q1andthepricethefirmsellsthisoutputatisPM.
MC'='MR'(and'MC'is'rising)
3)Costs:TheaveragecostofproducMonisshownat
2)pointE.
The'firm'produces''units'of'goods'and'charges'the'market'price'of'
4)Profit:Thisfirmisearningnormalprofitsbecause
PM.
AR=AC.
3) At'Q1'units'of'output,'the'firm'is'producing'where'AR'='AC'and'as'
5)Efficiency:Thefirmisproducingatthelowestpointof
such'is'earning'normal'profit.'A'perfectly'compe,,ve'firm'can'only'
ACcurvewhichshowsthatthefirmismakingthebest
earn'Normal'Profit'in'the'longrun.
useofitsscarceresources.Thefirmisproducingatthe
4)mostefficientlevelofoutputpossible.
The'firm'is'producing'at'the'minimum'point'of'the'AC'curve.'This'is'
JonathanTraynor10
considered'to'be'the'most'efficient'scale'of'produc,on'as'it'is'not'
wasteful'of'resources.
Q
LCEconomicswww.thebusinessguys.ie©
EconomicsProfitV’sAccounCngProfit
LookingatthelasttwodiagramswherethefirmearnedNormalProfit,it
mightseemunusualthatanyentrepreneurwouldconMnuetooperatea
businesswherethereisnomoneyleKoverfortheentrepreneurtokeep
forhimself.IfAverageRevenueequalsAverageCost(AR=AC),thenthe
entrepreneurisjustcoveringhiscostsandhasnothingtokeepfor
himself.Thatdoesn’tmakeanysense,peoplestartabusinesstomake
money.Sowhyisthisthecase?
Tounderstandexactlyhowmuchmoneytheentrepreneurgetstokeep
whenNormalProfitisbeingearned,wehavetodisMnguishbetween
“AccounMngProfit”and“EconomicProfit”.
AccounCngProfit:TotalRevenueminusTotalExplicitCosts
ExplicitCosts:areinputcoststhatrequireanoutlayofmoneybythe
firm
EconomicProfit:TotalRevenueminusTotalCosts,includingboth
ImplicitandExplicitCosts.
ImplicitCosts:inputcoststhatdonotrequireanoutlayofmoneybythe
firm
OpportunityCosts:IsthecostofforgonealternaMves
ExplanaConofAccounCngProfitV’sEconomicProfit
SomeMmespeopleneedtoreadjusttheirthinkingastowhatcostsmean
ineconomics.FromanaccounMngstandpoint,costrefertodirectoroutof-pocketorexplicitcosts.Inotherwords,whatdoI,thebusinessowner,
payfortheresourcesthatIusetoproducemyproduct.AccounMngcosts
areexplicitcosts.
ThismeansthatsomeaccounMngstandpointprofitistotalrevenueminus
explicitcostswhereTotalRevenuecanbefoundbytakingthenumberof
unitssoldMmesthepricechargeforeachunit.
TotalRevenue
-TotalExplicitCosts
AccounCngProfit
JonathanTraynor11
LCEconomicswww.thebusinessguys.ie©
Aneconomisthoweverwouldtellyouthatyou’reomiJngacriMcal
component.Whataboutthevalueoftheresourcesyoualreadyownthat
couldbeusedelsewhere?ForExample,yourlaborgoesinyourbusiness
butyoucouldsellthatlabourcouldn'tyouwehaveanameforthese
implicitorindirectcosts,OpportunityCosts.
OpportunityCosts:IsthecostofforgonealternaMves
EconomicCostdoofcourseincludetheexplicitoraccounMngcostsbut
alsotheimplicitoropportunitycost.Soeconomiccostsarebothexplicit
andimplicitcosts.Fromaneconomicstandpointthen,profitisgoingto
bethetotalrevenueminustheexplicitcostbutthenalsosubtracMngthe
implicitcosts.
TotalRevenue
-TotalExplicitCosts
-TotalImplicitCosts
EconomicProfit
ThequesMonyoumighthaveis,doesthisdisMncMonreallymaQer?The
answerisyes.Failuretoconsidertheimplicitoropportunitycostcould
leadyoutoafaultyconclusioninconsideringchoices.
Considerthis.Asmallfarmersellswheat.Hemanagestogrow20bushels
ofwheatwhichhecansellfor€5perbushel.Thismeansofcoursethatis
totalrevenueis€5Mmesof20bushelsor€100.
ThefarmersexplicitcostofproducMonare€40.Rememberthatexplicit
costarethedirectcostofpurchasingresources.Whatmightthis€40
represent?Maybeseeds,irrigaMon,machineryorworkers.What'sthe
farmersaccounMngprofitthan?AccounMngprofitisthetotalrevenue
minustheexplicitcost
€100-€40=€60
Sointhiscaseyouhave€60ofprofit.Thefarmershappywhenhis
accountanttellshimthathe'searning$60ofprofit.However,thenan
economistthatheknowstellsthemthathe'sforgoQensomething.What
abouthisopportunitycost?
JonathanTraynor12
LCEconomicswww.thebusinessguys.ie©
Supposethatthefarmercouldbeworkingintownatthelocalburger
jointfor€5anhour.Foreveryhourhespendsfarminghesacrifices€5
salaryelsewheresoifforexamplefarmingtookthree,eighthourlong
daysfortotalof24hourshisimplicitcostwouldbe€5anhourMmesthe
24hoursittookhimtogrowtothewheatfor€120.
What'sthefarmerseconomicprofit?Economicprofitwasatotalrevenue
minustheexplicitandimplicitcosts.
TotalRevenue
€100
-TotalExplicitCosts
-€40
-TotalImplicitCosts
-€120
EconomicProfit
-€60
Heactuallylosing€60.Fromaneconomicstandpoint,thefarmerslosing
moneyandtherefore,assumingasweare,thatallproducersare
interestedinmaximizingprofits,hewouldbebeQeroffworkingatthe
localburgerjoint.
Onelastnote,zeroeconomicprofitisalsoknownasanormalprofit.If
youfindabusinessownerismakingazeroeconomicprofititdoesn't
meanthatheisearningnothing.Itmeansthatrevenuesareenoughto
coverallofyourcostseventhevalueoftheownersMmethatcouldbe
spentelsewheredoinghisnextbestpayingjob.
ThreeFarmingExamples
Supposethattherearethreefarmers,Andrew,BrianandConor.They
havesetuptheirfarmsnexttoeachotherandtheirfarmsareexactlythe
samesize.Allthreefarmersaregrowingoatsandtheirfarmingabilityis
exactlythesame.Thismeansthattheycanexpecttoreceiveexactlythe
sameamountinrevenuefromtheirfarming.
Also,theyallhireoneworkereach,theybuythesameamountofoats,
waterandferMliser.Finallytheyeachpayasubcontractortoharvestthe
oats.EachoftheseEXPLICITCOSTSarethesame.If,fortheyearthey
eachearned€50,000andtheirexplicitcosts(liketheonesmenMoned
above)were€20,000,thentheirAccounMngProfitis€30,000.
JonathanTraynor13
LCEconomicswww.thebusinessguys.ie©
Andrew
Brian
Conor
€50,000
€50,000
€50,000
-€20,000
-€20,000
-€20,000
€30,000
€30,000
€30,000
Lookingatthesesetofnumbersabove,fromanaccounMngstandpoint,
theyareallmakinganaccounMngprofitof€30,000eachandassuchare
allearningthesameamountofaccounMngprofit.
However,letssupposethateachoftheworkerhavethefollowingskills
whichpaythefollowingamounts.
Andrewisaqualifiedaccountantandassuchcouldearn€80,000ayear
workingforKPMG.
Brianhasbeenaqualifiedbaristaandcouldearn€30,000workingfor
Starbucks.
Conor,hasonlyeverfarmedinhislifeandassuchhisnextbest
employmentwouldbeinTesco’searning€22,000peryear.
Withthisinmind,letslookagainatprofitbeingearnedbythese
gentlemenandnowcalculatetheEconomicProfitthateachofthemare
earning.
EconomicProfit
Andrew
Brian
Conor
€50,000
€50,000
€50,000
-€20,000
-€20,000
-€20,000
-€80,000
-€30,000
-€22,000
-€50,000
€0
€8,000
Lookingatthethreedifferenteconomicprofitslistedabove,weseea
verydifferentstorythanwedidwhenwejustlookedattheaccounMng
profit.AsAndrewhasgivenupanaccounMngjobwhichwouldpayhim
€80,000ayear,theopportunitycost(orimplicitcost)offarmingisvery
JonathanTraynor14
LCEconomicswww.thebusinessguys.ie©
high.Therefore,veryunliketheaccounMngprofit,theeconomicprofitis
actuallyaneconomicloss,likeweseeinthepreviousdiagramsonpages
8and9.ThismeansthatAndrewwouldbebeQeroff(fromafinancial
pointofview),leavingfarmingandgoingintoaccountancy.
Brianontheotherhandhasaneconomicprofitofzero,whichisthe
normalprofitwehaveseenonthepreviousdiagramsonpages10and
11.Inthiscase,Brianisearningtheexactsamethroughfarmingthathe
wouldearnthroughworkinginStarbucks.Ifhisincomefromfarmingfell,
hewouldbemateriallyorfinanciallybeQeroffleavinghisfarmand
workingforStarbucks.
Conor,whowasearninganaccounMngprofitof€30,000,isearningSuper
NormalProfitof€8,000.Thatmeansheisearninganeconomicprofitof
€8,000.ThisisthesituaMonweseeinthediagramsonpages6and7.If
Conorwastoleavehisfarmingjobandtakeupemploymentinhisnext
bestalternaMveemploymentopportunity(Tesco’s),thenhewouldbe
€8,000worseoff.
JonathanTraynor15