firm cost revenue and objectives

1. Economics IG -III (Part 3. Microeconomic decision
makers) Unit 3.7: Firms, cost, revenue and objectives

2. Unit 3.7:Firms, costs, revenue and
objectives
Learning Objectives
By the end of this unit you will be able to:
 Define total cost, average total cost, fixed cost, variable cost, average fixed cost and average
variable cost
 Calculate total cost, average total cost, fixed cost, variable cost, average fixed cost and average
variable cost
 Draw and interpret diagrams that show how changes in output can affect costs of production
 Define total revenue and average revenue
 Describe how sales affect revenue
 Discuss the objectives of firms including survival, social welfare, profit maximization and
growth

3. Unit 3.7:Firms, costs, revenue and
objectives
• What motivate firms to turn inputs into output?
• If you were setting up a business what would be your objectives?
• How do costs and revenue change as a firm changes its output?
3.7.1 Calculating the costs of production (Total and average total cost)
 Total cost (TC) is the cost of producing a given output. It is the total amount that has to be
spent on the factors of production used to produce a product.
 Average total cost (ATC, AC, Unit cost) is given as total cost divided by output.
 Fixed cost (FC) is a cost even when output is zero. It is a costs which do not change with
output in the short run. For example, rent for building, security charges e.t.c
 Table given below shows the relationship between output, total cost and average cost.
Output Total cost ($) Average total cost
0 10 -
1 30 30
2 48 24
3 60 20
4 88 22
5 125 25

4. Unit 3.7:Firms, costs, revenue and
objectives
 Total fixed cost (TFC) remains unchanged as
output changes. Fixed costs are also sometimes
referred to as overheads or indirect costs.
 Average fixed cost (AFC) is the total fixed cost
divided by output. As total fixed cost is
constant, AFC falls as output increases.
 Variable cost (VC) vary directly as output
changes. As output increases, TVC rises at
different rates. Figure shows the change of TVC
with output.

5. Unit 3.7:Firms, costs, revenue and
objectives
 Average variable cost (AVC) is TVC divided by output. As
output increases, AVC tends to fall and then rise.
 The sum of TFC and TVC equals total cost. For instance, if
fixed costs are $800 and variable costs are $4200 a week,
the total cost of production would be $5000 a week.
Figure shows how total cost is made up of fixed and
variable costs.
 In the long run, however, all costs are variable because all
FOP can be altered. Figure shows total cost in the long run
Long run is the time period when all factors of production
can be changed and all costs are variable.

6. Unit 3.7:Firms, costs, revenue and
objectives
 Average total cost (ATC) is total cost
divided by output. ATC consists of AFC and
AVC in the short run and is usually U-
shaped. As a firm alters its scale of
production in the long run, it first
experiences economies of scale and then,
after reaching a certain output, it may
encounter diseconomies of scale.
 Economies of scale are the advantages, in
the form of lower long run average costs
(LRAC) of producing on a larger scale.
 Diseconomies of scale are essentially the
disadvantages of ‘being too large’.

7. Unit 3.7:Firms, costs, revenue and
objectives
3.7.2 Calculating revenue
Total revenue (TR) is the total amount of money received by firms from selling a product.
TR= P X Q
Average revenue (AR) is found by dividing total revenue by the quantity sold and is the same
as price (the amount of money that has to be given to obtain a product).
AR= TR/Q = PXQ/Q = P
 In competitive markets each firm’s output may have no effect on price. In this case,
total revenue rises consistently as more quantity is sold.
Quantity
sold
Price
per unit
($)
Total
revenue (TR)
= P X Q
Average
revenue (AR)=
TR/Q
1 10 10 10
2 10 20 10
3 10 30 10
4 10 40 10

8. Unit 3.7:Firms, costs, revenue and
objectives
 In most markets, firms are price makers and need to lower price to sell more. The
given table illustrate the change in total revenue and average revenue in a
monopoly market. Average revenue falls as quantity sold rises. Total revenue rises
at first, reaches a peak and then falls beyond a certain level of sales.
 The average and total revenue curves of a monopoly firms
Quantity sold Average revenue
(price per unit) ($)
Total revenue
1 10 10
2 9 18
3 8 24
4 7 28
5 6 30
6 5 30
7 4 28

9. Unit 3.7:Firms, costs, revenue and
objectives
Objectives of firms: Firms may pursue a range of objectives
• Survival: When firms are started , their initial objective may be just to survive. A firm
may be content to just cover its costs. During recession or difficult times when
demand is falling, even large firms may have survival as their key objective in the
hope that conditions will improve.
• Growth: Some firms may pursue the objective of growth. It enable firms to take
advantage of economies of scale and so to raise finance more easily and to buy row
material at discounted rate. If growth is achieved by merging with other firms,
competition will be reduced and the firm will gain a larger market share.
• Social welfare: State-owned enterprises may be given by the government the
objective of improving social welfare. They may charge a relatively low price. In
recent years, some private sector firms have also been showing a greater concern
about the environmental and social effects of their actions.
• Profit Satisficing: Profit satisficing involves making enough dividends to keep
shareholders happy while pursuing other objectives.

10. Unit 3.7:Firms, costs, revenue and
objectives
• Profit maximization: Traditional theory suggests that firms
seek to maximize profits. Profit maximization is an objective
pursued by most private sector firms.
 Total profit is the positive difference between total
revenue and total cost. As shown in table, profit would
be maximized at 40 units of output.
 Profit per unit is the positive difference between
average revenue and average total cost. As shown in
table profit is maximized at 3 units.
Profit is maximised when the positive gap between revenue
and cost is greatest. Profits provide an incentive for
entrepreneurs to undertake production. An increase in profit
will encourage more firms to enter a competitive market. It
will also provide firms with more finance to update their
capital equipment and expand their business.
Output Total
revenue
($)
Total
cost ($)
Total
profit
($)
10 200 220 -20
20 380 380 0
30 500 480 20
40 600 540 60
50 660 620 40
60 700 710 -10
Output Average
revenue
($)
Average
cost ($)
Total
profit
($)
1 15 15 0
2 14 12 2
3 12 9 3
4 9 8 1
5 5 10 -5

11. Unit 3.7:Firms, costs, revenue and
objectives
A profitable firm will also find it easier to obtain external finance and also find it easier
to recruit top managers and directors.
• Ways of increasing profit: The two fundamental ways of increasing profit are to
 Reduce cost of production, and
 Raise revenue
There are a number of ways of reducing cost of production. One is by reducing any
wastages and inefficiency. Another is by increasing the productivity of factors of
production. A third way is by increasing the size of the firm through merger or takeover.
A larger firm will be able to take advantage of economies of scale.
Note: Remember that profit is not the same as revenue. Revenue might increase but
profit would fall, if costs rise by more than revenue.