Revenue, Costs, & Profit
Revenue, Costs, & Profit
This page defines and explains various terms used in economics graphs and microeconomic analysis - terms related to revenue, costs and profit.
The purpose is to define and explain the terms, so no organized discussion is involved.
Students in economics classes will likely be required to demonstrate that they understand these terms, and are able to apply this knowledge in graphs. This website does not include graphs, and therefore does not get as involved with these terms as the classes are likely to. The purpose here is just to familiarize users with terms that they are likely to come across in their studies.
If you are trying to learn the definitions of several of these terms, this page would be a good place to find them. If you are only interested in one or two, perhaps the Glossary section would be a better place to look. If you are teaching yourself by methodically going through the various sections of this website, you would probably be better off just to read through this page, familiarize yourself with what it is about, and not worry too much about memorizing what is here. You can always use this page as a reference whenever the relevant terms come up again in your studies.
Total Physical Product
These are interchangeable terms. They refer to the total number of units of output for a given quantity of a variable input.
TPP at first increases rapidly, then increases slower, eventually will decrease (for example, workers get in each other’s way).
Diminishing Marginal Returns: When additional units of a variable input are added, the quantity of output per unit of input will increase at first. But eventually it will decrease (eventually will be negative).
Marginal Physical Product (MPP) at first increases, then a constant decrease until negative.
Average Physical Product (APP) will be below MPP as MPP increases, above MPP when MPP declines.
MPP will cross APP at the point where APP is maximized.
What this means:
When marginal is above average, the average increases.
When marginal is below average, the average decreases.
Cost curves are mirror images of product curves.
Total Cost (TC) increases as output increases: at first rapidly, then more slowly, then increasingly more rapidly.
ATC (also called SRATC in the short run)
ATC = TC divided by Total Output
The ATC curve is u-shaped.
Marginal Cost (MC) = change in Total Cost divided by change in Total Output
MC = change in Variable Cost divided by change in Total Output, since VC are the only portion of TC that changes with output.
MC at first decreases, then increases steadily.
What this means: MC = ATC when ATC is at the minimum point of its u-shaped curve.
Total Fixed Cost (TFC): constant at all output levels
Average Fixed Cost (AFC): decreases as output decreases
Average Variable Cost (AVC) curve is u-shaped
MC = AVC where AVC is at its minimum.
The cost terms listed above all relate to short run situations.
In the long run, all costs are variable: all possible short run situations are available for consideration.
The LRATC curve connects all possible SRATC curves.
The shape of the LRATC curve depends on:
Economies of scale: if long run unit costs decrease as output increases
Diseconomies of scale: if long run unit costs increase as output increases
When economies of scale exist, the LRATC curve slopes downward
When diseconomies of scale exist, the LRATC curve slopes upward
The LRATC curve can be any shape, but is typically shown as u-shaped, having a section with economies of scale and a section with diseconomies of scale. This u-shape is not universal but is considered to be the most typical shape.
Minimum Efficient Scale (MES): the lowest point on the LRATC curve.
Planning Horizon: another name for the long run, since all planning options (nothing fixed) are open.
Profit is the amount remaining from total revenue after all costs have been taken into consideration.
Profit is a flow concept. It involves activity over a period of time rather than balances at a given point in time (which would be a stock, not a flow, concept). The period of time in question is called the accounting period.
In economics, two kinds of profit will be encountered: accounting profit and economic profit.
Accounting profit includes the items that a business will include in its income statement. This includes total revenue and the costs incurred from fixed and variable costs. Since these are costs that the business must actually pay out, they are called explicit costs.
Accounting methods that a business uses to match costs and revenue may create a timing difference within any accounting period between actual outlays and fixed costs shown on the income statement. But these costs are paid at some point in time, and are still explicit costs regardless of the accounting method used.
Accounting Profit = TR – TC
TC = TFC + TVC
A business will only remain in business as long as it can earn enough accounting profit to prevent its investor owners from investing in something else instead. If investors can earn a higher return somewhere else, they will sell their interest in the business and invest in something else instead. At the same time, if a business can earn more money doing something else, it will change its overall business strategy and move into a different market.
Since a certain amount of profit is required to keep the business operating in its current form, these profits represent a cost of the business. In the study of economics, they are called normal profits.
Normal profits are costs of the business, but are not explicit costs. They do not represent any actual money that the business has to pay for expenses. They are called implicit costs.
Normal profits, or implicit costs, are opportunity costs. They represent the benefit that would be received from investing in the next best alternative to the business. Normal profit is the amount of profit required to prevent resources from being diverted to another use.
When these opportunity costs are deducted from accounting profit, the result is called economic profit.
Economic profit = accounting profit minus opportunity cost
The opportunity cost in this equation may be shown with a different name, such as normal profit, implicit cost, even the cost of equity capital.
Positive economic profits mean that a business (or industry) will be more profitable than alternatives. This will attract new investments, or more competing businesses in the industry.
Negative economic profits mean that a business (or industry) will be less profitable than alternatives. This will result in less money being invested, or businesses exiting the industry.
Zero economic profits represent a situation of equilibrium. This is the level of profits that provides no incentive for investments or businesses to either enter or exit.
In economics, whenever the term "profit" is encountered, its context should determine whether it refers to accounting profit or economic profit. In general, when the context involves such things as demand & supply, and cost & revenue curves, any mention of the word "profit" would refer to economic profit.
Revenue maximization refers to the combination of price and quantity that maximizes total revenue, or the maximum of (price times quantity). This can be thought of as a specific point on a demand curve. This means that a typical downward sloping demand curve will have one point which is unit elastic. That is, one combination of price and quantity that will maximize total revenue.
The segment of the demand curve above and to the left of this unit elastic point, which is the segment with a higher price, is elastic. Total revenue along this segment increases as the price is lowered.
The segment of the demand curve below and to the right of the unit elastic point, which is the segment with a lower price, is inelastic. Total revenue along this segment increases as the price is raised.
The price elasticity of demand decreases with every movement down the demand curve.
Marginal Revenue Product (MRP) is the additional revenue generated by adding one more unit of a variable input, such as labor. This depends on two things: the MPP (see above) and the slope of the demand curve. MPP is the number of additional units of output generated by an additional unit of a variable input. Selling additional units at a constant market price would mean that MRP equals the price times the change in quantity.
In most types of market structure, however, the market price will not remain constant. For normal goods, the market, or industry, demand curve, as well as the demand curve for an individual firm in most market structures, slopes downward. This means that selling additional units of output will require lowering the price of the output.
Marginal Revenue (MR) is the additional revenue generated from selling one more unit of output. With a downward sloping demand curve, MR is below the market price.
Total revenue is maximized at the point where the demand curve is unit elastic. At the point where total revenue is maximized, marginal revenue is equal to zero, by definition.
At prices higher than the revenue maximizing price, demand is elastic and MR is positive: increasing output from this section of the demand curve will increase total revenue.
At prices lower than the revenue maximizing price, demand is inelastic, and MR is negative.
Increasing output from this section of the demand curve will decrease total revenue.
What this means for a downward sloping demand curve: the MR curve slopes downward, lies below the demand curve, is steeper than the demand curve, and crosses the horizontal axis (is equal to zero) at the quantity of output that maximizes total revenue.
In the special cases of a horizontal demand curve (such as for an individual firm in a perfectly competitive market) and a vertical demand curve, the MR curve is equal to the demand curve.
The formula MR=MC should be forever ingrained into the minds of everybody who has ever studied economics. This is probably the formula most known, most quoted in microeconomics (along with the related formula QD=QS). As a formula, MR=MC is at the heart of every management decision regarding how much to produce and what price to sell it for.
Also, MR=MC has universal application: it is a mathematical principle that applies to every situation. Whether a firm is in perfect competition, is a monopolist, or lies somewhere in between, the same profit maximizing rule applies.
Simply stated, this formula means that profits are maximized at the level of output where marginal revenue is equal to marginal cost.
The reason why this formula always works:
At any output level where MR is greater than MC, the last unit produced added more to total revenue than to total costs, and profits increased. When profits are rising, increasing output will increase profits.
At any output level where MR is less than MC, the last unit produced added less to total revenue than to total costs, and profits decreased. When profits are falling, decreasing output will increase profits.
Combining the above statements: If MR is greater than MC or if MR is less than MC, profits can be increased by changing the output level. As long as profits can be increased, they are not maximized.
The only production level that will maximize profits, then, is at the only remaining possibility: MR=MC.