Economic profits and revenues

Economic profits represent the difference between a firm's total revenues and its total economic costs.

Economic profits

$\text{π(Q)}=\text{TR(Q)}-\text{TC(Q)}$

Where:

• π(Q) = Economic profits at output level Q
• TR(Q) = Total revenues at output level Q
• TC(Q) = Total costs at output level Q

Total revenues

$\text{TR(Q)}=\text{P}\times \text{Q}$

Where:

• TR(Q) = Total revenues at output level Q
• P = Price per unit
• Q = Quantity of output

Average revenue

$\text{AR}=\frac{\text{TR}}{\text{Q}}=\text{P}$

Where:

• AR = Average revenue
• TR = Total revenues
• Q = Quantity of output
• P = Price per unit

The demand curve that a firm faces also serves as its average revenue curve.

Economic costs and normal profit

Economic costs encompass all resources sacrificed in the production process.

Components of economic costs

• Explicit costs - Direct payments made to suppliers, often called "out-of-pocket" expenses.
• Implicit costs - The value of resources owned by the firm that are used in production without direct payment.

Economic costs include both explicit and implicit elements.

Normal profit

Normal profit is the minimum return required by an entrepreneur to keep operating in a business. It equals the earnings that could be obtained from investing entrepreneurial capital in the next best alternative with similar risk. Normal profit forms part of economic costs.

Economic profits differ from accounting profits because they subtract all sacrificed resource values.

Average costs

$\text{AC}=\frac{\text{TC}}{\text{Q}}$

Where:

• AC = Average costs
• TC = Total costs
• Q = Quantity of output

Marginal cost and the law of diminishing marginal returns

Firms aim to maximise profits. Understanding marginal cost is essential to this process.

Marginal cost

$\text{MC}=\frac{\mathrm{\Delta }\text{TC}}{\mathrm{\Delta }\text{Q}}$

Where:

• MC = Marginal cost
• ΔTC = Change in total costs
• ΔQ = Change in quantity of output

Marginal cost represents the additional cost of producing one more unit and is the slope of the total cost function. It typically falls at first, then rises, forming a "Nike-swoosh" shape.

The law of diminishing marginal returns

In the short run, with at least one fixed factor of production, adding more variable factors initially boosts output at an increasing rate through specialisation. However, beyond a certain point, diminishing marginal returns occur, causing marginal cost to rise.

Marginal revenue for price takers and price makers

Marginal revenue helps firms decide on output levels by showing the extra income from selling one more unit.

Marginal revenue

$\text{MR}=\frac{\mathrm{\Delta }\text{TR}}{\mathrm{\Delta }\text{Q}}$

Where:

• MR = Marginal revenue
• ΔTR = Change in total revenues
• ΔQ = Change in quantity of output

Marginal revenue in different market structures

• Price taker - A small firm in a large market producing identical goods must accept the market price. Marginal revenue remains constant and equals the price.
• Price maker - A firm with market power faces a downward-sloping demand curve and must lower prices to sell more, affecting all units sold. The marginal revenue curve has twice the slope of the demand curve.

The profit maximisation rule

To maximise profits, firms select the output level where marginal revenue equals marginal cost.

Applying the profit maximisation rule

• Produce at the quantity Q where MR = MC.
• If MR > MC, increase output to boost profits or reduce losses.
• Continue adjusting until MR = MC.

Determining the level of profits