Economics Online Tutor
Revenue, Costs, & Profit
This page defines and explains various terms used in economics graphs and
microeconomic analysis, terms that are 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
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
TPP
Total 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 othersâ€™ way).

Diminishing Marginal Returns: With additional units of a variable input, output per input will increase at
first, but eventually 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 a steady increase.

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.

Long run:

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:

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

Economic Profit:

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:

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 that 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.

PROFIT MAXIMIZATION:   MR=MC

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, profits can always be increased by changing the output level if MR>MC
or if MR<MC.  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.