ECONOMICS

PAPER 2

MICROECONOMICS

TOPIC 6: DYNAMICS OF MARKETS: EFFECTS OF COST AND REVENUE:

Candidates should cover the following:

Explain and illustrate by means of Objectives of Application of revenue and costs

graphs the effects of cost and businesses analysis should include
revenue on prices and the levels of production and the pricing of
production. factors.

Vocabulary list:

Learners must first give a description of the following words in their notebook.

Total Product/ Output Marginal revenue

Fixed Costs Average revenue
(indirect costs/ overhead costs) The long-run
Variable Costs Economies of scale
(direct costs/prime costs) Diseconomies of scale
Total cost: Profit
Marginal costs ECONOMIC PROFIT
Average cost ECONOMIC LOSS
Average fixed cost NORMAL PROFIT
Average variable cost
Total Revenue

REVENUE AND COST ANALYSIS

MC = Marginal Cost
It is the amount by which the total cost increase when one extra unit of a product is
produced.
∆Total Cost (TC) ÷ ∆ Output (Q) = MC
MR = Marginal Revenue
Marginal revenue refers to the extra amount of revenue earned when an additional (extra)
unit of a product is sold.
∆TR ÷∆ Q = MR
AC = Average Cost
Total Fixed Cost + Total Variable Cost = Total Cost
Total Cost ÷ Total output = AC.
Also called unit cost.
AR = Average Revenue
Average revenue refers to the amount the enterprise earns for every unit sold.
TR ÷ Q = AR
Because TR = PQ,

1
 it follows that AR = PQ ÷ Q
therefore, AR = Price
AVC = Average Variable Cost
Total Variable Cost divided by number of units produced.
Total Variable Cost ÷ Total output = AVC.
P = Price
A value that will purchase a definite quantity, weight, or other measure of a good or
service.
Q = Quantity
The extent, size, or sum of countable or measurable discrete events, objects, or
phenomenon, expressed as a numerical value.

Objectives of the business according to the SMART principle.

Specific the idea must be identified and understood and not merely a random idea
Measurable it must be possible to test or measure whether the goal has been reached
Agreed in a small business, the goal is easy to set as the owner is the only one
who has to agree, in a larger business there will be many stakeholders
who need to agree
Realistic the goal must not be out of reach for the business, the business must be
capable of generating the required profit
Time there must be a time limit on achieving the goal
specific

Main objectives of the business:

 Survival
 Profit maximization
 Revenue Maximization
 Sales Maximization

Survival  Initially the objective of the firm will be to merely survive.

 New firms face constraints that could hamper their progress and
success.
Profit  Making as much profit as possible.
maximising  Profit is the difference between the revenue and the cost of the
business.
Revenue  Some businesses have very high costs
maximising  If they have a very large workforce, large business premises, etc.
Sales  Sales refer to the number of goods or services sold.
maximising  Reaching as many customers as possible can increase the size
and popularity of the business although the profit may fall if lower
prices have to be charged to reach this objective.

2
Short run and Long run

Short run
 It is that period where at least one input is fixed.
 The enterprise can increase its outputs by increasing its variable factors.

Long run
 It is that period where both fixed factors and variable factors can be changed.

Differentiate between long run costs and short run costs.

Long run cost

 It is the period of time in which the business is able to increase all of its output at will,
none of the factors of production are fixed.
 It is not only limited to increasing variable input.
 The period in which there are no fixed inputs, all the inputs are variable.
 In the long run, firms are all trying to produce at a level that will allow them to
experience economies of scale.

Short run cost

 The period of time during which the business is faced with at least one of its
production factors being fixed.
 One of the inputs are unable to be increased.
 Fixed inputs do not change in the short run, variable inputs change.
 If a firm wants to increase production in the short run, it can do so only by increasing
the number of labourers it employs.

3
FIXED FACTORS AND VARIABLE FACTORS:

The main difference between fixed factor and a variable factor is the time it takes to
change the input.

Fixed factors:
 These are inputs that take time and planning to increase.
 E.g. size of the factory or building, the type of machines that is used, etc.

Variable factors
 These are inputs that can be changed easily and quickly.
 E.g. electricity, labour, water, etc.

Abbreviations used in graphs:

Abbreviations used in
graphs
FC Fixed Cost

VC Variable Cost

TC Total Cost

TFC Total Fixed Cost

TVC Total Variable Cost

MR Marginal Revenue

MC Marginal Cost

4
AC Average Cost
ATC Average Total Cost

AC Average Cost
AVC Average Variable Cost

AR Average revenue

5
PERFECT MARKETS / PERFECT COMPETITION
COSTS IN THE SHORT RUN

FIXED COST, VARIABLE COST AND TOTAL COST

Output
 Output is the quantity of goods produced during a certain period.

Total Fixed Cost (TFC) / FC

 It is all those costs which stay the same, no matter how many products are
produced by the enterprise.
 It must be paid, irrespective whether 0 or 1 million units are being produced.
 E.g. insurance premiums, rent of the building, property taxes, etc.

Total Variable Cost (TVC) / VC

 It is those cost that change as the number of products being produced (output)
changes.
 E.g. the services of a labourer, electricity, telephone bills, water accounts, etc.

Total cost (TC)

 It is when fixed cost and variable cost are added together.
 TC = TFC + TVC

Total
Fixe
d Total Tota
Cost Variabl l
Outpu (TFC e Cost Cost
t ) (TVC) (TC)
0 3 0 3
1 3 5 8
2 3 8 11
3 3 10 13
4 3 11.5 14.5
5 3 13 16
6 3 15 18
7 3 18 21
8 3 23 26
9 3 31 34
10 3 43 46

6
Total Fixed Cost (TFC) also called Fixed Cost (FC).
 It is illustrated as a horizontal line on the graph.
 Fixed cost stays the same, regardless of the quantity of outputs produced.

Total Variable cost (TVC)

 The TVC curve starts from 0 because when zero (0) goods are being produced
the variable cost is zero (0)
 As the outputs increase, variable cost will increase.

Total Cost (TC)

 It is the sum total of Total Fixed Cost plus Total Variable cost.
 The total cost curve starts at the point where Fixed cost starts.
 TC = TFC + TVC

 The variable cost curve always has an S-Shape.

 It has to do with the law of diminishing returns.
 When resources are fully used and every time another worker is added, total costs will
increase at an increasing (faster) rate.
 The curve increases slowly at first, and when it reaches a particular point, the variable
cost starts to increase at a faster rate.

MARGINAL COST (MC)

Describe the term: Marginal cost:

It is the amount by which the total cost increase when one extra unit of a product is
produced.

∆ Total Cost (TC)

 The formula is: ∆ Output (Q)

Total cost of one unit – the total cost for the previous unit.

7
 Total Tota
Variabl l Margina
Outpu e Cost Cost l Cost
t (Q) (TVC) (TC) (MC)
0 0 3 -
1 5 8 5
2 8 11 3
3 10 13 2
4 11.5 14.5 1.5
5 13 16 1.5
6 15 18 2
7 18 21 3
8 23 26 5
9 31 34 8
10 43 46 12

 Total cost increase as output increase.

 Marginal cost decrease to a point and starts to increase again.
 When 5 products are produced, Marginal cost (MC) will be R1.50 per unit.
 When 6 products are produced, Marginal cost (MC) will increase to R2.00 per
unit.
 The law of diminishing returns sets in when producing more than 5 products.
 It now becomes more expensive to produce each additional unit of a product
 Each time when an extra product is produced, it becomes more expensive to
produce each additional unit of the product.
 However, even though the marginal cost is rising, the firm can still continue
producing more units of a good as long as the marginal revenue is greater than
the marginal cost.

Take note: The law of diminishing returns is also referred to as the law of diminishing
marginal returns.
AVERAGE COST CURVES

 It is the cost per unit of production.

 There are TWO types of average cost.

Average Fixed Cost (AFC)

Average Variable Cost (AVC)
Average Cost (AC)

8
 Averag
Averag e
Outpu e Fixed Variabl Averag
t Cost e cost e Cost
AFC + AVC =
AC
0
1 3 5 8
2 1.5 4 5.5
3 1 3.33 4.33
4 0.75 2.88 3.63
5 0.6 2.6 3.2
6 0.5 2.5 3
7 0.43 2.57 3
8 0.375 2.88 3.25
9 0.33 3.44 3.8
10 0.3 4.3 4.6

Average Fixed Cost (AFC)

Formula:
Total Fixed Cost
Average Fixed Cost = Total Output

 AFC is the amount of fixed cost allocated to the production of one unit of a
product.
 As the outputs increase, the average fixed cost decrease.

Average Variable cost (AVC)

Formula:
Total Variable Cost
Average Variable Cost (AVC) = Total Output

 As the outputs increase, the average variable cost will decrease to a point after which
it will start to increase.

9
Average Cost (AC)

Formula:
Total Cost
Average Cost (AC) = Total Output

 It is the sum total when Total Average Fixed Cost and Total Average Variable Cost is
added.

IMPERFECT MARKETS / IMPERFECT COMPETITION

COST IN THE SHORT RUN

The demand curve of the Monopoly: D = AR

Average
Total Revenu
Quantit Pric Revenu e
y e e

Total rev /quan(output)

0 100 0 0
1 90 90 90
2 80 160 80
3 70 210 70
4 60 240 60
5 50 250 50
6 40 240 40
7 30 210 30
8 20 160 20
9 10 90 10
10

Demand curve = Average Revenue Curve

 Demand curve is the quantity demand at each price – therefore the higher the price
the less quantity of a product is demanded. The demand curve is downward sloping.
 A revenue curve reflects the amount of money a business earns from the sale of
goods and services. It is the price per unit.
 If the business wants to sell extra units then they must cut the price – The Average
Revenue curve is also downward sloping.

NB: The Average Revenue curve is the same as the Demand curve.

10
 Average cost

Quantit Tota
y Pric TF TV l AV Averag
Output e C C cost C e cost
0 100 10 0 10
1 90 10 10 20 10 20
2 80 10 18 28 9 14
3 70 10 25 35 8.33 11.67
4 60 10 33 43 8.25 10.75
5 50 10 43 53 8.6 10.6
6 40 10 55 65 9.17 10.83
7 30 10 70 80 10 11.43
8 20 10 90 100 11.3 12.5
9 10 10 115 125 12.8 13.89
10 0 10 145 155 14.5 15.5

Total cost ÷ Output (Q) = AC or ATC.

 As the firm produces more of a product the average cost reduces to a certain point
then it increases again.
 The reason is average cost has a fixed part and a variable part. Adding them
together the AC will decrease to a point and then start to increase.

The law of diminishing returns

• Law of diminishing returns states that as more of a variable input is added to a fixed input,
the returns from the variable input will decrease.

Marginal cost

11
 Pric
Quantity / Output e Total cost MC
0 100 10
1 90 20 10
2 80 28 8
3 70 35 7
4 60 43 8
5 50 53 10
6 40 65 12
7 30 80 15
8 20 100 20
9 10 125 25
10 0 155 30

 Marginal cost is the cost of the resources to produce an additional product. (What
does it cost to produce one additional unit?)
 The cost to produce an additional unit will decrease to a point (5 units) then it will
increase again.

COST IN THE LONG RUN

 Long run refers to the time period where both fixed factors and Variable factors
change.
 E.g. business enterprises need time to:
 expand their business property.
 install new machinery.
 to develop new production techniques.

 The law of diminishing returns does not influence the business because businesses
can make any changes.
 The long term curve differs from the short term curve.
The most important decisions that enterprises have to take into consideration are the scale
of their operations.

REVENUE CALCULATIONS AND CURVES

12
PERFECT COMPETITION

TOTAL REVENUE, MARGINAL REVENUE, AVERAGE REVENUE / output (quantiy)

 Revenue = Flow of money that businesses receive.

 Cost = Payments made by businesses.

To calculate profit /loss: Profit = Total Revenue – Total Cost

TOTAL REVENUE
 Total revenue is the amount of money that a business earns in a particular period of
time.
 A business earns money by selling its output.

TR = Q x P

Total Revenue Output Price

Quantity Total
/Output Price Revenue
0 4 0
1 4 4
2 4 8
3 4 12
4 4 16
5 4 20
6 4 24

7 4 28
8 4 32
9 4 36
10 4 40

 Total revenue increase as the level of output increase.

AVERAGE REVENUE

13
Average revenue refers to the amount the enterprise earns for every unit sold. Also referred
to as unit cost.

AR = TR
Q

When every product is sold for the same price the average revenue will simply equal the
price of the product.

AR = P

Quantit Total Average

y Price Revenue Revenue
0 4 0 4
1 4 4 4
2 4 8 4
3 4 12 4
4 4 16 4
5 4 20 4
6 4 24 4
7 4 28 4
8 4 32 4
9 4 36 4
10 4 40 4

MARGINAL REVENUE
 Marginal revenue refers to the extra amount of income earned when an additional
(extra) unit of a product is sold.

MR = ∆TR
∆Q

14
 Total Marginal
Quantity Price Revenue Revenue
0 4 0 4
1 4 4 4
2 4 8 4
3 4 12 4
4 4 16 4
5 4 20 4
6 4 24 4
7 4 28 4
8 4 32 4
9 4 36 4
10 4 40 4

REVENUE CALCULATIONS AND CURVES

IMPERFECT COMPETITION

 Revenue = Flow of money that businesses receive.

 Cost = Payments made by businesses.
 To calculate profit: Profit = Total Revenue – Total Cost

TOTAL REVENUE
 Total revenue is the amount of money that a business earns in a particular period of
time.
 A business earns money by selling its output.

TR = Q x P

Total Revenue Output Price

15
 QUANTITY / Output Price Total Revenue

0 0
10 8 80
20 7 140
30 6 180
40 5 200
50 4 200
60 3 180
70 2 140

 Total revenue increase as the level of output increase to a certain amount but then it
decreases again.

AVERAGE REVENUE
 Average revenue refers to the amount the enterprise earns for every unit sold.

AR = TR
Q

 When every product is sold for the same price the average revenue will simply equal
the price of the product.
AR = P

QUANTITY / Total Average

Price
Output Revenue Revenue

0 0
10 8 80 8
20 7 140 7
30 6 180 6
40 5 200 5
50 4 200 4
60 3 180 3
70 2 140 2

16
MARGINAL REVENUE
 Marginal revenue refers to the extra amount of income earned when an additional
(extra) unit of a product is sold.

MR = ∆TR
∆Q

QUANTITY Total Marginal

Price
/ Output Revenue revenue
0 0
10 8 80 8
20 7 140 6
30 6 180 4
40 5 200 2
50 4 200 0
60 3 180 -2
70 2 140 -4

 The MR decrease with each additional unit of output as the level of output increase.

PROFIT MAXIMIZATION: PERFECT COMPETITION

Point e
 At point e the business produces at maximum profit where marginal income equals
marginal cost (MR = MC).

17
  This is known as the equilibrium point or profit maximization point.

Point a:
 At point a the marginal revenue is greater than marginal cost: (MR˃MC). (Marginal
revenue lies above the marginal cost)
 If the business produces at the level of point a, then the business can increase the
level of poduction until the profit maximization point is reached (point e).
 This is because every additional unit of production will add to the total profit of the
business.

Point c:
 At point c the marginal revenue is smaller than marginal cost (MR ˂MC). (Marginal
revenue lies below the marginal cost).
 If the business produces at the level of point c, then the business must decrease the
level of production until the profit maximization point is reached (point e).
 This is because every additional unit of production will contribute to the decrease in
profits. (Add to the losses of the business).

Conclusion:
1. MR = MC: Maximum profit
2. MR ˃ MC: Every additional unit produced adds to the profit of the business.
3. MR ˂ MC: Every additional unit produce will contribute to the decrease in profits.
(add to the loss of profits).

PROFIT MAXIMIZATION: IMPERFECT COMPETITION

Imperfect Competition
Profit maximization

 The monopolist maximize its profits were at the level of output where Marginal Cost
is equal to Marginal Revenue: (MC = MR)

18
 Quanti Pric Total Averag Tot M M
ty / e Reven e al C R
Output ue Reven cost
ue
0 100 0 10
1 90 90 90 20 10 90
2 80 160 80 28 8 70
3 70 210 70 35 7 50
4 60 240 60 43 8 30
5 50 250 50 53 10 10
6 40 240 40 65 12 -
10
7 30 210 30 80 15 -
30
8 20 160 20 100 20 -
50
9 10 90 10 125 25 -
70
10 155 30 -
90

PROFIT AND LOSS

Enterprises do business in different types of markets.

Some enterprises are:

PRICE TAKERS: They do not influence the prices for which products sell. They accept the
market price.

PRICE MAKERS (SETTERS): (Monopolies): They influence the price of products. They can
decide within limits at what price to sell their products.
E.g. diamond mines.

PRICE LEADERS: (E.g. oligopoly): They are large firms. They initiate price changes and
smaller businesses follow by increasing the prices of their products accordingly.
They lead with prices and other companies follows.
E.g. large supermarkets, travel agencies, etc.

PROFIT AND LOSS

 Profit is the difference between revenue and cost.

 An enterprise makes a profit when the revenue it earns is more than the production
cost.

19
Different types of profit

Accounting profit
 Also known as total profit.
 It is the difference between total revenue from sales and total costs.
 Accounting profit = Revenue minus explicit costs.

Normal profit
 It is the minimum return required by the owners to continue with the
 business.
 It is the remuneration for entrepreneurship.
 It is included in the total cost of production.
 When revenue is equal to explicit cost plus implicit costs.

Economic profit
 It is the extra profit that the firm makes.
 It is the profit that the business makes in addition to the normal profit.
 It is also known as surplus or excess or extra profit.
 Economic profit = Revenue minus explicit plus implicit costs.

PROFIT AND LOSS IN THE PERFECT PROFIT AND LOSS IN THE IMPERFECT
MARKET MARKET

20
TOPIC 6: SELF ASSESSMENT ACTIVITIES

21
1. Study the graphs below and answer the questions that follow.

1.1.1 Which market structure is shown in the above graphs. (1)

1.1.2 Identify the market price from the graph. (1)
1.1.3 Describe the term industry. (2)
1.1.4 How does the firm in this market increase its revenue? (2)
1.1.5 Why is the agricultural market regarded as a close example of a perfect market? (4)

Activity 2
2.1 Study the cartoon below and answer the questions that follow.

22
2.1. Name the market structure depicted on the above cartoon. (1)
2.2.1 Identify the barrier to entry from the cartoon above. (1)
2.3 Describe the term monopoly. (2)
2.4 Briefly explain how natural monopolies are created. (2)
2.5 Why would a monopolist continue to make economic product in the long-run? (4)

23