Total, average and marginal revenue

• Total revenue (TR) — all the money coming in from sales.
• Average revenue (AR) — revenue per unit. Since TR = P × Q, AR = (P × Q) ÷ Q = P. This is why the AR curve and the demand curve are the same line.
• Marginal revenue (MR) — the addition to TR from selling one more unit.

Two cases you must distinguish:

• Price taker (perfect competition): the firm can sell any quantity at the market price, so AR = MR = P and the demand curve it faces is horizontal.
• Price maker (everything else): to sell more it must cut the price on every unit, so MR < AR, and MR falls twice as steeply as AR.

Revenue and price elasticity of demand

The link between MR and PED is a favourite of examiners:

The killer point: a profit-maximising firm produces where MC = MR, and MC is always positive, so MR must be positive too. A profit maximiser therefore never operates on the price-inelastic part of its demand curve.

Marginal revenue from a schedule

Why is MR below AR?

The seven cost concepts

• Fixed costs (TFC) — do not vary with output (rent, insurance, business rates). They exist only in the short run as a distinct category.
• Variable costs (TVC) — rise with output (raw materials, energy, piece-rate wages).
• AFC falls continuously as output rises — the same fixed cost is "spread" over more units. This is "spreading the overheads".
• MC is the cost of producing one more unit. Because fixed costs don't change, MC is driven entirely by variable costs.

Definition of the short run: the period in which at least one factor of production is fixed. In the long run, all factors — including capital — are variable, so there are no fixed costs in the long run.

The law of diminishing marginal returns

This law explains why the short-run MC curve slopes upwards, and it is the foundation of the whole cost diagram.

Think of a kitchen with a fixed number of ovens. The first extra chef raises output a lot. The fifth adds less — they queue for the oven. Because each extra chef costs the same wage but produces less extra output, the cost of each extra meal — the marginal cost — must rise.

The "cricket average" intuition: if your next innings scores below your career average, your average falls. If it scores above, your average rises. So MC must cut AC exactly at AC's lowest point. Nothing else is possible.

Marginal cost from a table

Average total cost

Average variable cost

The identity AC = AFC + AVC

Where do the curves cross?

Economies of scale

In the long run all factors are variable, so the firm can change its scale. Economies of scale are falling long-run average costs as output rises.

Internal (arise from the growth of the firm itself) — remember RUFMPT:

• Risk-bearing — a diversified firm can absorb a shock in one market.
• Financial — big firms borrow more cheaply (lower risk premium, access to bond markets).
• Managerial — specialist managers (an HR director, a tax specialist) can be afforded and their cost spread.
• Technical — indivisible capital (a blast furnace, a container ship) works at lower unit cost when used at full capacity; also the division of labour.
• Purchasing (bulk-buying) — discounts from suppliers on large orders.
• Marketing — the cost of a national ad campaign is spread across far more units.

External economies arise from the growth of the whole industry, not the firm — e.g. a skilled local labour pool, specialist suppliers clustering nearby, better transport infrastructure. Silicon Valley is the textbook case; every firm there benefits, however small.

Diseconomies of scale, MES and the LRAC

Diseconomies of scale — rising LRAC — are essentially human: coordination problems, communication failures across layers of hierarchy, and falling worker motivation and morale ("alienation") in a vast organisation.

Minimum efficient scale (MES) is the smallest output at which the firm achieves the lowest possible LRAC. It matters enormously for market structure: if MES is huge relative to market demand, only a few firms can survive — you get oligopoly, or in the extreme a natural monopoly. If MES is tiny, many small firms coexist.

Why L-shaped, not U-shaped? Empirically, LRAC often flattens after MES rather than turning sharply up: firms avoid diseconomies by decentralising, and technology keeps lowering costs. The flat range means firms of very different sizes can all be cost-competitive.

Economy, diseconomy or external?

Tap a situation, then tap the correct box.

Normal profit, supernormal profit and losses

Economists count opportunity cost as a cost. That changes what "profit" means.

• Normal profit — the minimum reward needed to keep the entrepreneur in this industry; equal to what they could earn in their next best alternative. It is a cost of production, so it is included in AC. Normal profit occurs where AR = AC (also called break-even).
• Supernormal (abnormal) profit — any profit above normal. It exists where AR > AC. It is the signal that attracts entry into a market.
• Loss (subnormal profit) — where AR < AC. The signal for exit.

The classic mistake: writing that a firm making "zero economic profit" is doing badly. A firm earning only normal profit is doing exactly well enough to stay — it is covering every cost, including the opportunity cost of the owner's capital and time.

Supernormal profit

The short-run and long-run shut-down points

A loss-making firm faces a decision. The answer depends on the time horizon, because fixed costs are sunk in the short run — they must be paid whether the firm produces or not.

The logic: if the firm shuts in the short run, it loses all of its fixed costs. If it keeps producing and P > AVC, each unit generates a surplus (P − AVC) that contributes towards those fixed costs, so its loss is smaller. In the long run there are no fixed costs, so anything below AC means exit.

Contribution to fixed costs

Should it shut down?

Match the concept to its condition

Tap a condition on the left, then its concept on the right.

Normal profit

MES and market structure

The big ideas to know

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