Revenue Curves, Types of Profits.

Revenue Curves, Types of Profits. Revenue curves of the businessAs a business we need to know the most profitable output we can produce.

To find out how we can be the most profitable we need to understand more about the relationship between the revenue and cost curves of the business

Revenue = Income producers receive from selling goods and services on the market

ProfitProfit depends onThe price the goods are sold forHow much is soldCost of production

Profit = Revenue- CostsIncome from sales Includes rent wages interest and other costs of productionNormal Profit for a business is where:

Total Cost =Total RevenueTC=TREntrepreneurs include a return for risk in their costs of production this is why at TC=TR we call it normal profit even though there doesnt appear to be any at all.Revenue Curves Total Revenue (TR) = Price X Quantity of units soldCalculate the TR for a farmer that sells sheep at $40 each and sells 300 sheep.TR= 40 x 300 = $12,000

Average Revenue (AR) is the average contribution of each unit sold to TR. AR will be the same as price and is represented by the demand curve AR= TR/QWhat's the AR for the above situation?12,000/300 = 40 = Price per sheep

Marginal Revenue (MR) is the additional revenue the firm receives from the sale of one more unit of output. Its calculated by the change in TRMR= TR2-TR1

Types of ProfitSubnormal profitTRTCSupernormal profit will attract other businesses into the industry in the Long-run. Thus can only be achieved in the Short RunComparing Equilibrium situations for Monopoly and perfect CompetitionPerfect Competition Deriving the demand curve60504030201006050403020100PricePrice1 2 3 4 5 610 20 30 40 50 60Quantity (million)Output (000)SDPQDMarketDemand curve for the perfectly competitive firmBecause the perfectly competitive firm is a price-taker it faces a horizontal demand curve. The price is determined by demand and supply in the market. Example revenue curves for perfectly competitive firmPrice ($)QuantityTotal RevenueAverage RevenueMarginal Revenue6016060606021206060603180606060424060606053006060 1 2 3 4 5200

160

120

80

40

0

TRAR/MR/DAs a price taker, a perfectly competitive firm faces a price of $60 regardless of the amount they sell. This firm cannot affect this price in any way.The demand curve is horizontal. This means the firm can sell unlimited quantities at the same price (AR=MR). Cost Structures for perfect competitorsThe two most important curves to remember are theMarginal cost curves the big tickAverage cost curves the fruit bowl

The marginal cost curve always cuts the AC curve at its lowest point.Perfectly competitive firmMCACMR/AR/DProfit maximising equilibrium output is where MR=MCQPNormal ProfitsA firm will be earning normal profit when the revenue is sufficient to cover all the costs

AR=AC.

Remember the costs of production includeRent, paid for land Wages paid to labourInterest paid to capitalProfit paid for enterpriseNormal profit AR=ACARACMCSubnormal ProfitWhere the firms costs are greater than its revenue the firm is earning subnormal profits. It is quiet possible for the firm to be earning accounting profits but because our opportunity costs may be high it may be making an economic lossARACMCSUPERNORMAL PROFITWhere the firms costs are greater than its revenue the firm is earning subnormal profits.

Only a Monopolist can sustain supernormal profits in the long run.

Perfect competitors will make normal profits in the long run, as other firms will easily enter the market, being attracted to the supernormal profits, thus increasing supply and resulting in normal profitsARACMCMaking Subnormal ProfitsIf, in the short run firms are making subnormal profits in a perfectly competitive industry then in the long run some firms will exit the industry. As firms exit the industry the market supply will decrease and consequently the market price will increase. An increase in the market price will mean an increase in average revenue for the remaining firms. In the long run subnormal profits will be replaced by normal profits and only normal profits will be made in the long-run

Making Supernormal ProfitsIf firms are making short-run supernormal profits in a perfectly competitive industry then in the long- run new firms, attracted by the prospect of supernormal profits will enter the industry. As new firms enter the industry the market supply will increase resulting in a fall in the market price. A fall in the price will mean a fall in average revenue for the firms. Supernormal profits will be reduced and in the long-run only normal profits will be made. Making Normal ProfitsPerfectly competitive firms making normal profits in the short-run will continue to do so in the. There is no incentive for firms to either exit or enter the industry. Market supply does not change neither does the price nor average revenue. Normal profits will continue.Perfectly Competitive MarketUsing Marginal Analysis

Q1Q2Q3At Q1 MR > MCTherefore the firm should increase output to gain more profit on the additional units of output soldAt Q3 MC>MR, therefore the firm should decrease output to avoid making a loss on the additional units of output soldCharacteristics of a MonopolistA monopolist firm is the only supplier of a good or service in a market. The revenue curves for a monopoly are different from those of a perfect competitor. The monopolist is able to restrict output so that a high price can be charged, this means in order to sell more product the monopolist must drop its price.

Sound similar to the LAW OF DEMAND?As price decreases quantity demanded increases

This must mean the monopolist must have a downwards sloping demand curve! AR=DRevenues for a monopolist PriceQuantityTotal RevenueAverage Revenue Marginal Revenue301303030252502520203602010154601501055010-1056305-20Revenue Curves for the MonopolistThe AR curve is the firms demand curveBoth the AR and MR are downwards sloping, but AR < MRWhen TR is increasing, MR is positiveWhen TR is decreasing, MR is negativeWhen TR is at its maximum MR=O

Comparing Demand CurvesPerfect CompetitorMonopolistDemand CurveDegree of influence over priceRelationship between AR and MR

HorizontalDownwards slopingPrice TakerOnly producer, Price setterAR=MRMR AC Supernormal Profits

What happens in the SR and LR for a Monopoly?In the short run, a monopoly must stay in the industry no matter what the profits position , as at least on factor is fixed.

In the Long Run

Earning a supernormal profit this situation will continue as strong barriers to entry prevent any other firms entering the market

Earning a normal profit a firm will continue to operate, as it is earning just enough profit to be worthwhile

Earning a subnormal profit a firm will leave the market as better returns can be gained else whereBarriers to entryBarriers to entry- strategies available that will stop new firms from entering a marketThis means, existing firms will be able to keep earning supernormal profits in the long run. Examples of barriers to entryPatents give the firm intellectual property rights over a new inventionPredatory pricing policies to cut prices to a level that would force any new entrants to operate at a lossCost Advantages- resulting from economies of scale (allowing them to undercut price)Spending on R&D (research and development) Producing a good with no close substitutesAdvertising and marketing competitors find it expensive to break into the market

Monopoly VS Perfect CompetitionCompared to a perfectly competitive firm a monopoly will

Deliberately restrict output Set a price higher than MCBe able to earn supernormal profits in the LR. Not achieve the efficient level of output where AR=MR

Monopoly VS Perfect CompetitionHowever there are some situations where the monopolist can provide some advantages to society

Supernormal profits can be used to pay for R&D which could lead to further efficiencies

If the monopolist is earning sufficient economies of scale a firm could charge a price below that of a competitive firm.

Loss of Allocative EfficiencyWork book page 73In a perfectly competitive market, price is set by demand and supply at market equilibrium, so the market is allocatively efficient

Curves of a monopolistDemand curve is downwards sloping MR< ARThe monopoly restricts output to the profit maximising level where MR=MC

Where MR=MC, the monopolist charges a higher price and lower output than the market equilibrium where MC (S) = AR (D)

The allocative efficient level of output is where AR=MC

Deadweight loss will exist. .

Deadweight loss (DWL) = Represents a loss of allocative efficiency that is lost to the marketLoss of Allocative Efficiency

Government Policies and MonopoliesBecause monopolists operate at a non allocative efficient point governments may choose to intervene in the following waysPrice Controls-Force the monopoly to operate at a price where AR=MR (called marginal cost pricing )If costs are too high the firm may be forced into a subnormal profit. As a result the government may need to subsidise the firm- Force the monopoly to operate where AR=AC (called average cost pricing) The firm will then be making a normal profit and it will be operating at a close to the allocatively efficient point.

Remove all artificial barriers to entry for a firm e.g legal barriers

Encourage/legislate competition forcing monopolies to share facilities

Force any parts of a monopoly that can be broken up to be sold