Costs, revenue and profit: short-run and long-run cost curves, total, average and marginal revenue, the profit-maximising MC = MR rule, and the distinction between normal and abnormal profit.

What this key area is asking

Advanced Higher deepens the Higher theory of the firm into the analytical engine of the whole microeconomics area. You must understand how a firm's costs behave in the short and long run, how its revenues behave, and the rule that determines the profit-maximising level of output: marginal cost equals marginal revenue. This machinery, $MC$, $MR$, $AC$ and $AR$ on one diagram, is then reused for every market structure (perfect competition, monopoly, oligopoly), so getting it secure here pays off everywhere.

Short-run costs and diminishing returns

In the short run at least one factor (usually capital) is fixed.

The shape of the cost curves comes from the law of diminishing returns: in the short run, as more of a variable factor (labour) is added to the fixed factor (capital), the marginal product of each extra worker eventually falls. Because each extra unit of output takes more and more labour, marginal cost eventually rises. This gives the $MC$ curve its upward sweep and, with fixed costs spread over more units, produces the familiar U-shaped average cost curve. The $MC$ curve cuts both average variable cost and average total cost at their lowest points (when marginal is below average it pulls the average down; when above, it pulls it up).

Long-run costs and economies of scale

In the long run all factors are variable, so there are no fixed costs and the firm can change its scale. The long-run average cost (LRAC) curve is also U-shaped, but for a different reason:

• Falling LRAC reflects economies of scale: internal sources (technical, purchasing, managerial, financial, marketing, risk-bearing) that lower average cost as the firm grows.
• The flat minimum is the range of minimum efficient scale, the smallest output at which LRAC is minimised.
• Rising LRAC reflects diseconomies of scale: coordination, communication and motivation problems in very large firms.

Revenue: average and marginal

The shape of $MR$ depends on the market. For a price taker (perfect competition) price is fixed by the market, so $AR = MR = P$ and both are horizontal. For a price maker (monopoly, oligopoly, monopolistic competition) the firm faces a downward-sloping demand curve, so to sell more it must lower price on all units; then $MR$ lies below $AR$ and falls twice as steeply on a straight-line demand curve.

The profit-maximising rule: MC = MR

This single rule applies to every market structure; what differs between structures is the shape of the $MR$ curve and how much abnormal profit survives in the long run.

Normal versus abnormal profit

Economists fold normal profit (the minimum return needed to keep the entrepreneur in this line of business) into cost. So:

• $AR > AC$ at the profit-maximising output gives abnormal (supernormal) profit, the rectangle $(AR - AC) \times Q$.
• $AR = AC$ gives normal profit only.
• $AR < AC$ gives a loss.

The short-run shut-down decision

A loss-making firm should keep producing in the short run as long as price covers average variable cost ($P \ge AVC$), because it is still contributing something towards its unavoidable fixed costs. If price falls below $AVC$, the firm loses more by operating than by shutting down, so the shut-down point is the bottom of the $AVC$ curve. In the long run, where all costs are variable, the firm exits if it cannot cover average total cost.

Worked example: finding output and profit

Why this matters

The cost and revenue framework is the backbone of the structures area. The $MC = MR$ rule, combined with the shape of the demand curve and the height of barriers to entry, generates every result you need: why a perfectly competitive firm earns only normal profit in the long run, why a monopoly can hold abnormal profit, and why the labour market hires up to the point where the marginal cost of labour equals its marginal revenue product. Master the diagram once and you can answer the whole area.

Try this

Q1. A firm is producing where $MR$ is GBP 8 and $MC$ is GBP 5. Should it expand or cut output to raise profit, and why? [2 marks]

• Cue. Expand: while $MR > MC$ each extra unit adds more to revenue (GBP 8) than to cost (GBP 5), so producing more raises profit until $MC$ rises to meet $MR$.

Q2. Explain why marginal cost eventually rises in the short run. [2 marks]

• Cue. The law of diminishing returns: with capital fixed, the marginal product of extra labour eventually falls, so each extra unit of output requires more labour and costs more, raising marginal cost.