Micro‑economic Decision‑Makers – Firms’ Costs, Revenue and Objectives
1. Why cost calculations matter (AO1)
- Identify the output level that maximises profit (or minimises loss).
- Decide whether to increase, decrease or shut‑down production in the short run.
- Set appropriate pricing strategies in competitive markets.
- Analyse the effect of changes in input prices, technology or scale of production.
2. Key concepts & formulas (Cambridge IGCSE 0455)
| Concept |
Definition |
Formula |
| Fixed Cost (FC) |
Cost that does **not** vary with the level of output (e.g., rent, salaries of permanent staff). |
FC = constant for the period |
| Variable Cost (VC) |
Cost that varies directly with output (e.g., raw materials, hourly wages). |
VC = Σ (price of each variable input × quantity used) |
| Total Cost (TC) |
All costs incurred in producing a given output. |
TC = FC + VC |
| Average Fixed Cost (AFC) |
Fixed cost per unit of output. |
AFC = \dfrac{FC}{Q} |
| Average Variable Cost (AVC) |
Variable cost per unit of output. |
AVC = \dfrac{VC}{Q} |
| Average Total Cost (ATC) |
Total cost per unit of output. |
ATC = \dfrac{TC}{Q}=AFC+AVC |
| Total Revenue (TR) |
Value of output sold. |
TR = P \times Q |
| Average Revenue (AR) |
Revenue per unit of output. In perfect competition AR = P. |
AR = \dfrac{TR}{Q}=P \;(\text{perfect competition}) |
| Profit (π) |
Difference between revenue and cost. |
π = TR – TC |
3. Objectives of firms (AO2)
- Survival: cover all costs (TR ≥ TC) in the long run.
- Profit‑maximisation: produce where marginal revenue = marginal cost (MR = MC) and, in perfect competition, where price equals marginal cost (P = MC).
- Social‑welfare / non‑profit goals: may accept lower profit or even a loss to achieve a wider social aim.
- Growth / market‑share: may temporarily sacrifice profit to expand output or enter a new market.
4. Market structures that affect cost analysis (AO2)
- Perfect competition: many price‑taking firms, AR = MR = P, firm faces a horizontal demand curve.
- Monopoly (or other imperfect markets): a single price‑setting firm, AR = MR is downward‑sloping, the firm can set price above MC.
Cost calculations are identical in both structures; the difference lies in the revenue side and the resulting profit‑maximising output.
5. Short‑run cost curves and scale effects (AO1/AO2)
- AFC falls continuously as output rises because the same fixed cost is spread over more units.
- AVC is typically U‑shaped: it falls at low output (economies of variable inputs) and then rises (diminishing marginal returns).
- ATC = AFC + AVC, also U‑shaped; its minimum occurs where AFC and AVC intersect.
- Economies of scale: when ATC falls as Q increases because larger output spreads fixed costs and may improve variable‑input efficiency.
- Diseconomies of scale: when ATC rises at higher output due to coordination problems, higher input prices, etc.
In exam questions you may be asked to draw the ATC curve, label the minimum point, and explain whether the firm is experiencing economies or diseconomies of scale.
How to sketch the curves (exam tip)
- Vertical axis: “Cost (£ per unit)”, horizontal axis: “Output (Q)”.
- Draw a downward‑sloping AFC that approaches, but never touches, the horizontal axis.
- Draw a U‑shaped AVC that falls, hits a minimum, then rises.
- Place ATC above AVC; it has the same shape but is shifted upward by the amount of AFC at each Q.
- Mark the point where ATC is lowest – the cost‑minimising output.
- Label the axes, curves and the minimum point clearly.
6. Production & shutdown decisions (AO2)
- Short‑run production rule: produce as long as
TR ≥ VC ⇔ P ≥ AVC. If P < AVC the firm should shut down because it cannot cover its variable costs.
- Shutdown point: the output where
P = AVC and ATC is still above price.
- Break‑even (short‑run): the output where
TR = TC ⇔ P = ATC. At this point profit is zero (normal profit).
- Long‑run equilibrium rule: in a perfectly competitive market firms produce where
P = ATC = MC. If P > ATC firms earn super‑normal profit and new firms will enter; if P < ATC firms exit.
7. Step‑by‑step calculation of each cost type (AO1)
- Identify the total fixed cost (FC) for the period.
- Identify the total variable cost (VC) for each output level (Q).
- Compute total cost:
TC = FC + VC.
- Derive average costs:
- AFC = FC ÷ Q
- AVC = VC ÷ Q
- ATC = TC ÷ Q (or ATC = AFC + AVC)
- If revenue is required:
- TR = P × Q (use the given price)
- AR = P (in perfect competition) or AR = TR ÷ Q
- Profit π = TR – TC
8. Example 1 – Manufacturing (Bakery)
Price of a loaf of bread = £4.
| Q (loaves) |
FC (£) |
VC (£) |
TC (£) |
AFC (£/loaf) |
AVC (£/loaf) |
ATC (£/loaf) |
TR (£) |
Profit π (£) |
| 100 |
500 |
200 |
700 |
5.00 |
2.00 |
7.00 |
400 |
-300 |
| 200 |
500 |
380 |
880 |
2.50 |
1.90 |
4.40 |
800 |
-80 |
| 300 |
500 |
570 |
1,070 |
1.67 |
1.90 |
3.57 |
1,200 |
130 |
| 400 |
500 |
780 |
1,280 |
1.25 |
1.95 |
3.20 |
1,600 |
320 |
Interpretation
- AFC falls sharply as output rises – the rent and manager’s salary are spread over more loaves.
- AVC falls from 2.00 to 1.90, then rises slightly, showing economies of scale followed by the onset of diminishing marginal returns.
- ATC mirrors the combined pattern; its lowest point (≈£3.20) occurs at 400 loaves – the most efficient output in this data set.
- Profit becomes positive once Q ≥ 300, illustrating the break‑even point where TR exceeds TC.
- Because P (=£4) is above AVC for all Q, the firm would not shut down in the short run.
9. Example 2 – Service sector (Private tutoring)
Emma charges £30 per hour. Fixed costs = £150 per month (advertising, internet, rent). Variable cost = tutor’s hourly wage of £10.
| Q (hours taught) |
FC (£) |
VC (£) |
TC (£) |
AFC (£/hour) |
AVC (£/hour) |
ATC (£/hour) |
TR (£) |
Profit π (£) |
| 10 |
150 |
100 |
250 |
15.0 |
10.0 |
25.0 |
300 |
50 |
| 20 |
150 |
200 |
350 |
7.5 |
10.0 |
17.5 |
600 |
250 |
| 30 |
150 |
300 |
450 |
5.0 |
10.0 |
15.0 |
900 |
450 |
| 40 |
150 |
400 |
550 |
3.75 |
10.0 |
13.75 |
1,200 |
650 |
Interpretation
- AFC drops rapidly as more hours are taught – the fixed monthly costs are spread over a larger output.
- AVC stays constant because the variable input (the tutor’s hourly wage) is linear.
- ATC falls with output, showing economies of scale in a service‑based firm.
- Since P (£30) > AVC (£10) at every output level, the firm would continue operating in the short run.
10. Common pitfalls to avoid (AO3)
- Confusing total and average figures – TC is a total amount; AFC, AVC and ATC are per‑unit costs.
- Putting fixed cost into the VC column – FC must remain unchanged for the given short‑run period.
- Dividing by zero – AFC, AVC and ATC are undefined at Q = 0; start calculations from the first positive output level.
- For short‑run analysis treat at least one input as fixed; in the long run all inputs are variable, so FC = 0 and ATC = AVC.
- Remember that AR = P only in perfect competition; in monopoly AR ≠ P.
11. Quick revision checklist (exam‑style)
- Write down the relevant formulae before you start calculating.
- Check that FC is the same for every output level (short‑run assumption).
- Calculate VC for each Q, then add FC to obtain TC.
- Derive AFC, AVC and ATC by dividing the appropriate total cost by Q.
- If the question involves revenue, compute TR = P × Q, then profit = TR – TC.
- Sketch the three cost curves, label the minimum ATC point and indicate:
- Shutdown point (P = AVC)
- Break‑even point (P = ATC)
- Long‑run equilibrium (P = ATC = MC) for perfect competition.
- State the firm’s objective (e.g., profit‑maximisation) and link it to the rule you have used.
12. Extension – Linking costs, revenue and profit decisions (AO3)
Profit:
$$\pi = TR - TC$$
Revenue:
$$TR = P \times Q$$
Average revenue (perfect competition):
$$AR = \frac{TR}{Q}=P$$
Short‑run production rule
- Produce while TR ≥ VC ⇔ P ≥ AVC.
- If P < AVC, shut down because the firm cannot cover its variable costs.
Short‑run break‑even rule
- Produce where P = ATC. At this point profit is zero (normal profit).
Long‑run equilibrium (perfect competition)
- Produce where P = MC = ATC. Any price above ATC yields super‑normal profit and attracts entry; any price below ATC leads to exit.
These criteria are the backbone of many IGCSE questions on profit maximisation, shutdown decisions, and long‑run market equilibrium.