Costs Revenues and Profits - Key Terms

Constant returns

When long run average cost remains constant as output increases because output is rising in proportion to the inputs used in the production process

Consumer surplus

The difference between the total amount that consumers are willing and able to pay for a good or service (indicated by the demand curve) and the total amount that they actually pay (the market price).

Cost synergies

Cost synergies are the cost savings that a buyer aims to achieve as a result of taking over or merging with another business

Cost-plus pricing

Where a firm fixes the price for its product by adding a fixed percentage profit margin to the average cost of production. The size of the profit margin may depend on factors including competition and the strength of demand

Cost-reducing innovations

Cost reducing innovations causing an outward shift in supply. They provide the scope for businesses to enjoy higher profit margins with a given level of demand

Diminishing returns

Addition of a variable factor to a fixed factor results in a fall in marginal product

Diseconomies of scale (internal)

A business may expand beyond the optimal size in the long run and experience diseconomies of scale. This leads to rising LRAC

Dis-synergies

Negative or adverse effects of a takeover or merger. E.g. disruptions that arise from the deal which result additional costs or lower than expected revenues

Economies of scale

Falling long run average cost as output increases in the long run

Economies of scope

Where it is cheaper to produce a range of products

Experience curve

Pattern of falling costs as production of a product or service increases, because the company learns more about it, workers become more skilful

External diseconomies of scale

When the growth of an industry leads to higher costs for businesses that are part of that industry – for example, increased traffic congestion

External economies of scale

When the expansion of an industry leads to the development of ancillary services which benefit suppliers in the industry – causing a downward sloping industry supply curve. A business might benefit from external economies by locating in an area in which the industry is already established

Exit cost

A barrier to exit – the costs associated with a business halting production and leaving a market - linked to the concept of sunk costs

Fixed cost

Business expense that does not vary directly with the level of output

Forward vertical integration

Acquiring a business further up in the supply chain – e.g. a vehicle manufacturer buys a car parts distributor

Marginal cost

The change in total costs from increasing output by one extra unit – the formula for MC is 'change in total cost divided by change in quantity

Marginal profit

The increase in profit when one more unit is sold or the difference between MR and MC. If MR = £20 and MC = £14 then marginal profit = £6

Marginal revenue

The change in total revenue from selling one extra unit of output

Normal profit

Normal profit is the transfer earnings of the entrepreneur i.e. the minimum reward necessary to keep her in her present industry. The activities of the entrepreneur are independent of the level of output. Normal profit is therefore a fixed cost, included in the average, not the marginal, cost curve

Profit

The excess of revenue over expenses; or a positive return on an investment.

Profit margin

The ratio of profit over revenue, expressed as a percentage. Mainly an indication of the ability of a company to control costs

Profit maximization

Profit maximization occurs when marginal cost = marginal revenue

Profit per unit

Profit per unit (or the profit margin) = AR – ATC. In markets where demand is price inelastic, a business may be able to raise price well above average cost earning a higher profit margin on each unit sold. In more competitive markets, profit margins will be lower because demand is price elastic

Shut down price

In the short run the firm will continue to produce as long as total revenue covers total variable costs or put another way, so long as price per unit > or equal to average variable cost (P>AVC)

Sub-normal profit

Any profit less than normal profit – where price < average cost

Sunk costs

Sunk costs cannot be recovered if a business decides to leave an industry. The existence of sunk costs makes a market less contestable.

Supernormal profit

A firm earns supernormal profit when its profit is above that required to keep its resources in their present use in the long run i.e. when price > average cost

Total cost

Total cost = total fixed cost + total variable cost

Total revenue

Total revenue (TR) is found by multiplying price (P) by output i.e. number of units sold. Total revenue is maximized when marginal revenue = zero

Variable cost

Variable costs are business costs that vary directly with output since more variable inputs are required to increase output. Also known as prime costs