A2 Economics – Microeconomics revision notes

Formula sheets

Average Total Cost (ATC) = Total Cost / Q (Output is quantity produced or ‘Q’)

Average Variable Cost (AVC) = Total Variable Cost / Average Fixed Cost (AFC) = ATC – AVC

Total Cost (TC) = (AVC + AFC) X Output (Which is Q)

Total Variable Cost (TVC) = AVC X Output

Total Fixed Cost (TFC) = TC – TVC

Marginal Cost (MC) = Change in Total Costs / Change in Output

Marginal Product (MP) = Change in Total Product / Change in Variable Factor

Marginal Revenue (MR) = Change in Total Revenue / Change in Q

Average Product (AP) = TP / Variable Factor

Total Revenue (TR) = Price X Quantity

Average Revenue (AR) = TR / Output

Total Product (TP) = AP X Variable Factor

Economic Profit = TR – TC > 0

A Loss = TR – TC < 0

Break Even Point = AR = ATC

Profit Maximizing Condition = MR = MC

A2 Economics – Microeconomics revision notes

Chapter 1
What objectives do firms have?

P – Profit maximisation
 The point where the revenue gained from selling one more unit of output (MR) is exactly equal to the cost of
producing one more unit of output (Marginal cost, MC)  MR = MC/
R – Revenue maximisation
 Cuts its price down to the point where the extra revenue received from selling another unit is balanced by
the reduced price on every item  MR = 0
o If MR = 0  there are no variable costs  it might be the same as profit maximisation because if MR
= 0 and MC = 0, then MR = MC
 Revenue maximisation may be acceptable in certain circumstances
o If a firm is going to have to dispose of all of its stock then effectively costs are not relevant  flower
seller
o If a firm is owned and managed by different people  shareholders (Owners) may want profit
maximisation whereas managers may be paid according to how much they made or sold  so would
want revenue maximisation
o If a firm is about to be taken over by another firm it may be valued on the basis of its revenue
S – Sales maximisation
 Avoid attention of the competition authorities  if a firm is making a lot of profit they may be subject to
investigation
 High level of profitability might attract other firms into the market  cutting prices and selling more, new
entry is stopped

Why do firms grow?

Benefits of growth

E – Economies of scale  larger firms often have lower costs per unit of output in the long run

M – Market share  a larger firm has more market power, can control prices and retain customer loyalty  a larger
market share also means that the treat of competitors is reduced

E – Economies of scope  larger firms are less vulnerable to economic shocks if they are not narrowly focused

P – Psychological factors  a larger firms tends to carry a good reputation

How do firms grow

H – Horizontal integration firms merge at the exact same stage of the same production process  Kraft and
Cadbury  $11.9 billion

V  Vertical integration  firms merge at different stages of the production process

 Backward VI  One firm is buying another that is closer to the raw material stage of production
 Forward VI  buying another firm in the same production process but closer to the customer

C  Conglomerate integration or diversification  Firm buys another in a completely unrelated business  Virgin
A2 Economics – Microeconomics revision notes
Revenues

Price maker  a firm which has so much power that it sets the price within the market for other firms to follow

Price taker  has to sell its product at a set price

 Total revenue curve for a price a price taker is a parabola

 MR < AR  because if price is cut the firm loses money on all items it is already selling
 Average revenue  a price taker has a horizontal demand curve which is perfectly elastic
 Average revenue  downward sloping demand curve, MR on the same graph with a gradient which is twice
as steep

Costs in the short-run

Marginal costs
 Cricket game analogy
 If MC < AC  AC decreases
 If MC = AC  AC stays the same
 If MC > AC  AC increases
 The increasing marginal cost explains the law of diminishing marginal returns

Law of diminishing marginal returns

Law of diminishing marginal returns  as increasing units of a variable factor are added to a fixed factor, the
marginal product falls

Marginal product  is the extra output when one more factor of output is added

 LofDMR only applies in the SR  all factor are fixed

 In LR  variable
A2 Economics – Microeconomics revision notes
A2 Economics – Microeconomics revision notes
A2 Economics – Microeconomics revision notes

Costs in the long-run

Economies of scale

M – Managerial
 Larger firms can afford better managers (Risk takers) which may lead to better management, higher profits
and long-term sustainability
F – Financial
 Larger firms have a wider range of credit than small firms and at a lower price
 Because they have more collateral, larger firms are seen as a safer bet than smaller firms

M –Marketing
 Cost of advertising is more spread out over a larger number of potential customers
 Companies such as Apple which have a lot of brand recognition  advertising for one product effectively
advertises all of their other products

C – Commercial
 Large firms can bulk-buy from their suppliers
 Because they buy a large amount at a steady rate they are likely to get better deals

T – Technical
 A larger warehouse or lorry can carry much more per square metre

Diseconomies of scale

U – Unwieldiness
 Large firms can become difficult to manage 
o Harder to implement decisions
o Lack of co-ordination
o Lack of co-operation
 Unions can be more powerful in a large organisation because they have a greater ability to influence working
positions

C – Communication
 Harder to communicate to others

L – Lack of engagement
 In a large organisation the management may be very distant from the workers
 Workers may be less loyal to management and the purposes of the firm

X – X-inefficiency
 Lack of competition for a large firm may mean costs can rise
A2 Economics – Microeconomics revision notes

Efficiency

P – Productive efficiency
 Firm operates on the lowest average cost (Lowest pt. on the average cosy curve)
 If price = AC  customers can enjoy this price
 In terms of consumer surplus and effective use of FoP  this is optimum output
 Little incentive for firms to produce at this level and little incentive lower the price this far
 MC = AC  MC always crosses AC at its lowest point

A – Allocative efficiency
 Price = MC  people are paying amount it costs to produce the last unit
 If consumer satisfaction for the last unit is less than the cost of production  production should fall
 Pe kicks in at a lower output than Ae  as demand curves are downward sloping

X – X-inefficiency
 Costs rise because there is no competition  esp. those which are subsidised/owned by the public sector
 When costs start rising there is no incentive to cut back
 If wages and employment are not dependent on revenues the workers might not work as hard to raise the
volume of sales

Profit

N – Normal profit 
 Minimum necessary to keep the risk-taking resources
 It is built into the average cost curve
 Normal profit  AC = AR OR TC = TR
 Size of normal profit varies according to the level of risk involved and the invest opportunities available

S – Supernormal profit 
 This is the profit above the minimum required to stay in business
 It is the difference between TR and TC

Profit maximisation

 Firm cannot increase its profits either by increasing or decreasing price or output
 Profit maximisation point  MR = MC  MR - MC = 0
 MR = MC when the gradients of the TC and TR curves are the same
 Because they are concave to each other they must also be at the point where they are furthest apart
 Occurs when the cost of making one more unit is exactly equal to the revenue gained from that unit

 At a lower output MR > than the cost of producing that output  there is more profit to be made
 Marginal profit is greater than zero
 A rational firm would not stop producing when MR > MC as there is more money to be made

 If a firm is producing at an output higher than MR = MC

 Cost of making another unit is more than the revenue made from selling it
 The marginal profit is negative
 The firm should cut back production
A2 Economics – Microeconomics revision notes

Barriers to entry and exit

Barriers to entry  any obstacles that prevent a firm setting up or extending its reach into new markets

Barriers to exit  any factors which prevent firms’ leaving market or make it more unprofitable to stay on business
even if they are operating at a loss

1 – Some are deliberately imposed and can be seen by the regulators as illegal anti-competitive measures
- Predatory pricing
- Limit pricing

2 – Many barriers to entry exist sim0ly due to the nature of the business or the market
- Economies of scale, minimum efficient scale

3 – Some barriers to entry are actually imposed by the authorities in cases where too much competition might be
seen as working against the interest of the consumer
- Legal barriers such as patents
- State-owned franchises, such as the train operating companies
- Legislation to allow firms to operate such as 4G licences

IF THE BARRIERS TO ENTRY ARE HIGH THE FIRMS ARE LIKELY TO BE OPERATING WITH STRONG MARKET
POWER

IF THE BARRIERS TO ENTRY ARE HIGH BUT NOT IMPOSSIBLE TO OVERCOME THE FIRMS ARE LIKELY TO BE
OPERATING IN AN OLIGOPOLY

IF BARRIERS TO ENTRY ARE LOW FIRMS MIGHT BE IN MONOP0OLISTIC COMPETITION

IF THERE ARE NO BARRIERS TO NTRY AND EXIT THE MARKET IS PERFECTLY CONTESTABLE

Measuring market concentration

Do not include ‘Other’ in your calculations even though it might occupy a large space

Term Formula Explanation

Total profit TR – TC OR (AR- Supernormal, abnormal or subnormal (A loss)
AC) X Q
Normal profit TR = TC OR AR = Return to the entrepreneur is built into the cost curve, which is just
AC enough to keep the entrepreneur in this function
Profit maximisation MR = MC Marginal profit is zero; or the difference between TR and TC is at a
maximum
Sales maximisation AC = AR or TR = Highest level of output consistent with normal profits
TC when costs cross
revenue from below
Revenue MR = 0 Maximum total revenue  selling another unit adds the same to
maximisation total revenue as the amount lost from units being sold at a lower price
Price taker/perfectly AR = MR TR straight line is going through zero, AR & MR horizontal  PED =
elastic demand infinite
Price AR > MR AR downward sloping, MR twice gradient. The firm has some degree
maker/monopoly of price-setting power
Break even AR = AC Firm covers costs, and makes only normal profit
Productive efficiency MC = AC Minimum point on AC, lowest cost per unit
A2 Economics – Microeconomics revision notes