Revenues, Costs & Profit

TR, AR, MR, TC, ATC, MC, normal & supernormal profit, efficiency — the numbers behind every firm decision

SPEC 3.2 • BUSINESS BEHAVIOUR

Why Revenue & Costs Are Everything

Every market structure diagram you will draw — perfect competition, monopoly, monopolistic competition, oligopoly — uses the same set of curves: AR, MR, MC, ATC. If you don't know what these curves mean and how they behave, you cannot access Level 3 on any firm behaviour essay.

Revenue curves

Cost curves

Profit / loss

Firm's output decision

Efficiency judgement

This lesson gives you every definition, every formula, every diagram relationship, and the shut-down rules. Master this and every market structure lesson that follows becomes dramatically easier.

Exam Tip

This is a ⭐ HIGH PRIORITY topic. Revenue and cost definitions appear as MCQ, short-answer, and as essential building blocks in 20/25-mark essays. Getting these wrong cascades into errors across all of Theme 3.

Revenue — Key Definitions

TOTAL REVENUE (TR)

The total income received by a firm from sales. TR = Price × Quantity.

AVERAGE REVENUE (AR)

Revenue per unit of output. AR = TR ÷ Q. Under normal conditions, AR equals the price (AR = P). The AR curve is the demand curve.

MARGINAL REVENUE (MR)

The additional revenue gained from selling one more unit of output.

TR = P × Q | AR = TR ÷ Q = P | MR = ΔTR ÷ ΔQ

Critical Relationship

For a price-taking firm (perfect competition): AR = MR = P — the demand curve is horizontal.

For a price-making firm (monopoly, oligopoly, monopolistic competition): MR is below AR and falls at twice the rate. To sell one more unit, the firm must lower the price on ALL units — so MR < AR.

AR & MR — The Geometry

For any firm with a downward-sloping demand curve, MR lies below AR with twice the gradient. This underpins every market structure diagram.

Examiner Alert

A very common error is drawing MR parallel to AR. MR must be steeper — it hits the quantity axis at exactly half the distance that AR does. Get this wrong and your entire monopoly/oligopoly diagram loses marks.

TR & MR — The Link

The relationship between total revenue and marginal revenue is crucial for understanding revenue maximisation:

When MR > 0

Each extra unit adds to total revenue → TR is rising. Demand is elastic in this region (PED > 1).

When MR = 0

The next unit adds nothing to revenue → TR is at its maximum. This is the revenue-maximising output. PED = 1 (unit elastic).

When MR < 0

Each extra unit reduces total revenue → TR is falling. Demand is inelastic in this region (PED < 1).

Key Implication

A rational firm never operates where MR < 0 — it would be losing revenue by selling more. This means a profit-maximising firm always operates on the elastic portion of its demand curve.

Costs — Key Definitions

FIXED COSTS (FC)

Costs that do not vary with output in the short run. Examples: rent, machinery, insurance, salaried staff.

VARIABLE COSTS (VC)

Costs that change directly with output. Examples: raw materials, hourly labour, energy per unit.

TC = FC + VC

MARGINAL COST (MC)

The additional cost of producing one more unit of output. MC = ΔTC ÷ ΔQ.

The Short Run vs Long Run

Short run: At least one factor of production is fixed (usually capital). Firms can change output only by adjusting variable factors.

Long run: All factors are variable. The firm can change its scale of production entirely — this is where economies of scale operate.

Average Costs — The Per-Unit Picture

ATC = TC ÷ Q | AFC = FC ÷ Q | AVC = VC ÷ Q

ATC = AFC + AVC

MeasureFormulaBehaviour

AFCFC ÷ QAlways falls as Q rises (spreading fixed costs over more units)

AVCVC ÷ QU-shaped — falls initially (specialisation), then rises (diminishing returns)

ATCTC ÷ QU-shaped — pulled down by falling AFC initially, then pulled up by rising AVC

MCΔTC ÷ ΔQU-shaped — falls initially, then rises. Cuts AVC and ATC at their minimum points

The MC Rule

MC intersects ATC at ATC's minimum point. When MC < ATC, ATC is falling. When MC > ATC, ATC is rising. This is a mathematical necessity — like how your average exam score only rises if your next mark is above average.

Short-Run Cost Curves — Diagram

Exam Tip

Always draw MC crossing ATC at ATC's lowest point. If your MC curve crosses ATC anywhere else, the entire diagram is wrong and you lose the diagram marks.

Why Are Cost Curves U-Shaped?

The answer is the law of diminishing marginal returns (also called diminishing marginal productivity).

LAW OF DIMINISHING RETURNS

In the short run, as additional units of a variable factor (e.g. labour) are added to a fixed factor (e.g. capital), the marginal product of the variable factor eventually falls.

Capital is fixed (short run)

Add more workers

Initially: specialisation ↑, MP rises

Eventually: overcrowding, MP falls

MC rises → AVC & ATC rise

Examiner Alert

Diminishing returns ≠ diseconomies of scale. Diminishing returns is a short-run concept (fixed factor). Diseconomies of scale is a long-run concept (all factors variable but coordination problems). Mixing these up is one of the most common errors in examiner reports.

Shut-Down Rules

When should a loss-making firm stop producing?

Short-Run Shut-Down

A firm shuts down in the short run if P < AVC.

Why? If price is below AVC, the firm can't even cover its variable costs. It loses more by producing than by shutting down and just paying fixed costs.

If AVC < P < ATC: the firm makes a loss but still continues operating in the SR because it covers all variable costs and some fixed costs.

Long-Run Exit

A firm exits the industry in the long run if P < ATC.

Why? In the long run, all costs are variable. If price is below average total cost, the firm cannot cover all its costs and will make persistent losses — it should exit.

Long-run equilibrium requires P ≥ ATC for the firm to remain in the market.

SR shut-down: P < AVC | LR exit: P < ATC

Normal & Supernormal Profit

NORMAL PROFIT

The minimum level of profit needed to keep a firm in its current industry. Where total revenue equals total cost (TR = TC). Economic profit = zero. Normal profit is included inside the ATC curve as a cost.

SUPERNORMAL (ABNORMAL) PROFIT

Profit above normal profit. Where total revenue exceeds total cost (TR > TC). Economic profit is positive. On a diagram: the rectangle (AR − ATC) × Q at the profit-maximising output.

Why This Distinction Matters

In perfect competition, supernormal profit is competed away in the long run (free entry → supply increases → price falls to ATC). In monopoly, supernormal profit can persist in the long run (barriers to entry prevent competition). This is the fundamental difference between market structures.

Normal profit: TR = TC (AR = ATC) | Supernormal: TR > TC (AR > ATC)

Supernormal Profit — Diagram

The profit rectangle is the single most important shape in all of Theme 3. Learn to draw this perfectly.

How to Read the Diagram

Step 1: Find MC = MR → read Q* down to the horizontal axis. Step 2: Read P* up from Q* to the AR curve. Step 3: Read ATC at Q*. Step 4: Supernormal profit = shaded rectangle = (P* − ATC) × Q*.

Loss-Making Firm — Diagram

When ATC lies above AR at the profit-maximising output, the firm makes a loss. The loss rectangle = (ATC − AR) × Q*.

Continue in SR?

If P > AVC: Yes — the firm covers variable costs and contributes to fixed costs. Shutting down would mean losing all fixed costs.

Exit in LR?

If P < ATC persists: Yes — the firm exits. In perfect competition, loss-making firms exit → supply falls → price rises → remaining firms return to normal profit.

Four Types of Efficiency

Every market structure question requires you to assess efficiency. There are four types — know the condition for each:

EfficiencyDefinitionCondition

AllocativeResources allocated to produce goods consumers most wantP = MC

ProductiveFirm produces at minimum average costP = min ATC

DynamicEfficiency over time through R&D, innovation, new technologyRequires supernormal profit to fund investment

X-inefficiencyFirm fails to minimise costs due to lack of competitive pressureATC is above minimum — organisational slack

Examiner Alert

From examiner reports: "Candidates who refer vaguely to 'efficiency' without specifying which type score maximum Level 2." Always name the type and state the condition: "Allocatively inefficient because P > MC."

Worked Calculation — Revenue, Cost & Profit

A firm sells 500 units at a price of £12 each. Its total fixed costs are £2,000 and variable cost per unit is £6.

StepCalculationAnswer

Total RevenueTR = P × Q = £12 × 500£6,000

Total Variable CostTVC = AVC × Q = £6 × 500£3,000

Total CostTC = FC + VC = £2,000 + £3,000£5,000

Profitπ = TR − TC = £6,000 − £5,000£1,000 (supernormal)

Average RevenueAR = TR ÷ Q = £6,000 ÷ 500£12

Average Total CostATC = TC ÷ Q = £5,000 ÷ 500£10

Profit per unitAR − ATC = £12 − £10£2

Check

Profit per unit × Q = £2 × 500 = £1,000 ✓ — matches total profit. AR > ATC confirms supernormal profit.

Common Errors — Examiner Reports

Examiner Alert

Drawing MR parallel to AR — MR must be steeper, hitting the Q-axis at half the distance of AR. This is the most common diagram error in monopoly questions.

Confusing diminishing returns with diseconomies of scale — Diminishing returns = short-run, fixed factor. Diseconomies = long-run, all factors variable but coordination problems.

Saying "efficiency" without specifying which type — Name it: allocative (P = MC), productive (min ATC), dynamic (R&D), or X-inefficiency.

Forgetting that normal profit is inside ATC — Normal profit is a cost. When AR = ATC, the firm earns normal profit (not zero profit in the everyday sense). Many students confuse economic and accounting profit.

Not labelling the profit/loss rectangle — The supernormal profit rectangle (or loss rectangle) must be clearly shaded and labelled for diagram marks.

Ignoring shut-down rules — A firm making a loss in the SR does NOT automatically shut down. It continues if P > AVC.

Practice Question

A firm operates in a market where it faces a downward-sloping demand curve. At its current output of 200 units:

Price = £20 | ATC = £18 | MC = £15 | MR = £15

(a) Calculate the firm's total supernormal profit. (2 marks)

(b) Explain whether this firm is profit maximising. (2 marks)

(c) Explain whether the firm is allocatively efficient. (2 marks)

(d) Explain one reason why supernormal profit may persist in the long run. (3 marks)

(a)

Supernormal profit = (AR − ATC) × Q = (£20 − £18) × 200 = £400.

(b)

Yes, the firm is profit maximising because MC = MR = £15. At this output, the cost of producing one more unit equals the revenue gained — the firm cannot increase profit by changing output.

(c)

No, the firm is allocatively inefficient. Allocative efficiency requires P = MC. Here, P = £20 and MC = £15, so P > MC. The firm is charging a price above the marginal cost of production — resources are under-allocated to this good relative to consumer preferences.

(d)

Supernormal profit may persist if there are high barriers to entry — for example, high sunk costs, patents, or strong brand loyalty. These prevent new firms from entering the market and competing away the supernormal profit, as would occur under perfect competition. This is characteristic of a monopoly or oligopoly market structure.

AO4 Evaluation Toolkit

Use these evaluative points in essays on firm behaviour, profit, and efficiency:

1. Dynamic Efficiency Trade-Off

"Although monopoly is allocatively and productively inefficient in the static sense, supernormal profit may fund R&D and innovation — delivering dynamic efficiency that benefits consumers in the long run."

2. Short Run vs Long Run

"Supernormal profit in the short run does not necessarily persist. In markets with low barriers to entry, new entrants will shift supply right → price falls → profits are competed to normal."

3. X-Inefficiency Counter

"Even if a firm is theoretically at MC = MR, without competitive pressure it may operate with X-inefficiency — costs are higher than necessary because management lacks the incentive to minimise them."

4. Contestability

"The extent of supernormal profit depends on contestability. If sunk costs are low, even a firm with high market share may price near competitive levels to deter potential entrants."

5. Natural Monopoly Exception

"In industries with very high fixed costs and falling LRAC (natural monopoly), a single firm may achieve lower average costs than multiple competitors — productive efficiency is better served by monopoly."

Summary

Revenue & Cost Formulae

MeasureFormulaKey Rule

TRP × QMaximised when MR = 0

ARTR ÷ Q = PAR = demand curve

MRΔTR ÷ ΔQMR < AR for price makers (twice as steep)

TCFC + VC—

ATCTC ÷ QU-shaped; min ATC = productive efficiency

MCΔTC ÷ ΔQCuts ATC at its minimum

Profit Conditions

Profit max: MC = MR

Normal profit: AR = ATC

Supernormal: AR > ATC

Loss: AR < ATC

SR shut-down: P < AVC

Efficiency Conditions

Allocative: P = MC

Productive: P = min ATC

Dynamic: supernormal profit → R&D

X-inefficiency: lack of competition → slack

The Most Important Thing to Remember

Every market structure diagram uses the same curves: AR, MR, MC, ATC. What changes is the shape of AR and MR (horizontal in perfect competition, downward-sloping in monopoly) and whether supernormal profit persists. Master these curves once, and you've mastered the foundation of all of Theme 3.