Firms' costs, revenue and objectives

Key learnings

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  Fixed vs variable costs

  A fixed cost does not change as output changes in the short run — rent, insurance, managers' salaries. A variable cost changes directly with output — raw materials, electricity used in production, hourly wages. Total cost (TC) = total fixed cost + total variable cost. As output rises, total fixed cost stays the same while total variable cost rises, so total cost rises. Learn one clear example of each, because examiners reward precise classification.

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  Average cost vs total cost

  Average cost (AC) — also called average total cost — is the cost per unit: $AC = \dfrac{TC}{Q}$, where $TC$ is total cost and $Q$ is quantity. Average cost and total cost can move in opposite directions: buying machinery raises total cost but, if output rises by more, average cost per unit falls. That is the heart of economies of scale — falling average cost as a firm grows. Never treat total cost and average cost as the same thing.

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  Total and average revenue

  Total revenue (TR) is the money received from sales: $TR = \text{price} \times \text{quantity sold}$. Average revenue (AR) is revenue per unit: $AR = \dfrac{TR}{Q}$, which equals the price when every unit sells at the same price. Profit = total revenue minus total cost. Link revenue to price elasticity of demand (PED): if demand is price-inelastic, raising the price raises total revenue; if demand is price-elastic, raising the price lowers total revenue.

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  Objectives of firms

  The 0455 objectives of a firm are: survival (a new firm staying in business through hard early years), growth (more size and market share, bringing economies of scale and market power), profit maximisation (the largest gap between total revenue and total cost — the usual assumption for private firms), and social welfare (acting in consumers' or society's interest, common for state-owned firms or charities). A firm may switch objective over time.