Firms, Production, cost and revenue

Fixed cost (FC). A cost that does NOT change with the level of output.

• Rent on premises.
• Salaries (full-time managers).
• Insurance.
• Loan interest payments.

The firm pays these even if output is zero.

Variable cost (VC). A cost that CHANGES directly with output.

• Raw materials (more output = more materials).
• Hourly wages or piece-rate pay.
• Energy used in production.
• Packaging.

If output doubles, variable cost roughly doubles.

Total cost (TC) = TFC + TVC.

The firm's overall cost at a given output level.

Average total cost (ATC) = TC / Q.

Cost per unit. The firm needs price > ATC to make a profit on average.

Worked example. A bakery has TFC of $1,000 per week (rent + salaries). Variable cost is$0.50 per loaf (flour + energy). Output is 5,000 loaves.

• TVC = $0.50 × 5,000 =$2,500.
• TC = $1,000 +$2,500 = $3,500.
• ATC = $3,500 / 5,000 =$0.70 per loaf.

So if the bakery sells loaves for more than $0.70, it makes a profit.

Cambridge tip. Mark schemes for cost calculation reward 1 mark per formula step + 1 for the final answer. Show all working.

Total revenue (TR) = Price × Quantity.

If the firm sells 100 units at $20 each, TR =$2,000.

Profit = Total Revenue − Total Cost.

Profit is what's left for the firm's owners after paying all costs.

Worked example. A firm sells 100 units at $20 each. Total cost is$1,500.

• TR = $20 × 100 =$2,000.
• Profit = $2,000 −$1,500 = $500.

Profit categories:

• Profit > 0 (TR > TC). Firm is profitable.
• Profit = 0 (TR = TC). Break-even point.
• Profit < 0 (TR < TC). Firm makes a LOSS.

The firm's options when making a loss:

• Short term: continue if TR > TVC (covering variable costs at least). Fixed costs would be lost anyway.
• Long term: must cover all costs OR exit the market.

Cambridge tip. Mark schemes consistently distinguish revenue from profit. Don't confuse the two — TR is gross income; profit is what's left after costs.

Economies of scale. As a firm grows in size (and output rises), average cost per unit FALLS. The firm becomes more efficient.

Six main types:

1. Bulk-buying / purchasing economies. Larger firms buy raw materials in bulk → suppliers offer discounts → lower input cost per unit. e.g., a supermarket chain buying potatoes in volume pays less per kg than a local grocer.

2. Technical / production economies. Larger firms can use specialised, capital-intensive machinery and division of labour. The investment is justified at high output but not at low. e.g., a car factory using robotics.

3. Financial economies. Larger firms can borrow at LOWER interest rates because banks see them as less risky. e.g., a PLC borrows at 3%, a sole trader at 8%.

4. Managerial economies. Larger firms can afford specialist managers — HR, finance, marketing — each raising productivity in their domain. Small firms have one person doing everything.

5. Marketing economies. Advertising costs are spread over more units → lower advertising cost per unit.

6. Risk-bearing economies. Diversified firms (multiple products, multiple markets) can absorb a loss in one area without going under.

Diseconomies of scale.

Beyond a certain size, costs RISE again. Causes:

• Communication problems. With many employees, information takes longer to flow. Decisions slow.
• Coordination problems. Hard to align thousands of workers.
• Reduced motivation. Workers feel disconnected from purpose; productivity falls.
• Bureaucracy. Layers of management add cost without adding output.

The U-shape of average cost. As output rises, ATC first FALLS (economies dominate), reaches a MINIMUM, then RISES (diseconomies dominate). The minimum point is the firm's most efficient size.

Cambridge tip. Mark schemes for "economies of scale" questions expect 4-6 types depending on marks. The four most-credited are bulk-buying, technical, financial, managerial. Memorise these for full coverage.