Download Theory of the Firm-Revenue

THE THEORY OF THE FIRM:
COSTS, REVENUES AND PROFITS
REVENUE THEORY
IB Economics
A Course Companion 2009
REVENUE THEORY
Revenue is the income that a firm receives from
selling its products, goods and services over a
certain period of time
Revenue may be measured in three ways:
1. Total Revenue (TR)
2. Average Revenue (AR)
3. Marginal Revenue (MR)
Total Revenue (TR)
• TR is the total amount of money that a firm
receives from selling a certain quantity of a
good or service in a given time period.
• It is calculated using the formula:
TR = p (the price of the good/service) x q (quantity)
Example: If a firm sells 400 pizzas per week, at a price
of $6 per pizza than TR = $2400.
Average Revenue (AR)
• AR is the revenue that a firm receives per unit of
sales. It is calculated using the formula:
AR + TR (Total Revenue p x
q (Quantity)
q)
Since TR is (p x q), q is common to the top and
bottom of the formula, so AR is the same as p.
400 pizzas at $6 each AR= $2400 / 400 = $6
Marginal Revenue (MR)
• MR is the extra revenue that a firm gains
when it sells one more unit of a product in a
given time period. It is calculated by using the
formula:
MR = __ TR___ where
q
means “the change in”
Marginal Revenue (MR)
Example
• A pizza firms decides to lower the price of pizzas
from $6 to $5. Weekly sales increased as follows:
MR = $2500 – 2400 = $100 = $1
100
100
The extra revenue gain from selling an extra unit is
$1
Revenue Curves and Outputs
1. Revenue when price does not change with
output (elasticity of demand = infinite)
• If a firm does not have to lower price as output
increases and it wishes to sell more of its
product, then if faces a perfectly elastic demand
curve.
• This situation only happens in theory, but is very
useful for economists when they are building
their models of how markets work and they
start with the theoretical market form of perfect
competition.
REVENUE FOR A FIRM WITH A
PERFECTLY ELASTIC DEMAND CURVE
Assumptions
The firm is very small in terms of the size of the whole industry and they can
increase their output without affecting total industry supply, and thus price,
in any significant way. Therefore the firm can sell all that it produces at the
same price.
PRICE ELASTICITY OF
DEMAND – INFINITE :
REVENUE THEORY
When the price
elasticity of demand
is perfectly elastic,
the price, average
revenue, marginal
revenue and
demand are all the
same. In this case,
they are all $5.
Total revenue
increases at a
constant rate as
output increases.
Revenue Curves and Outputs
2. Revenue when price falls as output increase
(when the demand curve is downward
sloping i.e when elasticity of demand falls as
output increases)
• If a firm wishes to sell more of its output and
it can control the price at which it sells, then
it will have to lower the price if it wants to
increase demand.
Revenue when price
falls as output increases
If a firm wishes to
sell more of its
output and it can
control the price at
which it sells, then it
will have to lower
the price if it wants
to increase demand.
The firm will
face a downward
sloping demand
curve.
Output, revenue and PED figures for a firm with a normal
demand curve
REVENUE THEORY
Average revenue (AR) has
obvious correlation with price
and so it falls as output
increases, since the price has to
be lowered in order to sell more
products. This is shown where
demand curve is now labelled
D=AR.
Marginal Revenue (MR) also falls
as output increases, but at a
greater rate than AR. As shown
in the graph the MR curve is
twice as steeply sloping as the AR
Curve and also goes below the xaxis. This is a relationship that
holds for all downward sloping
AR curves and the MR curves
that relate to them.
Why is MR below AR in graphical
analysis?
• MR is below AR because in order to
sell more products, the firm has to
lower the price of all products sold,
losing revenue on the ones that
could have been sold at a higher
price in order to get the revenue
from the extra sales.
Total Revenue in Graphical Analysis
• For a normal, downward-sloping demand
curve, TR rises at first but will eventually start
to fall as output increases.
• This is because the extra revenue gained from
dropping the price and selling more units is
outweighed by the loss in revenue from the
units that were being sold at a higher price
and now have to be sold at the lower price.
Relationship between the value of
PED for a Demand Curve & TR
• The knowledge of the relationship between
the value of PED for a demand curve and TR is
very useful for firms when they are trying to
assess the impact that a change in price of
their product will have upon the total revenue
they receive.
Inelastic Demand & Total Revenue
• If the firm raises prices and the demand is
inelastic then the firm will find that total
revenue will increase, because the increase in
price will see a relatively smaller fall in the
quantity demanded.
Elastic Demand and Total Revenue
• If the firm raises price and demand is elastic then
the firm will find that total revenue will decrease,
because the increase in price will cause a
relatively larger fall in the quantity demanded.
• If a firm knows whether their demand is elastic
or inelastic they know what pricing policy to
adopt to increase their revenue.
ELASTICITY AND REVENUE POLICY
1. When PED is elastic any firm wishing to
increase revenue should lower its price.
2. When PED is inelastic any firm wishing
to increase revenue should increase its
price.
3. When PED is unity then any firm
wishing to increase revenue should
leave the price unchanged, since
revenue is already maximised.
Draw a graph to graphically model this
data. Clearly label all graphs.