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Operating leverage
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The operating leverage is a measure of how revenue growth translates into growth in operating income. It
can be a ratio of fixed costs to variable costs incurred to generate the revenue. Depending on the product,
it can be generated by the ratio of preproduction costs (e.g. design widgets) versus incremental production
costs (e.g. produce a widget).
The two, fixed costs and variable costs are the operating expenses. The ratio between the two determines
how growth in revenue impacts the operating margin. If the variable costs are all the operating costs, then
the operating margin would be constant as sales grow. A 10% increase in revenue generates a 10%
increase in operating income. If, however, fixed costs are high, then a 10% increase in revenue will
generate quite a bit more than 10% increase in operating earnings, essentially increasing the operating
margin.
Fixed cost
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Fixed costs are expenses whose total does not change in proportion to the activity of a business, within
the relevant time period or scale of production. For example, a retailer must pay rent and utility bills
irrespective of sales to be considered part of fixed costs, but treated differently. Unit fixed costs decline
with volume, following a rectangular hyperbola as the inverse of the volume of production.
Variable costs by contrast change in relation to the activity of a business such as sales or production
volume. In the example of the retailer, variable costs may primarily be composed of inventory (goods
purchased for sale), and the cost of goods is therefore almost entirely variable. In manufacturing, direct
material costs are an example of a variable cost.
Along with variable costs, fixed costs make up one of the two components of total cost. In the most
simple production function, total cost is equal to fixed costs plus variable costs.
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In microeconomics and business, the difference between fixed costs and variable costs (and the related
terms average cost and marginal cost) is crucial, as each will influence production decisions for profit
maximization differently. In the most simple cases, fixed costs do not affect production decisions,
because they cannot be changed, and management will choose to produce if sales prices are above the
cost of each additional unit (marginal cost).
Fixed costs should not be confused with sunk costs. From a pure economics perspective, fixed costs may
not be fixed in the sense of invariate; they may change, but are fixed in relation to the quantity of
production for the relevant time period. For example, a company may have unexpected and unpredictable
expenses unrelated to production, and these would not be considered part of variable costs.
Sunk cost
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Please discuss this issue on the talk page or replace this tag with a more specific message.
This article has been tagged since January 2006.
In economics and in business decision-making, sunk costs are costs that have already been incurred and
which cannot be recovered to any significant degree. Sunk costs are sometimes contrasted with variable
costs, which are the costs that will change due to the proposed course of action. In microeconomic theory,
only variable costs are relevant to a decision. Economics proposes that a rational actor does not let sunk
costs influence one's decisions, because doing so would not be assessing a decision exclusively on its own
merits. It is important to note that the decision-maker may make rational decisions according to their own
incentives; these incentives may dictate different decisions than would be dictated by efficiency or
profitability, and this is considered an incentive problem and distinct from a sunk cost problem.
For example, when one pre-orders a non-refundable movie ticket, the price of the ticket becomes a sunk
cost. Even if the ticket-buyer decides that he would rather not go to the movie, there is no way to get back
the money he originally paid.
Perfect competition
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Perfect competition is an economic model that describes a hypothetical market form in which no producer
or consumer has the market power to influence prices. According to the standard economical definition of
efficiency (Pareto efficiency), perfect competition would lead to a completely efficient outcome. The
analysis of perfectly competitive markets provides the foundation of the theory of supply and demand.
Consumer surplus
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It has been suggested that this article or section be merged into Economic surplus.
(Discuss)
Graph illustrating consumer (red) and producer (blue) surpluses on a supply and
demand chart
Consumer surplus or Consumer's surplus (or in the plural Consumers' surplus) is the difference between
the price consumers are willing to pay (or reservation price) and the actual price. If someone is willing to
pay more than the actual price, their benefit in a transaction is how much they saved when they didn't pay
that price. For example, a person is willing to pay a tremendous amount for water since he needs it to
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survive, however since there are competing suppliers of water he is able to purchase it for less than he is
willing to pay. The difference between the two prices is the consumer surplus.
Deadweight loss
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Deadweight loss created by a binding price ceiling. Producer surplus is necessarily
decreased, while consumer surplus may or may not increase; however the decrease in
producer surplus must be greater than the increase (if any) in consumer surplus.
In economics, a deadweight loss (also known as excess burden) is a loss of economic efficiency that can
occur when equilibrium for a good or service is not Pareto optimal. In other words, either people who
would have more marginal benefit than marginal cost are not buying the good or service or people who
would have more marginal cost than marginal benefit are buying the product.
Causes of deadweight loss can include monopoly pricing (see artificial scarcity), externalities, taxes or
subsidies (Case and Fair, 1999: 442), and binding price ceilings or floors. The term deadweight loss may
also be referred to as the "excess burden of monopoly" or the "excess burden of taxation".
[edit] Example
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For example, consider a market for nails where the cost of each nail is 10 cents and that the demand will
decrease linearly from a high demand for free nails to zero demand for nails at $1.10. In a perfectly
competitive market, producers would have to charge a price of 10 cents and every customer whose
marginal benefit exceeds 10 cents would have a nail. However if only one producer has a monopoly on
the product, then they will charge whichever price will yield the highest profit. For this market, the
producer would charge 60 cents and thus exclude every customer who had less than 60 cents of marginal
benefit. The deadweight loss is then the economic benefit forgone by these customers due to the
monopoly pricing.
Conversely, deadweight loss can also come from consumers buying a product even if it costs more than it
benefits them. To see this, let's use the same nail market, but instead it will be perfectly competitive with
the government giving a 3 cent subsidy to every nail produced. This 3 cent subsidy will push the market
price of each nail down to 7 cents. Some consumers then buy nails even though the benefit to them is less
than the real cost of 10 cents. This unneeded expense then creates the deadweight loss.
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