# Revenue, costs and profits

> Edexcel International A-Level Economics · 2018 Edexcel IAL Economics Unit 3
> Source: https://www.owlsprep.com/study/edexcel-ial-economics-u3-revenue-costs-and-profits/

This guide covers all core Edexcel IAL Economics Unit 3 revenue, cost and profit content, including formulae, curve relationships, economies of scale, and profit calculations required for your 2018 spec exams.

**Prerequisites:** [Basic demand and supply, and price elasticity of demand (PED)](https://www.owlsprep.com/study/edexcel-ial-economics-u1-demand-supply-ped/); [Introduction to business behaviour and objectives](https://www.owlsprep.com/study/edexcel-ial-economics-u3-introduction-to-business-behaviour/)

## Learning objectives

- Calculate total, average and marginal revenue, and explain the PED-revenue relationship
- Derive short-run cost curves from the law of diminishing returns, and interpret cost curve relationships
- Distinguish between short-run and long-run costs, and explain sources of economies and diseconomies of scale
- Calculate normal profit, supernormal profit and loss, and identify shutdown points in the short and long run
- Draw and label required revenue, cost and profit diagrams for exam questions
- Apply knowledge to respond to Edexcel IAL command words including calculate, explain, analyse and evaluate

## Revenue Concepts & PED-Revenue Relationship

**Revenue Metrics** — Total Revenue (TR) = Price × Quantity sold; Average Revenue (AR) = TR/Q = Price; Marginal Revenue (MR) = Change in TR / Change in Quantity sold. For price-taking firms, AR and MR are horizontal and equal. For price-making firms, AR is downward sloping (equal to demand) and MR is twice as steep, lying below AR.

*Example:* If a firm sells 50 units at £10 each, TR = £500, AR = £10

The relationship between PED and TR is frequently tested: when demand is price elastic (|PED| > 1), a fall in price increases total revenue. When demand is price inelastic (|PED| < 1), a rise in price increases total revenue. Total revenue is maximised when PED = 1 (unit elasticity).

**Worked example:** A café sells 100 coffees at £3 each, then cuts price to £2.80 and sells 120 coffees. Calculate TR before and after the price change, MR of the extra 20 coffees, and state if demand is elastic or inelastic.

1. Calculate initial total revenue: TR₁ = 100 × £3 = £300
2. Calculate new total revenue: TR₂ = 120 × £2.80 = £336
3. Calculate marginal revenue: MR = ΔTR/ΔQ = (£336 - £300)/(120 - 100) = £36/20 = £1.80
4. Calculate PED: %ΔQ = 20%, %ΔP = -6.67%, |PED| = 3 > 1, so demand is elastic, and the price cut increased TR as expected (a price fall raises revenue when demand is elastic).

> **Exam tip:** When calculating MR for price-making firms, never use the price of the last unit alone: price cuts apply to all units sold, so MR is always lower than price for downward sloping demand curves.

## Short-Run Costs & Diminishing Returns

**Law of Diminishing Returns** — In the short run, at least one factor of production (e.g. factory space) is fixed. As more variable factors (e.g. labour) are added, marginal product first rises (specialisation gains) then falls, leading to rising marginal costs after a certain output level. This gives MC, AC and AVC curves their U-shape.

*Example:* Adding extra baristas to a small café first speeds up service, but eventually workers get in each other’s way, reducing productivity per worker.

Short-run cost categories: Total Fixed Cost (TFC) = costs that do not change with output (e.g. rent); Total Variable Cost (TVC) = costs that change with output (e.g. raw materials); Total Cost (TC) = TFC + TVC. Average Fixed Cost (AFC) = TFC/Q (always falls as output rises); Average Variable Cost (AVC) = TVC/Q; Average Cost (AC) = TC/Q = AFC + AVC; Marginal Cost (MC) = ΔTC/ΔQ.

**Worked example:** A bookstore has fixed costs of £150 per day, and variable costs of £2 per book sold. Calculate AFC, AVC, AC and MC for 100 books sold, and 200 books sold.

1. For Q=100: TFC=£150, TVC=100×£2=£200, TC=£350. AFC=£150/100=£1.50, AVC=£200/100=£2, AC=£350/100=£3.50, MC=(£350 - £150)/100 = £2
2. For Q=200: TFC=£150, TVC=200×£2=£400, TC=£550. AFC=£150/200=£0.75, AVC=£400/200=£2, AC=£550/200=£2.75, MC=(£550 - £350)/100 = £2
3. AFC falls as output rises, while AVC and MC are constant in this output range, as no diminishing returns have set in yet.

> **Exam tip:** When drawing short-run cost curves, always label MC crossing AC and AVC exactly at their minimum points. You will lose 2 marks if you draw this intersection incorrectly.

## Long-Run Costs & Economies of Scale

**Long-Run Average Cost (LRAC) Curve** — Shows the lowest possible average cost of producing each output level when all factors of production are variable. The curve falls during economies of scale, is flat at the minimum efficient scale (MES), and rises during diseconomies of scale.

*Example:* A car manufacturer’s LRAC falls as it increases output from 10,000 to 50,000 units, then starts rising at output above 100,000 units.

Internal economies of scale sources include: financial (lower interest rates on loans), technical (specialised machinery), managerial (specialised staff), marketing (bulk advertising discounts), purchasing (bulk raw material discounts), risk-bearing (product line diversification). External economies of scale are industry-wide benefits, e.g. local skilled labour pools or shared infrastructure. Diseconomies of scale sources include poor communication, coordination issues, and X-inefficiency from lack of competition.

**Worked example:** A supermarket chain’s LRAC falls from £1.20 per item sold at 1 million weekly units to £0.90 per item at 5 million weekly units, then rises to £1.05 per item at 10 million weekly units. Identify the EoS and DoS ranges, and explain one internal EoS source driving falling LRAC.

1. Economies of scale range: 1 million to 5 million units, as LRAC falls as output rises.
2. Diseconomies of scale range: 5 million to 10 million units, as LRAC rises as output rises.
3. Purchasing economies: The supermarket can buy stock in larger bulk at lower per-unit costs when serving more customers, reducing average costs.

> **Exam tip:** When analysing economies of scale in extended answers, always link the specific source to lower average costs, not just name the source, to earn full KAA marks.

## Profit Calculations & Shutdown Points

**Profit & Shutdown Metrics** — Normal profit is counted as part of AC, so supernormal profit = (AR - AC) × Q. A loss occurs when AR < AC. Short-run shutdown point: P < AVC (firm cannot cover variable costs, so operating leads to larger losses than paying only fixed costs). Long-run shutdown point: P < AC (all costs are variable, so firm exits the industry to avoid losses).

*Example:* If AR = £12, AC = £15, AVC = £10, the firm makes a £3 per unit loss but should stay open in the short run, as it covers AVC and contributes £2 per unit to fixed costs.

Profit questions often require you to use cost and revenue values to identify if a firm is making supernormal profit, normal profit, or a loss, and advise on whether it should operate or shut down. Remember that in the short run, fixed costs are sunk costs, so they are irrelevant to the shutdown decision.

**Worked example:** A furniture manufacturer has AC = £180 per table, AVC = £110 per table, and sells tables for £130 each in the short run. Calculate if the firm makes supernormal profit or loss, and state if it should shut down in the short run.

1. AR = £130 < AC = £180, so the firm makes a loss of £50 per table.
2. AR = £130 > AVC = £110, so the firm covers all variable costs, and contributes £20 per table to fixed costs.
3. The firm should continue operating in the short run, as shutting down would mean it loses all fixed costs, which is a larger loss than operating.

> **Exam tip:** Always clearly distinguish between short-run and long-run shutdown points in exam answers: mixing these up is one of the most common marks-losing mistakes for this topic.

## Common pitfalls

- **Wrong:** Calculating marginal revenue as the price of the last unit sold for price-making firms.
  - Why it fails: When a price maker cuts price to sell more units, the price cut applies to all units sold, not just the extra unit, so MR is lower than the price of the last unit.
  - Correct: Always calculate MR as the change in total revenue divided by the change in quantity sold, for all firm types.
- **Wrong:** Drawing the MC curve crossing AC and AVC above their minimum points.
  - Why it fails: The marginal-average relationship means marginal pulls average up or down, so MC only crosses average cost curves at their minimum. Drawing this incorrectly loses 2 diagram marks.
  - Correct: Label MC intersecting AC and AVC exactly at their lowest points on all short-run cost curve diagrams.
- **Wrong:** Stating that normal profit is zero accounting profit.
  - Why it fails: Normal profit is counted as an implicit cost of production, so when a firm makes normal profit, accounting profit is positive, while economic profit is zero.
  - Correct: Define normal profit as the minimum return required to keep a firm in the industry, separate from zero accounting profit.
- **Wrong:** Confusing short-run and long-run shutdown points, saying a firm shuts down when P < AC in the short run.
  - Why it fails: In the short run, fixed costs are sunk, so a firm will keep operating as long as it can cover variable costs, even if it makes a loss on fixed costs.
  - Correct: Short-run shutdown = P < AVC; long-run shutdown = P < AC, as all costs are variable in the long run.
- **Wrong:** Naming economies of scale sources without linking to lower average costs in analysis questions.
  - Why it fails: Edexcel examiners require a clear chain of reasoning, just naming a source like 'purchasing economies' only earns 1 mark, not full KAA marks.
  - Correct: Use a clear chain: e.g. 'Larger firms buy raw materials in bulk → lower per-unit input costs → lower average cost per unit of output' to earn full marks.

## Cheatsheet

| Concept | Formula / Rule | Key Exam Reminder |
| --- | --- | --- |
| Total Revenue (TR) | TR = P × Q | Maximised when PED = 1 for price makers |
| Marginal Revenue (MR) | MR = ΔTR / ΔQ | Twice as steep as AR for downward sloping demand |
| Total Cost (TC) | TC = TFC + TVC | No fixed costs exist in the long run |
| Marginal Cost (MC) | MC = ΔTC / ΔQ | Cuts AC and AVC exactly at their minimum points |
| Supernormal Profit | (AR - AC) × Q | AC includes normal profit, so this is excess profit |
| Short-run Shutdown | P < AVC | Firm only shuts down if it cannot cover variable costs |
| Long-run Shutdown | P < AC | All costs are variable, so firm exits if no normal profit |
| Economies of Scale | Falling LRAC as Q rises | Always link sources to lower average cost in analysis |

## What's next

Now that you have mastered the core revenue, cost and profit toolkit, you are ready to apply these concepts to the next Unit 3 topic: market structures, where you will analyse how firms set prices and output in perfect competition, monopoly, monopolistic competition and oligopoly markets. This topic is the foundation for all higher-level Unit 3 analysis, including profit maximisation, efficiency, and government intervention in markets. Make sure you can draw all required curves from memory and practice calculating profit, revenue and cost values using past paper questions, as these are frequently tested in both multiple choice and extended response questions. Revise PED concepts from Unit 1 if you are struggling with the PED-revenue relationship, as this is often tested in 4-6 mark analysis questions.

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