Revenue and profit

50 marks: 12 multiple choice questions, a data response and an essay. Answers are at the end.

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The test

1For a price-taking firm, average revenue equals marginal revenue because:

A total revenue is the same at every output
B the firm has power over its price
C the price falls as the firm sells more
D each extra unit sells at the unchanged market price

2When a firm's marginal revenue is negative:

A demand is price elastic
B total revenue is at its maximum
C total revenue falls as output rises
D the firm must be making a loss

3A firm cuts its price and its total revenue rises. Over that range of prices, demand for its product is:

A unitary elastic
B price elastic
C price inelastic
D perfectly inelastic

4Normal profit is counted as part of a firm's:

A economic costs
B total revenue
C fixed costs only
D abnormal profit

5A firm is producing where marginal cost is greater than marginal revenue. It could raise its profit by:

A shutting down
B raising its price above average revenue
C reducing output
D increasing output

6Economic profit differs from accounting profit because economic profit:

A counts revenue before tax
B also deducts the opportunity cost of the owner's capital and time
C is always larger
D ignores fixed costs

7In the short run a firm making a loss should carry on producing if:

A the price is at least as high as its average variable cost
B its total revenue is greater than its total fixed cost
C the price covers its average fixed cost
D its marginal cost is rising

8The long-run shutdown point for a firm is where price equals:

A the minimum of average variable cost
B marginal cost
C average fixed cost
D the minimum of average total cost

9A firm sells 2,000 units a week at £12 each. Its average variable cost is £9 and its total fixed cost is £8,000 a week. In the short run it should:

A carry on, because revenue exceeds variable cost by £6,000, so the loss is £2,000 rather than £8,000
B shut down, because it is making a loss of £8,000
C shut down, because it is making a loss of £2,000
D raise its price until it covers all of its costs

10Marginal revenue is best defined as:

A total revenue divided by the number of units sold
B the revenue earned at the profit-maximising output
C price minus average cost
D the change in total revenue from selling one more unit

11A profit-maximising firm with market power will not produce on the inelastic part of its demand curve because there:

A marginal cost is zero
B average cost is rising
C marginal revenue is negative, so cutting output would raise revenue and lower cost
D the price is below average revenue

12Which one of the following is both a fixed cost and a sunk cost?

A Wages paid to temporary staff
B Non-refundable spending on launching a brand
C Raw materials bought as needed
D Rent paid monthly on a lease that can be ended at a month's notice

13Fieldfare is an independent bakery supplying bread to cafés and shops in one city. It rents its premises and ovens on a lease with 18 months to run, and employs bakers on permanent contracts. A new supermarket bakery has cut the price Fieldfare can charge. Table 1 shows its position at its current weekly output. Figures are illustrative.

Table 1: Fieldfare's weekly position
	Before the supermarket opened	Now
Price per loaf	£2.50	£2.00
Loaves sold per week	6,000	6,000
Total variable cost	£8,400	£8,400
Total fixed cost	£5,000	£5,000

(a)Using Table 1, calculate Fieldfare's weekly profit or loss now. [2]

(b)Using the data, explain whether Fieldfare should continue to produce in the short run. [4]

(c)With the aid of a diagram, explain how a firm with some power over its price chooses the output and price that maximise its profit. [6]

(d)Explain what Fieldfare should do in the long run if the price stays at £2.00, and one factor that might lead it to stay in business anyway. [6]

14Evaluate the usefulness of the rule that a firm maximises profit where marginal cost equals marginal revenue. [20]

Answers

Show the answers

AO1 knowledge, AO2 application, AO3 analysis, AO4 evaluation.

	Answer	Why
1	D	A price taker sells any amount at the market price, so every extra unit adds exactly that price to revenue: AR = MR = P.
2	C	Negative MR means selling one more unit brings in less in total: the firm is on the inelastic part of its demand curve.
3	B	Revenue rises after a price cut only if quantity rises by a larger percentage than price falls: price elastic demand, with MR positive.
4	A	Normal profit is the minimum return the owners need to stay in the industry, so economists count it as a cost; abnormal profit is anything above it.
5	C	The last units add more to cost than to revenue; cutting back to MC = MR removes them and raises total profit.
6	B	Accounting profit is revenue minus money costs; economic profit also deducts what the owner's money and time could have earned elsewhere.
7	A	Fixed costs are paid whether or not the firm produces; if price covers the variable cost of each unit, producing contributes towards them.
8	D	In the long run every cost can be avoided by leaving, so price must cover all costs including normal profit.
9	A	Revenue £24,000 against variable cost £18,000: producing contributes £6,000 towards the £8,000 of fixed costs, which are owed anyway.
10	D	Marginal means the effect of one more unit; total revenue divided by units sold is average revenue, which equals price.
11	C	Where demand is inelastic MR is negative, so cutting output raises revenue and saves cost: profit rises, so the firm was not maximising it.
12	B	Brand spending does not vary with output and cannot be recovered; monthly rent is fixed but not sunk, because the firm can stop paying by leaving.

13 (a) Using Table 1, calculate Fieldfare's weekly profit or loss now. [2: AO2 2]

AO2 (1) Revenue 6,000 × £2.00 = £12,000; total cost 8,400 + 5,000 = £13,400
AO2 (1) Loss of £1,400 a week (before the supermarket opened the bakery made a profit of £1,600)

13 (b) Using the data, explain whether Fieldfare should continue to produce in the short run. [4: AO1 1, AO2 2, AO3 1]

AO1 (1) In the short run a firm should produce as long as price at least covers average variable cost, because fixed costs have to be paid whether it produces or not
AO2 (2) Average variable cost is 8,400 ÷ 6,000 = £1.40 a loaf, below the price of £2.00; revenue of £12,000 exceeds variable cost by £3,600, which contributes towards the £5,000 of fixed costs
AO3 (1) So it should continue: the loss of £1,400 is smaller than the £5,000 loss it would make if it closed and still had to pay the rent and the bakers

Maximum 4: the shutdown rule (1), the calculation of AVC or the contribution to fixed costs (2), the conclusion with the comparison of losses (1).

13 (c) With the aid of a diagram, explain how a firm with some power over its price chooses the output and price that maximise its profit. [6: AO1 2, AO3 4]

AO1 (2) Diagram: a downward-sloping AR (demand) curve with MR below it falling twice as steeply; a rising MC curve and a U-shaped ATC curve; output Qm where MC = MR; price Pm read up from Qm to AR; the abnormal profit rectangle between Pm and ATC at Qm
AO3 (2) Each unit up to Qm adds more to revenue than to cost, so it raises profit; each unit beyond Qm adds more to cost than to revenue, so it lowers profit; profit is therefore greatest where the last unit adds exactly as much to each, MC = MR
AO3 (1) The firm then charges the highest price buyers will pay for Qm units, read up to the demand curve, not across from MC = MR
AO3 (1) Profit per unit is Pm minus average cost at Qm, and total abnormal profit is that gap multiplied by Qm, the shaded rectangle

Levels: 1 to 2 for a description with a partly correct diagram; 3 to 4 for a correct diagram with MC = MR and the price read up to AR; 5 to 6 for the full chain explaining why MC = MR maximises profit and how the profit rectangle is found.

13 (d) Explain what Fieldfare should do in the long run if the price stays at £2.00, and one factor that might lead it to stay in business anyway. [6: AO1 1, AO2 1, AO3 4]

AO1 (1) In the long run all costs are variable and can be avoided by leaving, so a firm stays only if price covers average total cost, including normal profit
AO2 (1) Fieldfare's average total cost is 13,400 ÷ 6,000 = £2.23 a loaf, above the price of £2.00, so at this price it cannot cover its costs once the lease and the bakers' contracts come up for renewal
AO3 (2) It should therefore plan to leave the industry when the lease ends in 18 months, or cut its costs below £2.00 a loaf, or find buyers who will pay more, such as cafés that value a different product from the supermarket's; otherwise its owners would earn more by putting their capital and time to another use
AO3 (2) Reasons it might stay: the owners may accept less than normal profit because they value running the business (non-profit objectives); they may expect the supermarket's low price to be temporary or demand to recover; leaving has costs of its own, such as redundancy pay; or the firm may be able to differentiate its bread and regain pricing power, so the long-run position is not fixed

Levels: 1 to 2 for the long-run rule or a description of the data; 3 to 4 for applying average total cost against price to the decision; 5 to 6 for the full chain with a developed reason the firm might stay.

14 Evaluate the usefulness of the rule that a firm maximises profit where marginal cost equals marginal revenue. [20: AO1 6, AO3 6, AO4 8]

Knowledge and analysis (AO1 to AO3)

State the rule and why it works: profit is total revenue minus total cost; each unit for which MR exceeds MC adds to profit and each unit for which MC exceeds MR reduces it, so profit is greatest at the output where they are equal (with MC cutting MR from below). Diagram: AR, MR, MC and ATC with Qm, Pm and the abnormal profit rectangle.
Its uses: it predicts how firms respond to changes in costs and demand (a rise in MC cuts output and raises price; a rise in demand raises both); it shows why a firm with market power restricts output below the competitive level, which underpins the analysis of monopoly, deadweight loss, price discrimination and competition policy; it gives the shutdown and break-even points when combined with average cost; it applies in every market structure, from the price taker whose MR equals price to the monopolist.
Its limits: most firms do not know their MR and MC curves and cannot measure the effect of one more unit, so in practice they set prices by adding a mark-up to average cost, or follow rivals; firms may not aim at maximum profit at all (revenue or sales maximisation, satisficing, growth, ethical objectives) because of the divorce of ownership from control; the rule is static and says nothing about long-run strategy, investment or the response of rivals in oligopoly, where interdependence and game theory matter more.
Behavioural points: managers face uncertainty and limited information and use rules of thumb; markets with many products and changing conditions make the single-product diagram a simplification.
Diagram to use: the profit-maximising diagram with Qm and Pm; optionally the objectives diagram showing Qr and Qs to the right of Qm.

Evaluation (AO4)

It depends on what the rule is for: as a description of what firms actually do it is weak, but as a prediction of the direction in which firms move when costs or demand change it works well, which is what economists mainly use it for.
It depends on the market: in competitive markets firms that do not get close to MC = MR are driven out, so the rule holds whether or not managers think in those terms; with market power there is slack for other objectives.
Mark-up pricing may reach much the same answer: a firm that raises its mark-up when demand is inelastic and lowers it when demand is elastic is approximating MC = MR without the curves.
The rule is the foundation for the models of monopoly and oligopoly that competition authorities use, so its usefulness goes beyond any one firm's decision.
Its usefulness falls where interdependence dominates: in oligopoly the profit-maximising output depends on rivals' reactions, and the kinked demand and game theory models are needed alongside it.

Judgement

A supported judgement might conclude that MC = MR is more useful as a tool of analysis than as a description of practice: few managers calculate marginal values, and many firms pursue other objectives, but the rule predicts how output and price respond to changes in cost and demand, explains the behaviour of firms with market power, and survives in disguise in the mark-up pricing that firms actually use. It is least useful on its own in oligopoly and in the long-run decisions where strategy, not the margin, decides.

Marking

Bands, out of 20 (AO1 knowledge 6, AO3 analysis 6, AO4 evaluation 8, as WJEC marks a 20-mark question). Top band (16 to 20): a range of points developed in full chains of reasoning, supported by an accurate diagram and real examples, with evaluation that weighs the arguments and reaches a judgement that depends on stated conditions. Middle band (9 to 15): some developed chains, a relevant diagram, evaluation present but one-sided or asserted. Bottom band (1 to 8): points listed or described, little use of theory or examples, judgement missing or unsupported.