A firm decides how much to produce by answering one question repeatedly: does making one more unit add more to revenue than it adds to cost? Everything else in the theory of the firm, the cost curves, the revenue curves, the whole apparatus of market structures, exists to answer that question precisely. Get the costs and revenue straight here and the rest of microeconomics becomes an application of them.
Firms are classified in several ways and questions use all of them. By sector: primary firms extract raw materials, secondary firms manufacture, tertiary firms provide services. By size, measured by number of employees, revenue, capital employed or market share, none of which agree with each other. And by ownership, from sole traders and partnerships through private and public limited companies to state-owned enterprises. Size matters analytically because it determines which economies of scale a firm can reach and how much market power it has.
Small and large firms each have advantages. Small firms can offer a personal service, respond quickly to customers and changes in the market, serve small or specialist markets that large firms ignore, and are easy to set up and control. Their disadvantages are higher costs per unit, because they cannot buy or produce in bulk, difficulty borrowing, and vulnerability if a single customer or product fails. Large firms benefit from lower average costs through economies of scale, easier and cheaper access to finance, the ability to spread risk across many products and markets, and the money to fund research. Their disadvantages are slower decision-making, communication problems and weaker motivation as they grow, and the market power to charge higher prices if competition is weak.
Merger
The joining together of two or more firms to form a single firm, whether by agreement or by one firm taking over another.
Mergers are classified by how the firms are related. A horizontal merger joins firms at the same stage of production in the same industry, such as two car manufacturers: it increases market share, removes a competitor and brings economies of scale, but may reduce competition so that prices rise. A vertical merger joins firms at different stages of the same industry. Backward vertical integration is with a supplier, such as a chocolate maker buying a cocoa farm, which secures supplies and cuts costs; forward vertical integration is with a customer or retailer, such as a brewer buying pubs, which secures outlets for its products. A conglomerate merger joins firms in unrelated industries, such as a food company buying an insurance firm, which spreads risk but brings little saving in costs, since the businesses have nothing in common. For consumers the effects of any merger depend on whether the lower costs are passed on in lower prices or kept as profit through greater market power.
A car manufacturer takes over a firm that makes car tyres. What type of merger is this?
Productivity
Output per unit of input in a given period, most commonly measured as output per worker or output per worker-hour.
Production and productivity are different words and examiners test the difference deliberately. Production is total output. Productivity is output per unit of input. A firm that doubles output by doubling its workforce has doubled production and left productivity unchanged. Using the words interchangeably costs marks in almost every paper.
Firms decide how many workers and machines to use, and the demand for any factor of production depends on four things: demand for the product it makes, since a factor is wanted only for what it produces; its price compared with other factors; whether it is available; and its productivity. Production is labour-intensive when it uses a high proportion of labour to capital, as in hairdressing, care work or hand-made goods, and capital-intensive when it uses a high proportion of machinery, as in car assembly or oil refining. Labour-intensive methods suit small outputs, personal or varied products, and countries where labour is cheap; they are flexible but costly per unit at large scale. Capital-intensive methods suit large, standardised outputs and countries where labour is expensive; they give low costs per unit and consistent quality, but need a large initial investment and are inflexible if demand changes. Productivity rises with better education and training, better technology, better management and above all investment in capital, since workers with more and better equipment produce more each hour.
Costs divide into two kinds and the division is about time rather than size. Fixed costs do not vary with output: rent, insurance, loan interest, salaried management. They must be paid even at zero output. Variable costs vary directly with output: raw materials, hourly wages, electricity used in production. Total cost is the two added together. Average cost, or cost per unit, is total cost divided by output, and it is average cost rather than total cost that determines whether a given selling price is profitable.
TC = TFC + TVC AC = TC / Q TR = price x quantity AR = TR / Q Profit = TR - TCNote that AR equals price whenever every unit sells at the same price, which is why the average revenue curve and the demand curve are the same line. Formulae are not printed in any 9708 paper, so recall all of these.
Finding the profit-maximising output from a cost table
A firm faces total costs of $100 at zero output, then $160, $200, $230, $270, $330 and $420 for outputs of 1 to 6 units. It can sell any quantity at $80 per unit. Identify its fixed cost, calculate profit at each output, and state the profit-maximising level.
Profit maximisation is the standard assumption but it is not the only objective firms pursue. Survival matters most for a new firm or one in a downturn, and may mean accepting losses for a period. Growth of market share can be pursued at the expense of current profit, on the argument that scale brings lower costs and greater power later. Social objectives matter to charities, cooperatives and state-owned firms, and increasingly to firms responding to consumer and employee expectations. Satisficing describes managers doing well enough to satisfy shareholders while pursuing other aims, which happens because in large firms the owners and the managers are different people with different interests.
A firm's total cost is $500 when it produces nothing. Which statement is correct?
A firm increases output from 100 to 120 units by hiring more workers, and its output per worker falls. What has happened?
Draw a diagram with output on the horizontal axis and cost on the vertical axis. Draw a horizontal total fixed cost line, an upward-sloping total variable cost curve starting at the origin, and the total cost curve above them. Then, on a second diagram, draw average fixed cost falling continuously and average total cost as a U shape.
The key insight is why average fixed cost falls continuously without ever reaching zero: a constant amount is being divided by a rising output. This is 'spreading the overheads', and it is the reason average total cost falls at low output even when variable costs per unit are rising.
Economies of scale
The fall in average (unit) costs of production that a firm experiences as it increases the scale of its output.
Internal economies of scale arise inside the firm as it grows. Purchasing economies come from buying raw materials in bulk at a discount. Technical economies come from using larger, more efficient machinery that a small firm could not use fully. Financial economies come from borrowing more cheaply, since large firms are seen as less risky. Managerial economies come from employing specialist managers. Marketing economies come from spreading the cost of advertising over more units. Risk-bearing economies come from selling many products in many markets. External economies of scale arise when the whole industry grows in an area, lowering costs for every firm in it: a pool of skilled workers, specialist suppliers nearby, and better transport and training built for the industry.
Beyond some size a firm's average costs can start to rise again, and these are diseconomies of scale. Internal diseconomies come from the difficulty of managing a very large organisation: communication becomes slow and unclear, decisions take longer, and workers feel less involved, so motivation and productivity fall. External diseconomies arise when an industry becomes too concentrated in one area, so that traffic congestion, higher land prices and competition for scarce skilled workers push up every firm's costs.
Draw an average total cost (ATC) curve with output on the horizontal axis and average cost on the vertical axis, shaped like a U. Label the falling section 'economies of scale', the lowest point 'lowest average cost', and the rising section 'diseconomies of scale'.
Label the axes with average cost, not total cost. The whole point of economies of scale is what happens to cost per unit, and a diagram of total cost cannot show it.
Short run, long run and diminishing returns
The short run and the long run are defined by flexibility, not by clock time. In the short run at least one factor of production is fixed, typically capital: a firm can hire more workers this week but cannot build another factory. In the long run every factor is variable, so the firm can change its entire scale of operation. How long that takes differs by industry, from weeks for a market stall to a decade for a nuclear power station, which is why the definition is about the fixed factor rather than about months.
The law of diminishing marginal returns is a short-run proposition and it drives the shape of every short-run cost curve. As successive units of a variable factor are added to a fixed factor, the marginal product of the variable factor eventually falls. The first extra workers may raise marginal product, because specialisation becomes possible, but beyond some point each additional worker has less capital to work with and adds less than the one before. Since marginal cost is the wage divided by marginal product, falling marginal product means rising marginal cost. The U shape of the marginal cost curve is diminishing returns viewed from the cost side.
AP = TP ÷ number of workers; MP = change in TP ÷ change in number of workersTotal product (TP) is the total output produced by a given number of workers. Average product (AP) is output per worker. Marginal product (MP) is the extra output from employing one more worker.
Calculating average and marginal product and finding diminishing returns
A firm with one machine employs 1 to 6 workers. Total product is 10 units with 1 worker, 24 with 2, 42 with 3, 56 with 4, 65 with 5 and 70 with 6. Calculate the average and marginal product of labour, and state where diminishing marginal returns begin.
MC = change in TC / change in Q MR = change in TR / change in Q Profit is maximised where MC = MR and MC is risingThe second condition matters. MC equals MR at two points on a U-shaped MC curve, and the lower one is the profit-minimising output. Stating only 'MC = MR' is an incomplete answer at A Level.
The relationships between the average and marginal curves follow from arithmetic rather than economics, and understanding that makes them impossible to forget. Whenever a marginal value lies below an average, the average must fall; whenever it lies above, the average must rise. It follows that marginal cost cuts average total cost and average variable cost at their minimum points, since that is the only place where the average is neither rising nor falling. The same logic gives the relationship between marginal and average product. Candidates who derive this rather than memorising it never draw the curves wrongly.
Revenue curves depend on whether the firm can influence price. A price taker faces a horizontal demand curve at the market price, so average revenue and marginal revenue are the same horizontal line: selling one more unit adds exactly the price. A price maker faces a downward-sloping demand curve, and to sell one more unit it must lower the price on every unit, not just the last. Marginal revenue therefore falls twice as steeply as average revenue and lies below it, and marginal revenue becomes negative once the loss on existing units outweighs the gain from the extra one. That single difference generates most of the contrast between market structures.
Profit in economics is not the accountant's profit. Economic cost includes opportunity cost, in particular the return the owner's capital and labour could have earned elsewhere. Normal profit is the minimum return needed to keep the firm in the industry, and because it is a cost of staying in business it is treated as part of total cost. Supernormal profit, sometimes called abnormal or economic profit, is anything above that. This is why a firm earning only normal profit is shown breaking even on a diagram while its owner is doing perfectly well, and why supernormal profit is the signal that attracts entry.
Profit comes in three sizes. Normal profit is the minimum return needed to keep the entrepreneur in the industry, equal to what the resources could earn in their next best use, and it is counted as a cost; it occurs where total revenue equals total cost, or average revenue equals average total cost. Supernormal profit is any profit above that, where average revenue is above average total cost. Subnormal profit, an economic loss, is where total revenue is below total cost, so the owners earn less than they could elsewhere. A firm making subnormal profit may keep producing in the short run as long as it covers its variable costs, but in the long run it will leave the industry unless its position improves.
Confirming the profit-maximising output with marginal analysis
Using the same cost schedule as before, with TC of $100, $160, $200, $230, $270, $330 and $420 for outputs 0 to 6 and a price of $80, calculate marginal cost at each output and use the MC = MR rule to find the profit-maximising level. Then explain why the rule and the total-profit method agree.
The long run and economies of scale
In the long run every factor is variable, so the firm chooses its scale. Internal economies of scale reduce long-run average cost as output rises and arise within the firm: technical economies from indivisible capital used more fully, purchasing economies from bulk buying, managerial economies from specialised staff, financial economies from cheaper borrowing, marketing economies from spreading advertising over more units, and risk-bearing economies from diversification. External economies arise from the growth of the whole industry rather than the individual firm, through a pool of skilled labour, specialist suppliers and shared infrastructure. Diseconomies of scale eventually push long-run average cost back up, and they are overwhelmingly about coordination: communication slows, monitoring becomes harder, and motivation weakens as individuals feel less connected to the outcome.
Returns to scale describe what happens to output when a firm increases all of its inputs in the same proportion. With increasing returns to scale, output rises by a larger proportion: doubling every input more than doubles output. With constant returns, output rises in the same proportion. With decreasing returns, it rises by a smaller proportion. Returns to scale are about physical output, while economies of scale are about average cost, but the two are linked: increasing returns to scale lower long-run average cost if input prices are unchanged. Neither should be confused with diminishing marginal returns, which is a short-run idea in which only one input changes.
The long-run average cost curve is the envelope of all the short-run curves, one for each possible scale of plant. Its shape determines the structure of the industry, which is the reason this topic precedes market structures. Minimum efficient scale is the lowest output at which long-run average cost reaches its minimum. Where minimum efficient scale is large relative to market demand, only a few firms can operate efficiently and the industry tends towards oligopoly or monopoly. Where it is small, many firms can coexist at efficient scale and the market can be competitive. Natural monopoly is the extreme case: economies of scale continue over the whole range of market demand, so one firm can always supply more cheaply than two.
Draw a set of short-run average cost curves for three different plant sizes, then draw the long-run average cost curve as the envelope beneath them. Mark minimum efficient scale. On a second diagram, draw an LRAC that falls continuously across the entire range of market demand and mark where market demand sits.
The second diagram is natural monopoly and is worth drawing separately, because it is the case where competition is not merely absent but inefficient: splitting output between two firms would raise average cost. That is the analytical basis for regulating rather than breaking up utilities, and it recurs in the market structures and government intervention topics.
How minimum efficient scale determines market structure
- An industry requires large indivisible capital equipment, so fixed costs are high relative to variable costs.
- Average fixed cost therefore falls steeply as output rises, and long-run average cost continues falling over a wide range of output.
- Minimum efficient scale is consequently large, perhaps a substantial fraction of total market demand.
- A small firm operating below that scale has higher average costs than a large rival.
- It cannot match the larger firm's price and remain profitable, so it either grows, exits or occupies a niche the large firm does not serve.
- The number of firms able to survive at efficient scale is limited by the size of the market divided by minimum efficient scale.
- The industry therefore settles into oligopoly or monopoly, not because of any anti-competitive conduct but because the cost structure permits nothing else.
This chain answers questions asking why some industries are concentrated and others are not, and it is a better answer than any list of barriers to entry, because it explains where the barrier comes from.
Practise this chain →Applied context
Compare commercial aircraft manufacture with hairdressing. Designing and certifying a new airliner costs billions before a single unit is sold, and those costs are almost entirely fixed, so average cost keeps falling across the whole plausible range of demand. Two firms dominate the market globally, and the concentration follows from the cost structure rather than from conduct. Hairdressing has minimal fixed costs, no meaningful economies of scale beyond a single salon, and consequently hundreds of thousands of small firms worldwide. Neither outcome reflects the intentions of the firms involved.
This contrast is a reliable way to answer 'why do some industries have few firms?' without resorting to a list. The economics is in the cost structure, and the market structure follows from it.
This note supplies the machinery the rest of A2 microeconomics uses. Market structures apply the same MC equals MR rule to differently shaped revenue curves, and the cost curves drawn here appear unchanged in every one of those diagrams. Efficiency arguments depend on these curves directly, since productive efficiency is production at minimum average cost and allocative efficiency is price equal to marginal cost. The growth of firms follows from economies of scale and minimum efficient scale. And the labour market topic uses the same marginal logic on the input side, where a firm hires up to the point where the marginal revenue product of labour equals the wage.
9708-7.3 · 9708-7.6 · 9708-7.7 · 9708-7.8 · 9708-8.1 · 9708-8.3
Assess whether firms always seek to maximise profits. (13 marks)
- Define and frameDefine profit maximisation as producing where MC equals MR with MC rising, and distinguish normal from supernormal profit. Identify the word carrying the question, which is 'always', and state that the answer depends on who controls the firm, over what time horizon, and in what market conditions.
- Analysis: the case forProfit maximisation is the assumption the whole model rests on and it is not arbitrary. Owners want returns; supernormal profit funds investment and provides a buffer; competitive pressure means a firm not maximising is vulnerable to takeover or to being undercut. Show the MC equals MR condition on a diagram and note that it predicts firm behaviour well in competitive markets over long periods.
- Analysis: the alternativesTake the alternatives seriously rather than listing them. The divorce of ownership from control means managers, whose pay and status depend on firm size, may pursue revenue or growth maximisation instead. Satisficing follows from that. Survival dominates in a downturn or for a start-up. Predatory or penetration pricing sacrifices present profit for market share, which is profit maximisation over a longer horizon rather than an alternative to it. Social and environmental objectives may be genuine or may be long-run profit maximisation through reputation.
- EvaluationWeigh rather than list. The time horizon dissolves several apparent exceptions: growth and market share strategies are consistent with maximising long-run profit. Market structure matters, since a firm in perfect competition that fails to maximise makes losses and exits, while a monopolist has slack to pursue other aims. Firm type matters, as cooperatives and state-owned firms have different constituencies. And information matters: firms may intend to maximise and fail, because they do not know their own marginal cost and revenue curves with any precision.
- JudgementConclude that profit maximisation is a good approximation rather than a universal description: strongest for owner-managed firms, for competitive markets and over long horizons; weakest where ownership and control are separated, where market power provides slack, and in the short run. Add that the model's usefulness does not depend on being literally true, since it predicts behaviour well enough to be the right starting point. A conclusion that merely lists exceptions without saying when they bind will not reach the top level.
AO3 evaluation is 30% of the written papers. The time-horizon point is the single most effective evaluation move here, because it reclassifies several supposed alternatives as long-run profit maximisation rather than departures from it.
How useful is the cost curve model?
- Its strength is that it generates precise, testable predictions from very few assumptions, and the MC equals MR rule holds across every market structure, which is unusual economy of explanation.
- Against that, real firms rarely know their marginal cost curves. Most price by adding a mark-up to average cost, which is a rule of thumb rather than marginal analysis, though it may approximate the same outcome if the mark-up is set by competitive pressure.
- The U-shaped average cost curve is drawn from the law of diminishing returns, which is a short-run proposition. Empirical studies of many industries find average cost roughly flat over a wide range of output rather than U-shaped, which weakens some conclusions drawn from the geometry.
- The distinction between fixed and variable cost is cleaner in the model than in practice, since almost every cost is variable given enough time and the boundary depends on the horizon being considered.
- Economies of scale are well evidenced and minimum efficient scale genuinely does explain differences in concentration across industries, so the long-run half of the model is on firmer ground than the short-run half.
- The strongest answers treat the model as a framework for reasoning rather than a description of how managers think, and judge it by whether its predictions hold rather than by whether firms consciously equate MC with MR.
Two habits recover marks routinely. Always state that profit maximisation requires MC equals MR with MC rising, since the second condition is frequently the difference between full and partial credit. And when a question involves losses, distinguish shutting down from exiting: in the short run a firm should continue producing while price exceeds average variable cost, because it is still covering something towards its unavoidable fixed costs, even though it is making a loss.