Pearson Edexcel International Advanced Level Economics: Revenue and short-run costs (YEC11) – Revision Notes

These notes condense section 3.3.2 items 1 and 2 (revenue; short-run costs and diminishing returns) of the Pearson Edexcel International Advanced Subsidiary/Advanced Level Economics (YEC11) specification, Issue 2, June 2018. Unit 3, Business behaviour, is International A2 content and an IAL compulsory unit; it is not part of the IAS. For full explanations use the study guide, then test yourself with the practice questions.

Hub: Edexcel A Level Economics. Checklist: printable checklist. Not sure what to revise first? Try the free 10-minute diagnostics. All data below are invented and fictional (a pottery in Country B, in currency units, cu).

Formulae to know

Measure	Formula	Note
TR	P x Q	Total sales receipts
AR	TR / Q	Always equals price; it is the demand curve
MR	change in TR / change in Q	Below AR if the firm must cut price to sell more
PED	% change in Q / % change in P	Negative; quote the size
TC	TFC + TVC
AFC	TFC / Q	Falls throughout, never zero
AVC	TVC / Q
ATC	TC / Q = AFC + AVC
MC	change in TC / change in Q	Ignores fixed cost
MP	change in TP / change in labour
AP	TP / labour

Revenue: key points

• Price taker: AR = MR = P. A horizontal line.
• Price maker with a straight-line demand curve: AR slopes down; MR starts at the same point on the price axis and falls twice as fast.
• MR positive: TR rising. MR = 0: TR at maximum. MR negative: TR falling.
• MR can be negative; AR (price) cannot be.

Worked reminder. Demand for pottery sets is P = 60 - 3Q, so MR = 60 - 6Q.

Q = 5: P = 45, TR = 225
Q = 6: P = 42, TR = 252
MR (5th to 6th set) = 252 - 225 = 27   (formula at Q = 5.5: 60 - 33 = 27)
TR is largest where MR = 0: Q = 10, P = 30, TR = 300

Diagram in words: price and revenue on the vertical axis, quantity on the horizontal axis. AR runs from 60 on the price axis to 20 on the quantity axis. MR runs from 60 to 10. TR is an arch peaking at Q = 10.

PED and revenue

PED (size)	Meaning	Price rises	Price falls
Above 1	Elastic	TR falls	TR rises
Equal to 1	Unitary	TR same	TR same
Below 1	Inelastic	TR rises	TR falls

Method in steps:

1. Find the percentage change in price using (new - old) / old x 100.
2. Find the percentage change in quantity the same way.
3. Divide the quantity figure by the price figure.
4. State the size, say elastic or inelastic, then give the effect on TR = P x Q.

Worked reminder. The price rises from 50 cu to 55 cu and quantity falls from 200 to 170.

%change P = +10%;  %change Q = -15%
PED = -15 / 10 = -1.5  (elastic)
TR: 50 x 200 = 10,000  ->  55 x 170 = 9,350   (falls by 650)

Along the demand curve P = 60 - 3Q, PED is -4.0 at Q = 4, -2.3 at Q = 6, -1.0 at Q = 10 and -0.67 at Q = 12. A straight-line demand curve is elastic above its midpoint and inelastic below it. Link: MR = P x (1 + 1/PED), so MR is positive where demand is elastic, zero where unitary and negative where inelastic.

Short run, diminishing returns

• Short run: at least one factor is fixed. Long run: all factors are variable, so no costs are fixed.
• Law of diminishing returns: adding more of a variable factor to a fixed factor eventually gives smaller and smaller extra output (MP falls). TP can still rise.
• Early on, MP may rise because workers specialise and use the fixed capital better.

Worked cost table

The pottery has TFC = 360 cu a week and pays 180 cu per worker. Q equals TP.

Workers	TP	MP	AP	TC	AFC	AVC	ATC	MC
1	6	6	6.0	540	60.00	30.00	90.00	30.00
2	18	12	9.0	720	20.00	20.00	40.00	15.00
3	36	18	12.0	900	10.00	15.00	25.00	10.00
4	50	14	12.5	1,080	7.20	14.40	21.60	12.86
5	60	10	12.0	1,260	6.00	15.00	21.00	18.00
6	66	6	11.0	1,440	5.45	16.36	21.82	30.00

Read-off:

• MP peaks at 18 with the third worker, so diminishing returns start with the fourth.
• MC = 180 / MP, so MC is lowest (10.00) where MP is highest.
• AP peaks at the fourth worker (12.5), so AVC is lowest there (14.40).
• ATC is lowest at the fifth worker (21.00). It bottoms after AVC because AFC is still falling.
• MC cuts AVC and ATC from below at their minima.

Relationships between curves

Link	Rule	Why
MP and MC	MP rises, MC falls; MP falls, MC rises	MC = wage / MP when the wage is constant
AP and AVC	AP rises, AVC falls; AP falls, AVC rises	AVC = wage / AP
TP and TC	TC is a mirror image of TP	Output needs workers, workers cost money
MC and average cost	MC below average pulls it down; above pulls it up	Marginal and average rule
SR and LR	LR has no fixed cost; new plant means a new SR curve	All factors can change

In words: the MC curve falls, reaches a minimum, then rises steeply. It crosses AVC and ATC at their lowest points. ATC lies above AVC by the amount of AFC, and the gap narrows as output grows. The TC curve starts at TFC on the vertical axis, rises at a decreasing rate at first, then more steeply once diminishing returns begin.

Must-know distinctions

• Diminishing returns (short run, fixed factor) is not diseconomies of scale (long run, all factors changing).
• Falling MP is not falling TP.
• AR is price; MR is the revenue from the extra unit.
• Average fixed cost always falls; average variable cost eventually rises.
• Average cost is a cost per unit; total cost is a sum.

Quick self-test

1. A firm sells 30 units at 8 cu each. What are TR and AR?
2. TR rises from 240 cu to 270 cu when sales rise from 30 to 33 units. What is MR?
3. Price rises from 20 to 22 and quantity falls from 500 to 400. Find PED and say what happens to TR.
4. Demand is inelastic. Should the firm raise or cut price to increase TR?
5. TFC = 300, TVC = 450 at 50 units. Find TC, AFC, AVC and ATC.
6. TC rises from 750 to 790 when output rises from 50 to 54. Find MC.
7. State the law of diminishing returns.
8. Wage is 200 cu per worker and MP is 25. What is MC?
9. At what point does MC cross AVC?
10. Why does ATC reach its minimum at a higher output than AVC?
11. What is different about costs in the long run?
12. If MR is negative, what is happening to TR, and what does it say about PED?

Answers

1. TR = 30 x 8 = 240 cu. AR = 240 / 30 = 8 cu.
2. MR = 30 / 3 = 10 cu.
3. %P = +10%, %Q = -20%, PED = -2.0 (elastic). TR: 10,000 falls to 8,800.
4. Raise price: a price rise raises TR when demand is inelastic.
5. TC = 750. AFC = 6. AVC = 9. ATC = 15 (= 6 + 9).
6. MC = 40 / 4 = 10 cu.
7. Adding units of a variable factor to a fixed factor eventually yields smaller extra output from each unit.
8. MC = 200 / 25 = 8 cu.
9. At the minimum of AVC (and likewise at the minimum of ATC).
10. AFC keeps falling after AVC starts rising, so ATC keeps falling until the rise in AVC outweighs the fall in AFC.
11. All factors are variable, so there are no fixed costs.
12. TR is falling; demand is inelastic at that output.

Check on 3: new TR = 22 x 400 = 8,800.

Where marks are usually lost

• Dividing by the new value instead of the original value in a percentage change.
• Giving PED with no verdict, or a verdict (elastic) with no effect on revenue.
• Treating MR as TR divided by Q.
• Including fixed cost in MC.
• Writing “output falls” when only marginal product falls.
• Drawing MC so that it misses the minimum points of AVC and ATC instead of cutting through them.
• Stating a curve relationship with no reason (say why MC rises: falling MP).
• Working out MC from a table by dividing TC by output instead of using the change in TC.

Official syllabus

Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics (YEC11), specification Issue 2, June 2018, section 3.3.2 items 1 and 2, published by Pearson Education Limited.