OxfordAQA A-level Economics: Costs of production, economies of scale, revenue and profit (9640)

Aligned to the OxfordAQA International AS and A-level Economics specification (9640), version 1.2, this guide covers sections 3.1.3.3 (costs of production), 3.1.3.4 (economies and diseconomies of scale) and 3.1.3.5 (average revenue, total revenue and profit). Section 3.1 is International AS content, and it also forms part of the full International A-level. Quantitative skills (section 3.5) can be assessed in any unit. Every firm and figure is made up for illustration.

Where to go next: revision notes, practice questions, the wider operation of markets guide, the course hub, the printable checklist and the free 10-minute diagnostics.

What you must be able to do

Section	Outcome
3.1.3.3	Explain the short run and long run; fixed and variable costs; average and total costs; calculate average and total costs; appreciate that the short-run average cost curve is likely to be U-shaped; understand that the long-run average cost curve’s shape comes from economies and diseconomies of scale
3.1.3.4	Distinguish internal from external economies of scale, categorise and give examples of both; give reasons for diseconomies of scale; link economies and diseconomies to the long-run average cost curve
3.1.3.5	Distinguish average and total revenue; know that the average revenue curve is the firm’s demand curve; profit is total revenue minus total costs; calculate average revenue, total revenue and profit

3.1.3.3 Costs of production

Short run and long run. These are not fixed lengths of time. In the short run, one or more inputs are locked in, such as the size of the factory or the number of ovens. In the long run every input can be varied, so the firm can change its scale.

Fixed and variable costs. Fixed costs stay the same whatever the output while the short run lasts (rent, a lease on equipment, insurance). They are still paid at zero output. Variable costs rise as output rises (ingredients, packaging, hourly wages for extra shifts). A cost is only “fixed” for a stated period: in the long run every cost is variable.

Total and average costs.

Measure	Formula
Total cost (TC)	fixed cost (FC) + variable cost (VC)
Fixed cost per unit, AFC	FC ÷ output
Variable cost per unit, AVC	VC ÷ output
Average cost (AC), also called average total cost	TC ÷ output, which equals AFC + AVC

Worked example 1: a small bakery

The bakery’s output is measured in batches of 20 loaves a day. Fixed costs are 90 a day (currency units, invented). Total costs are given; you complete the rest.

Batches	TC	VC (TC − 90)	AFC	AVC	AC
1	150	60	90.0	60.0	150.0
2	190	100	45.0	50.0	95.0
3	240	150	30.0	50.0	80.0
4	300	210	22.5	52.5	75.0
5	390	300	18.0	60.0	78.0
6	540	450	15.0	75.0	90.0

Working for 5 batches: VC = 390 − 90 = 300; AFC = 90 ÷ 5 = 18; AVC = 300 ÷ 5 = 60; AC = 390 ÷ 5 = 78, and AFC + AVC = 18 + 60 = 78, which checks the result.

Reading the table. AFC falls at every step because the 90 is shared among more batches. AVC first falls, then rises. AC falls until 4 batches (75), then rises, so the short-run average cost curve is U-shaped. The specification asks you to appreciate this shape; it does not expect a formal link to diminishing returns in this unit, which is left to Unit 3. A safe explanation: at low output the fixed cost is spread thinly, and at high output the firm’s fixed plant becomes crowded, so extra output costs more.

AC
 |\                /
 | \              /
 |  \            /
 |    ‾‾‾‾‾‾‾‾‾‾      lowest AC at 4 batches
 +---------------------- output

Worked example 2: a rise in fixed cost

Rent rises so that fixed costs go from 90 to 150. At 5 batches, VC is still 300. New TC = 150 + 300 = 450. New AC = 450 ÷ 5 = 90, up from 78 (+15.4%). AVC is still 300 ÷ 5 = 60. A change in fixed cost moves AFC and AC but leaves AVC unchanged.

A2 note (QS6). For A2 assessments you also need marginal values: marginal cost is the change in total cost from one extra unit. From the bakery table, going from 3 to 4 batches raises TC from 240 to 300, so the marginal cost of the fourth batch is 60. Marginal values are not part of the section 3.1.3.3 wording itself.

3.1.3.4 Economies and diseconomies of scale

Economies of scale are falls in long-run average cost as the scale of production increases. Diseconomies of scale are rises in long-run average cost as scale increases further. Both belong to the long run, because only then can a firm change all its inputs.

Internal economies arise from the growth of the firm itself:

• Technical: larger machines or production lines that cost less per unit; equipment that only makes sense above a certain output.
• Purchasing (bulk-buying): suppliers give lower prices per unit for large orders.
• Managerial: a large firm can employ specialist managers, such as a full-time accountant, instead of one owner doing everything.
• Financial: larger firms are often seen as less risky and can borrow at lower interest rates.
• Marketing: an advertising campaign costs about the same whatever the output, so the cost per unit sold falls.

External economies arise from the growth of the industry or its location, whatever the size of any single firm. Examples: a cluster of firms in one region attracts specialist suppliers and repairers; a local college trains the skills the industry needs; better roads or ports built because the industry is large. Every firm in the area benefits.

Feature	Internal	External
Source	growth of the individual firm	growth of the industry or area
Who gains	that firm	all firms in the industry or area
Effect on LRAC	movement down along the curve	the whole curve shifts down

Diseconomies of scale have causes you can state and apply:

• Co-ordination and communication: more layers of management slow decisions and distort information.
• Loss of control: owners and managers cannot monitor everything, so waste and error rise.
• Worker motivation: employees in a very large organisation can feel remote from its aims, so effort and productivity can fall.
• Duplication: separate departments or sites repeat tasks.

The long-run average cost (LRAC) curve. It is the lowest average cost at which each output can be made when all inputs can change. Falling LRAC means economies of scale; flat LRAC means neither; rising LRAC means diseconomies. The smallest output that reaches that lowest LRAC is the minimum efficient scale (MES).

Worked example 3: a juice producer

Output is in thousands of bottles a week; LRAC is the average cost per bottle (invented figures).

Output	10	20	30	40	50	60	70	80
LRAC	12.0	9.6	8.0	7.2	7.2	7.2	7.8	9.0
Total cost	120	192	240	288	360	432	546	720
Index (10 = 100)	100.0	80.0	66.7	60.0	60.0	60.0	65.0	75.0

Total cost is LRAC × output (for example 9.6 × 20 = 192). The index is each LRAC ÷ 12.0 × 100 (for example 7.2 ÷ 12.0 × 100 = 60.0).

• Economies of scale between 10 and 40: doubling output from 10 to 20 cuts LRAC by (9.6 − 12.0) ÷ 12.0 = −20.0%.
• Constant costs between 40 and 60; MES is 40.
• Diseconomies above 60: from 60 to 80 output rises 33.3% (20 ÷ 60) and LRAC rises (9.0 − 7.2) ÷ 7.2 = 25.0%.
• A new entrant at output 20 would have costs (9.6 − 7.2) ÷ 7.2 = 33.3% above a firm at MES, which is a barrier to entry for small firms.

Worked example 4: how bulk-buying reaches average cost

A bakery pays 1.20 a kilo for flour. A supplier offers 1.05 a kilo on orders of at least 1,000 kg. The saving on 1,000 kg is 1,200 − 1,050 = 150, a fall of 12.5% in the flour price. If flour is 0.80 of an average cost of 2.00 a loaf, flour cost per loaf falls to 0.80 × 0.875 = 0.70, so AC becomes 2.00 − 0.80 + 0.70 = 1.90, a fall of 5.0%. A 12.5% saving on one input is a smaller saving on total AC.

Evaluating economies of scale

Weigh the benefit against limits:

1. Do the economies exist at this scale? The firm may already be at MES.
2. Is demand large enough?
3. Time: economies are long-run, but the costs of expansion (borrowing, building) come first.
4. Diseconomies: past some scale, managing the larger firm can cost more than the saving.
5. Do consumers benefit? Only if lower costs are passed on in lower prices.

3.1.3.5 Average revenue, total revenue and profit

Measure	Formula
Total revenue (TR)	selling price × units sold
Average revenue (AR)	TR ÷ quantity
Profit	TR − TC
Profit per unit	AR − AC

If the firm sells every unit at the same price, AR equals price. Buyers decide how many units to take at each price, and that is what the firm sells. Plotting price (AR) against quantity therefore gives the demand curve, so the average revenue curve is the firm’s demand curve. A change in demand shifts the AR curve; a change in price moves the firm along it. (If a firm charges different prices to different buyers, AR is the average of those prices.)

Worked example 5: a tailoring workshop

Demand follows price = 48 − 2 × quantity (shirts a day). Total costs are given.

Shirts	AR (price)	TR	TC	AC	Profit
2	44	88	100	50.00	−12
4	40	160	140	35.00	20
6	36	216	190	31.67	26
8	32	256	250	31.25	6
10	28	280	330	33.00	−50
12	24	288	430	35.83	−142

Working at 4 shirts: TR = 40 × 4 = 160; profit = 160 − 140 = 20. Cross-check with profit per unit: AR − AC = 40 − 35 = 5, and 5 × 4 = 20. Profit is highest, at 26, at 6 shirts. The workshop makes a loss at 2 shirts and again from 10 shirts.

Worked example 6: more revenue is not more profit

Cutting the price from 36 to 32 raises sales from 6 to 8 shirts. TR rises from 216 to 256, an increase of 18.5% (40 ÷ 216). Profit falls from 26 to 6, because TC rises from 190 to 250, by 60, more than the 40 gained in revenue. Now suppose demand rises so that the price at every quantity is 4 higher (the AR curve shifts up). At 6 shirts the price is 40, TR is 240, and profit is 240 − 190 = 50.

A2 note. Marginal revenue, the change in TR from one extra unit, is a marginal value. Between 4 and 6 shirts, TR rises by 56 over 2 shirts, or 28 each, while marginal cost is (190 − 140) ÷ 2 = 25 each.

Common errors

• Dividing only FC by output to get AC, or forgetting that AC = AFC + AVC.
• Saying fixed costs are “zero” at zero output; they are not.
• Drawing the short-run AC curve as a straight line, or using it to show economies of scale. Short-run shape and long-run shape have different explanations.
• Mixing up internal and external economies: ask whether it is the firm or the industry that has grown.
• Saying a firm “makes a profit” because revenue is high. Profit needs costs compared.

Official syllabus

Source document: the OxfordAQA specification for International AS and A-level Economics (9640), version 1.2. Sections used: 3.1.3.3, 3.1.3.4 and 3.1.3.5, plus quantitative skills QS2, QS5 and QS6 from 3.5.