Difficulty: Introductory to Intermediate | Prerequisites: Unit 2 (Supply and Demand, Elasticity)
Tags: total revenue, marginal revenue, average revenue, total cost, fixed cost, variable cost, marginal cost, average total cost, profit maximisation, MR = MC, perfect competition, imperfect competition, AP Microeconomics, ECON 101, Unit 3
Unit 3 shifts from the market as a whole to the individual firm. The question is no longer "what price does the market set?" but "how does a single firm decide how much to produce, and does it make a profit doing so?" This requires understanding three things: how revenue behaves, how costs behave, and where those two meet.
Everything here builds on supply and demand from Unit 2. If you are comfortable with how markets reach equilibrium, you are ready for this unit.
Firms maximise profit by producing where marginal revenue equals marginal cost (MR = MC). Revenue tells you what comes in, cost tells you what goes out, and comparing the two at the margin tells you whether to produce one more unit. The structure of the market (perfect vs imperfect competition) determines whether the firm is a price taker or a price maker, which changes how MR relates to price.
Total revenue (TR)
Price multiplied by quantity sold. The total amount of money a firm receives from selling its output.
Average revenue (AR)
Total revenue divided by quantity of output. In simple terms, this is the revenue earned per unit sold. In perfect competition, AR equals price.
Marginal revenue (MR)
The change in total revenue from selling one additional unit. Think of it as: how much extra money does the firm earn by producing and selling one more?
Total cost (TC)
Total fixed cost plus total variable cost. Everything the firm spends to produce its output.
Total fixed cost (TFC)
Costs that do not change with the level of output. Think of it as: rent, insurance, equipment leases, anything you pay whether you produce zero units or a million.
Total variable cost (TVC)
Costs that change with the level of output. Think of it as: raw materials, hourly wages, electricity for production.
Average fixed cost (AFC)
Total fixed cost divided by quantity of output. Falls continuously as output rises (the fixed cost is spread over more units).
Average variable cost (AVC)
Total variable cost divided by quantity of output.
Average total cost (ATC)
Total cost divided by quantity of output, or equivalently, AFC plus AVC. In simple terms, this is the cost per unit produced.
Marginal cost (MC)
The change in total cost from producing one additional unit. Think of it as: how much does it cost to make one more?
Average product (AP)
Total product (total output) divided by the quantity of the input used. Output per unit of input.
Marginal product (MP)
The change in total product from using one additional unit of input. Think of it as: how much extra output do you get from hiring one more worker (or adding one more unit of any input)?
Profit maximisation rule
Produce where MR = MC. If MR > MC, the firm should produce more. If MR < MC, it should produce less.
Price taker
A firm in perfect competition that accepts the market price as given. It cannot influence the price by changing its own output.
Price maker
A firm in imperfect competition that faces a downward-sloping demand curve and can set its own price (subject to demand constraints).
Total Revenue = Price x Quantity
Average Revenue = TR / Q (equals price in perfect competition)
Marginal Revenue = Change in TR / Change in Q
TR is maximised at the output level where MR crosses zero (goes from positive to negative)
In perfect competition:
MR = Price = AR = Demand for the individual firm
The firm is a price taker: it sells at whatever the market sets
In imperfect competition:
MR < Price (because to sell more, the firm must lower the price on all units)
The firm IS the market, or a significant part of it: it is a price maker
Total Cost = Total Fixed Cost + Total Variable Cost
Total Cost can also be expressed as: unit cost x quantity of output
Average Fixed Cost = TFC / Q (always declining as Q rises)
Average Variable Cost = TVC / Q
Average Total Cost = TC / Q, or equivalently ATC = AFC + AVC
Marginal Cost = Change in TC / Change in Q
The MC curve typically falls initially (due to increasing marginal returns) then rises (due to diminishing marginal returns)
MC intersects ATC and AVC at their minimum points
Average Product = Total Product / Quantity of Input
Marginal Product = Change in Total Product / Change in Quantity of Input
Total product is maximised at the point where marginal product goes negative
Diminishing marginal returns: as you add more of one input while holding others constant, the additional output from each extra unit eventually falls
Profit maximisation rule for all market structures: produce where MR = MC
Total Profit = Total Revenue minus Total Cost
Total Revenue = Price x Quantity
Total Cost = Unit Cost x Quantity
Total Profit = Unit Profit x Quantity
If price is above ATC at the profit-maximising output, the firm earns economic profit
If price is below ATC but above AVC, the firm operates at a loss but continues producing in the short run (covering variable costs)
If price is below AVC, the firm shuts down
The market supply curve is the horizontal sum of all individual firms' marginal cost curves
S = the sum of all MCs
\text{TR} = P \times Q\text{AR} = \frac{\text{TR}}{Q}\text{MR} = \frac{\Delta \text{TR}}{\Delta Q}\text{TC} = \text{TFC} + \text{TVC}\text{AFC} = \frac{\text{TFC}}{Q}\text{AVC} = \frac{\text{TVC}}{Q}\text{ATC} = \frac{\text{TC}}{Q} = \text{AFC} + \text{AVC}\text{MC} = \frac{\Delta \text{TC}}{\Delta Q}\text{AP} = \frac{\text{TP}}{Q_{\text{input}}}\text{MP} = \frac{\Delta \text{TP}}{\Delta Q_{\text{input}}}\text{Profit} = \text{TR} - \text{TC}Profit maximisation: produce where MR = MC
The MR = MC rule is how every business, from a corner shop to a multinational, implicitly decides how much to produce. A bakery that notices each additional loaf costs more to make than it brings in (MC > MR) stops baking. Airlines use the same logic: a nearly empty flight has very low marginal cost per extra passenger, so selling a last-minute seat for a low price still adds to profit.
The distinction between price takers and price makers maps directly to industry structure. A wheat farmer is a price taker (they sell at whatever the global market pays). Apple, pricing the iPhone, is a price maker (they face a downward-sloping demand curve and choose where on it to sit).
Students often confuse "Total Cost = TFC + TVC" with "Total Cost = TFC + AVC." The formula chart says TC = TFC + TVC, not average cost. (The source document contains a typo listing "Total average cost" where it means TVC.)
MR = MC does not mean the firm earns zero profit. It means the firm is earning the maximum possible profit (or minimising its loss). Profit depends on whether price is above or below ATC at that output.
In perfect competition, MR = Price. Students sometimes apply this to imperfect competition too, where MR is less than price because the firm must lower the price on all units to sell one more.
Average fixed cost never reaches zero, it just keeps getting smaller. Students sometimes say AFC "disappears" at high output. It does not; it merely becomes negligible.
⚠️ MR = MC is the single most important rule in this unit. You will use it on nearly every production markets question, whether multiple choice or free response.
⚠️ Know the cost curve relationships cold: MC crosses ATC and AVC at their minimum points. This is tested graphically.
⚠️ Be able to distinguish perfect competition (MR = P, horizontal demand) from imperfect competition (MR < P, downward-sloping demand). The exam will test whether you can identify the market structure from a graph.
⚠️ The shutdown rule: if price falls below AVC, the firm should shut down in the short run. If price is between AVC and ATC, the firm operates at a loss but stays open. Expect a question on this.
True or false: in perfect competition, marginal revenue is less than price.
Fill in the blank: ATC = ______ + AVC.
True or false: total product is maximised where marginal product equals zero.
Fill in the blank: the profit-maximising output level is where MR = ______.
True or false: if price is below AVC, the firm should continue operating in the short run to cover some fixed costs.
Answers: 1. False (MR = Price in perfect competition). 2. AFC. 3. False (TP is maximised where MP goes from positive to negative, crossing zero). 4. MC. 5. False (the firm should shut down if price is below AVC).
Q: A firm produces 100 units. Total revenue is 5,000 and total cost is 4,200. What is the firm's total profit?
A: Total profit = TR minus TC = 5,000 minus 4,200 = 800.
Q: A perfectly competitive firm faces a market price of 10. What is its marginal revenue for the 50th unit?
A: In perfect competition, MR = Price for every unit. MR = 10.
Q: A firm's total cost rises from 500 to 530 when it increases output from 20 to 21 units. What is the marginal cost of the 21st unit?
A: MC = Change in TC / Change in Q = (530 minus 500) / (21 minus 20) = 30 / 1 = 30.
Q: A firm in imperfect competition faces a price of 15 but its marginal revenue is 9. Should the firm produce an additional unit if marginal cost is 8?
A: Yes. MR (9) > MC (8), so producing the additional unit adds more to revenue than it adds to cost. Profit increases.
Q: Explain why the market supply curve in perfect competition is the sum of individual firms' MC curves.
A: Each firm produces where P = MC. At any given price, each firm's MC curve tells you how much that firm will supply. Adding up all those quantities at each price gives the market supply.
The revenue concepts here build directly on the total revenue test from Unit 2 (Elasticity). Understanding whether demand is elastic or inelastic tells you how TR responds to price changes, which connects to how a firm in imperfect competition sees its MR curve.
The cost and product concepts feed into Unit 4 (Resource Markets), where the question shifts from "how much output to produce" to "how many workers (or other resources) to hire." Marginal product reappears as a key part of the marginal revenue product calculation.
Profit maximisation and market structure connect to Unit 5 (Government), where externalities cause the socially optimal output to differ from the privately profit-maximising output.
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