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To understand how firms make decisions, we have to look at the two forces that define their success: Cost and Revenue. At its simplest, Revenue is the total flow of money coming into the business from sales, while Cost represents the value of everything sacrificed to produce those goods or services. The magic happens in the gap between them, the Profit.

The Concept of Cost

The term cost means different things to different people. For business executives cost figure is very important in determination of price. Cost refers to the amount of expenditure incurred in obtaining the services of factors of production or we can say, the cost is the expense incurred in producing a commodity.

Types of Cost:

There are 4 types of cost: -

  1. Real Cost – It includes the efforts and sacrifice of the factors or its real cost. It is beyond accurate measurement.  In modern business economics, we usually swap "Real Cost" for Explicit and Implicit Costs.
  • Explicit Costs: Out-of-pocket payments (Money Cost).
  • Implicit Costs: The opportunity cost of using resources the owner already owns (like the owner's time or a building they already own).
  1. Money Cost – It refers to the total money expenditure incurred on various items which are used for production. It includes wages for labourers, price of raw material, fuel cost, rent of building, electricity bill, transportation bill etc.
  2. Opportunity Cost – It is the cost of producing any commodity which is next best alternative good, that is sacrificed.
  3. Total Cost – Actual cost that must be incurred in producing a given quantity. Total cost is equal to Total Fixed Cost and Total Variable Cost. TC = TFC + TVC

The Concept of Revenue

Revenue refers to the receipts obtained by a firm from selling various quantities of its products.

Types of Revenue:

There are 3 key concepts of revenue:

1. Total Revenue -

Price paid by the consumer for products form revenue. In other words, we can say it is the income of the seller. The whole income received by the seller from selling various units of a commodity either at same or different prices is called Total Revenue.

TR = P x Q

Where,

  • TR = Total Revenue
  • P = Price
  • Q = Quantity Sold

For eg.: if a seller sells 100 units of a product at Rs. 15, then the total revenue will be Rs. 1500.

2. Average Revenue –

It is revenue per unit of the product sold. It is calculated by dividing TR by no. of units.

AR = TR / Q

For eg.: If a firm makes 100 T-Shirts and sells each for Rs. 10.

  • TR = P x Q = 10 x 100 = Rs. 1000
  • AR = TR / Q = 1000 / 100 = Rs. 10

3. Marginal Revenue –

It is the net revenue earned by selling on additional units of the product. In other words, we can say Marginal Revenue is the addition made to the Total Revenue by selling one or more units of the commodity.

MR = ΔTR / ΔQ

Where,

  • MR = Marginal Revenue
  • ΔTR = Change in Total Revenue
  • ΔQ = Change in Quantity

For eg.: A company sold the first 100 units of an item for a total of Rs. 1,000 in one week. The next week it sold 115 units for Rs. 1,100. The change in revenue from week one to week two is Rs. 100, and the change in quantity is 15 units.

  • MR = ΔTR / ΔQ
  • MR = 100 / 15
  • MR = Rs. 6.67 per unit

Note: - When ΔQ = 1, then MR = TRn - TRn-1.

Relationship between Marginal Revenue and Average Revenue

A general relationship between AR and MR is as follows:

  1. If AR is constant, AR = MR (under perfect competition) - The seller is a "price taker." Since they can sell any amount at the market price, the price is constant. Therefore, P = AR = MR. The line is horizontal.
  2. In Imperfect Competition (Monopoly/Oligopoly): To sell more, the firm must lower the price. This makes the AR curve slope downward. Because the price cut applies to all units sold, the MR falls twice as fast as the AR.

The marginal revenue (MR) and average revenue (AR) relationship explains how the revenues of a company change when additional units are sold.

Rule of Profit Maximisation (MC = MR)

In economics, a firm maximises its profit at the specific level of output where Marginal Cost (MC) is equal to Marginal Revenue (MR).

Marginal Cost (MC) is simply the change in Total Cost from producing one more unit; Change in Total Cost / Change in Quantity Produced = Marginal Cost.

  • When MR > MC: The additional revenue from selling one more unit is greater than the cost of making it. The firm is "leaving money on the table." The firm must increase production to gain more profit.
  • When MC > MR: The last unit produced actually cost more to make than the money it brought in. This unit is eating into the total profit. The firm must decrease production to save money.
  • When MC = MR: The firm has squeezed every possible cent of profit out of the production process. Any further change would lead to lower total profit.

This is why, for profit maximisation firms ensure that Marginal Cost (MC) is equal to Marginal Revenue (MR).

In a typical business scenario, your Average Revenue (AR) and Marginal Revenue (MR) curves often slope downward, while your Marginal Cost (MC) curve is "U-shaped" (due to the law of diminishing returns). Where the MC curve intersects the MR curve from below, is your equilibrium point. And, your Profit Area is the vertical distance between Average Revenue (Price) and Average Total Cost (ATC), multiplied by the quantity sold.