Introduction
Microeconomics concerns individual and firm-level decisions regarding the allocation of resources. There are several important concepts to analyze a firm-level venture. We will just consider a single product firm for the sake of simplicity. Hence it is quite important for decision-making.
At its most basic level, microeconomics considers at what volumes and prices it makes sense for a enterprise to continue producing a good or service.
Revenues, Costs and Profits
General Definitions
Revenue (R) is the amount of money a firm receives in payment for a product sold.
Costs (C) are how much money a firm pays to make a product.
Profit (P) is the amount left over when cost is subtracted from revenue:
\(P = R – C\)
For example, a pizza requires $5 of ingredients, labor and overhead to make. A pizzeria can cell that pizza for $12. The profit would then be $7:
\($7 = $12 – $5\)
Definitions for Totals
Total Revenue (TR) is the sum of revenues a firm receives in payment for all units of the product sold.
Total Cost (TC) is the sum of costs a firm pays to make all units of the product sold.
Total Profit (TP) is the sum of profits obtained from all goods sold:
\(TP = TR – TC\)
The pizzeria sells 100 pizzas each for $12, resulting in $1,200 in total revenue. The pizzas cost $5 to make, resulting in total costs of $500. Then the total profit would be $700.
\($700 = $1,200 – $500\)
Definitions for Marginal Quantities
However, not all units of a product cost the same to make, nor are they always sold at the same price. So it is often of interest to determine the revenue, cost and profit of each additional unit produced and sold.
Marginal Revenue (MR) is the revenue received for one additional unit of product sold.
Marginal Cost (MC) is the cost paid to produce for one additional unit of product.
Marginal Profit (MP) is the profit obtained when producing one additional unit of product:
\(MP = MR – MC\)
Margins
Businesspeople often talk of Gross Margins (GM), which is:
\(GM = \frac{Revenue – Cost~of~Goods~Sold}{Revenue}\).
Here, the Cost of Goods Sold (COGS) is simply Costs (C). So Gross Margin becomes:
\(GM = \frac{R – C}{R}\)
Fixed Quantities
Fixed Costs (FC) are the minimum costs required to produce any amounts of units (even zero amount). For example, just to get into business, a pizzeria has to buy an oven.
Other Important Quantities
Entry costs are the minimum cost to start a particular business. Such are closely related to fixed costs.
Opportunity Cost (OC) is the amount of profit given up by not pursuing a course of action.
Risk (R) is cost due to uncertainty.
Interest rates (i) reflect a combination of costs due to risk and sacrificed opportunities. In reality, they can also represent bargaining power differentials.
Example
Imagine you are a celebrity setting up an online retail firm selling tee shirts with your photo for $10. All orders are fulfilled using a third-party online service. They charge you $5 amount for each tee shirt.
Your marginal revenue is $10. Your marginal cost is $3. Your marginal profit is $7.
If you sell 100 tee shirts, your total profit would be:
\(Total~Profit = Total~Revenues – Total~Costs\)
\($400 = 100~shirts~ (\frac{$7}{shirt} – \frac{$3}{shirt})\)
What if you had to pay for an up-front set-up fee of $100 to process your photo? This would be a fixed cost, as well as a start-up cost. Even if you sold no tee shirts, you would still incur the $100 just to go into business. If you sold no shirts, you would have a $100 loss instead of a profit.
However, if you once again sold $100 shirts, your profit after fixed costs would be the $400 from above less the $100 start-up fee, for a net profit of $300.
What is the minimum amount of shirts you should expect to sell in order to decide to go into business? You will need to at least break-even, which means to cover the fixed costs plus expected marginal costs. Here, marginal profit will provide $4 per shirt, so it takes 25 shirts to cover the initial $100 investment.