Model essay (a): when a firm's costs rise

What this lesson teaches

• I can explain profit as total revenue minus total cost and find the profit-maximising output where MR equals MC with MC rising.

  Syllabus 9570, 2.2.1(a). Objectives of Firms: Firms aim to maximise profits; Profit as the difference between total revenue and total cost; Profit-maximising output occurs at the point when marginal revenue (MR) equals marginal cost (MC) and where MC is rising

• I can explain a firm's cost and revenue concepts in the short run and the long run.

  Syllabus 9570, 2.2.2(a). Cost and Revenue: Firms' cost and revenue concepts in the short run and long run

Make a guess

Electricity prices rise for a bakery that uses ovens all day. What happens to its profit-maximising output and price?

1. Output rises to spread the higher cost over more loaves.
2. Output and price stay the same, because costs do not affect them.
3. Output falls and price rises, because marginal cost rises.

The answer to part (a)

Introduction

A profit-maximising firm produces the output where marginal revenue (MR) equals marginal cost (MC), and charges the highest price its demand curve allows for that output. Fixed costs, such as rent, do not change with output in the short run. Variable costs, such as electricity and ingredients, rise with each extra unit produced. The two kinds of cost rise affect the firm differently, because only variable costs change MC.

Paragraph 2: a rise in fixed cost

Suppose a cafe's monthly rent rises. Its total fixed cost rises, so its average cost (AC) rises at every output, because each cup must now cover a larger share of the rent. But the cost of making one more cup is unchanged, so MC does not move. Since MR and MC are both unchanged, MR still equals MC at the same output. The cafe keeps the same output and the same price, and its profit falls by the full rise in rent. In the short run it stays open as long as its revenue covers its variable costs. In the long run, if price falls below AC, it will leave the industry.

Paragraph 3: a rise in variable cost

Now suppose electricity and ingredient prices rise. Each extra cup now costs more to produce, so MC shifts up from MC0 to MC1 in Figure 1, and AC rises too. At the old output Q0, MC1 is now above MR, so the last few units add more to cost than to revenue. The firm cuts output until MR equals MC1, at Q1. With fewer cups to sell, it can charge a higher price on its demand curve, rising from P0 to P1. Profit falls, because costs have risen and the firm passes only part of the rise on to customers.

Paragraph 4: how much the price rises

How much of the cost rise is passed on depends on how price elastic the firm's demand is. A cafe with loyal customers and few nearby rivals faces fairly inelastic demand. Its AR curve is steep, so it can raise its price a lot without losing many sales. A cafe surrounded by rivals faces elastic demand, so it raises its price only a little and absorbs most of the cost rise as lower profit.

Conclusion

A rise in fixed cost leaves the profit-maximising price and output unchanged and reduces profit. A rise in variable cost shifts MC up, so the firm produces less, charges more and still earns less profit. The size of the price rise depends on the price elasticity of demand the firm faces.

Margin notes: how each paragraph scores

Introduction

States the MR = MC rule and defines both kinds of cost, which is the key to the whole answer.

Paragraph 2

Explains why MC does not move, then each of the three effects. Adding the short-run and long-run decision shows full understanding.

Paragraph 3

L3 analysis on Figure 1: the shift of MC, why the old output is no longer best, and the new price and output. Every label is used.

Paragraph 4

Extends the analysis with price elasticity, which explains why firms pass on different amounts. This depth helps a script reach the top of L3.

Conclusion

Summarises both cases clearly. No evaluation marks are available for a 10-mark part.

Overall: L3, 9 or 10 marks

Both cases explained with all three effects and a correct firm diagram. Saying that both cost rises raise the price would be a conceptual error that caps the answer at L1 or low L2.

Worked example: A 3-minute plan

Two cases, three effects each. Use MR = MC as the test.

1. Intro: profit maximised where MR = MC; fixed cost does not vary with output, variable cost does.
2. Fixed cost up (rent): AC up, MC unchanged; same Q and P; profit falls; may exit in the long run.
3. Variable cost up (energy, ingredients): MC and AC up; Q falls, P rises (Figure 1); profit falls.
4. Size of the price rise depends on how elastic the firm's demand is.
5. Close: only MC changes price and output; both cut profit.

Watch out for this

When rent goes up, a profit-maximising firm raises its price to cover the higher cost.

Rent is a fixed cost, so it does not change MC. The output where MR = MC, and so the best price, stay the same. The firm simply earns less profit.

Check your understanding

A cafe's monthly rent goes up by $2,000, while the cost of making each cup stays the same. How should it change what it charges and how many cups it sells?

1. Sell more cups, so the cafe can spread the higher rent over more sales.
2. Charge more and sell fewer cups, because the cafe's costs went up.
3. Leave both unchanged, since rent does not alter marginal cost.