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September 18, 2018 

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AGGREGATE EXPENDITURE EQUATION: An equation indicating that aggregate expenditures (AE) are the sum of consumption expenditures (C), investment expenditures (I), government purchases (G), and net exports (X-M), stated as: AE = C + I + G + (X-M). This equation surfaces in the Keynesian economic income-expenditure model in the form of the aggregate expenditures line. However, it's also central throughout the study of macroeconomics, including aggregate demand and the measurement of gross domestic product.

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PERFECT COMPETITION, REVENUE DIVISION:

The marginal approach to analyzing a perfectly competitive firm's short-run profit maximizing production decision can be used to identify the division of total revenue among variable cost, fixed cost, and economic profit. The U-shaped cost curves used in this analysis provide all of the information needed on the cost side of the firm's decision. The demand curve facing the firm (which is also the firm's average revenue and marginal revenue curves) provides all of the information needed on the revenue side.
The total revenue received by a perfectly competitive firm is divided among total fixed cost, total variable cost, and economic profit. This division can be illustrated using the marginal approach to analyzing the profit-maximization production decision.

The key to this division is to translate averages indicated by average curves into totals using the quantity produced. For example total revenue can be identified by multiplying average revenue by the quantity produced and total cost is obtained by multiplying average total cost by the quantity.

To see how revenue is divided, consider the production decision undertaken by Phil the zucchini gardener, a hypothetical perfectly competitive firm. On the revenue side, Phil is a perfectly competitive price taker with no market control. Because Phil's zucchinis are identical to those supplied by gadzillions of other zucchini growers nationwide, he has no market control and faces a perfectly elastic demand curve at the going market price of $4 per pound.

On the cost side, Phil's short-run zucchini production is guided by increasing, then decreasing marginal returns, which means that his cost is reflected by U-shaped cost curves.

Revenue Division
Revenue Division



The exhibit to the right sets the stage for identifying how the total revenue Phil receives from zucchini production is divided. The profit-maximizing situation illustrated in this exhibit is based on the intersection of two curves--the horizontal, perfectly elastic green marginal revenue curve (MR), which is also the demand curve Phil faces when selling zucchinis, and the U-shaped red marginal cost curve (MC). The intersection of these two curves at 7 pounds of zucchinis is the profit-maximizing production level.

The task at hand is first to identify the total revenue Phil receives from producing zucchinis, then to identify the division of this revenue.

  • Total Revenue: Because Phil is a perfectly competitive firm, the MR curve is also average revenue and the product price, $4 per pound. Total revenue is then simply the price ($4) times the quantity of output (7), which is $28.

    Total revenue can be graphically highlighted as the rectangle bounded by the vertical and horizontal axes on the left and bottom, the MR curve on the top, and the vertical line at the quantity of 7 pounds connecting the MR-MC intersection point with the quantity axis on the right. Click the [Total Revenue] button to highlight this area.


  • Total Cost: The next task is to divide Phil's revenue between the total cost of production and his profit. Unfortunately the MC is not sufficient for this task. Other cost information is needed, in particular, the average total cost curve. Click the [ATC Curve] button to add this curve, labeled ATC, to the graph. Much like price times quantity generates total revenue, average total cost times quantity generates total cost. The average total cost of producing 7 pounds of zucchinis is $3 per pound. This is found at the point where the vertical line designating the profit-maximizing 7 pounds of quantity intersects the ATC curve. Total cost is then average total cost ($3) times quantity (7), which is $21.

    This total cost can be graphically highlighted as the rectangle bounded by the vertical and horizontal axes on the left and bottom, the horizontal line indicating $3 average total cost on the top, and the vertical line indicating 7 pounds of zucchinis on the right. Click the [Total Cost] button to illustrate this area.


  • Profit: The difference between the total revenue area and the total cost area is economic profit, equal to $7. This is the smaller rectangle near the top of the total revenue area. It is bounded on the left by the vertical price axis, on the top by the MR curve, on the bottom by the horizontal line indicating $3 average total cost, and on the right by the vertical line indicating 7 profit-maximizing pounds of zucchini production. Click the [Profit] button to highlight this area.

  • Total Variable Cost: Next up is the division of total cost between total variable cost and total fixed cost. This division is possible by adding one more curve to the graph--the average variable cost curve. Click the [AVC Curve] button to add this curve, labeled AVC, to the graph. The point at which the vertical line indicating 7 pounds of zucchinis intersects this AVC curve identifies average variable cost, which is $2.57 per pound of zucchinis. Total variable cost is then average variable cost ($2.57) times quantity (7), which is $18. Total fixed cost is the difference between total cost ($21) and total variable cost ($18), which is $3. Total variable cost is the lower rectangular area bounded by the vertical and horizontal axes on the left and bottom, the line indicating average variable cost of $2.57 on the top, and the vertical line indicating 7 profit-maximizing pounds of zucchini production on the right. Clicking the [Total Variable Cost] button highlights this area.

  • Total Fixed Cost: The last area to identify is total fixed cost. The portion of the total cost area not used for total variable cost goes for total fixed cost. The middle rectangle bounded on the left by the vertical price axis, on the top by the horizontal line indicating $3 average total cost, on the bottom by the horizontal line indicating $2.57 average variable cost, and on the right by the vertical line indicating 7 profit-maximizing pounds of zucchini production is total fixed cost. Click the [Total Fixed Cost] button to highlight this area.
Before leaving Phil and his zucchini production, consider just how lucky Phil has been. The market price, though no action on Phil's part (because he has no market control) is high enough to generate economic profit. This $4 zucchini price generates sufficient total revenue for Phil to pay all cost--total variable cost and total fixed cost. However, should this market price, over which Phil has no control, drop, then Phil would have to reevaluate his production decision. If the price declines enough, Phil could incur a loss and be forced to decide if it is worthwhile to continue in the zucchini growing business.

<= PERFECT COMPETITION, REALISMPERFECT COMPETITION, SHORT-RUN PRODUCTION ANALYSIS =>


Recommended Citation:

PERFECT COMPETITION, REVENUE DIVISION, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2018. [Accessed: September 18, 2018].


Check Out These Related Terms...

     | perfect competition, profit maximization | perfect competition, loss minimization | perfect competition, short-run supply curve | short-run production alternatives | breakeven output |


Or For A Little Background...

     | marginal cost curve | marginal revenue curve | U-shaped cost curves | average total cost curve | average variable cost curve | average revenue curve | marginal cost | marginal revenue | average total cost | average variable cost | average revenue | total revenue | total cost | total variable cost | total fixed cost | profit | economic profit | perfect competition | perfect competition, characteristics | profit maximization | normal profit | accounting profit |


And For Further Study...

     | perfect competition, demand | perfect competition, short-run production analysis | perfect competition, long-run production analysis | perfect competition, efficiency | perfect competition, total analysis | perfect competition, marginal analysis | perfect competition, profit analysis | long run industry supply curve |


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