normal-profits-supernormal-profits-and-losses

Condition for Profit Maximisation

• To maximise profit firms should produce up to the level of output where marginal cost (MC) = marginal revenue (MR)

Calculations To Demonstrate the Profit Maximisation Rule

 Observations

• With the 7th unit of output, MC = MR and no additional profit can be extracted by producing another unit 

• Up to the 6th unit of output, MC < MR and additional profit can still be extracted by producing an additional unit 

• From the 8th unit of output, MC > MR and the firm has gone beyond the profit maximisation level of output

  • It is making a marginal loss on each unit produced beyond the point where MC = MR

Normal Profit, Supernormal Profit & Losses

• When calculating costs, Economists consider both the explicit and implicit costs of production

  • Explicit costs are the costs which have to be paid e.g raw materials, wages etc.

  • Implicit costs are the opportunity costs of production

    • This is the cost of the next best alternative to employing the firm’s resources

    • E.g. if an investor puts £1m into producing bicycles and they could have put it in the bank to receive 5% interest, then the 5% represents an implicit cost

  • Implicit costs must be considered as entrepreneurs will rationally reallocate resources when greater profits can be made elsewhere

• Profit = total revenue (TR) – total costs (TC)

  • Total costs include explicit and implicit costs

• Normal profit occurs when TR = TC 

  • This is also called breakeven

• Supernormal profit occurs when TR > TC

• A loss occurs when TR < TC

Calculations To Demonstrate Profits

 Observations

• Supernormal profit occurs up to the 6th unit of output

• Normal profits occur at the 7th unit

• From the 8th unit, the firm is making a loss

Short-run & Long-run Shut-down Points

• Firms do not always make a profit and may endure losses for a period

  • Entrepreneurs often keep firms going in the hope that market conditions will change and demand for their products will increase leading to profitability

  • This raises the question, ‘when is it the best time for a firm to shut down?‘

• The shut-down rule provides the answer by considering both the long-run and short-run periods

The short-run shut down point

• In the short-run, if the selling price (average revenue) is higher than the average variable cost (AVC), the firm should keep producing (AR > AVC)

  • If the selling price (AR) falls to the AVC it should shut down (AR = AVC)

Diagram analysis

• The firm produces at the profit maximisation level of output (Q) where MC=MR

• At this level, the P = AVC

  • This means that there is no contribution towards the firm’s fixed costs

    • The selling price literally only covers the cost of the raw materials used in production

    • There is no point in continuing production and the firm should shut down

The long-run shut down point

• In the long-run, if the selling price (AR) is higher than the average cost (AC) the firm should remain open (AR > AC)

  • if the selling price (AR) is equal to or lower than the average cost (AC), the firm should shut down (AR = AC)

Diagram analysis

• The firm produces at the profit maximisation level of output (Q) where MC=MR

• At this level, P < AC

  • It could continue operating in the short-run as the AR > AVC, but in the long-run they are making a loss and the firm will shut down