3.3.4 Normal Profits, Supernormal Profits & Losses

• 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

Output	MR (£)	MC (£)	Addition to Profit
5	50	32	+18
6	50	36	+14
7	50	50	0
8	50	68	-18

 

Observations

• With the 7th unit of output, MC = MR & no additional profit can be extracted by producing another unit 
• Up to the 6th unit of output, MC < MR & additional profit can still be extracted by producing an additional unit 
• From the 8th unit of output, MC > MR & 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
    
    
    

• 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 & 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

Output	TR (£)	TC (£)	Profit (TR - TC)
5	150	70	80
6	180	96	84
7	220	220	0
8	250	270	-20

 

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
  
  

• Firms do not always make a profit & may endure losses for a period
  • Entrepreneurs often keep firms going in the hope that market conditions will change & 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 & 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)

A firm should shut down in the short-run if the selling price (AR) is unable to cover the 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 & 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)
    
    

A firm should shut down in the long-run if the selling price (AR) is unable to cover the 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 & the firm will shut down