3.3.4 Normal profits, supernormal profits and losses

Question 1

Profit

Answer 1

Profit is the difference between revenue and costs.

Question 2

Condition for profit maximisation

Answer 2

• Profit is maximised when TR and TC are furthest apart, with TR above TC.
• It also occurs when MC=MR: this will always be true because if producing one more adds more to revenues than it does to cost (i.e. MR is higher than MC), producing that must have increased profit and vice versa. Sometimes, MR and MC may cross at two points and thus the profit maximising point is where marginal cost rises as it crosses the MR line.

Question 3

Normal profit, supernormal profit and losses

Answer 3

• Normal profit is the return that is sufficient to keep the factors of production committed to the business. In economics, costs include the level of profit needed to keep the producer in the market and to cover the opportunity cost. Therefore, if the firm covers its costs it earns normal profit. This is at the point where AC=AR or TC=TR.
• If the profit is greater than normal profit, it is earning supernormal, abnormal or monopoly. This occurs where AR>AC or TR>TC.
• A loss is where the firm fails to cover its costs, AR<AC or TR<TC.

Question 4

Short-run and Long-run shut-down points

Answer 4

• When a business is making a loss, it may not necessarily be the best decision to shut down straight away: this depends on the average variable cost.
• If AVC<AR then firms should continue production. Each good they make will generate more revenue than it cost for them to make it, and so this will help them to reduce the size of the loss by covering some of the fixed cost. In this case, they should only shut down when their fixed costs increase e.g. when machinery needs to be replaced, when their lease is up etc.
• However, if AVC>AR then producing more goods will increase the loss. As a result, they should leave the industry immediately.
• In the long run, the firm needs to make at least normal profit for them at stay in the industry. However, in the short run they should produce as long as their revenue covers their variable costs. Hence, the short run shut-down point is where AVC=AR.
• Firms tend to produce on the shut-down point even though it does not affect their losses as they do not want to let go of their workers or let down customers.