3.3.4 Normal profits, supernormal profits and losses Flashcards
Explain what normal profit is.
- Normal profit is the minimum profit needed to keep factor inputs in their current use in the long run.
- Normal profits reflect the opportunity cost of using funds to finance a business. If you put £200,000 of savings into a new business, those funds could have earned a low-risk rate of return by being saved in a bank account.
You might use the rate of interest on that £200,000 as the minimum rate of return that you need - Because we treat normal profit as an opportunity cost of investing financial capital, then we include normal
profit in the average total cost curve - Thus, if price at least covers AC then a business is making normal profits in a market
When is profit maximised?
Profits are maximised at an output level where marginal revenue (MR) is equal to marginal cost (MC).
Explain supernormal profit
- Profit achieved in excess of normal profit.
- Profit when AR > AC
- When firms are making supernormal profits, there is an incentive for other producers to enter a market
Explain subnormal profit
- This is profit less than normal (i.e. price per unit < average cost)
- Also known as an economic loss
- If we looked at a business’s accounts, it may appear that they are making an “accounting profit” (remember
that accountants do not include opportunity cost in the business’s costs of production)
What does supernormal, normal and subnormal profits look like on a cost/rev graph?
Why is profit an important objective of most but not all firms?
- Finance for capital investment and research: Retained profits are a key source of finance for businesses
undertaking investment + funds for acquisitions - Market entry: Rising supernormal profits send signals to other producers within a market
- Demand for and flow of factor resources: Resources flow where the risk-adjusted rate of profit is highest
- Signals about health of the economy: Rising profits might reflect improvements in supply-side performance.
They are also the result of higher levels of aggregate demand for example during an economic recovery
Show the Effect of a rise in variable cost on price, output and profit on a cost/rev diagram
The rise in variable costs causes an upward shift in MC and AC. This causes a fall in the profit maximising output from Q1 to Q2. Price rises from P1 to P2 which helps to partially absorb the rise in costs. But overall, the level of supernormal profit falls (Profit = Q2 x (P2-C2).
What are strategies to increase profit?
- Reduce overhead costs (fixed costs) so that average cost per unit falls
- Increase labour productivity / outsource some production to lower cost suppliers
- Move up the value chain – develop new products with a lower price elasticity of demand and higher income
elasticity of demand - Discount prices if the business estimates that demand is highly price elastic
- Find new customers in new markets e.g. from exporting to more countries
Explain the short run shutdown point
- In the short run a firm will supply their products as long as price per unit is greater than or equal to average
variable cost (i.e. where AR = AVC). - Providing that P>AVC, then firms will stay in the market in the short run because there is a contribution being
made to covering the fixed costs of production - If price (AR) is less than AVC, then the firm will likely shut down
- This is called the short-run shut-down price in a competitive market
Explain the long run shutdown point
- A business needs to make at least normal profit in the long run to justify remaining in an industry (i.e. at a
price and output where P=AC) - If price (or AR) is less than AC in the long run, then the firm will shut down in theory
- Firms can survive while making a loss because the managers are satisficing, or where a downturn is seen as
temporary and demand is expected to pick up again - Losses might be cross-subsidised by profits in another sector/market
What does shut down price in the short run look like on a cost curve?
