The definition and calculation of profit

Profit represents the financial gain a firm achieves when its income exceeds its expenses. It is vital for a business's survival, going beyond simply having more revenue than outflows, as it must account for all relevant costs to ensure long-term viability.

Formula for profit

Profit = total revenue (TR) - total costs (TC)

Where:

• Total revenue (TR) = All income generated from sales
• Total costs (TC) = Sum of all expenses, including both explicit money costs (such as wages and materials that require payment) and implicit opportunity costs (the value of alternatives forgone, like the next best use of resources)

Normal and supernormal profit

Economists differentiate between two key types of profit, based on whether revenue covers all costs, including opportunity costs.

Normal profit

Normal profit arises when a firm's total revenue exactly matches its total costs, resulting in an economic profit of zero once all opportunity costs are included.

Key characteristics:

• Total revenue equals total costs (TR = TC).
• It covers the opportunity costs of the factors of production, such as the returns that could be earned elsewhere.
• This is the minimum return required to keep resources committed to their current use in the long run.

Supernormal profit

Supernormal profit occurs when a firm's total revenue exceeds its total costs, meaning the business generates more income than could be achieved by using its resources in any alternative way.

Key characteristics:

• Total revenue is greater than total costs (TR > TC).
• Also referred to as abnormal profit.
• It signals high returns, attracting new firms to enter the industry in pursuit of similar gains.

Short-run and long-run shutdown decisions

Firms face different considerations for continuing operations depending on the time frame, influenced by fixed and variable costs. In the short run, some costs are unavoidable, while in the long run, all can be adjusted, affecting decisions on whether to stay open.

Short-run shutdown decisions

In the short run, firms have fixed costs that must be paid regardless of production levels, such as rent or equipment leases. Shutdown choices depend on how revenue compares to variable costs (those that change with output, like raw materials).

Decision criteria:

• Continue operating: If total revenue exceeds total variable costs (TR > TVC), the firm should keep producing, as it can cover variable costs and contribute towards fixed costs, minimising losses.
• Shut down immediately: If total revenue is less than total variable costs (TR < TVC), the firm should stop production right away, as continuing would increase losses beyond just the fixed costs.

Even a loss-making firm might stay open temporarily if it covers variable costs, buying time to improve or exit strategically.

Long-run shutdown decisions

In the long run, all costs become variable, allowing firms to escape fixed commitments. Decisions focus on achieving at least normal profit for sustainability.

Decision criteria:

• Exit the market: If prices remain below the level needed for normal profit, the firm will shut down, as ongoing losses are not viable.
• Continue if viable: If prices are between normal profit and loss level, the firm should continue to produce in the short run.
• Immediate cessation: If prices drop below average variable costs, production stops straight away, regardless of the time frame.

The profit maximisation rule

Firms are assumed to seek the highest possible profit by selecting the optimal output level. This involves comparing the additional revenue and costs from producing one more unit, applicable to both firms that set their own prices and those that accept market prices.

Rule for maximising profit

Profit is maximised at the output level where marginal cost equals marginal revenue (MC = MR).

Where:

• Marginal cost (MC) = The additional cost of producing one more unit
• Marginal revenue (MR) = The additional revenue from selling one more unit

Guidelines for adjusting output

• Increase output: If marginal revenue exceeds marginal cost (MR > MC), producing more units adds to profit, as the extra revenue outweighs the extra cost.
• Decrease output: If marginal revenue is less than marginal cost (MC > MR), reducing production boosts profit, as the cost savings exceed the revenue loss.
• Optimal point: Equilibrium is reached when MC = MR, where no further adjustments increase profit.

This rule holds for price takers (firms in competitive markets that accept given prices) and price makers (firms with market power to influence prices).