The calculation of profit

Profit represents the financial gain a firm achieves after covering all its expenses.

$\text{Profit}=\text{total revenue (TR)}-\text{total costs (TC)}$

Where:

• Total revenue (TR) = All income generated from sales (£)
• Total costs (TC) = Sum of all fixed and variable costs (£)

Normal profit and supernormal profit

Economists differentiate between two types of profit: normal and supernormal (also known as abnormal profit).

Normal profit

Normal profit occurs when total revenue equals total costs (TR = TC), resulting in an economic profit of zero. A firm might still show an accounting profit (where revenue exceeds explicit money costs), but if this does not match the opportunity costs, the economic profit is zero. Normal profit is the minimum required to keep factors of production in their current use long-term; below this, resources would be better allocated elsewhere.

Supernormal profit

Supernormal profit arises when total revenue exceeds total costs (TR > TC). This means the revenue from using factors of production surpasses what could be earned in any alternative use. Supernormal profits in an industry attract new entrants.

Conditions for firms to continue operating in the short run and long run

Firms must achieve at least normal profit to survive long-term.

Long-run requirements

Firms unable to make normal profit will eventually shut down, as revenue fails to cover all costs. Resources could be redeployed more profitably elsewhere.

Short-run requirements

In the short run, fixed costs (e.g., rent) must be paid regardless of output, so firms assess revenue against variable costs to decide on production.

Decision criteria:

• TR > total variable costs (TVC) or AR > AVC - Firm continues producing in the short run. Revenue covers variable costs and contributes to fixed costs, reducing overall losses compared to immediate shutdown.
• TR < TVC or AR < AVC - Firm shuts down immediately. Continuing production increases losses, as variable costs are not covered.

In the long run, fixed costs can be avoided (e.g., by ending a lease), so persistent losses lead to market exit.

Worked example - Deciding whether to continue production in the short run

A firm has total revenue of £18,000, total variable costs of £14,000, and fixed costs of £6,000. Calculate the profit and determine if the firm should continue operating in the short run.

Step 1: Identify the values

• Total revenue (TR) = £18,000
• Total variable costs (TVC) = £14,000
• Fixed costs = £6,000

Step 2: Calculate total costs and profit

Total costs (TC) = TVC + fixed costs = £14,000 + £6,000 = £20,000
Profit = TR - TC = £18,000 - £20,000 = -£2,000 (a loss)

Step 3: Compare TR and TVC

TR (£18,000) > TVC (£14,000), so the firm should continue producing in the short run.

Step 4: Interpretation

The £4,000 excess over variable costs helps cover part of the fixed costs, making continued operation better than shutting down immediately, where the full £6,000 fixed costs would still be lost without any revenue.

Shut-down points and their diagrammatic representation

Shut-down points help firms decide when to stop production based on price levels relative to costs. These can be illustrated on a graph showing cost curves.

Key elements of the shut-down diagram

• Axes:
  • Vertical - Revenue/Cost (£)
  • Horizontal - Quantity (units)
• Curves:
  • Marginal cost (MC) - Upward-sloping, intersects other curves at their minima.
  • Average total cost (ATC) - U-shaped, showing total costs per unit.
  • Average variable cost (AVC) - Lower U-shaped curve, showing variable costs per unit.
• Long-run shut-down point - If price remains below P, the firm should exit the market long-term, as losses are unsustainable.
• Short-run continuation point - If price is between P and P₁, the firm should continue to produce in the short run.
• Immediate shut-down point - If price falls below P₁, the firm should cease production immediately, as its variable costs aren't being covered.