3.8 - Profit
The distinction between normal and supernormal profit
Economists differentiate between two types of profit to understand how businesses perform and what motivates firms to enter or leave markets.
Normal profit
Normal profit, sometimes called zero economic profit, arises when a firm's total revenue exactly matches its total costs. This level of profit is essential as it covers all expenses, ensuring that resources are not better used elsewhere. It represents the minimum return required to keep factors of production in their current use over the long term.
Supernormal profit
Supernormal profit, also referred to as abnormal profit, occurs when total revenue exceeds total costs. In this case, the earnings from using resources in the business surpass what they could achieve in alternative activities. This excess acts as a signal to other firms, encouraging them to join the industry in pursuit of similar gains.
The basic profit equation and components of costs
Profit is calculated by comparing a firm's income from sales against all its expenses.
Formula for profit
Where:
- Total revenue (TR) = Income generated from selling goods or services
- Total costs (TC) = All expenses involved in production, including both money costs and opportunity costs
Components of total costs
- Money costs - These are explicit payments for resources, such as wages, rent, or raw materials.
- Opportunity costs - These represent the value of alternatives forgone. They are not paid in cash but must be included to measure true economic profit.
A firm achieving zero economic profit is still viable, as it fully compensates for all opportunity costs, including the owner's time and capital.
The importance of normal profit for long-run operation
Normal profit plays a critical role in a firm's sustainability. Without it, resources would eventually shift to more rewarding uses, leading to the business's closure.
Reasons normal profit is essential in the long run:
- It ensures that all costs, including opportunity costs, are covered, making the current use of resources worthwhile.
- If normal profit is not achieved, the firm will exit the industry, as owners could gain better returns elsewhere.
Shutdown decisions in the short run and long run
Firms face decisions about whether to continue operating when profits are low or negative. These choices differ between the short run, where some costs are fixed, and the long run, where all costs can be adjusted.
Factors influencing shutdown decisions:
- Long-run shutdown - A firm will leave the market if the price stays below the level needed to make normal profit, as it cannot cover all costs, including opportunity costs.
- Short-run continuation - Even if normal profit is not achieved, the firm may keep operating if revenue covers variable costs and contributes to fixed costs. This reduces losses compared to shutting down immediately.
- Immediate closure - If revenue falls below variable costs, the firm should stop production right away to avoid greater losses.
In the long run, firms can escape fixed costs, such as by terminating leases, making it easier to exit unprofitable situations.
Profit maximisation using marginal cost and revenue
Firms aim to produce at the output level where profits are highest. This is determined by comparing the additional cost and revenue from each unit produced.
The rule for maximising profit
Profit is maximised at the point where marginal cost equals marginal revenue.
Where:
- Marginal cost (MC) = The extra cost of producing one more unit
- Marginal revenue (MR) = The extra revenue from selling one more unit
How the MC = MR rule works:
- If MR > MC, increasing output adds more to revenue than to costs, boosting profit.
- If MR < MC, reducing output cuts costs more than revenue, increasing profit.
- At MC = MR, no further changes improve profit, marking the optimal production level.