3.3.4 normal profits, supernormal profits and losses

on a graph, at what output level are normal profits made

ac=ar. the same as the profit maximising output level because it is also where mc=mr

supernormal profit

any profit generated above the normal level is supernormal. therefore, if ar exceeds ac, supernormal profits are being made. in the long-run, supernormal profit will attract new firms into this industry. n.b. new entrants can't join a market in the short-run because in the sr capital is fixed.

conditions for profit maximisation

at the output level where MR=MC. this is called the MC=MR rule. this is because if MR exceeds MC, profits can't currently be maximised, because if an extra unit is produced and sold, the increase in total revenue will exceed the increase in total cost, and total profit will rise. on the other hand, if mc is greater than mr, a firm should reduce output because the fall in total cost is greater than the fall in total revenue. therefore, profit will rise.

the long-run shut-down point

in the long-run, both variable and fixed costs can be avoided. therefore, a firm will only continue to trade in the long run if ar is higher than atc (average total costs). therefore, the long run shut down point is th eoutpu level where ar=atc. see notes for graph

see notes for diagrams of normal, supernormal profit and losses

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the short run shut down point

in the short run, firms will stay open even if they are making a loss, provided that ar is greater than avc. this is because tfc- total fixed costs- have to be paid in the short run whether the firm stays in business or not. they cannot be avoided in the short run. if ar is less than atc, but exceeds avc, losses will be minimised if the firm continues to trade in the short run. however, if ar is less than the avc (average variable costs) the firm should shut-down immediately because this option will minimise the firm's loss. therefore, the short run shut down point is at the output level where ar=avc see notes for graph fixed costs can't be avoided in the short run. they're sunk costs (costs that cannot be recovered). therefore, as a policy of loss-minimisation in the short run, a firm will continue to trade, so long as price (AR) exceeds AVC (average variable costs). it is better to make some contribution towards paying off fixed costs, than to make none at all.

losses

losses arise when ac is higher than ar. this could be caused by - a change in consumer tastes which lower price and therefore total revenue - productive inefficiency losses will force firms out of the market.

shut-down points

the Neo-classical theory of the firm assumes that firms are profit maximisers. so when firms make losses they will not continue. it is worth noting that producing at the output level where mc=mr will also enable a loss-making firm to minimise its losses. when does a firm stop trading i.e the shut down point? it depends on whether they are operating in the short run or long run.

what is normal profit

the minimum profit that an entrepreneur will accept in order to keep their business open in the long-run. if profits falll below the normal level, firms will exit the market in the long-run. nomral profits are usually above 0. this is because the entrepreneur will have other income generating opportunities. e.g. if a person can earn a salary of 50,000 per annum working with Goldman Sachs, they will only keep their business open if it's generating a profit of more than 50,000. in developing countries, for framers normal profits can be very low because they don't have other income generating opportunities. n.b. an allowance for normal profit is included within a firm's MC and AC curves. therefore, at an output level where ac=ar, normal profits are being made.

on a graph, where are losses

the mr=ar curve is below the mc and ac. the difference between total costs and total revenues. tc= ac1 x q1 tr= p1 x q1

on a graph, where are supernormal profits

when the MR=AR is higher than the MC and Ac curves. draw the profit maximising level- MC=MR supernormal profits are equal to the difference between total revenue and total costs. total revenue= P1 x Q1 total costs= Ac1 x Q1 supernormal profits are basically the box separating p1 and ac1