Profit

Question 1

Economists distinguish between Normal Profit and Supernormal Profit

Answer 1

1. Here’s the basic equation for working out profit:
   Profit = Total Revenue (TR) - Total Costs (TC)
   TC consists of the money costs of the things that have been paid for and the opportunity costs of the things that aren’t paid for)
2. There are two kinds of profit = normal and supernormal (abnormal) profit.

Question 2

Normal Profit occurs when TR = TC

Answer 2

• A firm is making normal profit when its total revenue equals its total costs.
• So normal profit is an ‘economic profit’ of zero - i.e. a profit of zero if all costs are taken into account
• This means normal profit occurs when the extra revenue left, on top of what’s needed to cover the firm’s money costs, is equal to the opportunity costs of the factors of production that aren’t paid for.
• If the extra revenue is less than those opportunity costs, then the firm would have been better off putting the factors of production to a different use.
• In other words, normal profit is the minimum level of profit needed to keep resources in their current use in the long run.

Question 3

Supernormal Profit occurs when TR > TC

Answer 3

• A firm is making supernormal profit when its total revenue is greater than its total costs.
• This means the revenue generated from using the factors of production in this way is greater than could have been generated by using them in any other way.
• If firms in an industry are making supernormal profit, this will create an incentive for other firms to try to enter that industry

Question 4

A firm needs to make Normal Profit to Keep Operating in the Long Run

Answer 4

1. If a firm can’t make normal profit it will close in the long run, because its revenue is not covering all of its costs. Even if it’s making a money profit, the factors of production it’s using could be used to better effect elsewhere.
2. However, in the short run, a firm has fixed costs that it has to pay, whether or not it produces any output. So a loss-making firm may not close immediately - it all depends on how its revenue compares to its variable costs.
   - If a firm’s total revenue is greater than its total variable costs (or if average revenue is greater than average variable costs), then it’ll continue to produce in the short term.
   - Any revenue generated above the firm’s variable costs can contribute towards paying its fixed costs. If the firm stops production immediately, it’ll actually be worse off.

• If a firm’s total revenue is less than its total variable costs), then it’ll close immediately.
• If it continues to produce, it’ll actually be worse off

3. In the long run the firm can be released from its fixed coss and it will be shut down.
4. Shut-down points can be shown diagramatically:
   - In the long run, if the price remains below P, then the firm should exit the market. The losses the firm is making aren’t sustainable.
   - If the price is between P and P1, the firm should continue to produce in the short run.
   - If the price falls below P1, the firm should cease production immediately, as its variable costs aren’t being covered.
   * LOOK AT DIAGRAM ON PG 50*

Question 5

Profit is Maximised when Marginal Cost = Marginal Revenue

Answer 5

1. Economists generally assume that firms are aiming to maximise their profits. To do this, they need to find the optimum output level at which to operate.
   - If marginal revenue (MR) is greater than marginal cost (MC) at a particular level of output, the firm should increase output. This is because the revenue gained by increasing output is greater than the cost of producing it. So increasing output adds to profit.
   - If marginal revenue (MR) is less than marginal cost (MC) at a particular level of output, the firm should decrease output. This is because it’s costing the firm more to produce its last unit of output than it receives in revenue. So decreasing output adds to profit.
2. This means the profit-maximising output level occurs when MC = MR. This is known as the “MC = MR profit-maximising rule”.
   - Profits are maximised when MC = MR
3. You can use this rule to find a firm’s profit-maximising output level from a diagram showing MR and MC, as in two examples below.
   DIAGRAM 1 - Shows a price taker
   DIAGRAM 2 - This shows a price maker

-Both firms maximise profits by producing at the level where MC = MR