Normal Profits, Supernormal Profits, & Losses

This section explains normal profits, supernormal profits, and losses, including conditions for profit maximisation and short-run and long-run shut-down points.

Condition for Profit Maximisation

To maximise profit, firms need to determine the optimal level of output where the difference between total revenue (TR) and total cost (TC) is as large as possible. The condition for profit maximisation is:

Profit Maximisation Condition:

$$\text{Marginal Revenue (MR)} = \text{Marginal Cost (MC)}$$

Explanation: Profit is maximised when the cost of producing one more unit (marginal cost) is equal to the revenue gained from selling that additional unit (marginal revenue).

• If MR > MC, the firm should increase output, as the revenue from additional units exceeds the cost of producing them.
• If MR < MC, the firm should reduce output, as the cost of producing extra units is greater than the revenue generated.
• At MR = MC, the firm has no incentive to change the level of output, and profit is maximised.

Diagrammatic Representation
In a typical graph:

• The MR curve slopes downward (in imperfect competition), and the MC curve typically slopes upwards due to diminishing returns.
• The point where the MR curve intersects the MC curve is the profit-maximising output level.

Normal Profit, Supernormal Profit, and Losses

Normal Profit:

• Definition: Normal profit is the minimum level of profit that a firm needs to stay in business in the long run. It occurs when total revenue (TR) equals total cost (TC), which includes both explicit costs (e.g., wages, rent) and implicit costs (e.g., the opportunity cost of the entrepreneur’s time and capital).

Formula:

Normal Profit=Total Revenue (TR)=Total Cost (TC)

$$\text{Normal Profit} = \text{Total Revenue (TR)} = \text{Total Cost (TC)}$$ 

• Explanation: When a firm earns normal profit, it is covering all its costs, including the opportunity cost of the resources employed. The firm earns just enough to stay in the market, but it is not making extra profit above this.
• Diagram: The average total cost (ATC) curve touches the average revenue (AR) curve at the equilibrium output level. At this point, the firm earns just enough to cover all costs, including the normal profit. The firm does not make supernormal profits or incur losses.

Supernormal Profit (or Abnormal Profit):

• Definition: Supernormal profit is the profit a firm earns over and above the normal profit level. It occurs when total revenue (TR) exceeds total cost (TC), and the firm earns more than it would if it were operating in perfect competition.

Formula:

$$\text{Supernormal Profit} = \text{Total Revenue (TR)} > \text{Total Cost (TC)}$$ 

• Explanation: Supernormal profits arise when the firm’s average revenue (AR) is greater than its average total cost (ATC) at the profit-maximising output level. This typically happens in imperfectly competitive markets where firms have some degree of market power to set prices above marginal cost.
• Diagram: In a graph, supernormal profit is shown when the AR curve is above the ATC curve at the profit-maximising output level, resulting in the area of profit above the ATC curve.

Losses

• Definition: A loss occurs when a firm’s total revenue (TR) is less than its total cost (TC). The firm is unable to cover its costs, including the opportunity cost of its resources.

Formula:

$$\text{Loss} = \text{Total Revenue (TR)} < \text{Total Cost (TC)}$$ 

• Explanation: When a firm makes a loss, it is not covering all of its costs, and it is producing at a point where the AR curve lies below the ATC curve at the profit-maximising output level.
• Diagram: In a graph, losses are shown when the AR curve is below the ATC curve at the output level. The distance between the AR and ATC curves represents the loss per unit.

Short-Run and Long-Run Shut-Down Points: Diagrammatic Analysis

Short-Run Shut-Down Point:

• Definition: The short-run shut-down point is the level of output where a firm’s total revenue is equal to its variable cost. If the firm cannot cover its variable costs in the short run, it will choose to shut down temporarily, as it would lose less money by ceasing production than by continuing to produce.
• Explanation: In the short run, fixed costs are sunk, meaning they cannot be recovered, so the firm must cover at least its variable costs to stay in production. If the firm cannot cover its variable costs, it should shut down to minimise losses.

Diagram:

• The shut-down point occurs where the average variable cost (AVC) curve intersects the average revenue (AR) curve.
• If AR is below AVC, the firm is unable to cover its variable costs and will shut down in the short run.
• If AR = AVC, the firm will just break even on its variable costs and is indifferent between operating and shutting down.

Long-Run Shut-Down Point:

• Definition: The long-run shut-down point occurs when a firm’s total revenue is unable to cover its total cost (including both fixed and variable costs) in the long run. In the long run, all costs are variable, so a firm that cannot cover all its costs will exit the industry.
• Explanation: In the long run, if a firm cannot achieve at least normal profit (i.e., total revenue equals total cost), it will exit the market, as there is no point in continuing operations if the firm is unable to generate sufficient revenue to cover both explicit and implicit costs.

Diagram:

• The long-run shut-down point occurs when the average total cost (ATC) curve is tangent to the average revenue (AR) curve. At this point, the firm is only covering its costs (including the opportunity cost of the entrepreneur’s time and resources) and is earning normal profit.
• If the firm’s AR curve is below the ATC curve, it will exit the industry in the long run.

Diagrammatic Analysis:

Short-Run Shut-Down Point:

The firm will shut down if the price (AR) is below the AVC curve.

Diagram:

• MC curve is upward sloping.
• AVC curve is U-shaped, and the firm will operate as long as AR ≥ AVC.
• If AR < AVC, the firm should shut down in the short run.

Long-Run Shut-Down Point:

In the long run, firms can enter or exit the market.

Diagram:

• The ATC curve is U-shaped, and the firm will operate in the long run only if AR ≥ ATC.
• If AR < ATC, the firm will exit the market in the long run.

Summary

• Profit Maximisation occurs where MR = MC, and this is the point at which a firm maximises its profit.
• Normal Profit is when TR = TC, representing the minimum profit required to keep a firm in business.
• Supernormal Profit is the profit above normal profit, where TR > TC.
• Losses occur when TR < TC, and the firm is unable to cover its total costs.
• The Short-Run Shut-Down Point occurs where AR = AVC. If AR < AVC, the firm will shut down in the short run.
• The Long-Run Shut-Down Point occurs where AR = ATC. If AR < ATC, the firm will exit the market in the long run.