3.3.4 Normal Profits, Supernormal Profits and Losses (Edexcel)

This Edexcel study note covers Normal Profits, Supernormal Profits and Losses

a) Condition for profit maximization:

Profit maximization occurs when a firm or producer selects the level of output where its economic profit is the highest. Economic profit is calculated as total revenue minus total cost (including both explicit and implicit costs). The condition for profit maximization in the short run is as follows:

1. MR = MC: In the short run, a profit-maximizing firm produces the quantity of output where marginal revenue (MR) equals marginal cost (MC). In other words, the firm should continue producing as long as the additional revenue generated from selling one more unit of output is greater than or equal to the additional cost of producing that unit.

In the long run, under perfect competition, the condition for profit maximization is slightly different:

1. P = MR = MC: In the long run, in a perfectly competitive market, firms produce where the price (P) equals both marginal revenue (MR) and marginal cost (MC). This ensures not only profit maximization but also that firms do not enter or exit the industry in the long run.

b) Normal profit, supernormal profit, and losses:

• Normal Profit: Normal profit is the minimum level of profit required to keep a firm in the industry. It is the profit that covers all explicit and implicit costs of production but provides no extra income above those costs. In economic terms, normal profit is when Total Revenue (TR) equals Total Cost (TC), including the opportunity cost of the resources used.
• Supernormal Profit (Economic Profit): Supernormal profit, also known as economic profit, occurs when a firm's total revenue (TR) exceeds its total cost (TC), including both explicit and implicit costs. In other words, the firm is earning more than enough to cover all costs, including the opportunity cost of the resources used. This situation is generally temporary, as it attracts competition, which can drive down prices and reduce economic profit over time.
• Losses: Losses occur when a firm's total cost (TC) exceeds its total revenue (TR). In this situation, the firm is not covering all of its costs, including explicit and implicit costs. Losses can lead to a firm shutting down in the short run if it cannot cover its variable costs.

c) Short-run and long-run shutdown points:

• Short-run shutdown point: A firm should shut down in the short run if it cannot cover its variable costs. In other words, if the total revenue (TR) is less than the variable costs (VC), the firm should shut down. This is because even if the firm continues to produce and cover some of its fixed costs, it would be better off shutting down and minimizing its losses equal to the fixed costs.
• Long-run shutdown point: In the long run, firms should exit the industry if they cannot cover their total costs, including both fixed and variable costs. In a perfectly competitive market, firms enter or exit until economic profit is driven to zero. So, the long-run shutdown point is where TR equals TC, including both fixed and variable costs. If TR is less than TC in the long run, the firm should exit the industry.

These concepts are fundamental in understanding how firms make production and shutdown decisions in both the short run and the long run in various market structures.