Normal Profits, Supernormal Profits & Losses (Edexcel A Level Economics A)

Revision Note

Steve Vorster

Written by: Steve Vorster

Reviewed by: Jenna Quinn

Condition for Profit Maximisation

  • To maximise profit firms should produce up to the level of output where marginal cost (MC) = marginal revenue (MR)

Calculations To Demonstrate the Profit Maximisation Rule

Output

MR (£)

MC (£)

 Addition to Profit

5

50

32

+18

6

50

36

+14

7

50

50

0

8

50

68

-18

 Observations

  • With the 7th unit of output, MC = MR and no additional profit can be extracted by producing another unit 

  • Up to the 6th unit of output, MC < MR and additional profit can still be extracted by producing an additional unit 

  • From the 8th unit of output, MC > MR and the firm has gone beyond the profit maximisation level of output

    • It is making a marginal loss on each unit produced beyond the point where MC = MR

Normal Profit, Supernormal Profit & Losses

  • When calculating costs, Economists consider both the explicit and implicit costs of production

    • Explicit costs are the costs which have to be paid e.g raw materials, wages etc.

    • Implicit costs are the opportunity costs of production

      • This is the cost of the next best alternative to employing the firm's resources

      • E.g. if an investor puts £1m into producing bicycles and they could have put it in the bank to receive 5% interest, then the 5% represents an implicit cost

    • Implicit costs must be considered as entrepreneurs will rationally reallocate resources when greater profits can be made elsewhere

  • Profit = total revenue (TR) - total costs (TC)

    • Total costs include explicit and implicit costs

  • Normal profit occurs when TR = TC 

    • This is also called breakeven

  • Supernormal profit occurs when TR > TC

  • A loss occurs when TR < TC

Calculations To Demonstrate Profits

Output

TR (£)

TC (£)

 Profit (TR - TC)

5

150

70

80

6

180

96

84

7

220

220

0

8

250

270

-20

 Observations

  • Supernormal profit occurs up to the 6th unit of output

  • Normal profits occur at the 7th unit

  • From the 8th unit, the firm is making a loss

Short-run & Long-run Shut-down Points

  • Firms do not always make a profit and may endure losses for a period

    • Entrepreneurs often keep firms going in the hope that market conditions will change and demand for their products will increase leading to profitability

    • This raises the question, 'when is it the best time for a firm to shut down?'

  • The shut-down rule provides the answer by considering both the long-run and short-run periods

The short-run shut down point

  • In the short-run, if the selling price (average revenue) is higher than the average variable cost (AVC), the firm should keep producing (AR > AVC)

    • If the selling price (AR) falls to the AVC it should shut down (AR = AVC)

3-3-4-short-run-shut-down-point_edexcel-al-economics
A firm should shut down in the short-run if the selling price (AR) is unable to cover the AVC

Diagram analysis

  • The firm produces at the profit maximisation level of output (Q) where MC=MR

  • At this level, the P = AVC

    • This means that there is no contribution towards the firm's fixed costs

      • The selling price literally only covers the cost of the raw materials used in production

      • There is no point in continuing production and the firm should shut down

The long-run shut down point

  • In the long-run, if the selling price (AR) is higher than the average cost (AC) the firm should remain open (AR > AC)

    • if the selling price (AR) is equal to or lower than the average cost (AC), the firm should shut down (AR = AC)

3-3-4-long-run-shut-down-point_edexcel-al-economics
A firm should shut down in the long-run if the selling price (AR) is unable to cover the AC

Diagram analysis

  • The firm produces at the profit maximisation level of output (Q) where MC=MR

  • At this level, P < AC

    • It could continue operating in the short-run as the AR > AVC, but in the long-run they are making a loss and the firm will shut down

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Steve Vorster

Author: Steve Vorster

Expertise: Economics & Business Subject Lead

Steve has taught A Level, GCSE, IGCSE Business and Economics - as well as IBDP Economics and Business Management. He is an IBDP Examiner and IGCSE textbook author. His students regularly achieve 90-100% in their final exams. Steve has been the Assistant Head of Sixth Form for a school in Devon, and Head of Economics at the world's largest International school in Singapore. He loves to create resources which speed up student learning and are easily accessible by all.

Jenna Quinn

Author: Jenna Quinn

Expertise: Head of New Subjects

Jenna studied at Cardiff University before training to become a science teacher at the University of Bath specialising in Biology (although she loves teaching all three sciences at GCSE level!). Teaching is her passion, and with 10 years experience teaching across a wide range of specifications – from GCSE and A Level Biology in the UK to IGCSE and IB Biology internationally – she knows what is required to pass those Biology exams.