5.3.4

Profits

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Profit

Profit is the difference between revenue and costs.

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Equation for profit

  • Profit = total revenue - total costs.
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Normal profit

  • When total revenue is equal to total cost, a firm is said to be generating normal profit.
  • In the long run, normal profit is the minimum a firm can be making to be sustainable.
  • In a perfectly competitive industry, firms can only make normal profit.
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Supernormal profit

  • When total revenue exceeds total costs, a firm is said to be generating supernormal profits.
  • The existence of supernormal profits signals to firms that they should enter the market.
  • Their ability to do this depends on the barriers to entry and level of contestability.
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Short run profits

  • In the long run, a firm must make at least normal profits.
  • But in the short run, at least one factor of production is fixed.
  • If the firm makes enough revenue to cover its variable costs, and begin to pay off its fixed costs, operations can continue.
  • The shut down point is the revenue where a firm just covers its variable costs. Below this point the firm will cease production immediately.

Profit Maximisation

Traditional economic theory says that firms aim to maximise profits.

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When is profit maximised?

  • When marginal cost is equal to marginal revenue, a firm is profit maximising.
  • If marginal cost is less than marginal revenue, the firm could increase profit by expanding production.
  • If marginal cost is greater than marginal revenue, the firm could increase profit by reducing output.
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Profit can be a signal to enter a market

  • The existence of supernormal profits in an industry signals to potential entrants that they should enter the market.
  • Supernormal profits will be competed away if new firms enter.
  • This logic relies on a number of assumptions about the contestability of markets.

Jump to other topics

1Introduction to Markets

2Market Failure

3The UK Macroeconomy

4The UK Economy - Policies

5Business Behaviour

6Market Structures

7A Global Perspective

8Finance & Inequality

9Examples of Global Policy

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