Profits
Economics: Edexcel A A Level, topic 5.3.4
Profit
Profit is the difference between revenue and costs.
Equation for profit
- Profit = total revenue - total costs.
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.
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.
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.
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.
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.
Test yourself on Profits
What is the term for when total revenue exceeds total costs?
A firm may continue to function in the short-run, but not in the long-run when price is what?
Explain the difference between normal and supernormal profits.
What is the assumption which implies that firms will only be able to make supernormal profit in the short run?