Profit is a central concept in economics, influencing firm behaviour and market outcomes. This section explores different profit conditions and decisions around shutting down operations.
Understanding different profit conditions
Normal profit
Normal profit is the minimum reward necessary to keep an entrepreneur or firm in its current industry. It is not considered a surplus profit but is instead part of a firm’s total cost.
A firm is making normal profit when its total revenue (TR) is exactly equal to its total cost (TC).
Alternatively, in terms of per unit values, normal profit occurs when average revenue (AR) is equal to average cost (AC).
TR = TC
AR = AC
Normal profit includes the opportunity cost of the resources employed by the firm. This means that the return the entrepreneur receives is equal to what they could earn elsewhere with their skills and capital. As such, the entrepreneur has no incentive to leave the industry but also no strong motivation to expand.
In perfectly competitive markets, firms in the long run tend to make normal profit, as the absence of barriers to entry allows new firms to enter when supernormal profits are available, driving prices and profits down to normal levels.
Supernormal (abnormal) profit
Supernormal profit, also known as abnormal profit or economic profit, refers to any profit above the level of normal profit. It represents a return above all costs, including opportunity costs.
It arises when a firm’s total revenue (TR) exceeds its total cost (TC).
In per unit terms, it occurs when average revenue (AR) is greater than average cost (AC).
TR > TC
AR > AC
Supernormal profit provides an incentive for:
New firms to enter the market (if entry is possible).
Existing firms to expand production.
Innovation and investment, particularly in imperfectly competitive markets.
In monopoly and other forms of imperfect competition, firms can maintain supernormal profits in the long run due to barriers to entry, such as patents, brand loyalty, or control over key resources. In contrast, under perfect competition, these profits are typically eroded in the long run.
Losses
A firm is making a loss when its total revenue (TR) is less than its total cost (TC), or when average revenue (AR) is less than average cost (AC).
TR < TC
AR < AC
Losses mean the firm is not covering the full costs of production, including opportunity costs. Firms can continue to operate while making losses in the short run, especially if they are able to cover their variable costs. However, if losses persist in the long run, the firm may choose to exit the market.
Understanding losses is essential to determining a firm’s viability and whether it should continue operating, shut down temporarily, or exit the industry entirely.
Profit maximisation condition
The role of marginal revenue and marginal cost
The goal of most firms is to maximise profit. Profit maximisation occurs at the output level where:
Marginal cost (MC) = Marginal revenue (MR)
Marginal cost (MC) is the cost of producing one more unit of output.
Marginal revenue (MR) is the additional revenue earned from selling one more unit.
If:
MC < MR, the firm can increase profit by increasing output.
MC > MR, the firm should reduce output to avoid making a loss on additional units.
Profit is maximised precisely at the point where MC = MR. Producing beyond this point would result in additional units costing more to produce than they bring in revenue, thereby reducing overall profit.
This condition applies across all market structures, although the shape of the MR and AR curves differs between perfect and imperfect competition.
Cost-revenue diagrams
Normal profit on a diagram
In a cost-revenue diagram, normal profit is represented by the point where the firm’s AR curve (which is also the demand curve) is tangent to the AC curve.
The firm’s total revenue equals its total cost.
The area of profit or loss is zero.
This is a common scenario in the long-run equilibrium of perfectly competitive markets.
Supernormal profit on a diagram
When a firm is earning supernormal profit, its AR curve lies above the AC curve at the profit-maximising output.
The vertical distance between AR and AC at that quantity represents profit per unit.
The total supernormal profit is shown as a shaded rectangle, with height equal to (AR - AC) and width equal to the quantity sold.
The MC curve still cuts the MR curve from below at the point of profit maximisation.
This situation can occur in both short-run perfect competition and in the short and long run in imperfectly competitive markets with entry barriers.
Loss scenario on a diagram
A firm making a loss has its AC curve above the AR curve at the profit-maximising level of output.
The vertical distance between AC and AR shows the loss per unit.
The total loss is represented as a shaded area, with height equal to (AC - AR) and width equal to quantity sold.
The firm may choose to stay in business in the short run if it can cover variable costs, but this is not sustainable in the long run.
The shut-down decision
A firm does not immediately exit the industry when it makes losses. Whether it continues operating or shuts down temporarily depends on whether it can cover its variable costs in the short run and total costs in the long run.
Short-run shut-down point
In the short run, some costs such as rent, insurance, and salaried wages are fixed and must be paid regardless of output.
The short-run shut-down point is the output level and price at which:
Price = Average variable cost (AVC)
At this point:
The firm can just cover its variable costs.
Any price below AVC means the firm is better off shutting down production immediately, as it cannot cover the costs of producing the good.
By shutting down, the firm limits its losses to its fixed costs only.
If the price is equal to or greater than AVC, the firm should continue operating in the short run, even if it is making an overall loss, because it can still contribute something towards fixed costs.
Long-run shut-down point
In the long run, all costs are variable, including costs that were fixed in the short run. The firm is no longer committed to any specific expenditures and must cover total costs to justify remaining in the industry.
The long-run shut-down point occurs when:
Price = Average cost (AC)
At this point:
If the market price falls below AC, the firm cannot cover its total costs, including opportunity costs.
There is no economic justification to continue operating, and the firm should exit the market.
If Price ≥ AC, the firm is at least making normal profit, and should stay in the industry.
Firms must evaluate long-run viability based on expectations about future market conditions, competition, and the potential for cost reduction or innovation.
Diagrams for profit conditions and shut-down points
Profit-maximising output
The MC curve cuts the MR curve from below.
This intersection determines the profit-maximising output level.
A vertical line from this output to the AR and AC curves reveals:
Price (AR).
Cost per unit (AC).
The area between AR and AC indicates whether the firm is making a profit, loss, or breaking even.
Break-even point (normal profit)
This occurs where AR = AC.
In the diagram, the demand (AR) curve touches the AC curve.
There is no area of profit or loss.
This represents a situation of normal profit, often seen in the long-run equilibrium of competitive markets.
Shut-down points and loss regions
Short-run shut-down point:
Occurs at the lowest point on the AVC curve.
If the AR (price) falls below this level, the firm cannot cover variable costs and shuts down.
Long-run shut-down point:
Occurs at the lowest point on the AC curve.
Price below this level means the firm cannot cover total costs and should exit the industry.
These critical points can be clearly shown on a diagram with:
MC, MR, AR, AC, and AVC curves.
Labels for:
Profit-maximising output (where MC = MR).
Break-even point (AR = AC).
Short-run shut-down point (AR = AVC).
Long-run shut-down point (AR = AC at minimum point).
Shading the area between AR and AC for different output levels will illustrate supernormal profits, losses, or normal profit, depending on the relative positions of these curves.
Key calculations to remember
Total Revenue (TR) = Price × Quantity
Average Revenue (AR) = TR / Quantity
Total Cost (TC) = Total Fixed Cost + Total Variable Cost
Average Cost (AC) = TC / Quantity
Average Variable Cost (AVC) = TVC / Quantity
Marginal Cost (MC) = Change in TC / Change in Quantity
Marginal Revenue (MR) = Change in TR / Change in Quantity
These formulas, combined with a solid understanding of cost curves and market structures, will allow students to analyse and explain firm behaviour under a range of economic conditions.
FAQ
Accounting profit is the difference between total revenue and explicit costs, such as wages, rent, and materials. It reflects the profit figure used in financial statements. However, it does not account for the opportunity costs of the resources used in production, such as the income the owner could have earned elsewhere or the potential return on invested capital.Economic profit, by contrast, includes both explicit and implicit (opportunity) costs. It is calculated as total revenue minus total economic cost (explicit + implicit). This makes economic profit a more comprehensive and useful measure for decision-making. If a firm is making zero economic profit (normal profit), it means it is covering all its costs, including what the resources could earn in their next best use. This ensures the firm is efficiently allocating resources. A positive economic profit indicates that a firm is generating returns above what is necessary to keep it in business, attracting new firms if entry is possible.
Yes, a firm can be producing at the profit-maximising output level (where marginal cost equals marginal revenue) and still be making a loss. This situation occurs when the average cost (AC) at that level of output is greater than the average revenue (AR). In such a case, although the firm is maximising the difference between total revenue and total cost per additional unit, the overall cost structure results in total costs exceeding total revenue. This is especially relevant in the short run when fixed costs must be paid regardless of output. A firm may continue producing if the price (AR) covers the average variable cost (AVC), as it can still contribute something towards fixed costs. However, it is still making an economic loss because the full cost of production, including fixed costs, is not being met. This highlights the distinction between optimal output choice and long-run viability, reinforcing the importance of covering all costs in the long run.
In the short run, a firm has already committed to fixed costs—costs that do not change with output, such as rent or machinery. These costs must be paid whether the firm produces or not. Therefore, the firm's decision to continue operating depends on whether it can cover its variable costs, such as labour and raw materials. If the price per unit (equal to average revenue) is higher than average variable cost (AR > AVC), the firm is able to cover its variable costs and contribute something towards fixed costs. Although it is still making a loss overall (AR < AC), continuing production reduces the total loss compared to shutting down, where the firm would have to bear the full fixed cost without any revenue. The firm hopes that conditions improve, allowing prices to rise or costs to fall, thus returning to normal or supernormal profit. If losses persist and price falls below AVC, the firm is better off shutting down immediately.
Sunk costs are costs that have already been incurred and cannot be recovered, such as investments in advertising, specialised machinery, or non-refundable rent payments. In the short run, sunk costs should not influence the shut-down decision because they are irrelevant to future profitability—they cannot be retrieved regardless of what the firm does next. Instead, the shut-down decision should be based solely on whether the firm can cover its avoidable costs, primarily variable costs. If the price is above average variable cost (AVC), then continuing production helps reduce losses by covering some fixed costs, including sunk costs. However, if the price falls below AVC, the firm is not covering the costs directly linked to production and should shut down, even though sunk costs will still be lost. Economists emphasise that firms must ignore sunk costs in rational decision-making. This avoids the “sunk cost fallacy,” where firms continue operating or investing simply because they have already spent money, even if doing so worsens financial outcomes.
Market structure plays a critical role in determining whether a firm can sustain supernormal profits in the long run. In perfect competition, there are no barriers to entry, and many firms sell identical products. If one firm earns supernormal profit in the short run, new firms are incentivised to enter the market, increasing supply and reducing the market price. Over time, this process erodes supernormal profits, and firms return to earning normal profit where price equals average cost (P = AC).
Practice Questions
Explain, using a diagram, the short-run shut-down point for a firm in a perfectly competitive market.
In the short run, a firm will shut down if it cannot cover its variable costs. The shut-down point occurs when the market price equals the minimum point on the average variable cost (AVC) curve. At this price, the firm is indifferent between producing and shutting down. If the price falls below this point, the firm minimises losses by ceasing production, since producing would result in greater losses than paying fixed costs alone. In a diagram, this is shown where the price line just touches the AVC curve, with the marginal cost (MC) curve intersecting below it.
Assess the importance of the profit maximisation condition (MC = MR) in a firm’s decision to remain in the market in the long run.
The profit maximisation condition (MC = MR) is crucial for determining the most efficient output level. However, in the long run, a firm must also consider whether it can cover all its costs. If price is consistently below average cost (AC), the firm cannot earn normal profit and should exit. Thus, even if MC = MR holds, it is insufficient if the firm is making a loss. The firm will only remain if this condition coincides with at least normal profit (AR = AC). Therefore, long-run market survival depends on both profit maximisation and cost coverage.
