Condition for Profit Maximisation

The universally accepted condition for profit maximisation in economic theory is where Marginal Revenue (MR) equals Marginal Cost (MC):

• MR = MC

• Marginal Revenue (MR): The additional revenue gained from selling one extra unit of output.

• Marginal Cost (MC): The additional cost incurred from producing one extra unit of output.

Explanation

• If MR > MC: The revenue gained from selling the last unit is greater than the cost of producing it. This means the firm is adding more to Total Revenue (TR) than it is to Total Cost (TC), so total profit will increase by producing that unit. The firm should increase output.

• If MR < MC: The cost of producing the last unit is greater than the revenue it generates. This means the firm is adding more to TC than it is to TR, so total profit will decrease by producing that unit. The firm should reduce output.

• If MR = MC: This is the point where any change in output would lead to a reduction in total profit. The firm has found the output level that yields the maximum total profit.

Normal Profit, Supernormal Profit and Losses

In economics, Total Cost (TC) includes both explicit costs (like wages and raw materials) and implicit costs (the opportunity cost of the entrepreneur's time and capital).

• Profit = Total Revenue (TR) - Total Cost (TC)

Normal Profit

Normal profit is the minimum level of profit required to keep the entrepreneur's resources (enterprise, capital) in the current line of production in the long run. It is considered an implicit cost of production.

• Condition: Total Revenue (TR) is equal to Total Cost (TC), or on a per-unit basis, Average Revenue (AR) is equal to Average Total Cost (AC) AR = AC.

• The AR curve is tangent to the AC curve at the profit-maximising output. The firm is said to be at the break-even point. On the graph, it is the point where the MR1=AR1 line intersects the ATC at Price Level 1, showing that the company is able to cover all the explicit costs of the operation.

Supernormal Profit (Abnormal Profit)

Supernormal profit is any profit earned above and beyond the level of normal profit. This extra return is a strong incentive for new firms to enter the market, assuming low barriers to entry.

• Condition: Total Revenue (TR) is greater than Total Cost (TC), or on a per-unit basis, Average Revenue (AR) is greater than Average Total Cost (AC) (AR >AC).

• The AR curve is positioned above the AC curve at the profit-maximising output. The area between the AR and AC curves represents the supernormal profit. On the graph, it is the point where MR2=AR2 line intersects the MC, and at that point, the ATC curve is below the AR line, which shows the supernormal profit area.

Losses (Subnormal Profit)

A loss (or subnormal profit) occurs when the firm's total revenue is not enough to cover its total costs (including the opportunity cost).

• Condition: Total Revenue (TR) is less than Total Cost (TC), or on a per-unit basis, Average Revenue (AR) is less than Average Total Cost (AC) AR < AC.

• The AR curve is positioned below the AC curve at the profit-maximising output. The point on the graph where MR4=AR4 line intersect the MC, where the AR is lower than the ATC, showing the loss area at price level 4.

Short-run and Long-run Shut-down Points

The decision to shut down depends on whether the firm can cover its costs in the relevant time period. The decision is based on comparing the Average Revenue (AR), which is the price (P), to the relevant average cost curves.

Short-Run Shut-down Point (P = min AVC)

In the short run, a firm must pay Fixed Costs (FC) regardless of whether it produces or not. Therefore, the decision is whether to produce and cover some of the FC, or shut down and lose all of the FC.

• Rule: A firm should continue to produce in the short run as long as Average Revenue (Price) is greater than or equal to Average Variable Cost (AVC) AR >AVC

• The Shut-down Point: The firm will shut down if AR < AVC. This occurs at the minimum point of the AVC curve.

• The profit-maximising output is where MC=MR

• At this output, the Average Revenue (AR) curve is below the Average Total Cost (ATC) curve, meaning the firm is making a loss (since AR < ATC)

• However, if the AR curve is above the Average Variable Cost (AVC) curve, the revenue gained is more than enough to cover all variable costs. The surplus revenue goes towards paying a portion of the fixed costs. On the graph any point below the P3 level would be where the firm will exit.

• By producing, the firm's loss is less than its Total Fixed Costs (TFC). If it shut down, the loss would be equal to the entire TFC, so it minimises its loss by continuing to produce.

Long-Run Shut-down Point (P = min AC/ATC)

In the long run, all factors of production are variable, meaning the firm has no fixed costs.

• Rule: The firm must cover its Total Costs (TC), including normal profit, to justify remaining in the industry. It will exit the market if it cannot achieve at least normal profit.

• The Shut-down Point: The firm will exit or shut down permanently if AR < AC (or ATC). This occurs at the minimum point of the AC curve.

• If the price (AR) is permanently below the Average Total Cost (ATC) curve, the firm is making a sustained economic loss (less than normal profit).

• In the long run, the entrepreneur can re-allocate their factors of production to a different industry where they can at least earn normal profit.

• Therefore, any price below the minimum point of the ATC curve will signal the firm to exit the industry in the long run.