3.3.4 Normal Profits, Supernormal Profits and Losses

Edexcel A-Level Economics (9EC0) | Theme 3.3.4

Specification Coverage: Edexcel unit 3.3.4 - Normal Profits, Supernormal Profits and Losses. Students should be able to distinguish between explicit and implicit costs, define normal profit, supernormal profit, and loss in economic terms, apply the profit maximisation rule, analyse firm diagrams, and explain both the short-run and long-run shut-down rules.

Key Definitions

Explicit costs: Actual money payments for resources, such as wages, rent, and materials.

Implicit costs: The opportunity cost of using the entrepreneur's own resources, such as a forgone salary or forgone interest on capital.

Economic cost: \( TC = \text{Explicit Costs} + \text{Implicit Costs} \)

Normal profit: The minimum profit needed to keep an entrepreneur in an industry. It occurs when \( TR = TC \), so all explicit and implicit costs are covered. This is the break-even level of profit.

Supernormal profit: Any profit above normal profit, so \( TR > TC \).

Loss: When \( TR < TC \).

Profit Maximisation Rule

Firms maximise profit by producing where \( MC = MR \).

Diagrammatic Representation of Profits and Losses

Supernormal profit diagram
Figure 1: A firm making supernormal profit, where AR (price) is above AC at the profit-maximising output Qpm. The shaded area represents supernormal profit.
Loss diagram
Figure 2: A firm making a loss, where AR (price) is below AC at the profit-maximising output Qpm. The shaded area represents the loss.

The Shut-Down Rules

Short-Run Shut-Down Rule

In the short run, fixed costs must still be paid even if output is zero, so the firm compares price (AR) with average variable cost (AVC).

  • If \( AR > AVC \): Keep producing. Revenue covers all variable costs and makes a contribution towards fixed costs, so the loss is less than total fixed costs.
  • If \( AR = AVC \): This is the shut-down point. Revenue only covers variable costs, so loss equals total fixed costs.
  • If \( AR < AVC \): Shut down immediately. Revenue does not even cover variable costs, so the loss is greater than total fixed costs.
Short-run shutdown condition diagram
Figure 3: Short-run shut-down condition. The firm should shut down if the price (AR) falls below the minimum point of AVC, as shown in the diagram. At this point, the firm cannot cover its variable costs, leading to greater losses than if it were to shut down and only incur fixed costs.

Long-Run Shut-Down Rule

In the long run, all costs are variable, so a firm can leave the industry completely.

The firm compares price (AR) with average cost (AC).

If \( AR < AC \), the firm is making an economic loss because it is not covering all costs, including implicit costs, so it should leave the industry in the long run.

Exam Preparation

  • Define and distinguish between normal profit, supernormal profit, and loss in economic terms, including opportunity cost.
  • Draw diagrams to show a firm making supernormal profit or a loss.
  • Explain and apply the short-run shut-down rule by comparing AR and AVC.
  • Explain the long-run shut-down condition by comparing AR and AC.
  • Analyse why a firm may continue producing in the short run even when making a loss.