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Profit

 

Profit is very simply revenue minus costs. It's very important to remember that economists calculate costs in a different way to accountants - we include the opportunity cost of the economic resources employed in the total cost.

 

You run your own firm and total revenues are 40,000 and total costs are 20,000. You could work for a large firm and earn 30,000.

 

Accounting Profit = Total revenue - Total costs
20,000 = 40,000 - 20,000

 

Economic Profit = Total revenue - Total costs - Opportunity cost
-10,000 = 40,000 - 20,000 - 30,000

 

This example shows that you are in effect losing money by owning your own company, as your labour would be better employed with the large firm. This does ignore the benefits of working for yourself.

 

It is possible to highlight another example using capital. If you invest 10,000 into a business venture that yields a 10% accounting profit. In order to work out the economic profit the opportunity cost has to be taken away from the 1,000 accounting profit. It is possible to invest the 10,000 in a high interest account and earn 7.5%, which equals 750. The economic profit is therefore 250 (1,000 - 750).

 

Profit Maximising Level of Output

It is possible to find the profit maximising level of output by drawing the revenue and cost curves.  Finding the maximum profit level using total curves

is done by finding the output where the difference between TR and TC is greatest; in this case it occurs at an output of 3.

 

 

Economists assume that the objective of most firms is to maximize profits. It is possible to prove that if a firm wishes to profit maximize it must produce where the marginal cost is equal to the marginal revenue (MC=MR).

 

 

If the quantity is below 3, the marginal cost of an extra unit is less than the marginal revenue, therefore it makes sense to increase output as it will lead to greater profit. If production continues past 3, the marginal cost is greater than the marginal revenue, therefore any increases in the quantity will lead to a fall in profit.

 

If we add AC and AR curves to the above diagram it is possible for us to calculate the total profit the firm will earn.  If the firm produces at the profit maximising level of output (3), it will receive an AR (the price of the good) of 6.  It costs 4.50 (the AC) to produce each unit, therefore the firm will make a profit of 1.50 on each unit sold.  To calculate the total profit we multiply the profit per unit by the quantity sold, 1.50 3 = 4.50, which is equal to the shaded area in the diagram below.

 

 

Normal and abnormal profit

An economic profit of zero is described as being a normal profit (remember accounting profits are still being earned), i.e., normal profit is the same as what could be earned by investing the factors of production in the next best alternative (AR=AC).

 

Abnormal profits occur when the economic profit is greater than zero, i.e., it earns more money than it could by investing in the next best option (AR>AC).

An economic profit indicates that the factors of production could be used in a more profitable way (AR less than AC).

 

A Loss Making Firm

A firm who is making a loss in the short run may in fact continue to trade.  If it were to close it would still have to pay the fixed costs, therefore if it is able to make a contribution to the fixed costs it will be losing less money by continuing to operate; this is known as loss minimising.  If the price a firm receives is above the AVC, it will stay open.  Selling where P=AVC in the short run is a more favourable scenario than closing down.

 

 

In the long run a firm will shutdown if it is making an economic loss, unless it has an objective other than making a profit, e.g., schools and hospitals.  A firm in the long run is able to loss minimise by producing where MC=MR.

 

 

Notes on the Internet
Profits
Produced by Geoff Riley at RGS Newcastle
Profit Maximisation PowerPoint Model
Profit Maximisation PowerPoint Presentation
Profit
Profit Maximisation Worksheet

 

 

 

E-mail Steve Margetts