Economics – profit and revenue

28 November 2019 by Tejvan Pettinger

 Total revenue (TR): This is the total income a firm receives. 
This will equal price × quantity
 Average revenue (AR) = TR / Q
 Marginal revenue (MR) = the extra revenue gained from selling
an extra unit of a good
 Profit = Total revenue (TR) – total costs (TC) or (AR – AC) × Q
Profit maximisation

 In classical economics, it is assumed that firms will seek to

maximise their profits. This occurs when the difference
between TR – TC is the greatest.
  Profit maximisation will also occur at an output where MR =
MC
 When MR> MC the firms is increasing its profits and Total
Profit is increasing.
 When MR< MC total profit starts to fall
 Therefore profit is maximised where MR = MC
Definition normal profit

This occurs when TR = TC. This is the break-even point for a firm (P2). It is
the minimum profit level to keep the firm in the industry in the long run.
See more on normal profit.

Normal profit
 Normal profit is a situation where a firm makes sufficient
revenue to cover its total costs and remain competitive in an
industry.
 In measuring normal profit, we include the opportunity cost of
working elsewhere.
 When a firm makes normal profit we say the economic profit
is zero.
Normal profit = total revenue – total costs
 Where total costs =
 Explicit costs (rent, labour costs, raw materials +)
 Implicit costs (opportunity cost of capital/working
elsewhere)
Diagram showing normal profit
Normal profit occurs at an output where average revenue (AR) = average
total costs (ATC)

Does normal profit = zero profit?

Normal profit implies zero economic profit. However, this can include
‘accounting profit’. This is because included in the total costs is a minimum
level of recompense for the owners of the company. For example, if a
typical salary was £20,000 working elsewhere, this salary of £20,000 would
be included in total costs.

A firm can have accounting profits of £20,000 – but as this is an implicit

cost of owning a business it is included in total costs.

Normal profit in perfect competition

Perfect competition in the long-run

In perfect competition, there is freedom of entry and exit. If the industry
was making supernormal profit, then new firms would enter the market
until normal profits were made.

This is why normal profits will be made in the long run. At Q1 – AR=ATC.

Economic – Supernormal profit

Economic profit is any profit above the level of normal profit. It is also
referred to as supernormal profit.

In a monopoly, firms are able to make greater than normal profits. There
are barriers to entry and they can charge a price higher than average

Supernormal Profits
10 September 2019 by Tejvan Pettinger
 Supernormal profit is all the excess profit a firm makes above
the minimum return necessary to keep a firm in business.
 Supernormal profit is calculated by Total Revenue – Total
Costs (where total cost includes all fixed and variable costs,
plus minimum income necessary for the owner to be happy in
that business.)
 Normal profit is defined as the minimum level of profit
necessary to keep a firm in that line of business. This level of
 normal profit enables the firm to pay a reasonable salary to its
workers and managers. The definition of normal profit occurs
when AR=ATC (average revenue = average total cost)
 Supernormal profit is defined as extra profit above that level
of normal profit.
 Supernormal profit is also known as abnormal profit.
Abnormal profit means there is an incentive for other firms to
enter the industry. (if they can)

When the price is P3, the firm makes supernormal profit. This is because
at P3, Average revenue is greater than average total cost. (ATC)

Supernormal profit in perfect competition

The theory of perfect competition suggests that supernormal profit can

only be earned in the short term. In the long-term firms will make normal
profit.
Perfect competition is a market structure which involves:

 Perfect information
 Freedom of Entry and exit
Suppose there is a rise in demand, price rises and a firm can make
supernormal profit in the short-term.

The supernormal profit is (AR – AC) * Q2. Other firms will be aware of this
fact. Because there are no barriers to entry, firms will be encouraged to
enter the market until price falls back down to P1 and normal profits are
made.

Perfect competition in the long-run

This is why only normal profits will be made in the long run. At Q1 –
AR=ATC.

Supernormal profit in monopoly

Allocative Efficiency
Definition of allocative efficiency
This occurs when there is an optimal distribution of goods and services,
taking into account consumer’s preferences.

A more precise definition of allocative efficiency is at an output level

where the Price equals the Marginal Cost (MC) of production. This is
because the price that consumers are willing to pay is equivalent to the
marginal utility that they get. Therefore the optimal distribution is
achieved when the marginal utility of the good equals the marginal cost.

Example using diagram

At an output of 40, the marginal cost of the good is £6, but at this output,
consumers would be willing to pay a price of £15. The price (which reflects
the good’s marginal utility) is greater than marginal cost – suggesting
under-consumption. If output increased and price fell, society would
benefit from enjoying more of the good.
At an output of 110, the marginal cost is £17, but the price people are
willing to pay is only £7. At this output, the marginal cost (£17) is much
greater than the marginal benefit (£7) so there is over-consumption.
Society is over-producing this good.

Allocative efficiency will occur at a price of £11. This is where the marginal
cost (MC) = marginal utility.

Perfect competition – allocatively efficient

 Firms in perfect competition are said to produce at an
allocative efficient level because at Q1,  P=MC
This diagram shows how collusion enables firms to make supernormal
profit.

Whether to produce at all

  If AR > ATC The firm is making supernormal profits
 If AR= ATC The firm is making normal profits. This is the ‘break-
even’ price.
 If AR< ATC but AR > AVC. it is making an operating profit and is
covering its variable costs. However, it is making an economic
loss because it can not cover its fixed costs as well. At this level
(P1-P2) In the short run, it is best to keep producing because it
has already paid for its fixed costs. It is at least making a
contribution to its fixed costs
 If AR < AVC The firm is likely to shut down in the short run.
Evaluation
 In the real world, it is more difficult for firms to maximise
profits because they do not have access to costs and marginal
revenue data easily, it is difficult to predict.
 The firm may not close down at price of less than P1 – if they
expect the fall in demand to be temporary and they are
hopeful that they can cut costs. A firm will try to avoid shutting
down because it will lose market share and long-term
customers.
Factors that affect profitability
  Costs of production
 Can firm benefit from economies of scale?
 Are workers motivated and maximising labour productivity
 Exchange rate – appreciation makes exports expensive, but
imported raw materials cheaper
 Economic cycle – Recession reduces demand for normal goods
 Competitiveness. A firm with monopoly power can make
supernormal profit
 Investment in more efficient business.

Dynamic Efficiency
28 August 2019 by Tejvan Pettinger
Definition of Dynamic Efficiency
Dynamic efficiency is concerned with the productive efficiency of a firm
over a period of time.

A firm which is dynamically efficient will be reducing its cost curves by

implementing new production processes. Dynamic efficiency will enable a
reduction in both SRAC and LRAC.

Diagram showing dynamic efficiency

Therefore dynamic efficiency is concerned with the optimal rate of
innovation and investment to improve production processes which help to
reduce the long-run average cost curves.

For example, investment in new machines and technology may enable an

increase in labour productivity.

Dynamic efficiency may also involve implementing better working

practices and better management of human capital. For example, better
relationships with unions that help to introduce new working practices.

Dynamic efficiency involves a trade-off. To invest in better technology may

involve higher costs in the short run. But, without this investment and
innovation, the firm may be unable to improve over time.

Factors that affect dynamic efficiency

 Investment – investment in new technology and improved
capital can enable lower costs in future
 State of technology. The rapid development of technology can
enable firms to produce more for lower costs.
 The motivation of workers and managers – do managers have
incentives to take risks and innovate or is the structure of the
firm set up to encourage stagnant development?
 Access to finance. A firm without access to finance will struggle
to invest in new capital which will enable lower costs.
Examples of Dynamic efficiency
In 1923, Henry Ford’s car factory was one of the most efficient firms in the
world – making the most effective use of assembly lines. Throughout the
1920s and 30s, Ford was the most efficient car-producer. However, by the
1950s and 60s, it was starting to lose its competitive advantage as
Japanese car firms innovated and improved quality of car-building.

At the start of the internet, Yahoo was the dominant search engine, but it
quickly lost its position to a new entrant – Google. In an industry like the
internet, a firm cannot stand still but has to be continually innovating and
improving the quality of its product and lowering costs.

Productive Efficiency – definition

and diagrams
28 March 2019 by Tejvan Pettinger
Definition of Productive efficiency
Productive efficiency is concerned with producing goods and services with
the optimal combination of inputs to produce maximum output for the
minimum cost.
To be productively efficient means the economy must be producing on
its production possibility frontier. (i.e. it is impossible to produce more of
one good without producing less of another).

 Points A and B are productively efficient.

 Point D is inefficient because you could produce more goods
or services with no opportunity cost
 Point C is currently impossible.
Productive efficiency and short-run average cost curve

A firm is said to be productively efficient when it is producing at the lowest

point on the short run average cost curve (this is the point where marginal
cost meets average cost).
Productive efficiency is closely related to the concept of technical
efficiency. A firm is technically efficient when it combines the optimal
combination of labour and capital to produce a good. i.e. cannot produce
more of a good, without more inputs.

Note: An economy can be productively efficient but have very

poor allocative efficiency.
Allocative efficiency is concerned with the optimal distribution of
resources. For example, if you devoted 90% of GDP to defence, you could
be productively efficient, but, this would be a very unbalanced economy.

Related concepts
Economic Efficiency
28 June 2019 by Tejvan Pettinger
Definition of efficiency

Efficiency is concerned with the optimal production and distribution of

scarce resources.

Different types of efficiency

 Productive – producing for the lowest cost.

 Allocative – distributing resources according to consumer
preference P=MC
 Dynamic – Efficiency over time.
 X-efficiency – incentives to cut costs.
 Efficiency of scale – taking advantage of economies of scale.
 Social efficiency – taking into account external costs/benefits.
1. Productive efficiency

This occurs when the maximum number of goods and services are
produced with a given amount of inputs. This will occur on the production
possibility frontier. On the curve, it is impossible to produce more goods
without producing fewer services. Productive efficiency will also occur at
the lowest point on the firm’s average costs curve. (Q1)
See: Productive Efficiency
2. Allocative efficiency

This occurs when goods and services are distributed according to

consumer preferences. An economy could be productively efficient but
produce goods people don’t need this would be allocative inefficient.

Allocative efficiency occurs when the price of the good = the MC of

production. This occurs at an output of 80, where price £11 = MC.

At an output of 40, The price of £15 is much greater than MC of £6 – there

is underconsumption.

See: Allocative Efficiency
3. X inefficiency
This occurs when firms do not have incentives to cut costs, for example, a
monopoly which makes supernormal profits may have little incentive to
get rid of surplus labour.
If a firm’s average costs are higher than potential – then we are x-
inefficient.
See: X Inefficiency
4. Efficiency of scale

This occurs when the firms produce on the lowest point of its long-run
average cost (Q2) and therefore benefits fully from economies of scale
5. Dynamic efficiency
This refers to efficiency over time, for example, a Ford factory in 2010 may
be very efficient for the time period, but by 2017, it could have lost this
relative advantage and by comparison, would now be inefficient. Dynamic
efficiency involves the introduction of new technology and working
practices to reduce costs over time.

 Dynamic efficiency
 Static efficiency – efficiency at a particular point in time.
6. Social efficiency
This occurs when externalities are taken into consideration and occurs at
an output where the social cost of production (SMC) = the social benefit
(SMB)
Social efficiency occurs at an output of 16 – where SMB = SMC

See: Social efficiency
7. Technical efficiency
This requires the optimum combination of factor inputs to produce a
good: it is related to productive efficiency.

See: Technical efficiency
8. Pareto efficiency
A situation where resources are distributed in the most efficient way. It is
defined as a situation where it is not possible to make one party better off
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