3.3.4: Normal profits, supernormal profits and losses

what is accounting profit?

total revenue - total costs

where TR = P x Q

TC = cash flows of FC (fixed costs) + VC (variable costs)

what do economists also consider the opportunity cost of being in business?

• regarded as a fixed cost

• thus included in the TC figures

• OC of being in business = ‘normal profit’

what is normal profit?

• the minimum return needed for an entrepreneur to stay in business in the long run

• = OC (opportunity cost) of capital and enterprise

supernormal profit (abnormal/economic profit)

any profits in excess of normal profit

how to calculate normal profits?

= ask: how much could be earned as return if you invested your capital and enterprise elsewhere?

how to calculate supernormal profit?

= ask: how much is actually being earned as a return for capital and enterprise? Compare this figure to normal profit figure.

what are the key profit concepts?

what is sub-normal profit?

profit less than normal (i.e. price per unit < average cost)

what are supernormal profits?

• Profit achieved in excess of normal profit (known as abnormal profit).

• made when price > AC

• When firms are making abnormal profits, there is incentive for other producers to enter a market to acquire some of this profit

calculating economic profit example

• The data below is for an owner-managed firm for a given year

  • Total revenue £320,000

  • Raw material costs £30,000

  • Wages and salaries £85,000

  • Interest paid on bank loan £30,000

  • Salary the owner could have earned elsewhere £32,000

  • Interest forgone on capital invested in the business £20,000

• In a simple accounting sense, the business has total revenue of £320,000 and total costs of £145,000 giving an accounting profit of £175,000.

• But profit according to an economist should take into account the opportunity cost of the capital invested and the income that the owner could have earned elsewhere.

• Taking these two items into account we find that the economic profit is lower equal to £123,000

will a firm carry on in business if it is making less than normal profit? (scenario)

A firm faces total costs of £50m (remember: this includes the opportunity cost of being in business)

These costs are split into total fixed costs (£20m) and total variable costs (£30M). The fixed costs in that period are payable even if the plant is shut down.

Will the firm stay in business if it generates total revenue of £40M (i.e. a subnormal profit of £10m)? How does your answer change:

1. In the short run compared to the long run?

2. If total revenue was only £10m?

will a firm carry on in business if it is making less than normal profit?

• if TR > TVC or P > AVC

• the firm is able to pay all of its VC, and make some contribution towards FC

• better to do this in the short-run, than to exit the industry and make no contribution towards FC at all

• therefore stays open in the short-run if ATC > P > AVC

• AKA loss minimisation

profit maximisation

• In order to maximise profits, the firm must:

  • Choose an output level at which TR is as far above TC as possible (QPM)

  • …here, the gradients of both curves are equal

  • …hence MR = MC

• Before this point, TR and TC are still diverging, so profits are not yet maximised at Q1 – i.e. can still increase profits by raising output

• After this point, TR and TC are converging, so raising output to Q2 will only reduce profits

• In other words, when MR = MC:

  • The cost incurred from producing one more unit of output is equal to the revenue gained from selling it

  • Hence the profit-maximising potential of the firm has been reached

  • …and this is where all rational firms will want to operate

revenue maximisation

• In order to maximise revenues, the firm will:

  • Produce up to the point at which the TR curve is flat (QRM)

  • …here the slope of the TR curve is zero

  • …hence MR = 0

sales volume maximisation

• In order to maximise sales volumes, the firm will:

  • Produce the greatest level of output without incurring a loss (QSM)

  • …hence TR = TC (or AR = AC)

  • …so the firm covers only TC and returns a normal profit

objectives of the firm

• Profit maximisation (MC = MR)

• Revenue maximisation (MR = 0)

• Sales volume maximisation (AR = AC)

Efficiency Theories:

• Productive efficiency (Lowest possible average cost; MC =

  AC)

• Allocative efficiency (AR = MC)

Why Firms May Not Maximise Profits: The Principal-Agent Problem

The divorce between ownership and control in a PLC firm…

gives rise to the principal-agent problem, which…

…is made possible by information asymmetries between shareholders and management – this may lead to:

• Profit satisficing behaviour

• Personal ambitions I: Prestige

• Personal ambitions II: Pecuniary issues

Whether directors get away with all this will depend on the degree of shareholder activism.

Profit satisficing behaviour

• Like all human beings, directors have bounded rationality

• So they will make just enough profit to satisfy the demands of shareholders…

• …in order to prevent a hostile takeover or a shareholder revolt that would have them sacked

• Hence they make satisfactory profits rather than maximum

Personal ambitions I: Prestige

• Business press often report on the firm’s revenues and sales volumes more heavily than on profits

• ∴managers who want to appear successful will focus on boosting sales and revenue – to gain a sense of prestige from running a large firm

Personal ambitions II: Pecuniary issues

• Larger firms often have more money floating around – so directors are able to spend more on needless items like large offices, company cars, excess staff, pet projects, etc

• Also, director’s bonuses / salaries may be directly linked to revenues or sales volumes – so they will go beyond profit max. to maximise their own rewards