Types of Profit

1. Normal profit equals what the entrepreneur could earn in the next best use of their resources, so it is an opportunity cost and is included within costs.
   1. A firm earning only normal profit is therefore doing exactly as well as its next best alternative, which is why it stays put rather than leaving.
2. Supernormal profit is whatever total revenue leaves once every cost, including normal profit, has been covered.

Measuring profit on the diagram

$$Profit=TR-TC$$ $$Profit=(AR-AC)\times Q$$ $$AR=AC$$

1. The break-even condition is AR = AC: here supernormal profit is zero and the firm earns exactly normal profit.
2. On a cost and revenue diagram, output is on the horizontal axis and costs and revenue per unit on the vertical axis.
3. At the profit-maximising output, compare average revenue (AR) with average cost (AC) to read off profit or loss.
4. Where AR > AC the firm earns supernormal profit, shown by the rectangle between the AR and AC curves whose height is (AR − AC) and whose width is the output.
5. Where AR = AC the firm earns only normal profit and breaks even.
6. Where AR < AC the firm makes a loss, shown by the rectangle between the AC and AR curves multiplied by output.

Profit maximisation

$$MC=MR$$

1. Below the MC = MR output an extra unit adds more to revenue than to cost (MR > MC), so producing it raises profit and the firm should expand.
2. Above it the last unit costs more than it earns (MC > MR), so producing it lowers profit and the firm should cut back.
3. Profit is therefore greatest only where the two are equal, with MC rising through MR at that output.
4. On the diagram, find the output where MC cuts MR from below, then read the price up to the AR curve.

Shut-down points

1. In the short run some costs are fixed and must be paid whether or not the firm produces, so only the variable costs are avoidable by shutting.
2. So while price ≥ AVC the firm keeps producing, because the revenue covers all variable cost and makes some contribution to fixed cost, leaving a smaller loss than shutting down.
   1. A seaside hotel often stays open through a quiet winter while room takings still cover the variable costs of heating, cleaning and staffing, accepting a small loss rather than the larger loss of paying its fixed costs for nothing.
   2. Once price < AVC every unit deepens the loss, so the firm shuts down in the short run.
3. In the long run all costs are variable, so the firm must cover ATC; if price < ATC it cannot even earn normal profit and exits.
4. It breaks even where AR = ATC, earning normal profit, and between AVC and ATC it makes a loss yet stays open in the short run.

Profit as a signal

1. Supernormal profit signals that a market is attractive, drawing new firms in where entry is possible.
2. Losses signal that resources are better used elsewhere, driving firms out and releasing those resources.
3. Normal profit signals equilibrium, being just enough to keep a firm where it is.

Should we worry about supernormal profit?

1. It can be harmful: in an uncompetitive market persistent supernormal profit tends to come from a price above marginal cost and restricted output, so consumers pay more.
2. But it can be beneficial, because it funds investment and innovation (dynamic efficiency) and rewards the risk the entrepreneur took.
3. It is also the market's own correction: it attracts entrants who compete the profit away over time, improving choice and price for consumers.
4. On balance it depends on barriers to entry: with low barriers profit erodes and spurs efficiency, but with high barriers it can persist and may justify regulation.