The relationship between costs, revenue and profit
Here are some refreshers:
- Profit = TR - TC
What are the conditions for profit maximisation?
- Profit is maximised when the gap between TR and TC is the largest. This means the firm is earning much more in revenue than it is spending on costs, and therefore, profit is at its highest.
- Profit maximisation also occurs where Marginal Cost (MC) equals Marginal Revenue (MR).
- Marginal cost is the additional cost of producing one more unit of a good, while marginal revenue is the additional revenue from selling one more unit.
- If the marginal revenue of producing an additional unit is greater than the marginal cost (i.e., MR > MC), the firm makes a profit on that unit. Thus, it should continue producing until MR equals MC. Conversely, if the marginal cost exceeds marginal revenue, producing that additional unit would decrease profit, so production should stop.
- The point for profit maximisation is where the marginal cost curve is rising (sloping upwards) as it crosses the marginal revenue curve. This indicates that beyond this point, the cost of producing additional units would be higher than the revenue generated, thus reducing profit.
Normal profit, supernormal profit and losses
- In economic terms, costs are not just the explicit costs like wages and materials but also the implicit costs, which include the opportunity cost of the resources. Opportunity cost is the benefit that is foregone by not using resources in the next best alternative.
- When a business earns enough revenue to cover both its explicit and implicit costs, it is making normal profit. This means it is breaking even and covering all its expenses including opportunity costs.
- This is at the point where AC=AR or TC=TR: This means the business is not making any extra profit but is also not incurring losses.
Since normal profit is when AC = AR and AR=P we can conclude that normal profit occurs when AC=P
Supernormal profit:
- This occurs where AR>AC (or P>AC) or TR>TC.
- This means the business is generating excess profit above the normal profit level.
Losses:
- This happens when AR < AC (or P< AC) or when TR < TC, resulting in negative profit.
Short-run and long-run shut-down points
- This shutdown point occurs, most commonly when a firm continually incurs higher costs than the revenue generated if it were to continue production, as opposed to the reduced losses from ceasing production entirely.
- Simply, it is the point at which the profit from producing an additional unit is negative, hence making them worse off by producing more.
When a business is incurring losses, it isn't always the best decision to shut down immediately.
👉 The decision for a business to shut down depends on the average variable cost (AVC)
Short-run Decision
- If a firm's price is greater than or equal to the average variable cost in the short-run, they are likely to continue operating. This is because, in the short-run, fixed costs are considered sunk costs, and the firm only compares revenue to variable costs.
- Firms should continue production as each unit generates more revenue than its variable cost, helping cover fixed costs and reducing losses. They should only shut down when fixed costs increase (e.g., machinery replacement, lease renewal).
What are other reasons why a loss-making firm may continue to operate in the short run?
💰 Selling price/average revenue is greater than AVC: The revenue from selling products helps cover variable costs i.e P>AVC
🏠 Contribution towards fixed costs: Revenue minus variable costs helps pay fixed costs.
📉 Temporary downturn: The firm may predict that the downturn is temporary and profitability will recover, hoping that average revenue will equal average costs in the long run.
💼 Fulfilling orders/loyalty: Maintaining existing orders and customer loyalty.
💸 Reserves: The firm may have large reserves to cover losses.
⚙️ High shutdown/restart costs: The cost of shutting down and restarting capital equipment is high.
👷♂️ Workforce retention: Keeping the workforce to avoid high costs of replacing experienced or trained staff.
📉 Investor confidence: Avoiding loss of investor confidence by halting production or mothballing factories.
🌍 Strategic market presence: Maintaining a presence in certain markets for strategic purposes.
⏱️ Realisation delay: It may take time for the firm to realise they are making an operating loss.
🦠 Government restrictions (Covid-19): Decision-making may limit customers, but normal operations should resume later.
👩🍳 Staffing restrictions: Limitations on how many customers can be served in the hospitality sector due to restrictions.
😷 Consumer confidence: Loss of consumer confidence due to the increased risk of virus exposure.
💸 Anticipating support: Expectation of government financial support to help make normal profit in the future.
When should a business shut down immediently? 👇
- This would mean avoiding variable costs, but the firm would still be liable for its fixed costs, and likely have little to no incoming revenue – which would be considered in the decision.
- This would mean avoiding variable costs, but the firm would still be liable for its fixed costs, and likely have little to no incoming revenue – which would be considered in the decision.
Long-run and Short-run Shut-down Points
Long-run: Firms need to make at least normal profit to stay in the industry.