Written by Tom Furber, an economics tutor.
Contents
Profit maximisation
Profit = revenue – cost.
Profit maximisation occurs where marginal revenue = marginal cost (MR = MC). Why?
- Suppose MR > MC. Then the firm can increase its profit by producing one unit more of the good. The extra revenue gained from doing so exceeds the extra cost, increasing profit.
- Suppose MR < MC. Then the firm can increase its profit by producing one unit less of the good. The firm’s revenue would fall a little from doing so, but the firm’s cost would fall even more. So firm profits would rise.
- So when MR = MC, profit is not changing if one more unit is produced. For A-Level Economics purposes, given the shape of the cost and revenue curves we typically draw, this is therefore where profit is maximised.
Profit maximisation is shown below in a cost-revenue diagram:
- We can combine the MR/AR diagram and MC/AC diagram to show where a firm produces to maximise profit.
- Assume the firm is a price maker, so its MR and AR lines are downward-sloping.
- (You could draw this diagram for a price taker instead if you like. In this case MR = AR and this would be a horizontal line).
- MR = MC occurs at output level q.
- From q, we dot up to the AR line to find the price, labelling this p.
- From q, we also dot up to find the AC curve. This gives us the average cost for the firm.
- The firm’s “supernormal” profit is equal to the area (p-c)q, as shown by the shaded area in the diagram below.
- Supernormal profit is the profit above the level required to incentivise the entrepreneur to keep operating the business (see the definitions below the diagram for more on this).
Normal profit, supernormal profit and supernormal losses – key definitions
Further definitions:
- Normal profit
- Occurs when total revenue = total cost (TR = TC).
- Or equivalently, when average revenue = average cost (AR = AC).
- This means the firm is making enough revenue to pay exactly the payments required for the four factors of production: land, labour, capital and entrepreneurship.
- Note this includes a payment to the entrepreneur, which is just enough to incentivise the entrepreneur to keep operating the business.
- Supernormal profit.
- When TR > TC or equivalently, when AR > AC.
- The entrepreneur operating the business is making more profit than required to incentivise the entrepreneur to keep operating the business.
- Supernormal losses.
- When TR < TC or equivalently, when AR < AC.
- This is the opposite of supernormal profit; the business is making less profit than required to incentivise the entrepreneur to keep operating the business.
Shutdown
Shutdown refers to when a firm stops producing a good or service.
Shutdown conditions
There are two types of shutdown scenarios:
- Long-run shutdown occurs when AR < AC (equivalently when TR < TC).
- Short-run shutdown occurs when a firm’s revenue cannot cover its variable costs: AR < AVC (equivalently TR < TVC)
- In the short run, suppose the firm has already paid its fixed cost.
- Then to survive, the firm may only need to cover its variable costs.
The “shutdown point” refers to the lowest possible price (and corresponding level of output) where the firm still operates. Prices below this level would result in firm shutdown.
- Shutdown point in the long run: AR = AC.
- Shutdown point in the short run: AR = AVC.
Diagrammatic analysis of shutdown points
Long-run shutdown but not short-run shutdown (AVC < AR < AC) is shown in the diagram below:
Short-run shutdown (AVC > AR), which also implies long-run shutdown (AC > AR), is shown in the next diagram below:
Cost and revenue curve shifts – effects on profit.
1) Revenue curve shifts
Which factors shift a firm’s revenue curve? Any factor, apart from price, that changes demand for an individual firm’s product.
In the diagram below, AR and MR shift left (or down) from AR and MR to AR1 and MR1.
What could cause this? This could include:
- Decrease in quality of the product sold by that individual firm.
- Lower incomes (for a normal good).
- A decrease in advertising.
- Other firms entering the market and taking away customers.
- Etc.
How do the shifts left in AR and MR affect the diagram, assuming the firm maximises profits?
- The profit-maximising output falls from q1 (where MR = MC) to q2 (where MR1 = MC).
- The price falls from p1 to p2.
- Supernormal profit falls from (p1-c1)q1 to (p2-c2)q2.
2) Variable cost change
An increase in a firm’s variable cost shifts both AC and MC curves upwards.
Suppose, for example, there is an increase in wage costs for a firm. Assuming wages are a variable cost for the firm, this shifts AC and MC upwards to AC1 and MC1 respectively.
As a result:
- The profit maximising level of output falls from q (where MC = MR) to q1 (where MC1 = MR).
- Price rises from p to p1.
- Supernormal profit falls from (p-c)q to zero in this particular example.
- Note generally supernormal profit is likely to fall, but not necessarily to zero.
3) Fixed cost change
Suppose fixed cost increases, for example an increase in rent.
This shifts AC upwards from AC to AC1 but not MC.
- AC shifts upwards as fixed cost is a part of total cost.
- However, as the output level increases, the vertical gap between the new AC1 and original AC curves shrinks (see below). This is because the increase in fixed cost is being spread over more and more units of output, reducing the impact on average fixed cost and average total cost.
- Marginal cost is the change in total cost from an increase in output by one unit. However, fixed cost is independent of the number of units produced. So an increase in fixed cost does not shift the MC curve.
In this diagram, the output level does not change, as MR = MC remains at the same output level (q). MR and MC lines have not shifted.
The supernormal profit does fall from (p-c)q to (p-c1)q, however.
Evaluation points for cost-revenue shifts or shutdown
- Firm adaptation
- Example 1: Suppose costs increase for a manufacturing firm due to higher energy bills.
- Then firms can adapt by investing in energy efficiency. This reduces the extent to which costs rise in the long run, so profits may not fall as much etc.
- Example 2: Suppose revenues decrease for in-person retail stores, because of increased competition from e-commerce companies.
- Then in-person stores could adapt by setting up an online shop and reducing the number of in-person stores. So revenue may not fall as much as they can access online consumers too.
- Firm adaptation can therefore prevent firm shutdown.
- Percentage of cost or revenue affected.
- Suppose oil prices rise, increasing business costs for firms.
- However, some firms may not be dependent on oil.
- For example, firms could have their own renewable energy generators or their main cost may be labour instead.
- So business costs may not increase as much. So the increase in energy costs may not lead to firms shutting down unless they already have low profit margins.
- Offsets e.g. through government subsidies to prevent shutdown.
- Government may subsidise companies, such as steel firms.
- This could reduce a firm’s costs, making it less likely to shut down / see a fall in profits.
- Short run versus long run.
- A firm may struggle to survive in the long run but may continue to survive in the short run.
- This could occur when the firm can cover its variable costs but not its total costs (variable + fixed) with its revenue.
- See the section above on shutdown for more on this.
Practice questions on firm shutdown
Below is a short extract on firm shutdown, followed by two practice questions.
Buckingham Group was a construction company located near Buckingham in the UK. It had built buildings such as the London 2012 Copper Box arena, the Falmer Stadium for Brighton and Hove Albion FC and pit lane development for the Silverstone Formula 1 circuit. However, the company filed for administration in August 2023, indicating the company was facing financial difficulty.
Construction companies face cost challenges with high material costs and labour shortages could have contributed to losses on more recent contracts, with the company attributing some of its losses to “extreme inflation”. The business also faced cash flow difficulties, making it more difficult to pay for raw materials and subcontractors.
This failure could lead to the loss of 400 jobs and stall more recent projects, such as the expansion of Liverpool FC’s expansion of its Anfield Road stadium, a new stand at Fulham FC’s Craven Cottage stadium and in parts of the work for the HS2 high-speed railway. Companies dependent on Buckingham Group’s demand for subcontractors or raw materials are likely to be affected too.
Sources: The Construction Index, BBC, UK Construction Blog, miscellaneous others.
(a) Referring to the information provided and drawing a cost-revenue diagram, discuss one factor that may lead to firm shutdown. (12)
(b) Referring to the information provided, evaluate the microeconomic impacts of firm shutdown. (15)
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