Profit position of the firm

After you have worked through this section of the learning unit, you should be able to:

  • distinguish between normal profit, economic profit and a loss

Normal profit

Normal profit is the best return that the firm's self-owned, self-employed resources could earn elsewhere. It can be regarded as the minimum payment required by the owner of the firm to stay in the particular business. Normal profit includes the cost of the owner's time and capital. Thus, if an economist talks about the cost of doing business, he or she would include the normal profits that must be paid to the owners to keep them in the particular business.

Consider the diagram below where the average cost curve has been added to the marginal revenue and marginal cost curves. Average cost consists of average fixed cost and average variable cost and the average cost curve (AC) is U-shaped. The marginal cost curve (MC) is upward sloping and the marginal and average revenue curves (AR = MR) are the same and horizontal.

Given a market price of P, profit is maximised where MR = MC = P. This occurs at a quantity of Q. At Q, the firm's average revenue (AR) per unit of production is P, which is also equal to the average cost per unit (AC). Since AR = AC, the firm only earns a normal profit, since all its costs, including the opportunity cost of self-owned, self-employed resources, are fully covered. Point E is usually called the break-even point which is the point where the firm is able to cover its costs and earns only a normal profit.

As long as average revenue is equal to average cost, the firm is earning a normal profit.

If AR = AC, then a normal profit is earned.

Alternatively, you can find the firm's profit position by subtracting the firm's total cost from its total revenue. The firm's total revenue is equal to the price of the product P, multiplied by the quantity produced (and sold) Q. This is equal to the area 0-P-E-Q in the above diagram. The total cost of the firm is equal to the average cost, which is equal to P, multiplied by the quantity Q, and is also represented by the area 0-P-E-Q (the same as for total revenue). Therefore, total revenue equals total cost and the producer is only making a normal profit.