Shutdown, breakeven, and normal and supernormal profit

Overview

Normal profit, firm's breakeven point and breakeven price exceed the shutdown price.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What is normal profit, and why do economists treat it as a cost?

   Model answer

   Normal profit is the minimum return the owner must earn to keep resources in their present use, equal to what those resources could earn in their next best alternative. Because it is the opportunity cost of enterprise and capital, it has exactly the same status as the opportunity cost of labour or materials and is therefore included in total cost. A firm earning normal profit is covering all its costs, including this one, and so is content to stay in the industry without expanding.

2. 2

   What is the difference between normal and supernormal profit?

   Model answer

   Normal profit is the level of return just sufficient to keep the firm in its current line of business and is counted within total cost. Supernormal profit, sometimes called abnormal or economic profit, is any surplus of total revenue over total cost once normal profit has been included. Supernormal profit is therefore a signal that resources are earning more here than elsewhere, which attracts entry where entry is possible.

3. 3

   An owner invests 200,000 pounds of savings in her firm and gives up a job paying 45,000 pounds a year. Savings would otherwise earn 5 per cent. The firm's accounts show a profit of 70,000 pounds. Calculate normal profit and supernormal profit.

   Model answer

   Normal profit is the total opportunity cost of the owner's own resources, which is the forgone salary of 45,000 pounds plus forgone interest of 200,000 multiplied by 0.05 = 10,000 pounds, giving 55,000 pounds. Supernormal profit is the accounting profit minus normal profit, which is 70,000 - 55,000 = 15,000 pounds. The firm is earning more than its resources could earn elsewhere, so it has an incentive to remain and expand.

4. 4

   Why can a firm reporting a healthy accounting profit still be making an economic loss?

   Model answer

   Accounting profit deducts only explicit payments and conventional depreciation, whereas economic profit also deducts the implicit opportunity cost of resources the owner supplies. If the owner could earn 60,000 pounds elsewhere but the accounts show a profit of 40,000 pounds, the economic loss is 20,000 pounds even though the business looks profitable. Resources are then in the wrong use, and the owner would be better off closing and taking the alternative.

5. 5

   What is a firm's breakeven point, and what condition holds there?

   Model answer

   The breakeven point is the level of output at which total revenue exactly equals total cost, so the firm earns normal profit and no supernormal profit. Equivalently, price equals average total cost. On a diagram it is where the average revenue curve crosses the average total cost curve.

6. 6

   A firm has fixed costs of 60 pounds a week and average total costs of 100.00, 62.00, 46.00, 39.00, 38.00 and 41.00 pounds at outputs of one to six units. Identify the lowest price at which the firm could break even and the output at which it would do so.

   Model answer

   Breakeven requires price to equal average total cost, so the lowest price at which any output breaks even is the minimum of average total cost. That minimum is 38.00 pounds at an output of five units. At a price of 38 pounds, total revenue is 38 multiplied by 5 = 190 pounds and total cost is 190 pounds, so profit is exactly zero and the firm earns normal profit.

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