Theme 3: 3.3.4 Normal Profits, Supernormal Profits and Losses
Welcome to one of the most crucial microeconomics chapters for Pearson Edexcel A Level Economics A (9EC0)! You will encounter these concepts across Paper 1: Markets and Business Behaviour and Paper 3: Microeconomics and Macroeconomics.
Have you ever wondered why an accountant might look at a firm's books and declare a profit, while an economist looking at the exact same numbers says the firm made zero profit? Or why a struggling restaurant stays open on a rainy Tuesday evening even when it loses money on rent? By the end of these notes, you will master these exact economic puzzles with clear rules, step-by-step logic, and exam-ready precision.
Don't worry if this seems tricky at first—once you learn the difference between explicit and implicit costs, the rest falls into place easily!
---1. The Foundation: Explicit vs. Implicit Costs
To understand profit in economics, we must first change how we look at costs.
Explicit Costs (The Money Leaving the Bank Account)
Explicit costs are direct, out-of-pocket monetary payments made to outside factors of production.
• Examples: Paying staff wages, purchasing raw materials, paying utility bills, or paying monthly factory rent.
Implicit Costs (The Hidden Opportunity Costs)
Implicit costs are the opportunity costs of using resources already owned by the firm or the entrepreneur for which no direct cash payment is made.
• Examples: The salary the entrepreneur could have earned working for another company, or the interest foregone on personal savings invested into setting up the business.
Economic Total Cost Formula
In Economics, total cost is not just invoices and receipts. It includes both types of costs:
\(\text{Total Cost } (TC) = \text{Explicit Costs} + \text{Implicit Costs}\)
Accounting Profit vs. Economic Profit
Now we can see why accountants and economists calculate profit differently:
• Accounting Profit: \(\text{Accounting Profit} = \text{Total Revenue } (TR) - \text{Explicit Costs}\)
• Economic Profit: \(\text{Economic Profit} = \text{Total Revenue } (TR) - \text{Economic Total Costs} = TR - (\text{Explicit Costs} + \text{Implicit Costs})\)
Real-World Analogy: Imagine Maya leaves her job earning £40,000 a year to open a bakery. In her first year, she earns £100,000 in revenue and pays £60,000 in explicit costs (flour, rent, assistant wages). Her accounting profit is \(£100,000 - £60,000 = £40,000\). However, Maya gave up a £40,000 salary (implicit cost). Her economic total costs are \(£60,000 + £40,000 = £100,000\). Her economic profit is \(£100,000 - £100,000 = £0\)! Maya made exactly enough to keep her running the bakery.
Key Takeaway: Economic profit accounts for the entrepreneur's next-best alternative. If economic profit is zero, the business owner is still being fully compensated for their time and capital.
---2. The Three Types of Profit
1. Normal Profit (\(\text{Economic Profit} = 0\))
• Definition: The minimum level of profit required to keep the factors of production / entrepreneur in their current line of employment in the long run.
• Key Condition: \(\text{Total Revenue } (TR) = \text{Total Cost } (TC)\) or \(\text{Average Revenue } (AR) = \text{Average Cost } (AC)\) (where Price \(P = AC\)).
• Theoretical Meaning: Normal profit is treated as an internal component of the firm's total cost curve (\(TC\) and \(AC\)) because it represents the opportunity cost of the entrepreneur's resources. When \(TR = TC\), economic profit equals zero, but all resources (including the entrepreneur's time) are covered.
2. Supernormal Profit (Abnormal / Economic Profit)
• Definition: Any profit earned above and beyond normal profit (returns over and above the opportunity cost of capital/resources).
• Key Condition: \(TR > TC\) or \(AR > AC\) (where Price \(P > AC\)) at the profit-maximising level of output (\(MR = MC\)).
• Market Role: Supernormal profits act as a signal and incentive for new firms to enter an industry (particularly when barriers to entry are low), competing excess profits away over time.
3. Subnormal Profit / Economic Losses
• Definition: A situation where a firm fails to cover its total economic costs (including implicit opportunity costs).
• Key Condition: \(TR < TC\) or \(AR < AC\) (where Price \(P < AC\)).
• Meaning: Resources could generate higher returns in an alternative use elsewhere in the economy.
Memory Trick: Think of normal profit as the baseline. Below it = Loss (subnormal). At it = Normal (staying put). Above it = Super (bonus profits attracting newcomers)!
---3. Diagrammatic Analysis: Finding Output and Profit Areas
In Section A calculations, Section B data responses, and Section C essays, Edexcel examiners award high marks for correctly drawing and reading cost and revenue diagrams. Follow this 3-step process every time:
Step 1: Find Profit-Maximising Output (\(Q\))
Always locate where the Marginal Revenue curve intersects the Marginal Cost curve: \(MR = MC\). Project down to the horizontal axis to label output \(Q\).
Step 2: Find Price / Average Revenue (\(AR\)) and Average Cost (\(AC\)) at Output \(Q\)
From output \(Q\), project vertically upwards to read:
• The price on the \(AR\) curve (let's call it \(P\)).
• The cost per unit on the \(AC\) curve (let's call it \(C\)).
Step 3: Calculate and Shade the Profit/Loss Box
• If \(AR > AC\): The shaded rectangle between \(P\) and \(C\) across output \(Q\) represents Supernormal Profit, calculated as \((AR - AC) \times Q\).
• If \(AR = AC\): Price equals average cost at output \(Q\), so only Normal Profit is earned (no shaded box).
• If \(AR < AC\): The shaded rectangle between \(C\) and \(P\) across output \(Q\) represents an Economic Loss, calculated as \((AC - AR) \times Q\).
Key Takeaway: Never shade between the \(MR\) and \(MC\) curves. Profit is always measured between \(AR\) and \(AC\) across total output \(Q\).
---4. The Shut-Down Rules: Short-Run vs. Long-Run Decisions
When a firm makes a loss (\(AR < AC\)), should it close immediately or keep operating? The answer depends on whether we are looking at the short run or the long run.
A. The Short-Run Shut-Down Decision
In the short run, at least one factor of production is fixed. Total Fixed Costs (\(TFC\)) are sunk costs—they must be paid even if the firm produces zero output (e.g., long-term building leases).
• Scenario 1: \(Price \ (AR) \ge Average \ Variable \ Cost \ (AVC)\)
The firm covers all its variable costs and generates extra revenue that contributes towards paying off some fixed costs.
Decision: Continue producing in the short run to minimize total losses.
• Scenario 2: \(Price \ (AR) < AVC\) (or \(TR < TVC\))
Producing output adds more to running costs than it brings in from sales. Each unit sold increases the total loss. The shut-down point is reached when \(P < \min(AVC)\).
Decision: Shut down immediately in the short run to lose only fixed costs.
B. The Long-Run Exit Decision
In the long run, all factors of production and all costs are variable. There are no fixed contracts holding the firm back.
• Condition: \(Price \ (AR) < Average \ Total \ Cost \ (AC)\) (or \(TR < TC\))
If the firm cannot cover all its economic costs in the long run, it earns subnormal profits.
Decision: Exit the industry entirely in the long run and allocate resources to a more profitable market.
Real-World Analogy: Think of a seasonal seaside café during winter. The annual lease (\(TFC\)) must be paid anyway. If the café opens on a quiet weekday and takes in £200, while electricity and staff wages (\(TVC\)) cost £120, it covers all variable costs and has £80 left over to contribute towards rent (\(AR > AVC\)). It stays open! But if it only takes in £80 while variable costs are £120 (\(AR < AVC\)), staying open loses £40 more than staying shut. It closes its doors for the day immediately.
---5. Examiner Pitfalls & Common Mistakes to Avoid
Keep these frequent Edexcel examiner warnings in mind to protect your marks:
• Pitfall 1: Confusing Normal Profit with £0 Cash Profit.
Correction: Normal profit means zero economic profit, not zero cash in the bank. It includes the entrepreneur's wages and opportunity cost of capital as part of costs (\(AC\)).
• Pitfall 2: Shading Profit in the Wrong Place.
Correction: Do not shade between \(MR\) and \(MC\). Always determine output where \(MR = MC\), then shade the rectangle between \(AR\) and \(AC\).
• Pitfall 3: Assuming Any Loss Means Immediate Closure.
Correction: Do not confuse \(AC\) with \(AVC\). A firm losing money in the short run will still operate as long as \(AR \ge AVC\) because it contributes to paying fixed costs.
• Pitfall 4: Inserting Irrelevant Diagrams in Essay Questions.
Correction: If an exam question asks about changes in profitability, use revenue (\(AR, MR\)) and cost (\(AC, MC\)) diagrams rather than standalone economies of scale curves.
6. Quick Review Checklist
Use this summary table to test yourself before exam day:
• \(\text{Total Economic Cost}\) \(= \text{Explicit Costs} + \text{Implicit Costs}\)
• \(\text{Normal Profit}\) \(\implies TR = TC\) or \(AR = AC\) (\(\text{Economic Profit} = 0\))
• \(\text{Supernormal Profit}\) \(\implies TR > TC\) or \(AR > AC\) (attracts new entrants)
• \(\text{Subnormal Profit (Loss)}\) \(\implies TR < TC\) or \(AR < AC\)
• \(\text{Short-Run Shut-Down Point}\) \(\implies Price \ (AR) < AVC\)
• \(\text{Long-Run Exit Point}\) \(\implies Price \ (AR) < AC\)