Short Term Profits and Losses

NOTES ON SHORT RUN PROFITS (AND LOSSES)

There are two graphs to remember: (a) the graph of revenues and costs on a total basis; and (b) the graph of revenues and costs on a per-unit ("average") and marginal basis. The slope (or rate of change) of TR is known as marginal revenue (MR), while the slope (rate of change) of TC is called marginal cost (MC). What happens to profit depends on how fast these two magnitudes (TR and TC) are changing relative to each other, and that is shown by comparing their slopes, i.e., MR and MC. The "price line" shows the MR (drawn horizontal at the market price). The MC line is the familiar U-shaped curve.
Breakeven on the Total Revenue/Total Cost graph is where TR = TC and therefore where Profits (= TR - TC) are zero. This occurs at two different output levels:
-Below the first breakeven: TR < TC but MR > MC (revenue is rising faster than costs: addition to revenues > addition to costs, and losses are shrinking with greater output)
-After the first breakeven, TR > TC and MR > MC (profits are positive and increasing)
-At maximum profit, the slopes of the TR and TC lines are equal: MR = MC; costs are now rising as fast as revenues and profits are at a maximum.
-Beyond maximum profit, at first TR > TC but MR < MC (profits are decreasing because costs are rising faster than revenues with higher output)
-Finally, beyond the second breakeven, TR < TC once again and MR < MC (losses are increasing)
Profits = TR - TC = (P x Q) - (ATC x Q) = (P - ATC) x Q [profit per unit times # of units]:

On the totals graph, profits are measured as a vertical distance, the difference between TR and TC: TR - TC.

But on the per unit graph, profit is measured as an area of a rectangle: the number of units (Q) times the profit per unit (P - ATC).
Breakeven must occur at the same output levels on the per-unit graph as on the graph of totals: since TR = TC, then dividing both sides by Q means TR/Q = TC/Q or P = ATC at breakeven: the "price line" and the ATC line must cross each other at the same output levels that the TR and TC cross each other.
Notice that the output of the greatest total profit is not the same output level as where the greatest profit per unit (P - ATC) occurs. At this output level (where P - ATC is greatest), MR (represented by the "price line") is still higher than MC, and the change in profits will be positive and equal to the difference between MR and MC for an extra unit of output Q.
Therefore, if output is less than where MR = MC, output should be increased to achieve the maximum profit; if output is greater than where MR = MC, output should be decreased to achieve the maximum profit. (There will be less revenue, but costs will decrease by even more, thereby increasing profits with smaller output.)
The competitive firm cannot control its price. It is a price-taker. The firm can control its output, however, and being guided by the profit motive, it sets output so as to maximize profits, that is, it produces that output where MR = MC. The competitive firm is an output adjuster. (This is the output where the "price line" intersects the MC curve–equal slopes!)
Since the broad market sets the price level (based on market supply and demand), the firm faces three possible cases concerning the level of the market price relative to its own costs.

Case 1: P > ATC where MR = MC. The firm is covering all its costs (including a "normal profit") over that range of output where P > ATC, and is making above-normal or "economic" profits at that output level. [Of course, if P = ATC exactly (while MR = MC also), then it is maximizing its profits while making only a "normal" profit–no "economic" profits are being made.]

Case 2: AVC < P < ATC where MR = MC. ("The price line falls between the AVC and ATC curves.") At no level of output can the firm cover all of its costs, but it can at least cover (and perhaps more than cover) its variable cost per unit at that output where losses are minimized (that output level where MR = MC). Thus, the firm can justify staying in business in the short run, even though it is making an "economic loss" (the extent to which revenues do not cover costs including a normal profit). It can justify staying in business in the short run because, to the extent that P > AVC (and not just P = AVC), some revenues are being earned above and beyond variable costs, which can be applied to covering fixed costs, so that loss is less than if the firm did not produce at all and incurred fixed cost as a loss. But the firm will go bankrupt (will "exit") in the long run, by exhausting its equity capitalization, if it can’t do something either to increase revenues or to decrease costs!

Case 3: P < AVC at that output where MR = MC. The firm can’t even "pay the clerk’s salary" at any output level. It will magnify its losses by trying to produce output and making a loss even on its variable costs, not to mention not being able to cover fixed costs. It will shut down immediately (in the short-run). It produces nothing. The "shut down point" is where P = AVC (price line is tangent to AVC).

LONG RUN ADJUSTMENTS

A competitive industry is made dynamic by freedom of entry and exit. The effect of free entry by firms seeking to copy successful firms which are making above normal profits (Case 1), will be to drive price to the consumer down the lowest level consistent with covering all costs of production including a normal profit. Entry will continue until there is no further motivation for new firms to enter (that is, when P = ATC at its minimum point). (Market price will be driven down by new entry because new firms’ supply is added to existing market supply.)

In the case of short run losses (Case 2), firms making these losses will exit in the long run (as they go bankrupt or face the prospect of going bankrupt), their supply will be subtracted from market supply, and market price will rise until, once again, P = ATC at its minimum point. This is known as Social Darwinism: "Survival of the Fittest": Are markets like this this?

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This page was last updated on Friday, July 21, 2006.