PROFIT: AQA Economics Specification Topic 4.1

Topic 4.1 - Individuals, firms, markets and market failure

Snapshot of the AQA syllabus topic area we’ll be covering in this post.

PROFIT: PRODUCTION, COSTS AND REVENUE

AQA students must understand the following content [taken from the syllabus]

• Profit is the difference between total revenue and total costs.

• The difference between normal and abnormal (supernormal) profit.

• The role of profit in a market economy.

INFORMATION YOU NEED TO KNOW

[SUPPORTING QUESTIONS AT THE BOTTOM OF THIS PAGE]

Introduction: Understanding Profit’s Role in a Market Economy

Profit is a key idea in economics that determines how successful a business is financially. It acts as a major motivator for business owners and organisations, guiding their decisions and affecting market dynamics. We shall examine the idea of profit, its elements, and its importance in a market economy in this piece.

1. Defining Profit

Profit is the difference between total revenue and total costs. The difference between entire income and total costs is referred to as profit. It stands for the financial return that a company makes from its operations. Complete costs include all outlays made during the production process, including both fixed and variable costs. Total revenue is the complete amount of money made from the sale of goods or services which can also be worked out as Price x Qty.

2. Normal and Supernormal/Abnormal Profit

Profit can be divided into two groups:

a) Normal Profit: Normal profit and abnormal (or supernormal) profit. Normal profit is the bare minimum of profit necessary to keep a company running over the long term. It contains both explicit and implicit costs and accounts for the opportunity cost of resources. A company is said to be covering all of its expenses and generating a reasonable return on investment when it makes a regular profit.

The condition for normal profit is Total Revenue [TR] = Total Cost [TC]

b) Abnormal Profit: Contrarily, abnormal profit is defined as profit that is greater than normal profit. It stands for the extra revenue that a company makes over what is required to stay in operation. Atypical profit frequently results from elements like innovation, product distinction, or market dominance. It encourages businesses to enter a specific sector and promotes competition, which boosts market effectiveness and customer welfare.

Supernormal profit also could mean that a firm is being financially ‘overrewarded’ for its factors of production.

The condition for abnormal profit is Total Revenue [TR] > Total Cost [TC]

3. The Role of Profit in a Market Economy

Profit is essential in a market economy because it acts as a signal, encourages effective resource allocation, and fosters economic expansion. Here are some crucial facets of profit's function:

a. Market Signals: For business owners and entrepreneurs, profit serves as a crucial signal that influences how they make decisions. When businesses see strong earnings in a certain sector, it draws new entrants looking to seize the opportunity. As a result, there is more rivalry, which can spur innovation, better product quality, and lower consumer pricing.

b. Resource Allocation: In an economy, allocation of limited resources is influenced by profitability. Higher profits in a sector suggest that resources are being allocated and used efficiently to satisfy the needs of consumers. Conversely, lower profits or losses signify inefficiencies, causing resources to be redistributed to industries with higher rates of productivity.

c. Innovation and Investment: Companies are encouraged to invest in R&D and technical developments by the possibility of making a profit. Profitable businesses have the resources to finance innovation, advancing the economy, and raising standards of living.

d. Entrepreneurship and Risk-Taking: Risk-taking and entrepreneurial endeavours are rewarded with profit. In order to make money, entrepreneurs invest money, take risks, and deal with uncertainty. Profitability encourages people to take measured risks, generating creativity and promoting economic dynamism. It is assumed in traditional economic theory that entrepreneurs are rational and therefore wish to profit maximise.

[There is a condition for profit maximisation which is marginal cost = marginal revenue. But we will cover this in a future post.]

Conclusion:

To sum up, profit is a crucial component of economics that shows the monetary success of companies. The gap between total revenue and total costs makes up this amount. Analysing the success of a company requires an understanding of the difference between normal and abnormal profit. Profit serves as a market signal that influences how resources are allocated, encourages innovation, and promotes economic expansion. It acts as an essential motivator for business owners, shapes market dynamics, and promotes a thriving market economy.

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EXAMPLE QUESTIONS WITH SOLUTIONS TO HELP YOU CALCULATE PROFIT IN AN ECONOMICS EXAM

Here are the three example questions along with their worked solutions:

Question 1:

A firm sells 1,000 units of a product at a price of £20 per unit. Its total costs, including both fixed and variable costs, amount to £15,000. Calculate the firm's total profit.

Solution:

Total Revenue = Price per unit x Quantity Sold

Total Revenue = £20 x 1,000 = £20,000

Total Costs = £15,000

Total Profit = Total Revenue - Total Costs

Total Profit = £20,000 - £15,000 = £5,000

Therefore, the firm's total profit is £5,000.

Question 2:

A firm operating in a perfectly competitive market sells 500 units of a product at a price of £10 per unit. Its total costs, including both fixed and variable costs, amount to £6,000. Calculate the firm's supernormal profit.

Solution:

Total Revenue = Price per unit x Quantity Sold

Total Revenue = £10 x 500 = £5,000

Total Costs = £6,000

Total Profit = Total Revenue - Total Costs

Total Profit = £5,000 - £6,000 = -£1,000

Since the total profit is negative, the firm is experiencing a loss. Therefore, there is no supernormal profit.

Question 3:

A firm sells 200 units of a product at a price of £25 per unit. Its total costs, including both fixed and variable costs, amount to £7,500. Determine whether the firm is earning a normal profit, abnormal profit, or experiencing a loss.

Solution:

Total Revenue = Price per unit x Quantity Sold

Total Revenue = £25 x 200 = £5,000

Total Costs = £7,500

Total Profit = Total Revenue - Total Costs

Total Profit = £5,000 - £7,500 = -£2,500

Since the total profit is negative, the firm is experiencing a loss. Therefore, it is not earning a normal profit or abnormal profit.

These worked solutions provide step-by-step calculations to determine the total profit or supernormal profit based on the given data. Students can use these solutions to verify their own calculations and understand how profit is derived in different scenarios.