In Economics, total cost includes both explicit and implicit costs. Explicit costs are easily quantifiable (e.g. labour and raw materials), whereas implicit costs are not (e.g. opportunity cost). This is important to consider when working out economic profit (total revenue – total costs).
There are several types of economic profit. The first type of economic profit is normal profit. This is the minimum level of profit needed in order to keep existing factors of production running at their current level. Achieving normal profit indicates that factors of production are being used efficiently and resources are not better shifted elsewhere. The second type of economic profit is subnormal profit. This occurs when factors of production are better shifted elsewhere, meaning that the level of profit being made is not enough to cover opportunity cost. Lastly supernormal profit is any level of profit above normal profit. The three types of economic profit can be shown in the following example:
| Firm 1 | Firm 2 | Firm 3 | |
| Washing machines (Accounting profit) | £20,000 | £20,000 | £20,000 |
| Dishwashers (Accounting profit) | £15,000 | £20,000 | £30,000 |
| Economic profit (£) | £5,000 | £0 | – £10,000 |
| Type of Economic profit | Supernormal profit | Normal profit | Subnormal profit |
All 3 firms produce washing machines, however they could have instead produced dishwashers. The accounting profit achieved for the first 3 firms from making dishwashers also vary as a result of different explicit costs and price levels.
Firm 1 makes an accounting profit (total revenue – total explicit costs) of £20,000. If that firm were to make dishwashers it would make an accounting profit level of £15,000. This is less than they are currently making through the production of washing machines, therefore they are using their resources most efficiently as they have an opportunity cost of – £5,000. As a result of this, firm 1’s economic profit is equal to £5,000 (they’re £5,000 better off producing washing machines than they would have been producing dishwashers). This represents a supernormal level economic profit.
If firm 2 were to make dishwashers, then their accounting profit would be the same as it is now when producing washing machines. Therefore, their resources are being used most efficiently and factors of production wouldn’t be better shifted elsewhere. This means that firm 2’s economic profit is equal to 0. This represents a normal level of economic profit.
Firm 3 currently makes an accounting profit of £20,000 through the production of washing machines. However if they shifted their factors of production towards making dishwashers, they would make an accounting profit of £30,000. This is £10,000 more than they currently make which is also equal to the value of the opportunity cost. As shown by these figures, the firm’s resources are not being used efficiently, causing them to have an economic profit of -£10,000. This level of economic profit is known as subnormal profit.
The shutdown condition
When a firm is making the decision of whether or not to shut down in the short run they need to take into account their total revenue, total fixed costs and total variable costs. If the firm were to shut down, then their total variable costs and total revenue would drop to 0 as they’re producing 0 output. However, if they were to continue production then their total variable costs and total revenue would stay the same. Regardless of whether the firm stops production or continues with production, their total fixed costs will stay the same due to the fact that these costs don’t vary with output. Overall, this means that it is only rational for the firm to continue production in the short term if the firm’s total revenue is greater than its total variable costs. The following examples demonstrate this:
| Firm 1 | |
| Total revenue | £70,000 |
| Total fixed costs | £80,000 |
| Total variable costs | £80,000 |
| Total costs | £160,000 |
| Loss if firm shuts down | £80,000 (TFC) |
| Loss if firm stays open | £90,000 (TC-TR) |
Firm 1 has a total revenue of £70,000 and total variable costs of £80,000. If they were to continue producing in the short term then they would be making a £90,000 loss. This is in contrast to if they were to close, in which case they’d make a £80,000 loss. The option to stop production is cheaper due to the fact that the total variable costs that would occur if production was continued are greater than their total revenue. Therefore in order to minimize losses, the firm should close down, causing their total revenue to fall from £70,000 to 0 and their total variable costs to drop from £80,000 to 0.
| Firm 2 | |
| Total revenue | £90,000 |
| Total fixed costs | £80,000 |
| Total variable costs | £90,000 |
| Total costs | £170,000 |
| Loss if firm shuts down | £80,000 (TFC) |
| Loss if firm stays open | £80,000 (TC-TR) |
In this scenario, firm 2’s total revenue is equal to its total variable costs. As a result of this, the loss if the firm shuts down (£80,000) is the same as the loss if the firm stays open. Although it doesn’t make a difference to the firm in terms of losses whether or not they decide to stay open, they may do so for reasons such as keeping existing employees employed or to try and turn the firm’s finances around.
| Firm 3 | |
| Total revenue | £110,000 |
| Total fixed costs | £80,000 |
| Total variable costs | £100,000 |
| Total costs | £180,000 |
| Loss if firm shuts down | £80,000 (TFC) |
| Loss if firm stays open | £70,000 (TC-TR) |
Firm 3 has a total revenue of £110,000 and total variable costs of £100,000. As their total revenue is greater than their total variable costs, they are better off continuing production in the short run. This is because total revenue not only covers total variable costs, but there is also £10,000 left over to pay for some… Read more