Profit = the difference between total revenue and total cost
Profit per unit = AR - ATC
A firm adds to profits if marginal revenue from selling an extra unit is greater than the marginal cost of production
Break-even output occurs when AR=ATC
Revenue maximization is when MR = zero
Profit maximisation occurs at the output where MR = MC
TYPES OF PROFIT
In economics there is no unique definition of profit!
NORMAL PROFITS - are defined as the minimum level of profit required to keep the factors of production in their current use in the long run. Normal profits are included in the ATC curve, thus if the firm covers its ATC it is making normal profits.
ABNORMAL PROFIT - is any profit in excess of normal profit. Also known as supernormal profit or economic profit. When firms are enjoying abnormal profits in an industry there is an incentive for other producers to enter the industry to try to acquire some of this profit for themselves.
SUB-NORMAL PROFIT - is any profit less than normal profit. In the long run a firm will leave an industry if it continues to make only sub-normal profits. Also called an economic loss.
ILLUSTRATING PROFIT MAXIMISATION
The firm maximises profit when marginal cost equals marginal revenue.
It can sell output Q1 at price P. The profit per unit = P - ATC.
Total profits are shown by the yellow shaded area. Because price exceeds average total cost (and normal profits are included in the average cost curve) we can say that the firm is earning supernormal profits in this situation
A change in marginal costs causes a change in the profit maximising level of output. In the diagram above, lower variable costs cause MC to shift from MC1 to MC2. The profit maximising output expands from Q1 to Q2. Higher costs would cause a contraction of output because of an upward shift in the marginal cost curve.
Profits rise when demand for the goods or services that the business is producing increase, or when production costs fall allowing the business to increase the profit margin on their output. When the macro-economy is doing well, we expect to see rising profit levels. Britain enjoyed a period of sustained economic growth during the late 1990s when output and corporate profits were both rising strongly.
The chart above shows total gross profits for UK companies from 1998-2000. Profits dipped during the economic recession of the early 1990s but the sustained recovery in the British economy from 1993 onwards led to a large rise in profits.
But when there is an economic downturn, companies are found issuing profits warnings to the stock market and often announcing declines in pre-tax profits or losses on their operations. This then has a knock on effect on business confidence and investment. Consider this article published in July 2001.
British industry is poised on the brink of recession with profits in many sectors down 15% according to a new report. The UK has not been immune from the slowdown in the world economy and a strong pound and too much red tape are hurting profits - particularly in the manufacturing sector.
Since the start of the year (2001) UK industry has witnessed the foot-and-mouth disease and the technology and telecoms crisis. Seven industries have seen their profitability fall by more than one-fifth year-on-year - engineering, printing, paper and packaging, textiles and clothing, food manufacturing, media, non-food retailing and motor traders. Other areas such as food retailing, transport and support services have seen their profitability fall by 15% to 20%.
Update: October 2001: Profit Squeeze is Starting to Bite
New data from the Office of National Statistics shows company profitability falling steeply even before the negative impact of the terrorist attack on the USA.
The estimated rate of return for manufacturing industry for the second quarter of 2001 showed a dip to just 4.5 per cent, the lowest since 1992. In the services sector the rate dropped to an eight-year low of 12.4 per cent. Taken as a whole, the net rate of return for non-financial companies fell to 12 per cent, the lowest figure since 1995. Without a jump in profits for north sea oil companies, the average level of profitability would have fallen ever further.
The squeeze on profits is likely to persist going forward - and when profit margins are cut and profit warnings increase, so the risks grow of a severe cut in planned capital investment. This will hit capital expenditure (a component of aggregate demand) and may prompt further job losses across many sectors. So far it appears that small businesses are taking the brunt of the economic slowdown,
The latest survey of business failures from Dun and Bradstreet shows that 18,191 small firms have collapsed in the first three quarters of the year-a rise of 3.5% on the same period in 2000. Larger corporations have greater security to weather the expected downturn. It is smaller companies further down the supply chain that appear most vulnerable this winter.
Update November 2001
Ernst and Young estimate that 135 UK quoted companies issued profit warnings in the third quarter of this year - a figure 35% higher than in the previous three months. Of 48 warnings made in September 2001, ten were attributed by the companies themselves to the impact of the terrorist attacks of the 11th of September. Ernst and Young's figures show that 49% of the third quarter profit warnings emanated from just four sectors - Software and Computer Services (27), Media and Photography (17) Information Technology Hardware (11) and Support Services (11). The global recession in hi-technology industries cuts across all four of these sectors. Output is falling - so there is less market demand for businesses providing components; power sources; firms looking to recruit staff into the ICT sector; and retailers of finished products.
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