Short-run and long-run costs, revenues, the profit-maximising rule and the distinction between normal and abnormal profit.

What this dot point is asking

WJEC wants you to explain how a firm's costs and revenues behave in the short and long run, to state and justify the profit-maximising rule, and to distinguish normal from abnormal profit.

The answer

Costs in the short and long run

In the short run the law of diminishing returns applies: as more variable input (labour) is added to fixed capital, the marginal product of each extra worker eventually falls, so marginal cost eventually rises. This gives the familiar U-shaped average cost curve, with average cost falling while marginal cost is below it and rising once marginal cost is above it (the two intersect at the minimum of average cost). In the long run, the shape of the cost curve reflects economies of scale (falling average cost as the firm grows) and diseconomies of scale (rising average cost when it grows too large), examined in the next topic.

Revenue

In perfect competition the firm is a price-taker, so it can sell any quantity at the market price: AR is constant and equal to MR, and the demand curve facing the firm is horizontal. In imperfect competition the firm faces a downward-sloping demand curve, so to sell more it must lower the price on all units; AR falls as output rises and MR falls faster, lying below AR. The relationship between AR and MR is central to analysing different market structures.

Profit maximisation, normal and abnormal profit

A firm maximises profit where marginal cost equals marginal revenue. While MR exceeds MC, an extra unit adds more to revenue than to cost and raises profit; once MC exceeds MR, the extra unit reduces profit; so profit is greatest where they are equal. Normal profit is the minimum return needed to keep the entrepreneur supplying in the industry; it is treated as a cost of production, earned when total revenue equals total cost (price equals average cost). Abnormal (supernormal) profit is any profit above normal profit, earned when price exceeds average cost; it acts as a signal and incentive that, in a contestable market, attracts new entrants. A firm making less than normal profit (a loss) will leave in the long run.

Examples in context

Example 1. Fixed costs and survival in the short run. A firm with high fixed costs (an airline with aircraft leases, a pub with rent) can rationally keep operating in the short run even at a loss, provided price covers its average variable cost and makes some contribution to fixed costs. This short-run shut-down logic, comparing price with average variable cost, explains why heavily indebted firms keep trading through downturns rather than closing immediately.

Example 2. Abnormal profit as a signal in a growing market. When a new product market is highly profitable, the abnormal profits act exactly as the theory predicts: they signal opportunity and attract entrants. The wave of firms entering streaming, food delivery or electric vehicles illustrates abnormal profit drawing in competition, which over time tends to compete the abnormal profit away unless barriers to entry protect the incumbents, linking this topic to market structure.

Try this

Q1. State the profit-maximising rule for a firm. [1 mark]

• Cue. A firm maximises profit where marginal cost equals marginal revenue (MC = MR), with marginal cost rising.

Q2. Explain why normal profit is treated as a cost of production. [3 marks]

• Cue. Normal profit is the minimum reward needed to keep the entrepreneur in the industry, so it is an opportunity cost of supplying; if it is not earned, resources move to their next best use.