Economics · Ch 10 — The Theory of the Firm under Perfect Competition
The Normal Profit and Break-even Point
The Normal Profit and Break-even Point
Normal Profit: The Minimum Necessary to Stay in Business
Every firm needs to earn at least some minimum level of profit to remain in its current line of business. This minimum is called normal profit. If a firm fails to earn normal profit, it will not continue operating in that industry in the long run. The key insight is that normal profit is not a surplus or extra gain — it is treated as a cost of production. Why? Because the entrepreneur could have used their time, effort, and capital in the next best alternative business. The income they forgo by not choosing that alternative is an opportunity cost. Normal profit is that opportunity cost of entrepreneurship.
Think of normal profit as the minimum reward that keeps the entrepreneur from leaving the industry. It is the amount they could have earned running a different firm. Since it is a cost, it is included in the firm's total cost curves (both average and marginal).
Any profit earned above normal profit is called super-normal profit (or economic profit). This is the extra reward that attracts new firms into the industry in the long run.
The Break-even Point
The point on the firm's supply curve where it earns only normal profit — no more, no less — is called the break-even point. At this point, the firm's total revenue exactly covers its total cost, including normal profit as a cost. In terms of average curves, the break-even point occurs where price equals the minimum of the average cost curve.
For a firm in the long run, the relevant average cost curve is the Long Run Average Cost (LRAC) curve. The supply curve in the long run is the portion of the Long Run Marginal Cost (LRMC) curve that lies above the LRAC. The break-even point is where the LRMC curve cuts the LRAC curve at its minimum point. In the short run, the same logic applies using the Short Run Average Cost (SAC) curve and the Short Run Marginal Cost (SMC) curve.
Do not confuse the break-even point with the shut-down point. The shut-down point (in the short run) is where price equals minimum average variable cost (AVC). The break-even point is where price equals minimum average total cost (ATC or AC). A firm can produce below the break-even point in the short run (earning less than normal profit) but will not do so in the long run.
The Long Run Supply Curve of a Firm
The long run supply curve of a firm is derived from its cost curves. It is the portion of the Long Run Marginal Cost (LRMC) curve that lies above the Long Run Average Cost (LRAC) curve. The textbook illustrates this with Fig. 4.10 (described in words below).
Description of Fig. 4.10:
- The horizontal axis measures Output.
- The vertical axis measures Price, Costs (in rupees or any monetary unit).
- Two curves are drawn: the LRAC curve (U-shaped) and the LRMC curve (which cuts the LRAC at its minimum point from below).
- The bold line representing the firm's long run supply curve starts at the minimum point of the LRAC curve (the break-even point) and follows the LRMC curve upward for all higher prices. Below that point, the firm would not supply any output in the long run because it would earn less than normal profit.
In the long run, a perfectly competitive firm will only produce if the market price is at least equal to the minimum of its LRAC. The supply curve is therefore the upward-sloping portion of the LRMC curve starting from the break-even point.
Opportunity cost
In economics we constantly meet the idea of opportunity cost. The opportunity cost of any activity is the gain that is given up from the next best (second best) alternative activity.
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