Microeconomics guide, Unit 3, step 14 of 28Previous step Next step

Step 14: Profit Maximisation and Firm Decisions

By the EconTutorials team. 11-minute read with 6 practice questions.

SyllabusAP Micro 3.4–3.6 · Cambridge 7.5 · IB 2.11 (HL)

In 30 seconds

Economic profit = total revenue − explicit costs − implicit costs. Zero economic profit means the firm is earning normal profit: just enough to keep the owner in this business.
A firm maximises profit by producing where $ MR = MC $, the same output where the gap between total revenue and total cost is largest.
In the short run, a firm making a loss keeps producing as long as $ P \geq $ minimum AVC. Below that (the shutdown point) it shuts down. Fixed costs do not matter for this decision.
In the long run, firms enter when $ P > $ minimum ATC and exit when $ P < $ minimum ATC, so a competitive market settles where P = minimum ATC and economic profit is zero.

Video lesson coming soonA short animated lesson for this step will appear here.

What counts as profit? Accounting vs economic profit

Hana runs a small café. Over a year she takes in $120,000 from customers and pays $80,000 for rent, staff, coffee beans and electricity. Her accountant says she made $40,000 profit. But Hana left a job that paid $35,000 a year to run the café, and she put $50,000 of her savings into the business, which could have earned about $3,000 in interest in the bank. An economist says these are costs too.

Key termAccounting profit: total revenue minus explicit costs (the money actually paid out).

Key termEconomic profit: total revenue minus explicit costs and implicit costs (the opportunity cost of the owner’s own time and money).

Worked example

Calculate Hana’s accounting profit and economic profit.

Step 1Accounting profit $ = 120{,}000 – 80{,}000 = \$40{,}000 $.

Step 2Implicit costs $ = 35{,}000 + 3{,}000 = \$38{,}000 $.

Step 3Economic profit $ = 120{,}000 – 80{,}000 – 38{,}000 = \$2{,}000 $.

Hana earns $2,000 more than she could get from her next-best use of her time and money. The café is worth running.

Key termNormal profit: the minimum profit needed to keep the owner’s resources in their current use. It equals the implicit costs, and it occurs when economic profit is zero.

So zero economic profit is not a disaster: the owner earns exactly what they could earn elsewhere. Positive economic profit is called supernormal (or abnormal) profit in Cambridge and IB.

\[ \text{Economic profit} = TR – TC, \quad \text{where } TC \text{ includes implicit costs} \]

Finding the profit-maximising output: MR = MC

There are two ways to find the best output, and they always agree.

Total approach: calculate $ \text{profit} = TR – TC $ at every output and pick the largest.
Marginal approach: keep producing while each extra unit adds more to revenue than to cost, that is while $ MR \geq MC $. Stop where $ MR = MC $.

Here marginal revenue (MR) is the extra revenue from one more unit, $ MR = \frac{\Delta TR}{\Delta Q} $, and marginal cost (MC) is the extra cost, $ MC = \frac{\Delta TC}{\Delta Q} $. For a perfectly competitive firm, which is a price taker, every unit sells at the market price, so $ P = MR $.

\[ \text{Profit is maximised where } MR = MC \]

Worked example

For example, a farm sells boxes of tomatoes in a perfectly competitive market at P = $20. Its fixed cost is $20. Find the profit-maximising output.

Q	TR ($)	TC ($)	MR ($)	MC ($)	Profit ($)
0	0	20	–	–	−20
1	20	34	20	14	−14
2	40	44	20	10	−4
3	60	52	20	8	8
4	80	62	20	10	18
5	100	76	20	14	24
6	120	96	20	20	24
7	140	122	20	26	18

Step 1Find MC from the TC column: for example the 6th unit, $ MC = 96 – 76 = \$20 $.

Step 2MR = $20 for every unit. Units 1 to 5 have $ MC < MR $, so each adds to profit. The 6th has $ MC = MR = 20 $. The 7th has $ MC = 26 > 20 $ and would cut profit by $6.

Step 3So $ MR = MC $ at Q = 6. Profit $ = 120 – 96 = \$24 $, the largest value in the profit column.

Step 4Per-unit check: $ ATC = 96 / 6 = \$16 $, so profit $ = (P – ATC) \times Q = (20 – 16) \times 6 = \$24 $.

The 6th unit adds exactly as much revenue as cost, so profit is $24 at both 5 and 6 units. Exam mark schemes follow the rule and choose the output where MR = MC: 6 units.

Common mistakeProducing where profit per unit (P − ATC) is biggest, or where ATC is lowest. The firm wants the biggest total profit, which is at MR = MC. Another error is producing where MR = MC on the falling part of the MC curve; always use the point where MC is rising through MR.

The short-run shutdown rule

Now suppose the price falls to $12, so the farm makes a loss at every output. Should it stop producing? Not necessarily. In the short run, the $20 fixed cost (land rent, tractor lease) must be paid whether or not it produces. The question is whether producing makes the loss smaller.

If the farm shuts down, it earns nothing and still pays its fixed cost: loss = FC = $20.
If it produces, it is worth it as long as revenue covers the variable costs, because any extra revenue then helps pay off some of the fixed cost.

Key termShutdown rule: in the short run, a firm should produce if $ P \geq \text{min AVC} $ and shut down if $ P < \text{min AVC} $. The shutdown point is where P = minimum AVC.

Worked example

Using the same farm, the AVC at Q = 1 to 7 is $14, $12, $10.67, $10.50, $11.20, $12.67 and $14.57 (VC = TC − 20, divided by Q). Should the farm produce at P = $12? At P = $9?

Step 1Minimum AVC is $ 42 / 4 = \$10.50 $ at Q = 4.

Step 2P = $12: $ 12 > 10.50 $, so produce. Best output is Q = 4 (MC of the 4th unit is $10, of the 5th is $14). $ TR = 12 \times 4 = 48 $; $ TC = 62 $; loss $ = \$14 $, smaller than the $20 loss from shutting down.

Step 3Why: $ TR – VC = 48 – 42 = \$6 $, which pays off $6 of the $20 fixed cost. Loss $ = 20 – 6 = \$14 $.

Step 4P = $9: $ 9 < 10.50 $, so shut down. Producing 3 units, for example, gives $ TR = 27 $, $ TC = 52 $, loss $ = \$25 $, worse than the $20 loss from closing.

Below minimum AVC, every unit produced adds to the loss, so the firm does better by producing nothing.

Why fixed costs do not matter

Fixed costs do not change with output, so they do not affect MC, and they are the same whether the firm produces or shuts down. If the farm’s fixed cost doubled to $40, its MC curve would not move, its best output at any price would not change, and the shutdown point (minimum AVC) would stay at $10.50. Only the size of its profit or loss would change. In the short run, fixed costs are effectively sunk.

Break-even, shutdown and the long run

On the cost-curve diagram, two prices act as signposts.

Price compared with costs	Short-run result	Long-run response
$ P > $ min ATC	Economic profit	New firms enter
$ P = $ min ATC (break-even point)	Zero economic profit (normal profit)	No entry or exit
min AVC $ < P < $ min ATC	Loss, but keep producing	Firms exit
$ P < $ min AVC (below shutdown point)	Shut down; loss = FC	Firms exit

DiagramDraw the firm’s cost curves with “Price, cost ($)” on the vertical axis and “Quantity” on the horizontal axis. Draw a U-shaped ATC and a lower U-shaped AVC; the gap between them (AFC) narrows as output rises. Draw the MC curve rising and cutting through the lowest point of AVC first, then the lowest point of ATC. Label the minimum of ATC as the break-even point and the minimum of AVC as the shutdown point. For any price, draw a horizontal line P = MR; output is where it meets MC. If that line is above ATC at that output, shade the profit rectangle: height (P − ATC), width Q. If it lies between AVC and ATC, shade a loss rectangle. The part of the MC curve above the shutdown point is the firm’s short-run supply curve.

Entry and exit in the long run

In the long run all inputs are variable and, in perfect competition, there are no barriers to entry or exit, so:

If firms make economic profit (P above min ATC), new firms enter. Market supply shifts right, the market price falls, and profits shrink until P = min ATC.
If firms make losses (P below min ATC), some firms exit. Market supply shifts left, the price rises, and losses shrink until P = min ATC.

Long-run equilibrium is therefore where $ P = MR = MC = \text{min ATC} $. Each firm earns zero economic profit (only normal profit), and produces at the lowest possible average cost.

Common mistakeMixing up the two rules. The short-run shutdown decision compares P with AVC. The long-run exit decision compares P with ATC. A firm earning a price between the two keeps producing now, but will leave the industry in the long run if things do not improve.

Exam tipAP Micro FRQ: draw side-by-side graphs (market on the left, firm on the right) with the price carried across as a horizontal line labelled P = MR. Label MC, ATC and AVC, mark the output where MR = MC, and shade profit or loss using ATC at that output. For “Should the firm shut down?”, compare P with AVC and say so explicitly (“P > AVC, so it covers its variable costs and contributes to fixed costs”). For long-run questions, state the chain: profit → entry → market supply shifts right → price falls → zero economic profit. Cambridge 9708 and IB HL: define normal profit as a cost, and use “supernormal profit” for positive economic profit.

Practise: 6 questions

Try each one on paper first, then check the worked answer.

EasyQ1. A firm has revenue of $200,000 and explicit costs of $150,000. The owner could earn $60,000 a year working elsewhere. Calculate accounting profit and economic profit. Is the owner earning normal profit? Show worked answer

Accounting profit $ = 200{,}000 – 150{,}000 = \$50{,}000 $
Economic profit $ = 200{,}000 – 150{,}000 – 60{,}000 = -\$10{,}000 $
There is an economic loss of $10,000, so the owner earns less than normal profit: she could earn more in her next-best job.

EasyQ2. A perfectly competitive firm faces a price of $8. At its MR = MC output, ATC = $10 and AVC = $6. Should it produce or shut down in the short run? Show worked answer

Produce. $ P = 8 > AVC = 6 $, so revenue covers variable costs and contributes $2 per unit towards fixed costs. It still makes a loss of $ 10 – 8 = \$2 $ per unit, but that is smaller than the loss from shutting down.

MediumQ3. A price-taking firm sells at $15. Its fixed cost is $10 and its MC for units 1 to 6 is $9, $7, $9, $12, $15 and $19. Find the profit-maximising output and the profit. Show worked answer

MR = $15. MC is below 15 for units 1 to 4, equal at unit 5, and above (19) at unit 6. So $ MR = MC $ at Q = 5.
TC at Q = 5 $ = 10 + 9 + 7 + 9 + 12 + 15 = \$62 $
TR $ = 15 \times 5 = \$75 $
Profit $ = 75 – 62 = \$13 $

MediumQ4. A firm produces 1,000 units at its MR = MC output. P = $5, ATC = $6 and AVC = $4.50. Calculate its profit or loss if it produces, and its loss if it shuts down. What should it do? Show worked answer

TR $ = 5 \times 1{,}000 = \$5{,}000 $; TC $ = 6 \times 1{,}000 = \$6{,}000 $. Loss if it produces $ = \$1{,}000 $.
AFC $ = 6 – 4.50 = \$1.50 $, so FC $ = 1.50 \times 1{,}000 = \$1{,}500 $. Loss if it shuts down $ = \$1{,}500 $.
It should keep producing: the loss is $500 smaller, which matches the rule $ P = 5 > AVC = 4.50 $.

MediumQ5. In a perfectly competitive industry, the market price is $12 and the typical firm’s minimum ATC is $9. Explain what happens in the long run. Show worked answer

Since $ P = 12 > $ min ATC = 9, firms earn economic profit. With no barriers to entry, new firms enter. Market supply shifts right and the market price falls. Entry continues until the price reaches $9, where P = MR = MC = min ATC. Each firm then earns zero economic profit (normal profit only).

ExamQ6. A perfectly competitive firm has fixed cost of $40. Its total cost at outputs 0 to 6 is $40, $60, $76, $90, $110, $140 and $180. The price is $30. (a) Calculate MC for each unit. (b) Find the profit-maximising output and profit. (c) Find minimum AVC and explain what the firm should do if the price falls to $15. (d) Explain what will happen in the long run at a price of $30, and state the long-run price. [10 marks] Show worked answer

(a) MC: 1st = 20, 2nd = 16, 3rd = 14, 4th = 20, 5th = 30, 6th = 40. [2 marks]
(b) MR = $30 = MC at Q = 5. TR $ = 30 \times 5 = 150 $; TC $ = 140 $; profit $ = \$10 $. (Profit is also $10 at Q = 4, because the 5th unit’s MC equals MR; the 6th unit has MC 40 > 30, so it is not produced.) [2 marks]
(c) VC = TC − 40: 20, 36, 50, 70, 100, 140. AVC: 20, 18, 16.67, 17.50, 20, 23.33. Minimum AVC $ = 50/3 \approx \$16.67 $ at Q = 3. [1 mark] At P = $15, $ P < $ min AVC, so the firm should shut down; its loss is the fixed cost, $40. [1 mark] Producing would be worse, for example at Q = 3: $ 45 – 90 = -\$45 $. [1 mark]
(d) ATC: 60, 38, 30, 27.50, 28, 30, so minimum ATC = $27.50 at Q = 4. At P = $30 firms make economic profit, so new firms enter, market supply shifts right and price falls. [2 marks] The long-run price is minimum ATC, $27.50, where economic profit is zero. [1 mark]

Check yourself

1. In the short run, a firm should shut down when:

Below min AVC the firm cannot even cover variable costs, so producing loses more than the fixed cost.

2. A firm earning zero economic profit is:

Economic profit already subtracts implicit costs, so zero means the owner earns exactly their next-best return.

3. A firm’s fixed costs rise by $1,000. Its profit-maximising output will:

Fixed costs do not change MC or MR, so the MR = MC output does not change; only profit falls.

Your score: 0 out of 3

The short version

Accounting profit = TR − explicit costs; economic profit also subtracts implicit costs. Zero economic profit = normal profit.
Maximise profit where $ MR = MC $ (for a price taker, $ P = MC $); this is also where TR − TC is largest.
Short run: produce if $ P \geq $ min AVC, shut down if $ P < $ min AVC. Fixed costs are paid either way, so they do not affect the decision.
Break-even point = min ATC; shutdown point = min AVC. The MC curve above min AVC is the firm’s short-run supply curve.
Long run: profit attracts entry and losses cause exit, until P = MC = min ATC and every firm earns normal profit.

Step 14: Profit Maximisation and Firm Decisions

What counts as profit? Accounting vs economic profit

Finding the profit-maximising output: MR = MC

The short-run shutdown rule

Why fixed costs do not matter

Break-even, shutdown and the long run

Entry and exit in the long run

Practise: 6 questions

Check yourself

The short version

Further reading on EconTutorials

Contact Info

Quick Links

Success!