While the definition and measurement of profit can vary, in its simplest sense, profit is earned by an entrepreneur when revenue from sales is greater than production costs.

Profit can also be seen as the reward to risk taking. New entrepreneurs face a fundamental business risk which arises as a result of the time lag between costs being incurred, and revenue being earned. The entrepreneur bears this risk until revenue is sufficient to cover costs. This means the entrepreneur must either inject their own capital (or equity) into the business, or raise capital from capital markets.

Measuring costs and revenue

Costs and revenue can be measured in terms of ‘total’ quantities, average values, and marginal values, which measure the cost or revenue associated with producing (or selling) an additional unit.

While considering total and average values is important, economics is distinguished from other economic and financial disciplines by its interest in marginal values. Indeed, the ‘marginal revolution’ in economics involved the attempt to understand economic decision making by looking at very small changes in costs and revenue.

Profit maximisation

The attempt to maximise profit is assumed to be the main driver of business activity - this assumption is central to neoclassical economics.

Profit maximisation is best looked at through marginal analysis.

Marginal revenue, cost and profit

The condition for profit maximisation is for a firm to produce up to the point where marginal revenue equals marginal cost (MR = MC). At this point there is no more profit to be earned as the marginal profit at this point is zero.

Profits are maximised at the output where Marginal Revenue (MR) = Marginal Cost (MC)

If the firm stops short of this point, where MR is greater than MC, it suffers an opportunity cost because increasing output by one more unit will add to marginal profit - the opportunity cost is the lost marginal profit. However, if the firm increases output beyond the point where MR = MC it will make a loss on each marginal unit sold beyond this point - because MR is less than MC. (This can be shown graphically.)

Normal profits

Normal profits occur when entrepreneurs achieve a reward that is just sufficient to keep them supplying their enterprise. In other words, normal profits cover the entrepreneur's opportunity cost.

Normal profits are seen as efficient in that an entrepreneur will supply their enterprise for this reward, and although a greater reward would be beneficial, in terms of economic theory a reward above normal profit is not required to enable scarce resources to be used efficiently.


the tile maker example

Consider a firm making porcelain floor tiles, with the following costs per unit:

  • Raw materials $3
  • Labour costs $5
  • Finishing and packaging $1
  • Interest $1
  • Normal profit $5

To the economist, total costs are those required to supply a given quantity of goods to market. In the above example we will assume that the entrepreneur will not continue in business at a return below $5 – hence all the rewards to factors can be seen as costs to the firm.

In this case, the cost per tile is $15, and if the selling price is $15 then normal profits are made. Hence, when total revenue (TR) equals total cost (TC) normal profit is being made.

So, if the tile makers producers 4000 tiles a day, daily revenue is $60,000 and daily costs are $60,000.

Cost schedule

Cost schedule for the tiles example

Graph for average and marginal cost

Cost graph showing average and marginal cost

Graphically, the marginal cost (MC) curve cuts the average cost (AC, or ATC) curve at its lowest point.

The pattern is for average costs to be relatively high at low levels of output – because the impact of fixed costs, such as rents and interest payments, is high and drags up the average. However, as more variable factors are added to increase output, the significance of the fixed costs begins to diminish, and average costs fall. However, economic theory predicts that the returns to adding extra variable units of production will begin to diminish – the so-called law of diminishing returns. This drags up average costs and pushes the firm above its productively most efficient level.

Diminishing returns

Graph showing diminishing returns

Diminishing returns sets in when marginal cost begins to rise - in this case, at an output of 3000. The upward increase in marginal costs then drags up the average cost. In this example, the firm is productively efficient at 4000 units as this is the lowest average cost (at $15 per unit).

This can be seen more effectively in a graph for average costs. It is also true that average costs will be at their lowest when average cost equals marginal cost (per unit).

The case above is a special case where the seller can only charge one price and is a ‘price taker’ – a market described as perfectly competitive.

In this case, the best position for the firm is to make only normal profits, as any other output results in a loss. (with the exception of 3000 units – but when we have two identical profit levels we always move to the last case – this is because we never really discover the figure until we have arrived at it. So, if this was a real firm it would only stop production if profits fell – in this case it would not produce above 4000 units).

Revenue schedule for the price taker

In this case, the firm is assumed to be a price 'taker' and cannot set the price itself - hence the price remains at $15 whatever the quantity sold. The price is set by the interaction of demand and supply in the whole market. This type of market is said to be perfectly competitive.

Revenue schedule for the tiles example

Revenue graph for the price taker

Revenue graph for the tiles example

Profit schedule for the price taker

Profit schedule for the tiles example

Here we can see that the 'best' outcome for the price taker is to avoid making losses, and only to derive normal profits.

Graph for the price taker

Schedules for price taker

Super-normal profits

The above analysis considers normal profits as providing optimal efficiency.

However, in many circumstances profits can rise above normal - this is generally the result of higher revenue rather than lower costs because the producer can set their own price and become a price maker. Hence, the second case of profits involves the price making firm with the ability to set price which enables the firm to gain revenue and increases profits beyond of normal profits.

If the entrepreneur earns a reward greater than normal profit it is defined as super-normal (or excess) profits. In this case the reward is exceeding the entrepreneur’s opportunity cost. This can only be achieved if the firm has some power to fix its own price. This will happen when the firm operates in a less than perfectly competitive market, such as a monopolistically competitive market, and oligopoly or a pure monopoly.

Worked example

Assuming the firm can set its own price at $18, sales will be 3000 units per day, and revenue will be $54,000. Total costs will be $45,000, which enable the firm to make excess profits of $9,000. The complete schedules and graph are show below:

Revenue schedule for the price maker

Revenue schedule for the tiles example

Revenue graph for the price maker

Revenue schedule for the tiles price maker example

Here we can see that the revenue curves for the price maker slope downwards. Average revenue is total revenue (P x Q) /output (Q), which is also P [by cancelling out the Qs]. This means that the curve plotting AR is also the firm's demand curve (D). Mathematically, if the AR curve (demand curve) slopes downwards, the marginal revenue (MR) curve will fall at twice the rate.

If the average revenue curve slopes downwards, as in the case of a price maker, the marginal revenue curve falls at twice the rate.

Profit schedule for the price maker

Profit schedule for the tiles example

Graph for the price maker

Graph for the tiles example

Here we can see that profits can be found by subtracting the area for total costs (0 c b q) [45,000 - from the schedule], from the area for total revenue (0 p a q) [54,000 - from the schedule]. In this case, supernormal profits are being made at profit maximising output of 3000 units, with the profit area of (p a b c) 3000 x 3 = 9000.

The area under the average curves (average revenue and average costs) is the 'total' value being measured (total revenue and total cost)


  • For the price making firm, profit maximisation occurs at a price of $18 per unit, and output of 3,000 units.
  • When average revenue (price) falls, marginal revenue falls at twice the rate.
  • Profits are maximised when marginal cost equals marginal revenue.


There are several types of efficiency to consider with respect to the firm.

  1. Productive efficiency occurs when average costs are at a minimum. Average costs are also ‘unit costs’ given that they are arrived at by diving total costs for a given quantity by the quantity.
  2. Allocative efficiency occurs when the marginal cost of production (which is the value of scarce resources used) equals the price of the product (which equates to the marginal benefit derived by consumers.)
  3. Dynamic efficiency relates to innovation and technological progress. A dynamically efficient firm is one that employs new technology to innovate in terms of developing new products and new processes.
    Dynamic efficiency is associated with Austrian economist, Joseph Schumpeter, who argued that supernormal profits could be justified if the firm used the profits to innovate and become dynamically efficient. Innovation can help reduce costs which can lead to lower prices.
  4. Finally, there is a type inefficiency associated with management, called 'X' inefficiency. 'X' inefficiency is associated with US economist, Harvey Leibenstein  who suggested that when firms operate in uncompetitive markets, managers may be inefficient by not keeping costs under control. In essence, the 'X' refers to the unknown inefficiencies associated with the fact that real business decision are taken by humans who may, at time, make sub-optimal decisions.

Efficiency for the price taker

When considering the price taking firm, in the long run the firm will produce at output Q, which is both an allocatively and productively efficient output.

In the above case, and with a price of $15 per tile, at 4000 units, marginal cost also equals $15. Hence 4000 units sold is also allocatively efficient.

This output is also productively efficient as the average cost is the lowest or the production range - at $15.

This can be seen graphically:

Efficiency for the price taker

Efficiency for the price maker

In the real world most firms can set their own price – they are a price maker. If we look at the figures for the same firm as a price maker is can vary its price between $20 and $13 – selling more at the lower price. This significantly alters the calculation of profit maximisation, and hence the level of efficiency existing a profit maximisation.
With the new figures, although costs have remained the same, revenue has changed. Now, profits are maximised at a lower output, at 3000 units. But, at 3000, while average costs are at $15 (and still the lowest), price at $18 is higher than marginal cost at $13, and there is a loss of allocative efficiency.

This can also be shown graphically.

Efficiency for the price maker

Perfect competition

What is perfect competition?

Perfect competition

Should monopolies be regulated?

Price discrimination

Why do firms price discriminate?

Price discrimination

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