This final point is of huge importance. Consider Figure 4.10, which now also includes the average cost curve. In Figure 4.10 it is possible to compare the price the firm receives if it sells Q to the average cost it incurs for this output. The price and average cost of Q units of output are P and AC respectively. The difference between P and AC indicates that at Q , the price earned is more than sufficient to cover the firm’s average costs, meaning economic profits are earned. The size of the profits is given by the shaded rectangle.

If P = £100, AC = 50 and output at Q = 1800 total revenue (P × Q) = £180 000, total costs = £90 000 and profits = £90 000.

4.4.1PROFIT MAXIMIZATION, NORMAL PROFIT AND EFFICIENCY

For the example shown in Figure 4.10 we can comment on the efficiency of the production of the firm in question. The firm is producing the quantity of output for which its average costs are minimized. The quantity Q corresponds to the lowest point on its average cost curve so the firm is operating at the minimum efficient scale of production. The price charged of P is greater than the costs of AC so this firm earns supernormal profits (explained in Chapter 2) because its revenue more than covers the average costs. Remember that the firm’s costs include payment to the owner of the business that is sufficient to keep them in business, i.e. enough to cover the opportunity costs of the time and efforts of the owner.

Quite often it is considered that industries where firms make supernormal profits are not as efficient as they could be because profits are being made beyond normal

levels. Rather than having a portion of society’s resources used as profits, the argument is sometimes made that excess profits (excess relative to what business owners would be satisfied to receive to keep them in business) would be better be used for some other purpose.

One way of trying to reduce such supernormal profits would be to encourage greater competition in industries where supernormal profits exist and are considered high. This is the function of national competition authorities and national competition policies which is discussed in more detail in Chapter 6. Competition between firms could lead to a new lower-cost firm coming into the industry (if it has access to a more cost-effective technology for example) but as we will see in Chapter 6 whether this is possible depends on the overall structure of the market and how firms compete with others.

Also, we already know that firms compete more than just on price (other attributes also matter from consumers’ perspectives) so charging a lower price might in itself be insufficient to create a real alternative product in the eyes of consumers.

Finally, having noted that the firm in Figure 4.10 is operating efficiently in production terms, this is not the only possible outcome, as Figure 4.11 indicates. Another firm with different cost structures could have the cost curves as shown.

Here the firm’s profit-maximizing level of output is found where its MR intersects its MC which occurs at the output level Q1. This firm also makes supernormal profits since the price of its output P1 is greater than the average cost of production of Q1. The extent of the supernormal profit is indicated by the grey rectangle.

F I G U R E 4 . 1 1 P R O F I T M A X I M I Z A T I O N : O U T P U T N O T A T M I N I M U M A C

If we knew that P 1 = £75, that Q 1 = 2700 and AC1 = £35, the firm’s total revenue (P × Q) = £202 500, total costs = £94 500 and profits = £108 000. This firm, facing the same demand conditions as the firm in Figure 4.10, would produce a higher level of output (900 units extra) at a lower cost (£25 lower) but manages to make greater profit given its cost conditions.

Comparing Figures 4.10 and 4.11, the firm in Figure 4.11 (despite its higher supernormal profits) could be argued to operate less efficiently than the firm in Figure 4.10 since its output level does not coincide with the quantity at which it could minimize its average costs. However, Q1 makes economic sense for the firm because this is the quantity that generates maximum profits.

Because of cost conditions and demand conditions, profit-maximizing firms do not necessarily produce the level of output that minimizes costs.

If substantial supernormal profits are being made in an industry, it is usual to expect that some other firms would be anxious to enter the industry to try to compete and earn some supernormal profits for themselves. A competitor firm might be tempted to enter the industry and charge a price slightly less than the price that would maximize its profits so it would ‘grab’ the market for itself. Such behaviour, however, could lead to a price war in the industry with different firms cutting price in a ‘tit-for-tat’ strategy that might end up with all competing firms cutting prices down to their average costs.

The only way that firms can earn supernormal profits over the long run is if there are some obstacles or barriers to entry in the way of other firms entering and competing in the industry.

Barriers to entry exist when new firms cannot freely enter and compete in a new market. With no barriers all firms competing in the same market would have access to similar technology allowing them to have similar cost structures.

Many examples of such barriers to entry exist including:

•product differentiation, where firms attempt to offer attributes that differentiate their products from available substitutes;

•absolute cost advantages, where one firm’s costs may be so low that no others can compete efficiently (if the firm has a patented technology which others may not legally use, for example);

•scale economies, where established firms producing on a large scale have such low costs that a new firm producing a smaller share of the market output would not expect to compete.

Government-granted licences might confer rights to some firms but not to others. Patent restrictions operate somewhat similarly in terms of their impact on potential competitors. For example, newly developed drugs that are patented cannot be manufactured by competitors so pharmaceutical companies enjoy supernormal profits and benefit from barriers to entry for whatever period of time the patent is applicable. Such firms enjoy a ‘first-mover advantage’ because they are the first to come up with the drug even though others may have been trying to do so also. Any innovative firm that successfully launches a new product (or invents a new process) will wish to protect its investment in innovation to maximize its return and will benefit as long as imitators lack the required expertise or legal permission to imitate and if they operate in an environment where their patent is respected.

Society, however, also benefits from the dissemination of new inventions and innovations as resources can be used in more efficient ways and to produce previously unavailable products or services. The benefit from imitation can be perceived where increased supply of a product leads to a lower equilibrium price for consumers. However as prices fall, the return on the initial investment by the innovating firm declines. Hence, there can be a social effect of the private invention in the sense that society gets the benefit of lower prices and/or new previously unavailable products but the original developer loses out. The economist Joseph Schumpeter pointed out that without the incentive of making supernormal profits, some business would never be created and so some inventions and innovations might never occur.

Supernormal profits should not be considered always to reflect inefficiency in the economic system but rather may be the stimulus for creativity that leads to benefits both for users of invention or innovations and more broadly if economic resources are used more efficiently.

This explains why patents, which slow down the dissemination of inventions and innovations, are used as a policy to create incentives for producers to engage in some research activities. It also provides reasons for public – i.e. government – funding of basic research in universities, in government-owned laboratories and in private industry.