Profit Maximisation & Decision Rules
Profit maximisation: MC = MR
Firms produce where marginal cost equals marginal revenue. At any output below this, MR > MC so producing more adds to profit. Above this, MC > MR so each extra unit reduces profit.
Supernormal profit: AR > AC
Total profit = (AR − AC) × Q. If AR > AC at the profit-maximising output, the firm earns supernormal profit (above normal profit). In perfect competition this is competed away in the long run.
Loss-making: AR < AC
If AR < AC, the firm is making a loss. It should continue in the short run ONLY if AR > AVC (covering variable costs and contributing to fixed costs). If AR < AVC → shutdown immediately.
Shutdown Decision
Short run: AR ≥ AVC → Continue
If revenue covers variable costs and makes some contribution to fixed costs, it's better to continue than shut down (which still incurs fixed costs).
Short run: AR < AVC → Shutdown
Revenue doesn't even cover variable costs. Every unit produced increases losses. Better to shut down and only pay fixed costs.
Long run: AR < AC → Exit market
In the long run, all costs are variable. If the firm can't cover total average costs, it should leave the industry.
AQA exam tip: When analysing profit/loss diagrams: (1) identify MC=MR to find profit-maximising output, (2) compare AR and AC at that output to determine profit/loss, (3) if making a loss, compare AR with AVC to determine shutdown decision. Always show your reasoning on the diagram with clear labels.