Profits and Losses
~30 min · WEC13 · 3.3.2
WEC13 · 3.3.2 · 30 min
A firm making a loss doesn't always , and a firm shutting down doesn't always mean the same threshold — the short run and the long run give a genuinely different rational answer to the same question.
Key terms in this lesson
Before you read on
Two or three questions on exactly what this lesson teaches. Being wrong here is fine — it's the fastest way to find out what to pay attention to next.
Three states, one comparison
A firm's economic profit compares total revenue against total cost — where total cost, crucially, already includes normal profit (the minimum return needed to keep the owner's capital and effort invested in this business rather than its next-best alternative). That's why the spec's three-way distinction — normal profit, supernormal profit, loss — is really just AR compared to AC: AR = AC means normal profit only (TR covers every cost, including the opportunity cost of being here at all, with nothing left over); AR > AC means supernormal profit (a genuine surplus above and beyond what was needed to keep the firm in business); AR < AC means a loss (not even covering the full opportunity cost of operating).
The shutdown question is different from the profit question: a firm making a loss is not automatically a firm that should stop producing right now — conflating the two is a real, named trap on this topic (see the trap taxonomy below). Whether a loss-making firm should stop producing depends on which time horizon you're in, because a fixed cost behaves completely differently depending on whether it can be escaped.
Why a firm keeps losing money on purpose — before the algebra
In plain terms
You run a stall at a weekend market. The pitch fee is £50, paid in advance and non-refundable — you owe it whether you turn up or not. Saturday morning, the forecast is terrible, and you're deciding: skip the day, or set up anyway? Skip it, and your only cost is the £50 already gone — you finish the day £50 down, guaranteed. Set up instead, and you'll spend another £20 on stock and a coffee to get through the day, but a few damp shoppers still hand you £35 for what you're selling. Work out the actual damage from setting up: £35 comes in, £20 goes out on top of the £50 already spent — £70 spent total against £35 taken, so you finish £35 down. £35 down beats £50 down: opening the stall makes you £15 better off than staying in bed, even though you're still poorer at the end of the day either way. Now push the weather worse: suppose only £15 of shoppers turn up instead of £35. Setting up now costs you £20 in stock for just £15 back — a fresh £5 loss stacked on top of the £50 you owe regardless, finishing you £55 down. Staying in bed — just the £50 — is now the smaller loss, so this time you don't open.
Name what you were comparing. The £50 pitch fee is the fixed cost (TFC) — signed, sunk, and identical in both scenarios, which is exactly why it never tipped the decision either way. The £20 for stock and a coffee is the variable cost (TVC) — money you only spend if you actually operate. The £35 (or £15) shoppers hand over is total revenue (TR). Skipping the day is shutting down; setting up anyway is producing. What decided it wasn't the size of the loss — it was whether TR beat TVC: at £35 in for £20 spent, showing up shrank the loss; at £15 in for £20 spent, showing up would have grown it. That's the whole rule.
Formally
In the short run, at least one cost is fixed and unavoidable regardless of the output decision — so a firm compares the loss from producing (TR − TVC − TFC) against the loss from shutting down (−TFC), and since TFC appears identically on both sides, it cancels out of the comparison entirely: producing is the rational choice whenever TR > TVC, which — dividing both sides by output — is AR ≥ AVC. A firm should therefore keep producing at a loss as long as price covers average variable cost, because shutting down doesn't erase the fixed cost already owed; it only forfeits whatever contribution toward that fixed cost the firm could otherwise have earned. Only once AR falls below AVC does producing start losing more than shutting down would — at that point every extra unit sold loses money even before fixed costs are counted, and the short-run shutdown point has been crossed.
Mechanism
Why the shutdown threshold moves between the short run and the long run
In the short run, at least one cost is fixed by definition — a lease already signed, a machine already bought — and fixed costs are owed whether or not a single unit gets produced. That changes what "shutting down" actually saves: it saves the variable costs, not the fixed ones. In the long run, nothing is fixed anymore — every contract can lapse, every lease can end, every asset can be sold. Shutting down in the long run (exiting the industry entirely) saves everything, because there's no cost left that survives the decision to leave.
Worked, in full
Deriving both shutdown rules from the same comparison
- 01
Short run, option 1 — produce: the firm earns TR and pays both TVC and TFC. Its loss is TR − TVC − TFC.
Earns: K — both options set up as an explicit payoff, not a rule quoted from memory.
- 02
Short run, option 2 — shut down: the firm earns nothing and pays no variable cost, but TFC is still owed (it's fixed — sunk in the short run regardless of the output decision). Its loss is exactly −TFC.
Earns: An1 — the 'shutting down still costs you TFC' fact stated as part of the comparison, not as a caveat afterward.
- 03
Producing beats shutting down whenever its loss is smaller: TR − TVC − TFC > −TFC. The TFC terms cancel from both sides — fixed cost, correctly, plays no role in a short-run produce-or-not decision. What's left is TR > TVC, which — dividing both sides by output — is AR > AVC.
Earns: An2 — the short-run rule (produce if AR ≥ AVC) derived algebraically, with the cancellation shown as the reason fixed cost is irrelevant here, not asserted as a fact to memorise.
- 04
Long run: there is no fixed cost left to cancel, because nothing is fixed anymore. The comparison is simply operate (TR − TC) versus exit (0) — so the rule is TR > TC, i.e. AR > AC. The two rules aren't independent facts; they're the same comparison, run once with a cost that can't be escaped and once with a cost that can.
Earns: Eval — the two rules unified as one mechanism rather than left as two things to separately memorise.
x-axis: Output, Q · y-axis: Price and cost, £
- AR / MR (or D)
- Depends on market structure — a horizontal AR=MR line under perfect competition, downward-sloping otherwise.
- AC
- U-shaped average total cost.
- AVC
- U-shaped average variable cost, below AC by the AFC gap.
- Short-run shutdown point
- Where AR equals AVC. Under price-taking (a horizontal AR), that's exactly at AVC's minimum; with a downward-sloping AR, the AR=AVC point instead sits left of AVC's minimum, for the same geometric reason as the AC case below — below this point, stop producing.
- Long-run shutdown point
- Where AR equals AC. Under price-taking, exactly at AC's minimum; with a downward-sloping AR, AR is tangent to AC strictly left of its minimum, since a downward-sloping line can never be tangent to a U-shaped curve exactly at its lowest point — below this point, exit the industry entirely.
- The gap between them
- Every price strictly between the two shutdown points: the firm is making a loss, correctly keeps producing in the short run, and correctly plans to exit if the price stays there into the long run.
Common error: Marking a single 'shutdown point' on the diagram without specifying which time horizon it applies to.
Correct: Two separate, correctly-labelled points — AR=AVC (short-run) and AR=AC (long-run) — since a real exam question checks specifically for the short-run/long-run distinction, confirmed in an examiner report on this exact topic.
Mechanism
Why market structure changes what "surviving the long run" actually requires
The long-run rule above — stay if AR≥AC — is the headline version, but a real Jan 2021 mark scheme adds a genuine refinement most lessons skip: "For perfect competition & monopolistic competition, firms would need to profit maximise (MC = MR) in the long-run to avoid losses. Monopoly & oligopoly - firms can survive in the long-run without necessarily maximising profit." The mechanism is the same free-entry-and-exit force that competes supernormal profit away under low barriers to entry (see the monopolistic-competition trap below): with many rival firms and nothing stopping a new one from entering, a firm that isn't actually sitting at its profit-maximising output isn't just earning a little less than it could — it's leaving room for a leaner competitor to enter, undercut, and replace it outright, so AR≥AC has to be true at the ACTUAL output the firm is producing at, not just achievable in principle somewhere on its cost curve. A monopoly or an oligopolist, protected by real , doesn't face that same discipline: there's no swarm of new entrants ready to profit-maximise it out of the market the moment it falls short, so it has genuine room to pursue a different objective from the Business Objectives lesson's list — sales-volume maximisation, satisficing, growth — and still survive the long run without ever actually solving MC=MR. Same AR≥AC test, same conclusion ("stays in business" vs "exits"), but only one of the two market-structure families requires the firm to be found precisely at its profit-maximising point to pass it.
In your own words
In one sentence: why does fixed cost drop out of the short-run shutdown decision entirely, when it's still a real cost the firm is paying?
Complete it yourself
Complete the chain — applying both shutdown rules to a named industry (Flybe, the airline that shut down in 2020)
- 01
In early 2020, demand for European flights collapsed as the coronavirus spread, and Flybe's revenue fell below its costs of production — the real trigger named in this lesson's own anchor exam question (WEC13 Jan 2021, Q9). Suppose that, one week that spring, Flybe's remaining schedule brought in £4m in ticket revenue against £3m in variable costs (fuel, crew, airport landing fees) and £3.5m in fixed costs (aircraft leases, head-office overheads) it owed that week regardless of whether a single plane took off — illustrative figures, not Flybe's actual reported accounts, chosen only to apply the short-run rule.
- 02
Comparing the two options for that one week in totals: keep flying (loss = TR − TVC − TFC = 4 − 3 − 3.5 = −£2.5m) versus ground the fleet (loss = −TFC = −£3.5m). Because TR (£4m) still exceeded TVC (£3m) — the short-run rule AR≥AVC, in totals form — flying lost £1m less than grounding would have, so the short-run case said keep the planes in the air even at a weekly loss.
Named traps
- loss-does-not-mean-shut-down
- The most common conflation on this topic: treating "making a loss" and "should shut down" as the same condition. They aren't — a firm covering its variable costs but not its full costs is rationally continuing to produce in the short run, precisely because shutting down doesn't erase the fixed cost it's already committed to.
- must-specify-the-time-horizon
- Confirmed in an examiner report on the real shutdown-points essay: "better responses showed a clear understanding of the distinction between the short-run and the long-run when considering shut down points... price needed to cover average variable cost in the short-run and average total cost in the long-run." A shutdown point named without its time horizon is an incomplete answer, not a simplified one.
- must-name-an-industry
- Confirmed in the same report: strong short-run/long-run analysis "could only secure a Level 4 KAA mark if they referred to an industry in their answers." Correct theory with no named real or plausible industry caps below the top band on this question type.
- monopolistic-competition-long-run-is-normal-profit-only
- One of the most repeatedly-confirmed MCQ facts across the archive checked this session: in the long run, monopolistic competition converges to normal profit only, because low barriers to entry let supernormal profit attract new entrants until it's gone. Confirmed in two separate series' examiner reports (Jan 2021 and Oct 2021), worded almost identically each time — this is a well-established, frequently-tested fact, not an edge case.
- shutdown-boundary-price-is-not-the-zero-profit-price
- On a labelled diagram with several price levels marked against AVC and AC, don't confuse "the price that lets the firm keep producing in the short run while it's still due to exit in the long run" (any price strictly between AVC's minimum and AC's minimum) with "the price at which the firm earns exactly normal profit in the long run" (AR=AC — AC's own minimum, under price-taking). Confirmed as a real, examiner-reported error on a genuine WEC13 Jan 2025 diagram-reading MCQ: "Most could identify the correct price level but many selected the price that resulted in the long run equilibrium where normal profit is generated." The two prices sit on the same diagram, close together, and only one of them is the answer to "survives short-run, exits long-run."
Five more reasons a real loss-making firm keeps going
Cash reserves, credit and government support (the route the conditional-judgement drill below builds out in depth) are real, but they're only three of the eight Eval-band routes a real Jan 2021 mark scheme actually credits on this exact essay — and three of the remaining five describe a firm that's still genuinely chasing profit, just not through the plain AR-vs-AVC-vs-AC comparison alone. A firm can choose to lose money on purpose as an investment in a bigger payoff later: "the firm may be pursuing therefore continue producing whilst making a loss until other firms leave the market" — sacrifice profit now specifically to force a smaller rival out, then raise the price back up once the competition is gone (the same mechanism this course's oligopoly content develops from the other side, as something a firm on the receiving end has to watch for). A firm can also lose money on one thing because it's making money on another: "the firm may be cross subsidising the product, and cover losses with profits from sales of other goods" — a real business rarely sells only one product, so the shutdown test that actually matters is whether the WHOLE firm covers its costs, not any one loss-making line judged in isolation; a firm can deliberately keep a line running at a loss for exactly as long as profit from its other lines is willing to pay for it. And a firm doesn't have to just wait a downturn out — it can fix it directly: "if the firm is able to reduce costs/increase revenue it will be able to survive in the long run," closing the AR<AC gap outright rather than surviving through it on reserves.
The other two routes describe a firm (or organisation) that was never optimising for profit in the first place, which means the whole AR≥AC shutdown test doesn't even apply to it the way it applies to a private, profit-seeking firm. "Public sector firms are able to run at a loss as there is no profit incentive" — a state-run hospital or transport network's actual objective is providing the service, not covering AC, so a loss that would force a private firm to plan an exit doesn't trigger the same decision at all. And "a start up firm may not have a profit incentive in the short run and will accept losses as its objective is survival" — connecting back to this paper's own Business Objectives lesson: a new firm's real short-run goal can genuinely be establishing itself in the market rather than profit, so accepting a loss its own AR≥AC test would call "exit" on is still the rational choice, because exiting isn't what the firm's actual objective function is optimising for. Both routes are independently confirmed as real, commonly-used candidate evaluation on this exact essay type by a separate, later series' examiner report (Jan 2024, Q8, a differently-worded version of the same shutdown-points question): "students were able to consider reasons why a firm may stay open, citing start-up companies and state-owned enterprises as examples."
The conditional move
Complete: "A firm whose price has fallen below its short-run shutdown point should exit the industry immediately only if ___."
Beyond the spec
The worked chain above already proves fixed cost is irrelevant to a live short-run decision — the TFC terms cancel out algebraically. What the spec doesn't cover is that real decision-makers, including trained managers, are demonstrably bad at actually applying that cancellation: they let a cost that's already been spent distort a decision the model says it shouldn't touch at all, which is exactly the kind of gap between the correct theory and predictable real behaviour a Level 4 evaluation point can draw on.
The formal name for exactly this error is the sunk cost fallacy: treating a cost that's already been paid and can't be recovered as though it should still count toward a forward-looking decision, when — as the algebra in the worked chain above shows — it cancels out of that decision entirely. The psychologists Hal Arkes and Catherine Blumer ran a well-known demonstration of it in 1985: people who had already paid for a ski trip were more likely to go on it even after learning that a different trip they'd since bought was objectively more enjoyable, purely because more money had already been sunk into the first one. The same mechanism explains why a real firm can keep a failing division or a loss-making factory running long past the point the AR≥AVC/AR≥AC comparison would recommend closing it — the money already spent on it feels like a reason to keep going, even though every pound of it is exactly as unrecoverable, and therefore exactly as irrelevant, as the TFC that cancelled out of the short-run shutdown decision in the worked chain above. The correct comparison was never "how much have we already spent on this" — it was always AR against AVC or AC, looking forward only.
Retrieval — with feedback on every choice
A firm's current price is £8 per unit. Its average variable cost at this output is £9, and its average total cost is £13.
What should the firm do in the short run, and what should it plan for the long run? (VERIDIAN-original, same calculation pattern confirmed across the archive.)
A firm's price exactly equals its average total cost. What is it earning?
A firm's current price is £11 per unit. Its average variable cost at this output is £9, and its average total cost is £13.
Assuming the price stays where it is, what should the firm do in the short run, and what should it plan for the long run? (VERIDIAN-original, same calculation pattern confirmed across the archive.)
A firm in monopolistic competition is earning supernormal profit today. What happens to that profit in the long run, and why?
A diagram shows MC, AC and AVC curves for a profit-maximising firm in a perfectly competitive market, with four price levels marked: P1 (below AVC's minimum), P2 (between AVC's minimum and AC's minimum), P3 (exactly at AC's minimum), and P4 (above AC's minimum).
At which price would the firm sell in the short run, but shut down in the long run? (VERIDIAN-original, same diagram-reading pattern confirmed in a real WEC13 Jan 2025 MCQ.)
Same question, every level
Assess the claim that a firm running at a loss ought to shut down immediately. Illustrate your answer with an appropriate diagram(s), and refer to an industry of your choice. (VERIDIAN-original question, modelled on the shutdown-point essay pattern tested in the WEC13 archive — most closely Jan 2021 Q9 on Flybe — with its own wording throughout, not the original question's phrasing.)
20 marks available
A firm making a loss should shut down because it isn't making money. If a business isn't profitable it should close down.
Treats "making a loss" and "should shut down" as the same condition — the exact conflation named in the trap taxonomy above. No formula, no diagram, no time-horizon distinction.
- Normal profit: AR=AC. Supernormal: AR>AC. Loss: AR<AC.
- Short-run shutdown: produce if AR≥AVC (fixed cost is sunk either way, so it cancels out of the decision).
- Long-run shutdown (exit): stay if AR≥AC (nothing is fixed, so every cost must be covered).
- Loss ≠ automatic shutdown. A loss between the two thresholds means: keep producing now, plan to exit if it persists.
- Monopolistic competition: supernormal profit is competed away to normal profit in the long run — low barriers to entry.
- PC/monopolistic competition must actually hit MC=MR to survive the long run (free entry replaces anyone who doesn't); monopoly/oligopoly can survive it without, protected by real barriers to entry.
- Beyond cash reserves/government support, a real mark scheme also credits: predatory pricing, cross-subsidisation, direct cost cuts/revenue growth, and a public-sector or start-up firm's objective simply not being profit.
Not affiliated with or endorsed by Pearson Edexcel. Every quotation and figure attributed to a mark scheme or examiner report in this lesson was independently verified against the primary Pearson document, not carried over from prior course material.
A firm's current price is £8 per unit. Its average variable cost at this output is £9, and its average total cost is £13.
What should the firm do in the short run, and what should it plan for the long run? (VERIDIAN-original, same calculation pattern confirmed across the archive.)
- AProduce now; stay in the long run if nothing changes
Price (£8) is below AVC (£9) — producing loses more than shutting down would, since it can't even cover its own variable costs. This is below the short-run shutdown point, not above it.
- Shut down now; and plan to exit in the long run if the price doesn't rise
Correct. £8 < AVC of £9, so the short-run shutdown rule says stop producing immediately — every unit sold loses money even before counting fixed costs. And since £8 is also below AC of £13, there's no long-run case for staying unless price recovers.
- CProduce now; exit in the long run
This gets the long-run call right but the short-run call wrong — price is below AVC, not just below AC, so this firm shouldn't even wait it out in the short run.
- DShut down now; stay in the long run
The short-run call is right, but there's no basis to plan on staying long-run — price is well below AC too, so unless something changes, exit is the correct long-run plan, not an indefinite short-run shutdown.
Traps tested: Misreads avc comparison · Inconsistent time horizons
A firm's price exactly equals its average total cost. What is it earning?
- AA loss
A loss requires price below AC — here price equals AC exactly, which covers every cost including the opportunity cost of the owner's capital and effort.
- BSupernormal profit
Supernormal profit requires price ABOVE average cost, not equal to it — at exactly AR=AC there's no surplus left over beyond what was already needed to keep the firm operating.
- Normal profit only
Correct. AC already includes the opportunity cost of the resources tied up in the business — so AR=AC means every cost, including that opportunity cost, is exactly covered. Nothing extra, nothing short.
- DZero profit and a loss simultaneously
This isn't a real outcome — normal profit (AR=AC) means the firm's accounting profit may look like "zero" on paper, but economically it's covering everything it needs to, which is a meaningfully different statement from making a loss.
Traps tested: Misreads equality as shortfall · Misreads equality as surplus · Confuses accounting and economic profit
A firm's current price is £11 per unit. Its average variable cost at this output is £9, and its average total cost is £13.
Assuming the price stays where it is, what should the firm do in the short run, and what should it plan for the long run? (VERIDIAN-original, same calculation pattern confirmed across the archive.)
- AShut down now; exit in the long run
Price (£11) is above AVC (£9), so shutting down loses more than producing would — this firm should keep producing right now, not stop.
- Produce now; plan to exit in the long run if the price doesn't rise
Correct. £11 > AVC of £9, so the short-run rule says keep producing — it's covering all its variable costs and contributing something toward fixed costs. But £11 < AC of £13, so unless price rises, the long-run plan is to exit: this is exactly the 'gap between them' case from the diagram above.
- CProduce now; stay in the long run regardless
The short-run call is right, but there's no basis for staying long-run regardless — price is below AC too, so absent a change in price, exit is the correct long-run plan.
- DShut down now; stay in the long run
Both calls are wrong here, and inconsistent with each other besides: price covers AVC, so there's no short-run case for shutting down, and price is below AC, so there's no long-run case for staying either.
Traps tested: Misapplies shutdown when avc is covered · Ignores long run ac comparison · Inconsistent time horizons
A firm in monopolistic competition is earning supernormal profit today. What happens to that profit in the long run, and why?
- AIt persists, because the firm has a differentiated product
Product differentiation gives some pricing power, but it doesn't block entry the way a true barrier would — new firms selling their own differentiated version can still enter and compete the supernormal profit away.
- It falls to zero (normal profit only), because low barriers to entry let new firms enter until it's competed away
Correct: monopolistic competition makes only normal profit in the long run, because low barriers to entry let new firms keep entering and undercutting until there's no supernormal profit left to attract further entry.
- CIt turns into a loss, because too many firms enter
Entry stops once supernormal profit reaches zero — there's no mechanism pushing it below that, since firms stop entering exactly when there's no more profit incentive to attract them.
- DIt depends on whether the firm advertises
Advertising can slow how fast entry erodes the profit, but it doesn't change the long-run outcome — low barriers to entry win eventually regardless of marketing spend.
Traps tested: Confuses differentiation with a barrier · Overshoots the equilibrium · Wrong mechanism
A diagram shows MC, AC and AVC curves for a profit-maximising firm in a perfectly competitive market, with four price levels marked: P1 (below AVC's minimum), P2 (between AVC's minimum and AC's minimum), P3 (exactly at AC's minimum), and P4 (above AC's minimum).
At which price would the firm sell in the short run, but shut down in the long run? (VERIDIAN-original, same diagram-reading pattern confirmed in a real WEC13 Jan 2025 MCQ.)
- AP1
P1 is below AVC's minimum — the firm doesn't even clear the short-run test here, so it wouldn't be selling at all, in the short run or otherwise.
- P2
Correct. P2 sits strictly between AVC's minimum and AC's minimum: above AVC, so the short-run rule says keep producing, but below AC, so the long-run rule says exit unless price rises — exactly the 'sells short-run, exits long-run' gap this question asks for.
- CP3
This is the real, examiner-confirmed trap: P3 sits exactly at AC's minimum, where the firm earns normal profit in the long run and has no reason to exit at all — this is the zero-supernormal-profit price, not the short-run-survive/long-run-exit boundary the question is asking about.
- DP4
P4 is above AC's minimum — the firm is earning supernormal profit here, well clear of any exit decision in either the short run or the long run.
Traps tested: Misreads avc comparison · Confuses zero profit price with shutdown boundary · Misreads ac comparison
Practice this for real
This site teaches the mechanism; the exam is sat on Pearson's own real questions. Go find and attempt these yourself — nothing here substitutes for actually sitting a timed paper.
Pearson's official past-papers portalSelect International Advanced Level → Economics → any series, then look for WEC13.
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