Will a profit-making firm cease to exist if it makes losses?

 

Profit is a positive difference between revenue and cost. Firms maximise profit where they neither make nor lose money on the last item produced and sold. This is the level of production where marginal cost is equal to marginal revenue. The actual amount of profit in such circumstances will be defined by the difference between average cost and average revenue at that level of production. 

Economics also makes a distinction between normal, break-even, and abnormal (sometimes called supernormal) profits. Normal profit is the level of profit at which a firm covers its opportunity cost, usually defined as what it could have earned by doing something else with its money in the same time period. Break-even is an accounting concept in which a firm’s revenues are equal to its costs and is usually treated as the same thing as normal profit by economists. Abnormal profit is what most people understand as profit, which is a surplus of cash over spending.

Economic theory does not assume that firms will maximise profits, it assumes that maximising profits is the most rational thing firms can do in most circumstances. All value is labour value, but bringing labour, capital, and land together in an enterprise is something entrepreneurs and companies need an incentive to do, which in most cases is the potential profit to be made.

Firms might have other objectives.  For instance, they could try to sell everything in their inventory for any revenue, as sandwich shops tend do at the end of the day, or beach clothing stores do at the end of the summer season. This would ensure that all stock was at least sold for something, even if little or no money was made on the good and would avoid the item in question being wasted. It would also raise money if the firm needed it quickly for a loan or rent payment. This tactic is called revenue maximisation and occurs where MR=0.

Equally, a firm may decide to maximise its sales, by producing at the point where AC=AR. This might allow the firm to flood the market, displace a competitor, or gain useful complementary sales.

All of these options are available to firms, but in the long run, the aim for any business which is neither a charity nor a folly should rationally be to maximise profit. In some market structures there is no choice; perfect competition in the long run does not allow firms which wish to continue in operation to do anything else. Monopolies and oligopolies may have some discretion, and choose, for instance, profit-satisficing, but directors and shareholders will still usually demand some move towards profit rather than revenue or sales.

If revenue does not cover costs, firms are making a loss. The decision as to whether to shut down is not an easy one, however. This is because costs are made up of fixed and variable elements. Average fixed costs fall with output. They represent expenditures which are not associated with output, such as, for instance, ‘overhead’ costs of power, water and utilities, salaries, rents, or payments on loans. It is possible that a firm which can make some contribution to these things, even if it does not pay them in full for a matter of weeks or months, can survive so long as it can eventually find the money. For instance, a landlord might take three months and incur considerable expenditure to remove one commercial tenant and gain new ones, and so might accept one month of partial or no payment.

By contrast, firms which cannot cover variable costs are dead in the water. Variable costs are costs that relate directly to output, such as wages for workers, the cost of raw materials, and the maintenance of machinery related to its use. If firms cannot pay for these items, they cannot produce.

It follows that a firm making a loss, but able to cover average variable costs in the short run by the earnings from reduced revenues, can survive for a time, even if it can only make a small contribution to fixed costs. Firms unable to pay average variable costs must shut down unless subsidised from elsewhere. Such subsidy might come from being part of a wider and more productive group, though will be subject to considerations of wider objectives by the larger body. Similarly, a government could in theory choose to subsidise a firm which cannot cover costs for its own reasons, such as a pandemic, a crisis, the strategic importance of jobs and production to the wider economy, or to allow the firm to grow from ‘infant’ status.

It follows that most firms will act to maximise profits, but will neither automatically do so, nor automatically shut down if it fails to do so.