Profit (economics)
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In economics, profit is the difference between the
revenue In accounting, revenue is the total amount of income generated by the sale of goods and services related to the primary operations of the business. Commercial revenue may also be referred to as sales or as turnover. Some companies receive rev ...
that an economic entity has received from its outputs and the
total cost In economics, total cost (TC) is the minimum dollar cost of producing some quantity of output. This is the total economic cost of production and is made up of variable cost, which varies according to the quantity of a good produced and includes ...
of its inputs. It is equal to total revenue minus total cost, including both explicit and implicit costs. It is different from
accounting profit Profit, in accounting, is an income distributed to the ownership , owner in a Profit (economics) , profitable market production process (business). Profit is a measure of profitability which is the owner's major interest in the income-formati ...
, which only relates to the explicit costs that appear on a firm's
financial statements Financial statements (or financial reports) are formal records of the financial activities and position of a business, person, or other entity. Relevant financial information is presented in a structured manner and in a form which is easy to un ...
. An
accountant An accountant is a practitioner of accounting or accountancy. Accountants who have demonstrated competency through their professional associations' certification exams are certified to use titles such as Chartered Accountant, Chartered Certifie ...
measures the firm's accounting profit as the firm's total revenue minus only the firm's explicit costs. An
economist An economist is a professional and practitioner in the social sciences, social science discipline of economics. The individual may also study, develop, and apply theories and concepts from economics and write about economic policy. Within this ...
includes all costs, both explicit and implicit costs, when analyzing a firm. Therefore, economic profit is smaller than accounting profit. ''Normal profit'' is often viewed in conjunction with economic profit. Normal profits in business refer to a situation where a company generates revenue that is equal to the total costs incurred in its operation, thus allowing it to remain operational in a competitive industry. It is the minimum profit level that a company can achieve to justify its continued operation in the market where there is competition. In order to determine if a company has achieved normal profit, they first have to calculate their economic profit. If the company's total revenue is equal to its total costs, then its economic profit is equal to zero and the company is in a state of normal profit. It must be noted that normal profit occurs when resources are being used in the most efficient way at the highest and best use. Normal profit and economic profit are economic considerations while
accounting profit Profit, in accounting, is an income distributed to the ownership , owner in a Profit (economics) , profitable market production process (business). Profit is a measure of profitability which is the owner's major interest in the income-formati ...
refers to the profit a company reports on its financial statements each period. Economic profits arise in markets which are non-competitive and have significant
barriers to entry In theories of Competition (economics), competition in economics, a barrier to entry, or an economic barrier to entry, is a fixed cost that must be incurred by a new entrant, regardless of production or sales activities, into a Market (economics) ...
, i.e.
monopolies A monopoly (from Greek Greek may refer to: Greece Anything of, from, or related to Greece, a country in Southern Europe: *Greeks, an ethnic group. *Greek language, a branch of the Indo-European language family. **Proto-Greek language, the ...
and oligopolies. The inefficiencies and lack of competition in these markets foster an environment where firms can set prices or quantities instead of being price-takers, which is what occurs in a perfectly competitive market. In a
perfectly competitive market In economics Economics () is the social science that studies the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods and services. Economics focuses on the beha ...
when long-run
economic equilibrium In economics, economic equilibrium is a situation in which economic forces such as supply and demand are balanced and in the absence of external influences the (:wikt:equilibrium, equilibrium) values of economic variables will not change. For ...
is reached, economic profit becomes non-existent, because there is no incentive for firms either to enter or to leave the
industry Industry may refer to: Economics * Industry (economics), a generally categorized branch of economic activity * Industry (manufacturing), a specific branch of economic activity, typically in factories with machinery * The wider industrial sect ...
.Lipsey, 1975. pp. 285–59.


Competitive and contestable markets

Companies do not make any economic profits in a
perfectly competitive market In economics Economics () is the social science that studies the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods and services. Economics focuses on the beha ...
once it has reached a
long run In economics Economics () is the social science that studies the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods and services. Economics focuses on the behavio ...
equilibrium. If an economic profit was available, there would be an incentive for new firms to enter the industry, aided by a lack of
barriers to entry In theories of Competition (economics), competition in economics, a barrier to entry, or an economic barrier to entry, is a fixed cost that must be incurred by a new entrant, regardless of production or sales activities, into a Market (economics) ...
, until it no longer existed.Lipsey, 1975. p. 217. When new firms enter the market, the overall supply increases. Furthermore, these intruders are forced to offer their product at a lower price to entice consumers to buy the additional supply they have created and to compete with the incumbent firms (see ).Chiller, 1991.Mansfield, 1979.LeRoy Miller, 1982. As the incumbent firms within the industry face losing their existing customers to the new entrants, they are also forced to reduce their prices. Therefore, increased competition reduces price and cost to the minimum of the long run average costs. At this point, price equals both the marginal cost and the average total cost for each good production. Once this has occurred a perfect competition exists and economic profit is no longer available. When this occurs, economic agents outside the industry find no advantage to entering the market, as there is no economic profit to be gained. Then, the supply of the product stops increasing, and the price charged for the product stabilizes, settling into an equilibrium. The same is likewise true of the
long run In economics Economics () is the social science that studies the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods and services. Economics focuses on the behavio ...
equilibria of monopolistically competitive industries, and more generally any market which is held to be contestable. Normally, a firm that introduces a differentiated product can initially secure ''temporary'' market power for a ''short while'' (See Monopoly Profit § Persistence). At this stage, the initial price the consumer must pay for the product is high, and the demand for, as well as the availability of the product in the market, will be limited. In the long run however, when the profitability of the product is well established, and because there are few
barriers to entry In theories of Competition (economics), competition in economics, a barrier to entry, or an economic barrier to entry, is a fixed cost that must be incurred by a new entrant, regardless of production or sales activities, into a Market (economics) ...
, the number of firms that produce this product will increase. Eventually, the supply of the product will become relatively large, and the price of the product will reduce to the level of the average cost of production. When this finally occurs, all economic profit associated with producing and selling the product disappears, and the initial monopoly turns into a competitive industry. In the case of contestable markets, the cycle is often ended with the departure of the former "hit and run" entrants to the market, returning the industry to its previous state, just with a lower price and no economic profit for the incumbent firms. Economic profit can, however, occur in competitive and contestable markets in the short run, since short run economic profits attract new competitors and prices fall. Economic loss forces firms out of the industry and prices rise till marginal revenue equals marginal cost, then reach long run equilibrium. As a result of firms jostling for market position. Once risk is accounted for, long-lasting economic profit in a competitive market is thus viewed as the result of constant cost-cutting and performance improvement ahead of industry competitors, allowing costs to be below the market-set price.


Uncompetitive markets

Economic profit is much more prevalent in uncompetitive markets such as in a perfect
monopoly A monopoly (from Greek language, Greek el, μόνος, mónos, single, alone, label=none and el, πωλεῖν, pōleîn, to sell, label=none), as described by Irving Fisher, is a market with the "absence of competition", creating a situati ...
or
oligopoly An oligopoly (from Ancient Greek, Greek ὀλίγος, ''oligos'' "few" and πωλεῖν, ''polein'' "to sell") is a market structure in which a market (economics), market or Industry (economics), industry is dominated by a small number of l ...
situation, where few substitutes exit. In these scenarios, individual firms have some element of
market power In economics Economics () is the social science that studies the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods and services. Economics focuses on the behav ...
. Although monopolists are constrained by
consumer demand In economics Economics () is the social science that studies the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods and services. Economics focuses on the beh ...
, they are not price takers, but instead either price or quantity setters. Since the output effect and the price effect, marginal revenue for uncompetitive markets is very different from marginal revenue for competitive firms. In the output effect, more output is sold, quantity sold is higher. In the price effect, this reduces the prices firms charge for every unit they sell, and cut in price reduces revenue on the units it was already selling. Therefore, in uncompetitive market, marginal revenue is less than its price. This allows the firm to set a price which is higher than that which would be found in a similar but more competitive industry, allowing the firms to maintain an economic profit in both the short and long run. The existence of economic profits depends on the prevalence of
barriers to entry In theories of Competition (economics), competition in economics, a barrier to entry, or an economic barrier to entry, is a fixed cost that must be incurred by a new entrant, regardless of production or sales activities, into a Market (economics) ...
, which stop other firms from entering into the industry and sapping away profits like they would in a more competitive market.Tirole, 1988. Examples of barriers to entry include
patents A patent is a type of intellectual property that gives its owner the legal right to exclude others from making, using, or selling an invention for a limited period of time in exchange for publishing an sufficiency of disclosure, enabling disclo ...
,
land rights Land law is the form of law that deals with the rights to usufruct, use, alienation (property law), alienate, or right to exclude, exclude others from wikt:land, land. In many jurisdictions, these kinds of property are referred to as real estate ...
, and certain
zoning laws Zoning is a method of urban planning Urban planning, also known as town planning, city planning, regional planning, or rural planning, is a technical and political process that is focused on the development and design of land use and the b ...
. These barriers allow firms to maintain a large portion of
market share Market share is the percentage of the total revenue or sales in a Market (economics), market that a company's business makes up. For example, if there are 50,000 units sold per year in a given industry, a company whose sales were 5,000 of those ...
due to new entrants being unable to obtain the necessary requirements or pay the initial costs of entry. An
oligopoly An oligopoly (from Ancient Greek, Greek ὀλίγος, ''oligos'' "few" and πωλεῖν, ''polein'' "to sell") is a market structure in which a market (economics), market or Industry (economics), industry is dominated by a small number of l ...
is a case where barriers are present, but more than one firm is able to maintain the majority of the market share. In an oligopoly, firms are able to collude and limit production, thereby restricting supply and maintaining a constant economic profit.Black, 2003. An extreme case of an uncompetitive market is a monopoly, where only one firm has the ability to supply a good which has no close substitutes. In this case, the monopolist can set its price at any level it desires, maintaining a substantial economic profit. In both scenarios, firms are able to maintain an economic profit by setting prices well above the costs of production, receiving an income that is significantly more than its implicit and explicit costs.


Government intervention

The existence of uncompetitive markets puts consumers at risk of paying substantially higher prices for lower quality products. When monopolies and oligopolies hold large portions of the market share, less emphasis is placed on consumer demand than there would be in a perfectly competitive market, especially if the good provided has an
inelastic In economics Economics () is the social science that studies the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods and services. Economics focuses on the beha ...
demand. Government intervention basically creates uncompetitive markets by restrictions and subsidies. Governments also intervene in uncompetitive markets in an attempt to raise the number of firms in the industry, but these firms cannot support the needs of consumers as if they were born out of a profit generated on a competitive market basis.
Competition law Competition law is the field of law that promotes or seeks to maintain market competition by regulating anti-competitive conduct by companies. Competition law is implemented through public and private enforcement. It is also known as antitrust l ...
s were created to prevent powerful firms from using their
economic power Economic power refers to the ability of countries, businesses or individuals to improve living standards. It increases their ability to make decisions on their own that benefit them. Scholars of international relations also refer to the economic p ...
to artificially create barriers to entry in an attempt to protect their economic profits. This includes the use of
predatory pricing Predatory pricing is a Pricing strategies, pricing strategy, using the method of undercutting on a larger scale, where a Article 102 of the Treaty on the Functioning of the European Union#Dominance, dominant firm in an industry will deliberately ...
toward smaller competitors. For example, in the United States,
Microsoft Corporation Microsoft Corporation is an American multinational corporation, multinational technology company, technology corporation producing Software, computer software, consumer electronics, personal computers, and related services headquartered at th ...
was initially convicted of breaking Anti-Trust Law and engaging in anti-competitive behaviour in order to form one such barrier in '' United States v. Microsoft''. After a successful appeal on technical grounds, Microsoft agreed to a settlement with the Department of Justice in which they were faced with stringent oversight procedures and explicit requirements"United States of America, Plaintiff, v. Microsoft Corporation, Defendant", Final Judgement
Civil Action No. 98-1232, 12 November 2002.
designed to prevent this predatory behaviour. With lower barriers, new firms can enter into the market again, making the long run equilibrium much more like that of a competitive industry, with no economic profit for firms and more reasonable prices for consumers. On the other hand, if a government feels it is impractical to have a competitive market—such as in the case of a
natural monopoly A natural monopoly is a monopoly in an industry in which high infrastructural costs and other barriers to entry relative to the size of the market give the largest supplier in an industry, often the first supplier in a market, an overwhelming adv ...
—it will allow a monopolistic market to occur. The government will regulate the existing uncompetitive market and control the price the firms charge for their product. For example, the old AT&T (regulated) monopoly, which existed before the courts ordered its breakup, had to get government approval to raise its prices. The government examined the monopoly's costs, and determined whether or not the monopoly should be able raise its price. If the government felt that the cost did not justify a higher price, it rejected the monopoly's application for a higher price. Though a regulated firm will not have an economic profit as large as it would in an unregulated situation, it can still make profits well above a competitive firm in a truly competitive market.


Maximization

It is a standard economic assumption (although not necessarily a perfect one in the real world) that, other things being equal, a firm will attempt to maximize its profits.Hirshleifer et al., 2005. p. 160. Given that profit is defined as the difference in total revenue and total cost, a firm achieves its maximum profit by operating at the point where the difference between the two is at its greatest. The goal of maximizing profit is also what leads firms to enter markets where economic profit exists, with the main focus being to maximize production without significantly increasing its marginal cost per good. In markets which do not show
interdependence Systems theory is the Interdisciplinarity, interdisciplinary study of systems, i.e. cohesive groups of interrelated, interdependent components that can be natural or man-made, human-made. Every system has causal boundaries, is influenced by its c ...
, this point can either be found by looking at these two curves directly, or by finding and selecting the best of the points where the gradients of the two curves (marginal revenue and marginal cost respectively) are equal. In the real world, it is not so easy to know exactly firm's marginal revenue and the marginal cost of last goods sold. For example, it is difficult for firms to know the price elasticity of demand for their good – which determines the MR. In interdependent markets, It means firm's profit also depends on how other firms react,
game theory Game theory is the study of mathematical models of strategic interactions among rational agents. Myerson, Roger B. (1991). ''Game Theory: Analysis of Conflict,'' Harvard University Press, p.&nbs1 Chapter-preview links, ppvii–xi It has appl ...
must be used to derive a profit maximizing solution. Another significant factor for profit maximization is ''market fractionation''. A company may sell goods in several regions or in several countries. Profit is maximized by treating each location as a separate market. Rather than matching supply and demand for the entire company the matching is done within each market. Each market has different competitions, different supply constraints (like shipping) and different social factors. When the price of goods in each market area is set by each market then overall profit is maximized.


Other applications of the term

The ''social'' profit from a firm's activities is the accounting profit plus or minus any
externalities In economics, an externality or external cost is an indirect cost or benefit to an uninvolved third party that arises as an effect of another party's (or parties') activity. Externalities can be considered as unpriced goods involved in either co ...
or
consumer surplus In mainstream economics, economic surplus, also known as total welfare or total social welfare or Marshallian surplus (after Alfred Marshall), is either of two related quantities: * Consumer surplus, or consumers' surplus, is the monetary gain ...
es that occur in its activity. An externality including positive externality and negative externality is an effect that production/consumption of a specific good exerts on people who are not involved.Black, 2003.
Pollution Pollution is the introduction of contaminants into the natural environment that cause adverse change. Pollution can take the form of any substance (solid, liquid, or gas) or energy (such as radioactivity, heat, sound, or light). Pollutants, the ...
is an example for negative externality.
Consumer surplus In mainstream economics, economic surplus, also known as total welfare or total social welfare or Marshallian surplus (after Alfred Marshall), is either of two related quantities: * Consumer surplus, or consumers' surplus, is the monetary gain ...
is an economic indicator which measures consumer benefits.Black, 2003. The price that consumers pay for a product is not greater than the price they desire to pay, and in this case there will be consumer surplus. A firm may report relatively large monetary profits, but by creating negative externalities their social profit could be relatively small or negative.


See also

*
Economic surplus In mainstream economics, economic surplus, also known as total welfare or total social welfare or Marshallian surplus (after Alfred Marshall), is either of two related quantities: * Consumer surplus, or consumers' surplus, is the monetary gain ...
*
Economic rent In economics Economics () is the social science that studies the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods and services. Economics focuses on the be ...
* Economic value added *
Externality In economics, an externality or external cost is an indirect cost or benefit to an uninvolved third party that arises as an effect of another party's (or parties') activity. Externalities can be considered as unpriced goods involved in either co ...
*
Inverse demand function In economics Economics () is the social science that studies the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods and services. Economics focuses on the behavio ...
*
Profit motive In economics, the profit motive is the motivation of Company, firms that operate so as to profit maximization , maximize their profits. Mainstream microeconomic theory posits that the ultimate goal of a business is "to make money" - not in the sen ...
*
Profitability index Profitability index (PI), also known as profit investment ratio (PIR) and value investment ratio (VIR), is the ratio of payoff to investment of a proposed project. It is a useful tool for ranking projects because it allows you to quantify the amo ...
*
Rate of profit In economics and finance, the profit rate is the relative Profit (accounting), profitability of an investment project, a capitalist enterprise or a whole capitalist economy. It is similar to the concept of rate of return on investment. Historical ...
* Superprofit *
Surplus value In Marxian economics, surplus value is the difference between the amount raised through a sale of a product and the amount it cost to the owner of that product to manufacture it: i.e. the amount raised through sale of the product minus the cost ...
*
Tendency of the rate of profit to fall The tendency of the rate of profit to fall (TRPF) is a theory in the crisis theory of political economy, according to which the rate of profit—the ratio of the profit to the amount of invested Capital (economics), capital—decreases over ti ...
*
Value (economics) In economics, economic value is a measure of the benefit provided by a goods, good or service (economics), service to an Agent (economics), economic agent. It is generally measured through units of currency, and the interpretation is therefore ...


Notes


References

* * * * * * * * * *


External links


Entrepreneurial Profit and Loss
Murray Rothbard Murray Newton Rothbard (; March 2, 1926 – January 7, 1995) was an American economist of the Austrian School, Economic history, economic historian, Political philosophy, political theorist, and activist. Rothbard was a central figure in ...
's ''
Man, Economy, and State ''Man, Economy, and State: A treatise on economic principles'' is a 1962 book of Austrian School The Austrian School is a heterodox school of economic thought that advocates strict adherence to methodological individualism, the concept that ...
'', Chapter 8. * {{Authority control