Profit (economics)
Encyclopedia
In economics, the term profit has two related but distinct meanings. Normal profit represents the total opportunity cost
s (both explicit
and implicit
) of a venture to an entrepreneur or investor, whilst economic profit (also abnormal, pure, supernormal or excess profit, as the case may be monopoly or oligopoly profit, or simply profit) is, at least in the neoclassical microeconomic theory
which dominates modern economics, the difference between a firm
's total revenue
and all costs, including normal profit. In both instances economic profit is the return to an entrepreneur
or a group of entrepreneurs. Economic profit is thus contrasted with economic interest
which is the return to an owner of capital stock or money or bonds. A related concept, sometimes considered synonymous in certain contexts, is that of economic rent
- economic profit can be considered as entrepreneurial rent.
Other types of profit have been referenced, including social profit (related to externalities
). It is not to be confused with profit in finance and accounting
, which is equal to revenue minus only explicit costs, or superprofit
, a concept in Marxian economic theory. Indeed, the dominant definition of the term today - and the one in use in this article - should be differentiated from that of the previously dominant school of classical economics
, which defined profit as the return to the employer of capital stock (such as machinery, factories, and ploughs) in any productive pursuit involving labor. The definitions of neo- and classical theory are actually, however, equivalent, if one considers that profits return to those who invested (financial) capital.
.
Only normal profits arise in circumstances of perfect competition
when long run economic equilibrium
is reached; there is no incentive for firms to either enter or leave the industry.Lipsey, 1975. pp. 285-259.
exceeds the opportunity cost of inputs, noting that these costs include the cost of equity capital that is met by normal profits. If a firm is making an economic loss (its economic profit is negative), it follows that all costs are not being met in full, and the firm would do better to leave the industry in the long run. In terms of the wider economy, economic profit indicates that resources are being employed in useful endeavours, while economic losses indicate that those resources would be better employed elsewhere.
in long run equilibrium; if it did, there would be an incentive for new firms to enter the industry, aided by a lack of barriers to entry
until there was no longer any profit. As new firms enter the industry, they increase the supply of the product available in the market, and these new firms are forced to charge a lower price to entice consumers to buy the additional supply these new firms are supplying (they compete for customers). Incumbent firms within the industry face losing their existing customers to the new firms entering the industry, and are therefore forced to lower their prices to match the lower prices set by the new firms. New firms will continue to enter the industry until the price of the product is lowered to the point that it is the same as the average cost of producing the product, and all of the economic profit disappears. When this happens, economic agents outside of the industry find no advantage to entering the industry, supply of the product stops increasing, and the price charged for the product stabilizes.
The same is likewise true of the long run 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 market power for a short while. At this stage, the initial price the consumer must pay for the product is high, and the demand for, as well as the available 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. The number of firms that produce this product will increase until the available supply of the product eventually becomes relatively large, the price of the product shrinks down to the level of the average cost of producing the product. When this finally occurs, all monopoly 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.
Profit can, however, occur in competitive and contestable markets in the short run, as firms jostle 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.
or oligopoly
situation. In these scenarios, individual firms have some element of market power: Though monopolists are constrained by consumer demand
, they are not price takers, but instead either price-setters or quantity setters. 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 them economic profit in both the long and short run.
The existence of economic profits depends on the prevalence of barriers to entry: these stop other firms from entering into the industry and sapping away profits, like they would in a more competitive market. In cases where barriers are present, but more than one firm, firms can collude to limit production, thereby restricting supply in order to ensure the price of the product remains high enough to ensure all of the firms in the industry achieve an economic profit.
However, some economists, for instance Steve Keen
, argue that even an infinitesimal amount of market power can allow a firm to produce a profit and that the absence of economic profit in an industry, or even merely that some production occurs at a loss, in and of itself constitutes a barrier to entry.
In a single-goods case, a positive economic profit happens when the firm's average cost is less than the price of the product or service at the profit-maximizing
output. The economic profit is equal to the quantity of output multiplied by the difference between the average cost and the price.
(US) or competition (elsewhere) laws were created to prevent powerful firms from using their economic power to artificially create the barriers to entry they need to protect their economic profits. This includes the use of predatory pricing
toward smaller competitors. For example, in the United States, Microsoft Corporation was initially convicted of breaking Anti-Trust Law and engaging in anti-competitive behavior 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 designed to prevent this predatory behaviour. With lower barriers, new firms can enter the market again, making the long run equilibrium much more like that of a competitive industry, with no economic profit for firms.
If a government feels it is impractical to have a competitive market - such as in the case of a natural monopoly
- it will sometimes try to regulate the existing uncompetitive market by controlling the price 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 and 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 a economic profit as large as it would be in an unregulated situation, it can still can make profits well above a competitive firm has in a truly competitive market.
Profitability is a term of economic efficiency. Mathematically it is a relative index – a fraction with profit as numerator and generating profit flows or assets as denominator.
, 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 interdependent markets, game theory
must be used to derive a profit maximising solution.
Opportunity cost
Opportunity cost is the cost of any activity measured in terms of the value of the best alternative that is not chosen . It is the sacrifice related to the second best choice available to someone, or group, who has picked among several mutually exclusive choices. The opportunity cost is also the...
s (both explicit
Explicit cost
An explicit cost is a direct payment made to others in the course of running a business, such as wage, rent and materials, as opposed to implicit costs, which are those where no actual payment is made...
and implicit
Implicit cost
In economics, an implicit cost, also called an imputed cost, implied cost, or notional cost, is the opportunity cost equal to what a firm must give up in order to use factors which it neither purchases nor hires. It is the opposite of an explicit cost, which is borne directly...
) of a venture to an entrepreneur or investor, whilst economic profit (also abnormal, pure, supernormal or excess profit, as the case may be monopoly or oligopoly profit, or simply profit) is, at least in the neoclassical microeconomic theory
Neoclassical economics
Neoclassical economics is a term variously used for approaches to economics focusing on the determination of prices, outputs, and income distributions in markets through supply and demand, often mediated through a hypothesized maximization of utility by income-constrained individuals and of profits...
which dominates modern economics, the difference between a firm
Firm
A firm is a business.Firm or The Firm may also refer to:-Organizations:* Hooligan firm, a group of unruly football fans* The Firm, Inc., a talent management company* Fair Immigration Reform Movement...
's total revenue
Revenue
In business, revenue is income that a company receives from its normal business activities, usually from the sale of goods and services to customers. In many countries, such as the United Kingdom, revenue is referred to as turnover....
and all costs, including normal profit. In both instances economic profit is the return to an entrepreneur
Entrepreneur
An entrepreneur is an owner or manager of a business enterprise who makes money through risk and initiative.The term was originally a loanword from French and was first defined by the Irish-French economist Richard Cantillon. Entrepreneur in English is a term applied to a person who is willing to...
or a group of entrepreneurs. Economic profit is thus contrasted with economic interest
Interest
Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds....
which is the return to an owner of capital stock or money or bonds. A related concept, sometimes considered synonymous in certain contexts, is that of economic rent
Economic rent
Economic rent is typically defined by economists as payment for goods and services beyond the amount needed to bring the required factors of production into a production process and sustain supply. A recipient of economic rent is a rentier....
- economic profit can be considered as entrepreneurial rent.
Other types of profit have been referenced, including social profit (related to externalities
Externality
In economics, an externality is a cost or benefit, not transmitted through prices, incurred by a party who did not agree to the action causing the cost or benefit...
). It is not to be confused with profit in finance and accounting
Profit (accounting)
In accounting, profit can be considered to be the difference between the purchase price and the costs of bringing to market whatever it is that is accounted as an enterprise in terms of the component costs of delivered goods and/or services and any operating or other expenses.-Definition:There are...
, which is equal to revenue minus only explicit costs, or superprofit
Superprofit
Superprofit , is a concept in Karl Marx's critique of political economy, subsequently elaborated by Lenin and other Marxist thinkers.-The origin of the concept in Marx's Capital:...
, a concept in Marxian economic theory. Indeed, the dominant definition of the term today - and the one in use in this article - should be differentiated from that of the previously dominant school of classical economics
Classical economics
Classical economics is widely regarded as the first modern school of economic thought. Its major developers include Adam Smith, Jean-Baptiste Say, David Ricardo, Thomas Malthus and John Stuart Mill....
, which defined profit as the return to the employer of capital stock (such as machinery, factories, and ploughs) in any productive pursuit involving labor. The definitions of neo- and classical theory are actually, however, equivalent, if one considers that profits return to those who invested (financial) capital.
Normal profit
Normal profit is a component of (implicit) costs, and so not a component of economic profit at all. It represents the opportunity cost for enterprise, since the time that the owner spends running the firm could be spent on running another firm. The enterprise component of normal profit is thus the profit that a business owner considers necessary to make running the business worth his while i.e. it is comparable to the next best amount the entrepreneur could earn doing another job. Particularly if enterprise is not included as a factor of production, it can also be viewed a return to capital for investors including the entrepreneur, equivalent to the return the capital owner could have expected (in a safe investment), plus compensation for risk.Lipsey, 1975. p. 217. In other words, the cost of normal profit varies both within and across industries; it is commensurate with the riskiness associated with each type of investment, as per the risk-return spectrumRisk-return spectrum
The risk-return spectrum is the relationship between the amount of return gained on an investment and the amount of risk undertaken in that investment. The more return sought, the more risk that must be undertaken.-The progression:...
.
Only normal profits arise in circumstances of perfect competition
Perfect competition
In economic theory, perfect competition describes markets such that no participants are large enough to have the market power to set the price of a homogeneous product. Because the conditions for perfect competition are strict, there are few if any perfectly competitive markets...
when long run economic equilibrium
Economic equilibrium
In economics, economic equilibrium is a state of the world where economic forces are balanced and in the absence of external influences the values of economic variables will not change. It is the point at which quantity demanded and quantity supplied are equal...
is reached; there is no incentive for firms to either enter or leave the industry.Lipsey, 1975. pp. 285-259.
Economic profit
An economic profit arises when revenueRevenue
In business, revenue is income that a company receives from its normal business activities, usually from the sale of goods and services to customers. In many countries, such as the United Kingdom, revenue is referred to as turnover....
exceeds the opportunity cost of inputs, noting that these costs include the cost of equity capital that is met by normal profits. If a firm is making an economic loss (its economic profit is negative), it follows that all costs are not being met in full, and the firm would do better to leave the industry in the long run. In terms of the wider economy, economic profit indicates that resources are being employed in useful endeavours, while economic losses indicate that those resources would be better employed elsewhere.
In competitive and contestable markets
Economic profit does not occur in perfect competitionPerfect competition
In economic theory, perfect competition describes markets such that no participants are large enough to have the market power to set the price of a homogeneous product. Because the conditions for perfect competition are strict, there are few if any perfectly competitive markets...
in long run equilibrium; if it did, there would be an incentive for new firms to enter the industry, aided by a lack of barriers to entry
Barriers to entry
In theories of competition in economics, barriers to entry are obstacles that make it difficult to enter a given market. The term can refer to hindrances a firm faces in trying to enter a market or industry - such as government regulation, or a large, established firm taking advantage of economies...
until there was no longer any profit. As new firms enter the industry, they increase the supply of the product available in the market, and these new firms are forced to charge a lower price to entice consumers to buy the additional supply these new firms are supplying (they compete for customers). Incumbent firms within the industry face losing their existing customers to the new firms entering the industry, and are therefore forced to lower their prices to match the lower prices set by the new firms. New firms will continue to enter the industry until the price of the product is lowered to the point that it is the same as the average cost of producing the product, and all of the economic profit disappears. When this happens, economic agents outside of the industry find no advantage to entering the industry, supply of the product stops increasing, and the price charged for the product stabilizes.
The same is likewise true of the long run equilibria of monopolistically competitive
Monopolistic competition
Monopolistic competition is imperfect competition where many competing producers sell products that are differentiated from one another...
industries and, more generally, any market which is held to be contestable
Contestable market
In economics, the theory of contestable markets, associated primarily with its 1982 proponent William J. Baumol, holds that there exist markets served by a small number of firms, which are nevertheless characterized by competitive equilibria because of the existence of potential short-term...
. Normally, a firm that introduces a differentiated product can initially secure market power for a short while. At this stage, the initial price the consumer must pay for the product is high, and the demand for, as well as the available 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. The number of firms that produce this product will increase until the available supply of the product eventually becomes relatively large, the price of the product shrinks down to the level of the average cost of producing the product. When this finally occurs, all monopoly 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.
Profit can, however, occur in competitive and contestable markets in the short run, as firms jostle 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.
In uncompetitive markets
Economic profit is, however, much more prevalent in uncompetitive markets such as in a perfect monopolyMonopoly
A monopoly exists when a specific person or enterprise is the only supplier of a particular commodity...
or oligopoly
Oligopoly
An oligopoly is a market form in which a market or industry is dominated by a small number of sellers . The word is derived, by analogy with "monopoly", from the Greek ὀλίγοι "few" + πόλειν "to sell". Because there are few sellers, each oligopolist is likely to be aware of the actions of the others...
situation. In these scenarios, individual firms have some element of market power: Though monopolists are constrained by consumer demand
Demand (economics)
In economics, demand is the desire to own anything, the ability to pay for it, and the willingness to pay . The term demand signifies the ability or the willingness to buy a particular commodity at a given point of time....
, they are not price takers, but instead either price-setters or quantity setters. 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 them economic profit in both the long and short run.
The existence of economic profits depends on the prevalence of barriers to entry: these stop other firms from entering into the industry and sapping away profits, like they would in a more competitive market. In cases where barriers are present, but more than one firm, firms can collude to limit production, thereby restricting supply in order to ensure the price of the product remains high enough to ensure all of the firms in the industry achieve an economic profit.
However, some economists, for instance Steve Keen
Steve Keen
Steve Keen is a Professor in economics and finance at the University of Western Sydney. He classes himself as a post-Keynesian, criticizing both modern neoclassical economics and Marxian economics as inconsistent, unscientific and empirically unsupported...
, argue that even an infinitesimal amount of market power can allow a firm to produce a profit and that the absence of economic profit in an industry, or even merely that some production occurs at a loss, in and of itself constitutes a barrier to entry.
In a single-goods case, a positive economic profit happens when the firm's average cost is less than the price of the product or service at the profit-maximizing
Profit maximization
In economics, profit maximization is the process by which a firm determines the price and output level that returns the greatest profit. There are several approaches to this problem...
output. The economic profit is equal to the quantity of output multiplied by the difference between the average cost and the price.
Government intervention
Often, governments will try to intervene in uncompetitive markets to make them more competitive. AntitrustCompetition law
Competition law, known in the United States as antitrust law, is law that promotes or maintains market competition by regulating anti-competitive conduct by companies....
(US) or competition (elsewhere) laws were created to prevent powerful firms from using their economic power to artificially create the barriers to entry they need to protect their economic profits. This includes the use of predatory pricing
Predatory pricing
In business and economics, predatory pricing is the practice of selling a product or service at a very low price, intending to drive competitors out of the market, or create barriers to entry for potential new competitors. If competitors or potential competitors cannot sustain equal or lower prices...
toward smaller competitors. For example, in the United States, Microsoft Corporation was initially convicted of breaking Anti-Trust Law and engaging in anti-competitive behavior in order to form one such barrier in United States v. Microsoft
United States v. Microsoft
United States v. Microsoft was a set of civil actions filed against Microsoft Corporation pursuant to the Sherman Antitrust Act of 1890 Section 1 and 2 on May 8, 1998 by the United States Department of Justice and 20 U.S. states. Joel I. Klein was the lead prosecutor...
; 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 designed to prevent this predatory behaviour. With lower barriers, new firms can enter the market again, making the long run equilibrium much more like that of a competitive industry, with no economic profit for firms.
If a government feels it is impractical to have a competitive market - such as in the case of a natural monopoly
Natural monopoly
A monopoly describes a situation where all sales in a market are undertaken by a single firm. A natural monopoly by contrast is a condition on the cost-technology of an industry whereby it is most efficient for production to be concentrated in a single form...
- it will sometimes try to regulate the existing uncompetitive market by controlling the price firms charge for their product. For example, the old AT&T (regulated) monopoly, which existed before the courts ordered its breakup
United States v. AT&T
United States v. AT&T was the antitrust case in the United States that led to the 1984 Bell System divestiture, the breakup of the old American Telephone & Telegraph into the new, seven regional Bell operating companies s and the much smaller new AT&T.In the 1970s, the Federal Communications...
, 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 and 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 a economic profit as large as it would be in an unregulated situation, it can still can make profits well above a competitive firm has in a truly competitive market.
Other applications of the term
The social profit from a firm's activities is the normal profit plus or minus any externalities that occur in its activity. A firm may report relatively large monetary profits, but by creating negative externalities their social profit could be relatively small.Profitability is a term of economic efficiency. Mathematically it is a relative index – a fraction with profit as numerator and generating profit flows or assets as denominator.
Maximization
It is a standard economic assumption (though not necessarily a perfect one in the real world) that, other things being equal, a firm will attempt to maximize its profits. Given that profit is defined as the difference in total revenue and total cost, a firm achieves a maximum by operating at the point where the difference between the two is at its greatest. In markets which do not show interdependenceInterdependence
Interdependence is a relation between its members such that each is mutually dependent on the others. This concept differs from a simple dependence relation, which implies that one member of the relationship can function or survive apart from the other....
, 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 interdependent markets, game theory
Game theory
Game theory is a mathematical method for analyzing calculated circumstances, such as in games, where a person’s success is based upon the choices of others...
must be used to derive a profit maximising solution.
See also
- Economic surplusEconomic surplusIn mainstream economics, economic surplus refers to two related quantities. Consumer surplus or consumers' surplus is the monetary gain obtained by consumers because they are able to purchase a product for a price that is less than the highest price that they would be willing to pay...
- Economic value addedEconomic value addedIn corporate finance, Economic Value Added or EVA, a registered trademark of Stern Stewart & Co., is an estimate of a firm's economic profit – being the value created in excess of the required return of the company's investors . Quite simply, EVA is the profit earned by the firm less the cost of...
- ExternalityExternalityIn economics, an externality is a cost or benefit, not transmitted through prices, incurred by a party who did not agree to the action causing the cost or benefit...
- Inverse demand functionInverse demand functionIn economics, an inverse demand function, P = f−1,is a function that maps the quantity of output demanded to the market price for that output. Quantity demanded, Q, is a function of price; the inverse demand function treats price as a function of quantity demanded, and is also called the price...
- SuperprofitSuperprofitSuperprofit , is a concept in Karl Marx's critique of political economy, subsequently elaborated by Lenin and other Marxist thinkers.-The origin of the concept in Marx's Capital:...
- Surplus valueSurplus valueSurplus value is a concept used famously by Karl Marx in his critique of political economy. Although Marx did not himself invent the term, he developed the concept...
- Tendency of the rate of profit to fallTendency of the rate of profit to fallThe tendency of the rate of profit to fall is a hypothesis in economics and political economy, most famously expounded by Karl Marx in chapter 13 of Das Kapital Vol. 3. It was generally accepted in the 19th century...
- Profit (accounting)Profit (accounting)In accounting, profit can be considered to be the difference between the purchase price and the costs of bringing to market whatever it is that is accounted as an enterprise in terms of the component costs of delivered goods and/or services and any operating or other expenses.-Definition:There are...
- Profit efficiencyProfit efficiencyProfit efficiency is a macro-economic concept used in assessing whether an economy, industry or supply chain is expending an optimally balanced level of rent for the use of capital....
- Profit motive
- Profitability indexProfitability indexProfitability index , also known as profit investment ratio and value investment ratio , is the ratio of payoff to investment of a proposed project...
- Rate of profitRate of profitIn economics and finance, the profit rate is the relative profitability of an investment project, of a capitalist enterprise, or of the capitalist economy as a whole...
External links
- Entrepreneurial Profit and Loss, Murray RothbardMurray RothbardMurray Newton Rothbard was an American author and economist of the Austrian School who helped define capitalist libertarianism and popularized a form of free-market anarchism he termed "anarcho-capitalism." Rothbard wrote over twenty books and is considered a centrally important figure in the...
's Man, Economy, and StateMan, Economy, and StateMan, Economy, and State: A Treatise on Economic Principles, first published in 1962, is a book on economics by Murray Rothbard, and is one of the most important books in the Austrian School of economics...
, Chapter 8. - Lester C. Thurow Profits, The Concise Encyclopedia of Economics.