HOME

TheInfoList




An economic profit is the difference between the revenue a commercial entity has received from its outputs and the
opportunity cost In microeconomic theory Microeconomics (from Greek prefix ''mikro-'' meaning "small" + ''economics'') is a branch of economics Economics () is the social science that studies how people interact with value; in particular, the Produ ...
s of its inputs. Unlike an
accounting profit Profit, in accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non financial information about economic entity, economic entities such as businesses and corporations. Accounting, which has ...
, an economic profit takes into account both a
firm A company, abbreviated as co., is a legal entity In law, a legal person is any person A person (plural people or persons) is a being that has certain capacities or attributes such as reason, morality, consciousness or self-consciousness ...

firm
's implicit and explicit costs, whereas an accounting profit only relates to the explicit costs which 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 ...
. Because it includes additional implicit costs, the economic profit usually differs from the accounting profit.
Economists An economist is a professional and practitioner in the social science Social science is the Branches of science, branch of science devoted to the study of society, societies and the Social relation, relationships among individuals within t ...
often view economic profits in conjunction with normal profits, as both consider a firm's implicit costs. A normal profit is the profit that is necessary to cover both the implicit and explicit costs of a firm and of the owner-manager or investors who fund it. In the absence of this profit, these parties would withdraw their time and funds from the firm and use them to better advantage elsewhere, as to not forgo a better opportunity. In contrast, an economic profit, sometimes called an excess profit, is the profit remaining after both the implicit and explicit costs are covered. The enterprise component of normal profit is the profit that
business owner A business person (business man, business woman) is a person involved in the business sector In business Business is the activity of making one's living or making money by producing or buying and selling Product (business), products (such a ...
s consider necessary to make running the business worth their time, i.e., it is comparable to the next-best amount the
entrepreneur Entrepreneurship is the creation or extraction of value. With this definition, entrepreneurship is viewed as change, generally entailing risk beyond what is normally encountered in starting a business, which may include other values than simply ...

entrepreneur
could earn doing another job.Carbaugh, 2006. p. 84. In particular, if
enterprise Enterprise (or the archaic spelling Enterprize) may refer to: Business and economics Brands and enterprises * Enterprise GP Holdings, an energy holding company * Enterprise plc, a UK civil engineering and maintenance company * Enterprise ...
is not included as a
factor of production In economics Economics () is a social science that studies the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods and services. Economics focuses on the behavio ...
, it can also be viewed as 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 In simple terms, risk is the possibility of something bad happening. Risk involves uncertainty Uncertainty refers to Epistemology, epistemic situations involving imperfect or unknown information. It applies to predictions of future events, to ...

risk
.Lipsey, 1975. p. 217. Normal profit varies both within and across industries; it is commensurate with the riskiness associated with each type of investment, per the risk-return spectrum. Economic profits arise in
market Market may refer to: *Market (economics) *Market economy *Marketplace, a physical marketplace or public market Geography *Märket, an island shared by Finland and Sweden Art, entertainment, and media Films *Market (1965 film), ''Market'' (1965 ...
s which are non-competitive and have significant
barriers to entry In theories of competition Competition arises whenever two or more parties strive for a common goal A goal is an idea of the future or desired result that a person or a group of people envision, Planning, plan and commit to achieve. Peop ...
, i.e.
monopolies A monopoly (from Greek language, Greek el, μόνος, mónos, single, alone, label=none and el, πωλεῖν, pōleîn, to sell, label=none) is as described by Irving Fisher, a market with the "absence of competition", creating a situation whe ...

monopolies
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 when long-run
economic equilibrium In economics Economics () is the social science that studies how people interact with value; in particular, the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods ...
is reached, an 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) In macroeconomics, an industry is a branch of an economy that produces a closely related set of raw materials, goods, or services. For example, one might refer to the wood industry ...
.Lipsey, 1975. pp. 285–59.


Competitive and contestable markets

Companies do not make any economic profits in a perfectly competitive market once it has reached a
long runIn economics the long run is a theoretical concept in which all markets are in economic equilibrium, equilibrium, and all prices and quantities have fully adjusted and are in equilibrium. The long run contrasts with the short run, in which there are ...
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 Competition arises whenever two or more parties strive for a common goal A goal is an idea of the future or desired result that a person or a group of people envision, Planning, plan and commit to achieve. Peop ...
, until it no longer existed. 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. An individual firm can only produce at its aggregate production function. Which is a calculation of possible outputs and given inputs; such as capital and labour. New firms will continue to enter the market until the price of the product is lowered to equal the average cost of producing the product. 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. Therefore, the supply of the product stops increasing, and the price charged for the product stabilizes, settling into an
equilibrium List of types of equilibrium, the condition of a system in which all competing influences are balanced, in a wide variety of contexts. Equilibrium may also refer to: Film and television * Equilibrium (film), ''Equilibrium'' (film), a 2002 scien ...
. The same is likewise true of the
long runIn economics the long run is a theoretical concept in which all markets are in economic equilibrium, equilibrium, and all prices and quantities have fully adjusted and are in equilibrium. The long run contrasts with the short run, in which there are ...
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 ). 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 Competition arises whenever two or more parties strive for a common goal A goal is an idea of the future or desired result that a person or a group of people envision, Planning, plan and commit to achieve. Peop ...
, 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, 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 el, μόνος, mónos, single, alone, label=none and el, πωλεῖν, pōleîn, to sell, label=none) is as described by Irving Fisher, a market with the "absence of competition", creating a situation where a specific ...

monopoly
or
oligopoly An oligopoly (from Greek Greek may refer to: Greece Anything of, from, or related to Greece Greece ( el, Ελλάδα, , ), officially the Hellenic Republic, is a country located in Southeast Europe. Its population is approximately 10.7 mi ...
situation. In these scenarios, individual firms have some element of
market power In economics Economics () is the social science that studies how people interact with value; in particular, the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods a ...
. Although monopolists are constrained by
consumer demand In economics Economics () is the social science that studies how people interact with value; in particular, the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods ...
, they are not price takers, but instead either price 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 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 Competition arises whenever two or more parties strive for a common goal A goal is an idea of the future or desired result that a person or a group of people envision, Planning, plan and commit to achieve. Peop ...
, 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 Intellectual property (IP) is a category of property Property is a system of rights that gives people legal control of valuable things, and also refers to the valuable things themselves. Depe ...
,
land rights Land law is the form of law Law is a system A system is a group of Interaction, interacting or interrelated elements that act according to a set of rules to form a unified whole. A system, surrounded and influenced by its environment ...
, and certain zoning laws. 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 Market may refer to: *Market (economics) *Market economy *Marketplace, a physical marketplace or public market Geography *Märket, an island shared by Finland and Swe ...
due to new entrants being unable to obtain the necessary requirements or pay the initial costs of entry. An
oligopoly An oligopoly (from Greek Greek may refer to: Greece Anything of, from, or related to Greece Greece ( el, Ελλάδα, , ), officially the Hellenic Republic, is a country located in Southeast Europe. Its population is approximately 10.7 mi ...
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 how people interact with value; in particular, the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods ...

inelastic
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 a law Law is a system A system is a group of Interaction, interacting or interrelated elements that act according to a set of rules to form a unified whole. A system, surrounded and influenced by its environment, ...
s were created to prevent powerful firms from using their
economic power Economists use several concepts featuring the word power: * Market power is the ability of a firm to profitably raise the market price of a good or service over marginal cost. ** Monopoly power is a strong form of market power—the ability to set ...
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 strategy, using the method of undercutting on a larger scale, where a dominant Domination or dominant may refer to: Society * World domination, which is mainly a conspiracy theory * Colonialism in which one group ( ...
toward smaller competitors. For example, in the United States,
Microsoft Corporation Microsoft Corporation is an American multinational corporation, multinational technology company with headquarters in Redmond, Washington. It develops, manufactures, licenses, supports, and sells Software, computer software, consumer electroni ...
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 ''United States v. Microsoft Corporation'', 253 F.3d 34 (D.C. Cir. 2001) is a noted American antitrust law Competition law is a that promotes or seeks to maintain by regulating conduct by companies. Competition law is implemented through ...
''. 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 A monopoly (from Greek el, μόνος, mónos, single, alone, label=none and el, πωλεῖν, pōleîn, to sell, label=none) is as described by Irving Fisher, a market with the "absence of competition", cre ...

natural monopoly
—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 interdisciplinary study of systems, i.e. cohesive groups of interrelated, interdependent parts that can be natural or man-made, human-made. Every system is bounded by space and time, influenced by its environment, defined by i ...
, 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 is the study of mathematical model A mathematical model is a description of a system A system is a group of Interaction, interacting or interrelated elements that act according to a set of rules to form a unified whole. ...
must be used to derive a profit maximising 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 competition, 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 Economics () is the social science that studies how people interact with value; in particular, the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods ...
or
consumer surplus In mainstream economics, economic surplus, also known as total welfare or Marshallian surplus (after Alfred Marshall), refers to two related quantities: * Consumer surplus, or consumers' surplus, is the monetary gain obtained by consumers because ...
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 contaminant Contamination is the presence of a constituent, impurity, or some other undesirable element that spoils, corrupts, infects, makes unfit, or makes inferior a material, physical body, natural en ...

Pollution
is an example for negative externality. Consumer surplus 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 Mainstream economics is the body of knowledge, theories, and models of economics, as taught by universities worldwide, that are generally accepted by economists as a basis for discussion. Also known as orthodox economics, ...
* Economic rent *
Economic value added#REDIRECT Economic value added In corporate finance, as part of fundamental analysis, economic value added is an estimate of a firm's economic profit, or the value created in excess of the Required rate of return, required return of the types of comp ...
*
Externality In economics Economics () is the social science that studies how people interact with value; in particular, the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods ...

Externality
*
Inverse demand function Inverse or invert may refer to: Science and mathematics * Inverse (logic)In logic Logic (from Ancient Greek, Greek: grc, wikt:λογική, λογική, label=none, lit=possessed of reason, intellectual, dialectical, argumentative, transl ...
*
Profit motive In economics Economics () is the social science that studies how people interact with value; in particular, the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods a ...
*
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 amou ...
*
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 Superprofit, surplus profit or extra surplus-value (german: extra-Mehrwert) is a concept in Karl Marx Karl Heinrich Marx (; 5 May 1818 – 14 March 1883) was a German philosopher, economist, historian, sociologist, political theorist, journ ...
*
Surplus value In Marxian economics Marxian economics, or the Marxian school of economics, is a Heterodox economics, heterodox school of political economic thought. Its foundations can be traced back to Karl Marx, Karl Marx's Critique of political economy#M ...
*
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 Crisis theory, concerning the causes and consequences of the tendency for the rate of profit to fall in a capitalist system, is associated with Marxian cri ...
*
Value (economics) In economics Economics () is a social science Social science is the Branches of science, branch of science devoted to the study of society, societies and the Social relation, relationships among individuals within those societi ...


Notes


References

* * * * * * * * * *


External links


Entrepreneurial Profit and Loss
Murray Rothbard Murray Newton Rothbard (; March 2, 1926 – January 7, 1995) was an American heterodox economist Heterodox economics is any economic thought or theory that contrasts with orthodox schools of economic thought, or that may be beyond neoclas ...

Murray Rothbard
'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 economics, heterodox Schools of economic thought, school of economic thought that is based on methodological ind ...
'', Chapter 8. * {{Authority control