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An economic profit is the difference between the revenue a commercial entity has received from its outputs and the
opportunity cost In microeconomic theory, opportunity cost is the loss of the benefit that ''could'' have been enjoyed if the best alternative choice was chosen. As a representation of the relationship between scarcity and choice, the objective of opportunity cost ...
s of its inputs. Unlike an
accounting profit Profit, in accounting, is an income distributed to the owner in a profitable market production process (business). Profit is a measure of profitability which is the owner's major interest in the income-formation process of market production. T ...
, an economic profit takes into account both a
firm A company, abbreviated as co., is a legal entity representing an association of people, whether natural, legal or a mixture of both, with a specific objective. Company members share a common purpose and unite to achieve specific, declared goals. ...
'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 und ...
. Because it includes additional implicit costs, the economic profit usually differs from the accounting profit.
Economists An economist is a practitioner in the 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 field there are many sub-fields, r ...
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 particular someone undertaking activities (commercial or industrial) for the purpose of generating cash flow, sales, and revenue by utilizing a comb ...
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 e ...
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 Holdings, their parent company * Enterprise plc, a UK civil enginee ...
is not included as a
factor of production In economics, factors of production, resources, or inputs are what is used in the production process to produce output—that is, finished goods and services. The utilized amounts of the various inputs determine the quantity of output according to ...
, 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 about the effects/implications of an activity with respect to something that humans value (such as health, well-being, wealth, property or the environmen ...
.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 markets which are non-competitive and have significant
barriers to entry In theories of 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 that incumbents do not have or have no ...
, such as 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, as occurs in a perfectly competitive market. In a perfectly competitive market 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 (equilibrium) values of economic variables will not change. For example, in the standa ...
is reached, an economic profit becomes non-existent - because there is no incentive for firms either to enter or to leave the 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 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 some constraints and m ...
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 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 that incumbents do not have or have no ...
, 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), a 2002 science fiction film * ''T ...
. The same is likewise true of the
long runIn economics the long run is a theoretical concept in which all markets are in 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 some constraints and m ...
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 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 that incumbents do not have or have no ...
, 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) exists when a specific person or enterprise is the only supplier of a particular commodity. This contrasts with a monopsony wh ...
or
oligopoly An oligopoly (from Greek ὀλίγος, ''oligos'' "few" and πωλεῖν, ''polein'' "to sell") is a market form wherein a market or industry is dominated by a small group of large sellers (oligopolists). Oligopolies can result from various form ...
situation. In these scenarios, individual firms have some element of
market power In economics and particularly in industrial organization, market power is the ability of a firm to profitably raise the market price of a good or service over marginal cost. In perfectly competitive markets, market participants have no market power ...
. Although monopolists are constrained by
consumer demand In economics, demand is the quantity of a good that consumers are willing and able to purchase at various prices during a given period of time. The relationship between price and quantity demanded is also called the demand curve. Demand for a spec ...
, 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 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 that incumbents do not have or have no ...
: these stop other firms from entering into the industry and sapping away profits,Tirole, 1988. like they would in a more competitive market. To understand the barriers, see them as certain fixed cost a firm must pay to enter into the market. Other examples of barriers include;
patents NPOV disputes from March 2021 A patent is a title that gives its owner the legal right to exclude others from making, using, or selling an invention for a limited period of years in exchange for publishing an enabling public disclosure ...
,
land rights Land law is the form of law that deals with the rights to use, alienate, or exclude others from land. In many jurisdictions, these kinds of property are referred to as real estate or real property, as distinct from personal property. Land use agre ...
and certain
zoning laws Zoning is a method of urban planning in which a municipality or other tier of government divides land into areas called zones, each of which has a set of regulations for new development that differs from other zones. Zones may be defined for a sin ...
. These barriers allow firms to maintain a large portion of
market share Market share is the percentage of a market (defined in terms of either units or revenue) accounted for by a specific entity. "Marketers need to be able to translate and incorporate sales targets into market share because this will demonstrate w ...
as new entrants are unable to obtain the necessary requirements or pay the initial costs of entry. An
Oligopoly An oligopoly (from Greek ὀλίγος, ''oligos'' "few" and πωλεῖν, ''polein'' "to sell") is a market form wherein a market or industry is dominated by a small group of large sellers (oligopolists). Oligopolies can result from various form ...
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 An oligopoly (from Greek ὀλίγος, ''oligos'' "few" and πωλεῖν, ''polein'' "to sell") is a market form wherein a market or industry is dominated by a small group of large sellers (oligopolists). Oligopolies can result from various form ...
firms are able to collude and their 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 such as; monopolies and oligopolies, puts consumers at risk of paying substantially higher prices for a lower quality product. As Monopolists and Oligopolists hold large portions of the market share, there is a smaller significance placed consumer demands when compared to a perfectly competitive market, especially if the good provided has an
inelastic In economics, elasticity is the measurement of the percentage change of one economic variable in response to a change in another. An ''elastic'' variable (with an absolute elasticity value greater than 1) is one which responds more than proporti ...
demand. Due to this, governments must intervene in uncompetitive markets, in an attempt to raise the number of firms in the industry, and therefore reduce prices and increase the overall quality for consumers.
Competition law Competition law is a 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 ''anti-monopoly law'' i ...
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 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 strategy, using the method of undercutting on a larger scale, where a dominant firm in an industry will deliberately reduce its prices of a product or service to loss-making levels in the short-term. The aim is that e ...
toward smaller competitors. For example, in the United States,
Microsoft Corporation Microsoft Corporation is an American multinational technology company with headquarters in Redmond, Washington. It develops, manufactures, licenses, supports, and sells computer software, consumer electronics, personal computers, and related s ...
was initially convicted of breaking
Anti-Trust Law Competition law is a 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 ''anti-monopoly law'' i ...
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 case in which the U.S. government accused Microsoft of illegally maintaining its monopoly position in the personal computer (PC) market pri ...
''. 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 advan ...
 – 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, which are cohesive groups of interrelated, interdependent parts that can be natural or human-made. Every system is bounded by space and time, influenced by its environment, defined by its st ...
, 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 models of strategic interaction among rational decision-makers.Myerson, Roger B. (1991). ''Game Theory: Analysis of Conflict,'' Harvard University Press, p.&nbs1 Chapter-preview links, ppvii–xi It has ...
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, an externality is a cost or benefit that is imposed on a third party who did not agree to incur that cost or benefit. For the purpose of these statements, overall cost and benefit to society is defined as the sum of the imputed mone ...
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 contaminants into the natural environment that cause adverse change. Pollution can take the form of chemical substances or energy, such as noise, heat, or light. Pollutants, the components of pollution, can be ...
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, 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 ...
*
Economic rent#REDIRECT Economic rent#REDIRECT Economic rent {{R from other capitalisation ...
{{R from other capitalisation ...
*
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 return of the company's shareholders. EVA is the net profit less the capital charg ...
*
Externality In economics, an externality is a cost or benefit that is imposed on a third party who did not agree to incur that cost or benefit. For the purpose of these statements, overall cost and benefit to society is defined as the sum of the imputed mone ...

Externality
*
Inverse demand function Inverse or invert may refer to: Science and mathematics * Inverse (logic), a type of conditional sentence which is an immediate inference made from another conditional sentence * Additive inverse (negation), the inverse of a number that, when add ...
*
Profit motive In economics, the profit motive is the motivation of firms that operate so as to maximize their profits. Mainstream microeconomic theory posits that the ultimate goal of a business is "to make money" - not in the sense of increasing the firm's stoc ...
*
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 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 cost ''vs.'' market v ...
* 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 o ...
*
Tendency of the rate of profit to fall The tendency of the rate of profit to fall (TRPF) is a hypothesis 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—decreases over time. This hypothesis g ...
*
Value (economics) In economics, economic value is a measure of the benefit provided by a good or service to an economic agent. It is generally measured relative to units of currency, and the interpretation is therefore "what is the maximum amount of money a spec ...


Notes


References

* * * * * * * * * *


External links


Entrepreneurial Profit and Loss
Murray Rothbard Murray Newton Rothbard (; March 2, 1926 – January 7, 1995) was an American heterodox economist of the Austrian School, economic historian and political theorist. Rothbard was the founder and leading theoretician of anarcho-capitalism, a ...

Murray Rothbard
's ''
Man, Economy, and State ''Man, Economy, and State: A Treatise on Economic Principles'' is a 1962 book of Austrian School economics by Murray Rothbard. When originally published in 1962, the final eight chapters were removed by the publisher; these were later published as ...
'', Chapter 8. * {{Authority control