Profit (economics)

Last updated

In economics, profit in the accounting sense of the excess of revenue over cost is the sum of two components: normal profit and economic profit. All understanding of profit should be broken down[ by whom? ] into three aspects: the size of profit, the portion of the total income, and the rate of profit (in comparison to the initial investment).[ citation needed ] Normal profit is the profit that is necessary to just cover the opportunity costs of an owner-manager or of a firm's investors. In the absence of this profit, these parties would withdraw their time and funds from the firm and use them to better advantage elsewhere. In contrast, economic profit, sometimes called excess profit, is profit in excess of what is required to cover the opportunity costs.

Contents

The enterprise component of normal profit is the profit that a business owner considers necessary to make running the business worth his or her while, i.e., it is comparable to the next-best amount the entrepreneur could earn doing another job. [1] In particular, if enterprise is not included as a factor of production, 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. [2] 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 spectrum.

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. [3]

Profits can be theorized by the phenomena of equilibrium or disequilibrium. These phenomena have the ability to retain its[ which? ] activity as static or dynamic. Economic variables such as effects of size, share or rate, or source of profits are determined by these theories.

In competitive and contestable markets

Only in the short run can a firm in a perfectly competitive market make an economic profit. Perfect competition in the short run (simple).svg
Only in the short run can a firm in a perfectly competitive market make an economic profit.

Economic profit does not occur in perfect competition 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 economic profit. [2] 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 as the firms all compete for customers (see Monopoly profit § Persistence). [4] [5] [6] [7] Each individual firm can only produce at their aggregate production function. These functions are a calculation of possible outputs given inputs such as capital and labor. Once each firm's aggregate production function is equal, perfect competition exists and economic profit no longer occurs. [8] 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. [4] [5] When this happens, economic agents outside of the industry find no advantage to forming new firms that enter into the industry, the supply of the product stops increasing, and the price charged for the product stabilizes, settling into an equilibrium. [4] [5] [6]

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 a 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, [4] [5] [6] 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 profit associated with producing and selling the product disappears, and the initial monopoly turns into a competitive industry. [4] [5] [6] 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

A monopolist can set a price in excess of costs, making an economic profit (shaded). The above picture shows a monopolist (only one firm in the industry/market) that obtains a (monopoly) economic profit. An oligopoly usually has "economic profit" also, but usually faces an industry/market with more than just one firm (they must share available demand at the market price). Imperfect competition in the short run.svg
A monopolist can set a price in excess of costs, making an economic profit (shaded). The above picture shows a monopolist (only one firm in the industry/market) that obtains a (monopoly) economic profit. An oligopoly usually has "economic profit" also, but usually faces an industry/market with more than just one firm (they must share available demand at the market price).

Economic profit is, however, much more prevalent in uncompetitive markets such as in a perfect monopoly 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. [4] [5]

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, [7] like they would in a more competitive market. To understand the barrier, see it as certain fixed cost to entry the market for a new firm. 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. [4] [7] [9] An extreme case can be monopoly, which is able to achieve the most desirable profits at the most time compared to other non-monopoly companies.

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.

Government intervention

Often, governments will try to intervene in uncompetitive markets to make them more competitive. Antitrust (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. [5] [6] [7] This includes the use of predatory pricing toward smaller competitors. [4] [7] [9] 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 [10] 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.

In a regulated industry, the government examines firms' marginal cost structure and allows them to charge a price that is no greater than this marginal cost. This does not necessarily ensure zero economic profit for the firm, but eliminates a monopoly profit. Imperfect competition after regulation.svg
In a regulated industry, the government examines firms' marginal cost structure and allows them to charge a price that is no greater than this marginal cost. This does not necessarily ensure zero economic profit for the firm, but eliminates a monopoly profit.

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. [5] [6] 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 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. [6]

Other applications of the term

The social profit from a firm's activities is the accounting profit plus or minus any externalities or consumer surpluses 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. Pollution is an example for negative externality.

Consumer surplus is an economic indicator which measures consumer benefits. 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.


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. [11] 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 other words, the firm wants to maximize its production without overwhelming marginal cost. In markets which do not show interdependence, 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.

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.

See also

Notes

  1. Carbaugh, 2006. p. 84.
  2. 1 2 Lipsey, 1975. p. 217.
  3. Lipsey, 1975. pp. 285–59.
  4. 1 2 3 4 5 6 7 8 Chiller, 1991.
  5. 1 2 3 4 5 6 7 8 Mansfield, 1979.
  6. 1 2 3 4 5 6 7 LeRoy Miller, 1982.
  7. 1 2 3 4 5 Tirole, 1988.
  8. Desai, Meghnad (16 March 2017). "Profit and Profit Theory" (PDF). The New Palgrave Dictionary of Economics. 2. pp. 1–14. doi:10.1057/978-1-349-95121-5_1319-2. ISBN   978-1-349-95121-5.
  9. 1 2 Black, 2003.
  10. "United States of America, Plaintiff, v. Microsoft Corporation, Defendant", Final Judgement, Civil Action No. 98-1232, November 12, 2002.
  11. Hirshleifer et al., 2005. p. 160.

Related Research Articles

Microeconomics branch of economics that studies the behavior of individual households and firms in making decisions on the allocation of limited resources

Microeconomics is a branch of economics that studies the behaviour of individuals and firms in making decisions regarding the allocation of scarce resources and the interactions among these individuals and firms.

Monopoly Market structure with a single firm dominating the market

A monopoly exists when a specific person or enterprise is the only supplier of a particular commodity. This contrasts with a monopsony which relates to a single entity's control of a market to purchase a good or service, and with oligopoly which consists of a few sellers dominating a market. Monopolies are thus characterized by a lack of economic competition to produce the good or service, a lack of viable substitute goods, and the possibility of a high monopoly price well above the seller's marginal cost that leads to a high monopoly profit. The verb monopolise or monopolize refers to the process by which a company gains the ability to raise prices or exclude competitors. In economics, a monopoly is a single seller. In law, a monopoly is a business entity that has significant market power, that is, the power to charge overly high prices. Although monopolies may be big businesses, size is not a characteristic of a monopoly. A small business may still have the power to raise prices in a small industry.

Monopolistic competition Imperfect competition of differentiated products that are not perfect substitutes

Monopolistic competition is a type of imperfect competition such that many producers sell products that are differentiated from one another and hence are not perfect substitutes. In monopolistic competition, a firm takes the prices charged by its rivals as given and ignores the impact of its own prices on the prices of other firms. In the presence of coercive government, monopolistic competition will fall into government-granted monopoly. Unlike perfect competition, the firm maintains spare capacity. Models of monopolistic competition are often used to model industries. Textbook examples of industries with market structures similar to monopolistic competition include restaurants, cereal, clothing, shoes, and service industries in large cities. The "founding father" of the theory of monopolistic competition is Edward Hastings Chamberlin, who wrote a pioneering book on the subject, Theory of Monopolistic Competition (1933). Joan Robinson published a book The Economics of Imperfect Competition with a comparable theme of distinguishing perfect from imperfect competition.

In economics, specifically general equilibrium theory, a perfect market, also known as an atomistic market, is defined by several idealizing conditions, collectively called perfect competition, or atomistic competition. In theoretical models where conditions of perfect competition hold, it has been theoretically demonstrated that a market will reach an equilibrium in which the quantity supplied for every product or service, including labor, equals the quantity demanded at the current price. This equilibrium would be a Pareto optimum.

This aims to be a complete article list of economics topics:

In economics, profit maximization is the short run or long run process by which a firm may determine the price, input, and output levels that lead to the highest profit. Neoclassical economics, currently the mainstream approach to microeconomics, usually models the firm as maximizing profit.

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 standard text perfect competition, equilibrium occurs at the point at which quantity demanded and quantity supplied are equal. Market equilibrium in this case is a condition where a market price is established through competition such that the amount of goods or services sought by buyers is equal to the amount of goods or services produced by sellers. This price is often called the competitive price or market clearing price and will tend not to change unless demand or supply changes, and quantity is called the "competitive quantity" or market clearing quantity. But,the concept of equilibrium in economics also applies to imperfectly competitive markets, where it takes the form of a Nash equilibrium.

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 not had to incur.

In economics a monopoly is a firm that lacks any viable competition, and is the sole producer of the industry's product. In a normal competitive situation, no firm can charge a price that is significantly higher than the Marginal (Economic) cost of producing the product. If any firm doing business within a competitive situation tries to raise prices significantly higher than the Marginal cost of producing the product, it will lose all of its customers to either other existing firms that charge lower prices, or to a new firm that will find it profitable to use a lower price to take customers away from the firm charging the higher price. But since the monopoly firm does not have to worry about losing customers to competitors, it can set a Monopoly price that is significantly higher than its marginal cost, allowing it to have an economic profit that is significantly higher than the normal profit that is typically found in a perfectly competitive industry. The high economic profit obtained by a monopoly firm is referred to as monopoly profit.

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. A firm with total market power can raise prices without losing any customers to competitors. Market participants that have market power are therefore sometimes referred to as "price makers" or "price setters", while those without are sometimes called "price takers". Significant market power occurs when prices exceed marginal cost and long run average cost, so the firm makes economic profit.

Bertrand competition is a model of competition used in economics, named after Joseph Louis François Bertrand (1822–1900). It describes interactions among firms (sellers) that set prices and their customers (buyers) that choose quantities at the prices set. The model was formulated in 1883 by Bertrand in a review of Antoine Augustin Cournot's book Recherches sur les Principes Mathématiques de la Théorie des Richesses (1838) in which Cournot had put forward the Cournot model. Cournot argued that when firms choose quantities, the equilibrium outcome involves firms pricing above marginal cost and hence the competitive price. In his review, Bertrand argued that if firms chose prices rather than quantities, then the competitive outcome would occur with price equal to marginal cost. The model was not formalized by Bertrand: however, the idea was developed into a mathematical model by Francis Ysidro Edgeworth in 1889.

In 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 markets are not fully in equilibrium.

Partial equilibrium is a condition of economic equilibrium which takes into consideration only a part of the market, ceteris paribus, to attain equilibrium.

Competition (economics) concept in economics

In economics, competition is a condition where different economic firms seek to obtain a share of a limited good by varying the elements of the marketing mix: price, product, promotion and place. In classical economic thought, competition causes commercial firms to develop new products, services and technologies, which would give consumers greater selection and better products. The greater selection typically causes lower prices for the products, compared to what the price would be if there was no competition (monopoly) or little competition (oligopoly).

In neoclassical economics, a market distortion is any event in which a market reaches a market clearing price for an item that is substantially different from the price that a market would achieve while operating under conditions of perfect competition and state enforcement of legal contracts and the ownership of private property. A distortion is "any departure from the ideal of perfect competition that therefore interferes with economic agents maximizing social welfare when they maximize their own". A proportional wage-income tax, for instance, is distortionary, whereas a lump-sum tax is not. In a competitive equilibrium, a proportional wage income tax discourages work.

Outline of economics Overview of and topical guide to economics

The following outline is provided as an overview of and topical guide to economics:

In economics, a monopsony is a market structure in which a single buyer substantially controls the market as the major purchaser of goods and services offered by many would-be sellers. In the microeconomic theory of monopsony, a single entity is assumed to have market power over sellers as the only purchaser of a good or service, much in the same manner that a monopolist can influence the price for its buyers in a monopoly, in which only one seller faces many buyers.

Williamson trade-off model

The Williamson trade-off model is a theoretical model in the economics of industrial organization which emphasizes the trade-off associated with horizontal mergers between gains resulting from lower costs of production and the losses associated with higher prices due to greater degree of monopoly power.

In microeconomics, the Bertrand–Edgeworth model of price-setting oligopoly looks at what happens when there is a homogeneous product where there is a limit to the output of firms which they are willing and able to sell at a particular price. This differs from the Bertrand competition model where it is assumed that firms are willing and able to meet all demand. The limit to output can be considered as a physical capacity constraint which is the same at all prices, or to vary with price under other assumptions.

Monopoly price

A Monopoly price is set by a Monopoly. A monopoly occurs when a firm lacks any viable competition, and is the sole producer of the industry's product. Because a monopoly faces no competition, it has absolute market power, and thereby has the ability to set a monopoly price that will be above the firm's marginal (economic) cost. Since marginal cost is the increment in total required to produce an additional unit of the product, the firm would be able to make a positive economic profit if it produced a greater quantity of the product and sold it at a lower price.

References