Profits

We now put costs and revenues together and look at profits. Economists have different interpretations of what profit is, we look at this together with the roles that profit plays in a market-based economy. The meaning of profit and different profit concepts Profit measures the return to risk when committing scarce resources to a market or industry.Entrepreneurs take risks for which they require an adequate expected rate of return. The higher the market risk and the longer they expect to have to wait to earn a positive return, the greater will be the minimum required return that an entrepreneur is likely to demand. 1. Normal profit - is defined as the minimum level of profit required to keep the factors of production in their current use in the long run. Normal profits reflect the opportunity cost of using funds to finance a business. If you decide to put 200,000 of your personal savings into a new business, then those funds could easily have earned a fairly risk-free rate of return by being saved in a bank or building society deposit account. You might therefore use the rate of interest on that 200,000 as the minimum rate of return that you need to make from your business investment in order to keep going in the long run! Of course we are ignoring here differences in risk and also the non-financial (or non-pecuniary) benefits of running and building your own business or investing funds in someone elses project. Because we treat normal profit as an opportunity cost of investing financial capital in a business, we normally include an estimate for normal profit in the average total cost curve, thus, if the firm covers its ATC (where AR meets AC) then it is making normal profits. 2. Sub-normal profit - is any profit less than normal profit (where price < average total cost) 3. Abnormal profit - is any profit achieved in excess of normal profit - also known as supernormal profit. When firms are making abnormal profits, there is an incentive for other producers to enter the market to try to acquire some of this profit. Abnormal profit persists in the long run in imperfectly competitive markets such as oligopoly and monopoly where firms can successfully block the entry of new firms. We will come to this later when we consider barriers to entry in monopoly. Profits are maximised when marginal revenue = marginal cost

Price Per Unit () 50 48 46 44 42 40 38

Demand / Output (units) 33 39 45 51 57 63 69

Total Revenue () 1650 1872 2070 2244 2394 2520 2622

Marginal Revenue () 37 33 29 25 21 17

Total Cost () 2000 2120 2222 2312 2384 2444 2480

Marginal Cost () 20 17 15 12 10 6

Profit () -350 -248 -152 -68 10 76 142

36 34

75 81

2700 2754

13 9

2534 2612

9 13

166 142

Consider the example in the table above. As price per unit (average revenue) declines, so demand expands. Total revenue rises but at a decreasing rate (as shown by column 4 marginal revenue). Initially the firm is making a loss because total cost exceeds total revenue. The firm moves into profit at an output level of 57 units. Thereafter profit is increasing because the marginal revenue from selling units is greater than the marginal cost of producing them. Consider the rise in output from 69 to 75 units. The MR is 13 per unit, whereas the marginal cost is 9 per unit. Profits increase from 142 to 166. But once marginal cost is greater than marginal revenue, total profits are falling. Indeed the firm makes a loss if it increases output to 93 units.

As long as marginal revenue is greater than marginal cost, then total profits will be increasing (or losses decreasing). The profit maximisation output occurs when marginal revenue = marginal cost. In the next diagram we introduce average revenue and average cost curves into the diagram so that, having found the profit maximising output (where MR=MC) we can then find (i) the profit maximising price (using the demand curve) and then (ii) the cost per unit. The difference between price and average cost marks the profit margin per unit of output. Total profit is shown by the shaded area and equals the profit margin multiplied by output

Changes in demand and the profit maximising price and output A change in demand and/or production costs (supply) will lead to a change in the profit maximising price and output. In exams you may often be asked to analyse how changes in demand and costs affect the equilibrium output for a business. Make sure that you are confident in drawing these diagrams and you can produce them quickly and accurately under exam conditions. In the diagram below we see the effects of an outward shift of demand from AR1 to AR2 (assuming that short run costs of production remain unchanged). The increase in demand causes a rise in the market price from P1 to P2 (consumers are now willing and able to buy more at a given price perhaps because of a rise in their real incomes or a fall in interest rates which has increased their purchasing power) and an expansion of supply (the shift in AR and MR is a signal to firms to move along their marginal cost curve and raise output). Total profits have increased.

Roles of profit in a market economy Profits serve a variety of purposes to businesses in a market-based economic system Finance for investment Retained profits remain the most important source of finance for companies undertaking new capital investment projects. The alternatives such as issuing new shares (equity) or bonds may not be attractive depending on the state of the financial markets. It is easier for companies to raise fresh capital when stock markets are performing strongly or when the demand for corporate bonds is high (reflected in a high price) and correspondingly, bond interest rates are low. Market entry: Rising profits send signals to other producers within a market. When the existing firms are earning supernormal profits, this sends a signal that profitable entry may be possible. In contestable markets, we would see a rise in market supply and downward pressure on prices. But in a monopoly, the existing dominant firm(s) may be able to protect their market position in the long run. Demand for factor resources: Scarce factor resources tend to flow where the expected rate of return or profit is highest. In an industry where demand is strong more land, labour and capital are then committed to that sector. Equally in a recession, national output, employment, incomes and investment all fall leading to a squeeze on profit margins and attempts by businesses large and small to cut costs and preserve their market position. In a flexible labour market, a fall in demand can quickly lead to a reduction in planned investment and cut-backs in labour demand

Two steps to higher profits! In an ideal world, running a business would be easy! You come up with an innovative idea, create a new product or service so popular you cant stop people from buying it. Word spreads and, before you know it, sales and profits are growing rapidly. If only. In reality, few businesses are able to sit back and watch the profits roll in. Creating and subsequently increasing profitability depends on doing a hundred little things better than the existing competition. So what are the best ways for a business to increase its profitability? Method 1: Grow the Top Line Every business and every market is different. But for most businesses, the best long-term way to improve profitability is to increase sales (also known as turnover). This is for four main reasons: o If a business has a high gross profit margin, every extra sale is highly profitable. Once your turnover reaches the break-even level (i.e. where price = average cost) then each additional sale adds to profits. Cutting your prices may reduce profit margins, but the extra sales should still add to total profits. Acquiring new customers is made easier by greater market presence and reputation. As you grow, unit costs are reduced through economies of scale. If your customers tend to be loyal, the value of each new customer lays not just in the immediate sale, but in future sales as well. The cost of selling to existing customers is almost always lower than the cost of acquiring new customers. Loyal customers also tend to be your best promotional tool, because they recommend the business via word-of mouth. Behavioural economists have lots to say about this aspect of business growth. From popular restaurants to emerging technologies, there is often a tipping point in a market where sales surge partly on the back of recommendations from satisfied customers. Defending a high market share against competitors is easier than defending high profit margins. Businesses can happily depart from a narrow profit maximization objective in order to protect their existing demand.

o o

However, not every business can increase their turnover easily. Many businesses operate in what are calledlow growth markets - where expansion only comes by taking a bigger share of the available demand. That usually requires investment in marketing and possibly increased production capacity. Low growth markets tend to be where the income elasticity of demand is low, so that as the real incomes of consumers increase, there is little positive effect on total market demand. Method 2: Keep Costs under Control If a business has a low gross profit margin, reducing direct costs dramatically increases the profit on each sale. Eliminating unnecessary overheads has an immediate impact on profit. Every business can increase profitability by reducing hidden costs. Hidden costs include the costs of employing inappropriate people since poor recruitment can lead to lower quality, increased training costs and ultimately redundancy costs.

Profit (economics)
In economics, the term profit has two related but distinct meanings. Normal profit represents the total opportunity costs (both explicit and implicit) of a venture to an investor or entrepreneur, 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 theneoclassical microeconomic theory which dominates modern economics, the difference between a firm's total revenue and all costs, [1] including normal profit. Economic profit is thus contrasted with economic interest which is the return to [citation needed] 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 [citation needed] entrepreneurial rent. Economic profit in contemporary neoclassical economics should be differentiated from that of the previously dominant school of classical economics and Marxian 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. 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 [1] costs, and superprofit, a concept in Marxian economic theory.

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 [1] 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 [2] compensation for risk. 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 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.

Economic profit
An economic profit arises when revenue 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

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 [2] 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 [4][5][6][7] 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 [4][5] 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 [4][5][6] 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 [4][5][6] 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 [4][5][6] 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

A monopolist can set a price in excess of costs, making an economic profit (shaded). The above Picture shows a Monopolist (only 1 Firm in the Industry/Market). An Oligopoly usually has "Economic Profit" also, but usually faces an Industry/Market with more than just 1 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 [4][5] and short run. The existence of economic profits depends on the prevalence of barriers to entry: these stop other firms [7] 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 [4][7][8] 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 theprofit-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 [5][6][7] [4][7][8] 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 [9] 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.

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 "Pure 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 [5][6] 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 [6] 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 [3] 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 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.