Profit (economics)

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 into three aspects: the size of profit, the portion of the total income, and the rate of profit (in comparison to the initial investment). 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. 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 into three aspects: the size of profit, the portion of the total income, and the rate of profit (in comparison to the initial investment). 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. 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. 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. 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. Profits can be theorized by the phenomena of equilibrium or disequilibrium. These phenomena have the ability to retain its activity as static or dynamic. Economic variables such as effects of size, share or rate, or source of profits are determined by these theories. 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. 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). 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. Incumbent firms within the industry face losing their existing customers to the new firms entering the industry, and are therefore forced to lower their prices to match the lower prices set by the new firms. New firms will continue to enter the industry until the price of the product is lowered to the point that it is the same as the average cost of producing the product, and all of the economic profit disappears. When this happens, economic agents outside of the industry find no advantage to 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. 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, 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. 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.