Profits

The Nature and Role of Profits

Profits

The Concept of Profit

Profit – the return to risk-taking and entrepreneurship

Profit measures the excess of revenue over cost

Profits are maximised when marginal revenue = marginal cost

The neo-classical assumption underlying much of standard textbook economics is that corporations seek to maximise profits

This assumes that businesses have sufficient information about their costs of production and revenue conditions in their market

Profits

Profit Maximisation

Output (Q)

Revenue

ARMR

(1) Profit maximising output = Q1

(2) Price per unit found by drawing up to the demand curve

(3) Cost per unit shown by ATC curve

(4) Total profit is shaded area

MC

ATC

P1

Q1

AC1

Profits

Accounting Profit and Economic Profit

Accounting Profit The difference between total revenue and costs incurred in the production of goods and services

Economic Profit Total revenue-economic costs. Note that economic costs= total costs+ opportunity costs

E.g. if I leave teaching to open a coffee shop my opportunity cost would be my teacher’s salary.

When economic profit is zero, this is referred to as normal profit (see Table 6.5 p95)

Profits

Different Types of Profit

Normal Profit The minimum level of profit required for a firm to stay in

the industry in the long run, but not high enough to attract new firms into the market

If less than normal profits are being made in the long run then firms will leave the industry (known as sub-normal profits)

Normal profit is determined by the rate of rate that can be achieved using funds in their next best alternative – I.e. it is linked to the concept of opportunity cost

Normal profit is treated as a cost of production and included in the average cost curve

If a firm is breaking even (I.e. ATC = AR) then it is making normal profit

Supernormal Profit Any profit above normal profits. New firms will be attracted

into the industry by the presence of supernormal profit Also known as economic profit or abnormal profit

Profits

Normal Profit

Output (Q)

Revenue

ARMR

(1) Profit maximising output is at Q1

(2) Supernormal profit is shown by shaded area

(3) Total profit =

(P1-AC1) Q1

(1) Normal profit is achieved when the firm breaks even (I.e. at output Q2)

MC

ATC

P1

Q1

AC1

Q2

Supernormal Profit

Profits

The Importance of Profit

Profit measures the return to risk when making an investment

The higher the risk the greater the minimum required return that an entrepreneur is likely to demand

Rising profits send important signals within a market Supernormal profits signal to other firms that profitable entry may be possible

Can the existing firms continue to enjoy supernormal profits?

Much depends on whether there are barriers to the successful entry of new competitors into the market

Resources tend to flow where the expected rate of return is highest. In an industry where demand is growing strongly, the rate of return rises, and land, labour and capital are then committed to that sector