7.20 - Profit
The definition of profit and its calculation
Profit represents the financial gain a business achieves after covering all its expenses. It is a key indicator of success and sustainability in economic activities.
How profit is calculated
Profit is determined by subtracting the total costs of production from the total revenue generated by sales.
Where:
- Total revenue = Income from selling goods or services
- Total costs = All expenses involved in production, including both explicit costs (like wages and materials) and implicit costs (such as opportunity costs)
Economic vs accounting perspectives on profit
Economists take a broader perspective on profit compared to accountants. While accountants focus on explicit financial transactions, economists include the full range of private costs associated with production.
Key differences:
- Economic perspective - Incorporates opportunity costs, which represent the value of the next best alternative use of resources. For example, an entrepreneur's own capital used in the business must account for what it could earn if invested elsewhere with minimal risk.
- Accounting perspective - Typically excludes these implicit costs, focusing only on direct monetary outlays.
Entrepreneurs require a minimum level of profit to justify using their resources in the business rather than alternative options. This minimum reflects the rewards they could obtain elsewhere.
The concept of normal profit
Normal profit is the baseline return necessary to keep a firm operating in its current market. It acts as an essential cost of production, ensuring that entrepreneurs are compensated for their involvement.
Characteristics of normal profit
- Normal profit is the minimum earnings required to prevent a firm from leaving the market. Without it, production would cease as resources would be redirected to more rewarding uses.
- It includes compensation for the entrepreneur's risk and the opportunity cost of their capital and effort.
- Normal profit is treated as part of a firm's total costs, similar to other production expenses like rent or wages.
Inclusion in profit calculation
When calculating overall profit, normal profit is embedded within total costs.
This means that if a firm exactly achieves normal profit, its economic profit is zero, but it remains viable in the long term.
Supernormal profit and its implications
Supernormal profit occurs when earnings exceed the minimum required to stay in business. It provides additional rewards beyond basic compensation.
How supernormal profit is determined
Supernormal profit is the excess above normal profit.
Where:
- Total profit = Overall financial gain after all costs
- Normal profit = Minimum return to remain in the market
Market implications of supernormal profit
Supernormal profits serve as an important signal in competitive markets:
- Entry signal for new firms - High profits indicate opportunities, encouraging other businesses to enter the market and increase competition.
- Resource allocation - These profits motivate efficient use of resources, as firms strive to maintain or achieve them.
- Long-term effects - In perfectly competitive markets, supernormal profits are often temporary, as new entrants increase supply and drive down prices until only normal profit remains.
Subnormal profit and market exit
Subnormal profit arises when a firm's earnings fall short of the minimum needed for sustainability. This situation can threaten a business's long-term presence in the market.
Features of subnormal profit
- Subnormal profit means the return is below normal profit, failing to cover all opportunity costs and entrepreneurial rewards.
- It indicates that resources could be better used elsewhere, as the firm is not meeting the minimum threshold for viability.
Consequences for firms and markets
Firms experiencing subnormal profit face critical decisions:
- Short-term response - Businesses might continue operating if they can cover variable costs, hoping for market improvements.
- Long-term outcome - Persistent subnormal profits often lead to market exit, as firms redirect resources to more profitable ventures.
- Market adjustment - The departure of underperforming firms reduces supply, which can help restore normal profit levels for remaining competitors.