Theory of profit in economics pdf

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This article may be too technical for most readers to understand. Please help improve it to theory of profit in economics pdf it understandable to non-experts, without removing the technical details. The talk page may contain suggestions. 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.


Normal profit is the profit that is necessary to just cover the opportunity costs of the owner-manager or of the firm’s investors. In the absence of this much 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. Only in the short run can a firm in a perfectly competitive market make an economic profit. 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. 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.

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. 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. 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, 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 in the industry achieve an economic profit. However, some economists, for instance Steve Keen, a professor at the University of Western Sydney, 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 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.

Often, governments will try to intervene in uncompetitive markets to make them more competitive. 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 agreed to a settlement with the Department of Justice 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.

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. The social profit from a firm’s activities is the normal profit plus or minus any externalities or consumer surpluses 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.