In
neoclassical economics,
economic profit is the difference between a
firm's total
revenue and its
opportunity costs. In
classical economics profit is the return to the employer of capital stock (machinery, factory, a plow) in any productive pursuit involving labor. These two definitions are actually the same. In both instances
economic profit is the return to an
entrepreneur or a group of entrepreneurs.
Economic profit is thus contrasted with economic
interest which is the return to an
owner of capital stock or money or bonds. In finance or accounting
profit is the increase in monetary
wealth that an
investor realizes from making an investment, taking into consideration all costs associated with that investment including the
opportunity cost associated with other monetary investments.
Definition
Normal profit is a component of the firm's opportunity costs. The time that the owner spends running the firm could be spent on running another firm. Normal profit is the return the entrepreneur can expect to earn or the profit that a business owner considers necessary to make running the business worth his/her while. When a firm earns positive economic profits, we say returns to entrepreneurial ability are supernormal. In the short run, a firm earning subnormal profits (i.e. an economic loss) can continue to do business as long as revenues cover average
variable costs. In a perfect market, positive economic profits cannot be sustained in the long run as more firms enter the market and increase competition.
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." A business is said to be making an
accounting profit if its revenues exceed the accounting cost of the firm.
All enterprises can be stated in
financial capital of the owners of the enterprise. The economic profit may include an element in recognition of the risks that an investor takes. It is often uncertain, because of
incomplete information, whether an enterprise will succeed or not. This extra risk is included in the minimum rate of return that providers of financial capital require, and so is treated as still a cost within economics. The size of that return is commensurate with the riskiness associated with each type of investment, as per the
risk-return spectrum.
"Normal profits" arise in circumstances of
perfect competition when
economic equilibrium is reached. At equilibrium, average cost equals marginal cost at the profit-maximizing position. Since normal profit is economically a cost, there is no
economic profit at equilibrium. 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.
Economic profit does not occur in
perfect competition in long run equilibrium. Once risk is accounted for, long-lasting economic profit is thus viewed as the result of constant cost-cutting and performance improvement ahead of industry competitors, or an
inefficiency caused by
monopolies or some form of
market failure.
Positive economic profit is sometimes referred to as
supernormal profit or as
economic rent.
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 economical efficiency. Mathematically it is a relative index – a fraction with profit as numerator and generating profit flows or assets as denominator.
Maximizing Profits
Profit is defined as the difference in total revenue, TR, and total cost, TC. A firm maxmizes profit by opertaing at the point where the distance between the total revenue curve and total cost curve is at its maximum. This point occurs where the slopes of the two functions are equal. The slope of the TR function is marginal revenue, MR, while the slope of the total cost function is marginal costs, MC. Thus a profit maximizing firm will produce that quantity of output at which marginal revenue, MR, equals marginal cost, MC. This rule applies regardless of market structure. The only "special" case is a firm operating in a perfectly competitive market. Such a firm operates where price, P, equals MC. However, this is not a true exception to the rule because an assumption of PC is that all firms face a perfectly elastic demand curve. With a perfectly elastic demand curve there is no separate margian revenue curve - MR equals demand and equals price. So with a PC firm MR = D = P.
∏= TR - TC
∏ = (120Q - 0.5Q²) - (420 +60Q + Q²)
∏= -420 + 60Q - 1.5Q²
∏’ = 60 - 3Q
∏’ = 0
60 - 3Q = 0
60 = + 3Q
20 = Q
The profit maximizing quantity is 20. To find the profit maximizing price you need the price equation.
TR = 120Q - 0.5Q²
TR = PxQ
P = TR/Q
P = 120Q - 0.5Q²/Q
P = 120 - 0.5Q
P = 120 - 0.5(20)
P = 120 - 10
P = 110.
The results can be checked by using the standard rule for maximizing profits - equating marginal revenue (MR) and marginal costs(MC).
TR = 120Q - 0.5Q²
MR = 120 - Q
TC = 420 +60Q + Q²
MC = 60 + 2Q
MR = MC
120 - Q = 60 + 2Q
60 = 3Q
Q = 20.
See also
