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
Revenue
MC
(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
P1
ATC
AC1
MR
Q1
Profits
AR
Output (Q)
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
Revenue
MC
P1
Profit maximising
output is at Q1
(2)
Supernormal profit is
shown by shaded area
(3)
Total profit =
(P1-AC1) Q1
ATC
Supernormal
Profit
(1)
AC1
Q1
Normal profit is
achieved when the
firm breaks even (I.e.
at output Q2)
AR
MR
Profits
(1)
Q2
Output (Q)
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
Profits