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In neoclassical economics, economic profit, or 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.

Contents

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.[1]

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.[2] 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.[3]

∏= TR - TC

∏ = (120Q - 0.5Q²) - (420 +60Q + Q²)[4]

∏= -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

Notes

  1. ^ Albrecht, p. 409
  2. ^ This assumes that the behavioral assumption of profit maximization applies.
  3. ^ MR also equals average revenue, AR.
  4. ^ Samuelson & Marks, Managerial Economics 4th ed. (Wiley 2003) at 100

References

  • Albrecht, William P. (1983). Economics. Englewood Cliffs, New Jersey: Prentice-Hall. ISBN 0132243458

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