Profit (economics)

In neoclassical microeconomic theory, the term profit has two related but distinct meanings. Normal profit represents the total opportunity costs (both explicit and implicit) of a venture to an investor, whereas economic profit (also abnormal, pure, supernormal or excess profit, as the case may be monopoly or oligopoly profit) is, at least in the neoclassical microeconomic theory which dominates modern economics, the difference between a firm's total revenue and all costs (including normal profit).[1] A related concept, sometimes considered synonymous in certain contexts, is that of economic rent.[citation needed] In Classical economics and Marxian economics, profit is the return to an owner of capital stock (means of production) in any productive pursuit involving labor, or a return on bonds and money invested in capital markets.[2] Specifically in Marxian economic theory, the maximization of profit and the accumulation of capital is the driving force behind economic activity within capitalist economic systems. Other types of profit have been referenced, including social profit (related to externalities). It is not to be confused with profit in finance and accounting, which is equal to revenue minus only explicit costs,[1] and superprofit, a concept in Marxian economic theory. Profit is not synonymous with the concepts of profitability and the profit motive. Normal profit Only in the short run can a firm in a perfectly competitive market make an economic profit. Economic profit does not occur in perfect competition in long run equilibrium; if it did, there would be an incentive for new firms to enter the industry, aided by a lack of barriers to entry until there was no longer any profit.[3] As new firms enter the industry, they increase the supply of the product available in the market, and these new firms are forced to charge a lower price to entice consumers to buy the additional supply these new firms are supplying (they compete for customers).[5][6][7][8] 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.[5][6] When this happens, economic agents outside of the industry find no advantage to entering the industry, supply of the product stops increasing, and the price charged for the product stabilizes.[5][6][7] 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. Normally, a firm that introduces a differentiated product can initially secure market power for a short while. At this stage, the initial price the consumer must pay for the product is high, and the demand for, as well as the available 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,[5][6][7] 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 associated with producing and selling the product disappears, and the initial monopoly turns into a competitive industry.[5][6][7] 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.

Government intervention Often, governments will try to intervene in uncompetitive markets to make them more competitive. Antitrust (US) or competition (elsewhere) laws were created to prevent powerful firms from using their economic power to artificially create the barriers to entry they need to protect their economic profits.[6][7][8] This includes the use of predatory pricing toward smaller competitors.[5][8][9] 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; after a successful appeal on technical grounds, Microsoft agreed to a settlement with the Department of Justice in which they were faced with stringent oversight procedures and explicit requirements[10] 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. If a government feels it is impractical to have a competitive market - such as in the case of a natural monopoly - it will sometimes try to regulate the existing uncompetitive market by controlling the price firms charge for their product.[6][7] For example, the old AT&T (regulated) monopoly, which existed before the courts ordered its breakup, had to get government approval to raise its prices. 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 a economic profit as large as it would be in an unregulated situation, it can still can make profits well above a competitive firm has in a truly competitive market.