A2 Micro: The Importance of Profit

Profit measures the return to risk when committing scarce resources to a market or industry. Entrepreneurs take risks for which they require an adequate rate of return. The higher the market risk and the longer they expect to have to wait to earn a positive return, the greater will be the minimum required return that an entrepreneur is likely to demand. Economists distinguish between different types of profit – explained below:

1. Normal profit - is the minimum level of profit required to keep factors of production in their current use in the long run. Normal profits reflect the opportunity cost of using funds to finance a business. If you decide to put £200,000 of your savings into a new business, those funds could have earned a low-risk rate of return by being saved in a bank account. You might therefore use the rate of interest on that £200,000 as the minimum rate of return that you need to make from your investment in order to keep going in the long run! Because we treat normal profit as an opportunity cost of investing financial capital in a business, we include an estimate for normal profit in the average total cost curve, thus, if the firm covers its AC then it is making normal profits.

2. Sub-normal profit - is any profit less than normal profit (where price

< average cost)

3.

Abnormal profit - is any profit achieved in excess of normal profit - also known as supernormal profit. When firms are making abnormal profits, there is an incentive for other producers to enter a market to try to acquire some of this profit. Abnormal profit persists in the long run in imperfectly competitive markets such as oligopoly and monopoly where firms can successfully block the entry of new firms.

Key revision points on profit:

a) Understand the links between market structure and profits and the key role played by barriers to entry and exit
b) Understand how government intervention can affect profits e.g. price regulation and policies that affect costs of production
c) Be able to show how changes in AR/MR and changes in MC/AVC/AC can affect the profit maximising equilibrium for a business
d) Understand how macroeconomic variables affect profitability e.g. the recession and changes in the exchange rate
e) Be able to explain and show how pricing strategies such as price discrimination impact on revenues and profits

The Functions of Profit in a Market Economy

Profits serve a variety of purposes to businesses in a market-based economic system

1. Finance for investment Retained profits are source of finance for companies undertaking investment. The alternatives such as issuing new shares (equity) or bonds may not be attractive depending on the state of the financial markets especially in the aftermath of the credit crunch.

2. Market entry: Rising profits send signals to other producers within a market. When existing firms are earning supernormal profits, this signals that profitable entry may be possible. In contestable markets, we would see a rise in market supply and lower prices. But in a monopoly, the dominant firm(s) may be able to protect their position through barriers to entry.

3. Demand for factor resources: Scarce factor resources tend to flow where the expected rate of return or profit is highest. In an industry where demand is strong more land, labour and capital are then committed to that sector. Equally in a recession, national output, employment, incomes and investment all fall leading to a squeeze on profit margins and attempts by businesses to cut costs and preserve their market position. In a flexible labour market, a fall in demand can quickly lead to a reduction in investment and cut-backs in labour demand.

4. Signals about the health of the economy: The profits made by businesses throughout the economy provide important signals about the health of the macroeconomy. Rising profits might reflect improvements in supply-side performance (e.g. higher productivity or lower costs through innovation). Strong profits are also the result of high levels of demand from domestic and overseas markets. In contrast, a string of profit warnings from businesses could be a lead indicator of a macroeconomic downturn.

The standard neo-classical assumption is that private sector businesses are profit-seeking and/or profit maximisers. But we know that the reality is that pure profit maximisation is a highly unlikely assumption to hold and that in the real world a wide range of alternative objectives are likely.