Economic profits play very important role in a market economy

“A strong market-based economy is the fertile ground for democratic freedoms that we think are important. The freedoms that people have that flow from all civic institutions fundamentally come from the success of a market system”.

Definition of Economic Profit

In neoclassical economics, economic profit, or profit, is the difference between a firm’s total revenue and its opportunity costs. In classical economics 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 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 investments.

 The economist’s understanding of profit is different from the accountant’s, and the distinction the two is important in understanding how the invisible hand works. Accountants define the annual profit of a business as the difference between revenue it takes in over the year and its explicit costs for the period. Profit thus defined is called accounting profit. Economists by contrast, define profit as the difference between the firm’s total revenue and not just its explicit, which are the opportunity costs of all the resources supplied by the firm’s owners. Profit defined is called economic profit or excess profit. Economic profit expressed by formula:

Economic Profit = Total revenue – Explicit Costs – Implicit Costs.

Economic Profit is “Total Revenue minus economic cost. An amount of profit earned in a particular endeavor above the amount of profit that the firm could be earning in its next best alternative activity".

Definition of Market Economy

A market economy is economy based on the division of labor in which the prices of goods and services are determined in a free price system set by supply and demand. This is often contrasted with planned economy, in which a central government determines the price of goods and services using a fixed price system. Market economies are also contrasted with mixed economy where the price system is not entirely free but under some government control or heavily regulated, which is sometimes combined with state-led economic planning that is not extensive to constitute a planned economy.

In the real world, market economies do not exist in pure form, as societies and governments regulate them to varying degrees rather than allow self-regulation by market forces. The term free-market economy is sometimes used synonymously with market economy. Economist Ludwing von Mises also pointed out that a market economy is still a market economy even if the government intervenes in pricing. Different perspectives exist as to how strong a role the government should have both in guiding the market economy and addressing the inequalities the market procedures. The term market economy is not identical to capitalism where a corporation hires workers as a labor commodity to produce material wealth and boost shareholders profits.

Economic Profits Role in a Market Economy

Contrary to the public opinion, profits do not embody “exploitation” of laborers or customers. Profits embody information in the form of a lucrative reward for the entrepreneur or capitalist who is able to combine labor, capital goods, and other inputs in such a way as to produce an output that customers value more highly than they value the inputs in another configuration. In plain English, the Coca-Cola Company earns profits because people are willing to pay a dollar for two-liter of Coke that may only cost ninety cents to produce. Profits are the rewards enjoyed by Coca-Cola for producing a product that people want to buy at a price they are willing to pay.

Economic profits reflect the difference between what consumers are willing to pay for goods and services and the costs of producing them. In a well-functioning market economy, enterprise profits are performance-related: they can only be earned by serving consumers in resourceful and innovative ways. Profits can thus serve as an indicator of each enterprise’s contribution to welfare of people in general. As such, profits and losses provided an indispensable economic signaling function. How well they serve this purpose depends largely on the extent of competition and economic freedom – they cease to perform the same role if they are due to subsidies, protection or exploitation of a monopoly position.

Uncertainty, innovation, and monopoly power are major sources of economic profit, but what functions do profits? Economic profits signal that prices exceed average costs and indicate that social welfare can be improved by shifting resources from unprofitable to profitable endeavors. Conversely, industry-wide economic losses signal that too many resources are devoted to particular forms of production and could beneficially be shifted elsewhere. Profits are also stimulus for efficiency. Entrepreneur’s desires profits cause costs to be cut wherever possible, freeing resources for other uses. Competition forces down to normal levels as imitators mimic successful firms, whether success is derived from being in a certain product line from using a more efficient technology. Competition also punishes relatively inefficient high-cost firms with economic losses. Profits also reward the entrepreneurs who innovate new products and technologies in an uncertain business environment. The drive for entrepreneurial profit propels society along a path of economic growth and progress. Predictable rents, interest, or profits are translated into wealth through capitalization processes when resources that generate these income flows can be sold.

Profits are the life blood of most commercial companies. Retained profits are the most important source of internal finance wanting to go ahead with major capital investment projects. Rising profits also send important signals within a market or industry. When the existing firms in a market are earning supernormal profits, this sends a 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.

To understand the theory of the firm and the role of the firm in a market economy, the nature of profits must be understood. Profits are such an essential element in the free enterprise system that the system would fail to operate without profits and the profit motive. Nonetheless, regardless of what aspects of economic conditions they represent, profits play a critical role both in providing an incentive for innovation, productive efficiency and in directing the allocation of scarce resources.

According to Joseph Schumpeter, an Austrian born economist who taught at Harvard “the only source of profit is economic innovation.” An entrepreneur has been assigned an important role, that of an innovator. He is the man with vision, originality and daring. He need not be a scientist who invents new process, but he is one who successfully introduces them. An innovation may consist of :

a)      The introduction of new product.

b)      The introduction of new method of production.

c)      Development or acquisition of a new source of raw materials.

d)     Substantial change in business organization.

Boyes & Melvin stated the following in regard to the role of economic profit:

·         Economic profit operates as a coordinating factor in the economy.

·         When a firm earns a positive economic profit, investors in the firm are earning better returns that they normally would with competing investments.

·         Other investors will want to invest in the firm, too. As a result, resources will flow to where they earn more.

The Central Role of Economic Profit: A firm’s accounting profit is the difference between its revenue and the sum of all explicit costs it occurs. Economic profit is the difference between the firm’s revenue and all cost it incurs – both explicit and implicit. Normal profit is the opportunity cost of the resources supplied by the owners of the firm. When firm’s accounting profit is exactly equal to the opportunity cost of the inputs supplied by the firm’s owners, the firm’s economic profit is zero. Industries in which firms earn a positive economic profit tend to attract new firms, shifting industry supply to the right. Firms tend to leave industries in which they sustain an economic loss, shifting supply curves to the left. In each case, supply movements continue until economic profit reaches zero.

Conclusion

After the above analysis it is obvious that profits play a catalytic role in a market economy for the following reasons:

·         Profits embody information in the form of a lucrative reward for the entrepreneur.

·         Profits are the reward to the entrepreneur for producing a product that people want to buy at a price they are wiling to pay.

·         In a well-functioning market economy, enterprise profits are performance related.

·         Economic profits signal that prices exceed average costs and indicate that social welfare can be improved by shifting resources from unprofitable to profitable endeavors.

·         Profits are also stimulus for efficiency.

·         Profits also reward entrepreneurs who introduce new innovate products and technologies in an uncertain business environment.  

·         Profits are the life blood of most commercial companies.

·         Profit it’s a source of innovation.

Finally, economic profits can be characterized as the motive of a contemporary market economy.

 “The market economy emerges naturally from our ability to choose, because choice allows people to produce and consume goods or services as they see fit”.