Unit 7 profit

In a perfectly competitive system, economic profits are merely temporary rewards for innovations and for those entrepreneurs who anticipate changes in the pattern of consumer demand. When monopoly exists or when barriers to entry prevent new firms from entering markets, profits can be maintained over longer periods.

In the United States, corporate profits account for about 10 percent of the national income. The income earned by owners of proprietorships and partnerships comprises an additional 5 percent of national income. It therefore appears as though business profits account for 15 percent of national income. Beware, however: that appearance can be misleading!

Recall that normal profit is a cost of production that equals the opportunity cost of all owner-supplied inputs. An important component of normal profit is the opportu­nity cost of owner-supplied funds used to acquire physical capital. This cost represents the interest income that stockholders and proprietors of business firms forgo by tying their own funds up in their business. When market interest rates are high, the normal profit is also high.

The problem with the official statistics on profit is that they include both normal and economic profits. Much of the profit earned by corporations is really normal profit. Similarly, much of the income earned by owners of sole proprietorships includes wages of owner-supplied labor and the opportunity cost of owner-supplied funds invested in the firm. Actual profits, as a percentage of national income, are therefore significantly lower than 15 percent. Official statistics on labor income and interest income may understate the amounts actually earned because these statistics don’t include imputed wages and interest earned by owners of business enterprises. The following sources of economic profit can be identified:

Innovations and anticipation of consumer demands. This is a source of short-term profit even under perfect competition. Those who market new products and are shrewd enough to predict changes in the pattern of consumer demand will earn temporary economic profits. Of course, under perfect competition, free entry will reduce these profits to zero in the long run. However, shrewd entrepreneurs continually shift their funds around to support expansion of growing industries while removing their funds from declining industries. This is what playing the stock market is all about! Investors with the skills to supply funds to finance expansion of industries with the right ideas at the right time can turn temporary profits into a permanent source of income. Financial support of those who innovate represents the drive that keeps the capitalist system moving.

Risk taking. Innovations more often than not involve risks. Profit can be regarded as a payment to entrepreneurs for taking risks. As you’re well aware, not everyone who plays the stock market succeeds. Only a few shrewd or lucky investors strike it rich by always buying the stock of the right company just as that company begins to earn economic profits, and then selling it just when those profits fall to zero. There are thousands of other investors who make little profit or lose money by taking risks. In effect, investing and starting new enterprises are a bit like gambling. The rewards can be viewed as profits.

Exercise of monopoly power. The exercise of monopoly power can be a source of long-term profits in an industry. For this to be the case there must be a barrier to entry that prevents the market from becoming contestable. In monopolis­tic markets, barriers to entry result in profits that are more than temporary rewards for innovation. They are a source of concern to consumers and policymakers because they stem from prices that are higher than the marginal cost of producing goods. Increased competition can eliminate monopoly profits and result in net gains in well-being as production increases and prices fall to the minimum possible average cost. Often governments cooperate with firms to allow monopoly profits to be earned by granting exclusive franchises and enacting policies that set up barriers to entry in industries.