Economics (9640) | Profit

💰 Chapter 3.1.3.5 & 3.3.2.5: Understanding Profit 💰

Welcome to the chapter on Profit! This is arguably the most fundamental concept in the theory of the firm. Why do businesses exist? To make profit! Understanding how profit is calculated, what different types of profit mean, and why profit matters will unlock your understanding of how markets actually work. Don't worry, even if the definitions seem confusing at first, we will break down the crucial difference between economic costs and accounting costs step-by-step.

1. The Simple Definition: Total Revenue minus Total Costs (TR - TC)

At its most basic level, profit is simply what is left over for the business owner after all expenses have been paid.

The core formula for profit is:

\[\text{Profit} = \text{Total Revenue (TR)} - \text{Total Costs (TC)}\]

Key Definitions:

• Total Revenue (TR): This is the total money a firm receives from selling its goods and services.
  

  \[\text{TR} = \text{Price (P)} \times \text{Quantity Sold (Q)}\]

• Total Costs (TC): This is the total expenditure incurred by the firm to produce its output. This includes all costs, whether they are fixed (like rent) or variable (like raw materials).

Quick Example: If a baker sells 100 loaves of bread for $4 each, their TR is $400. If their ingredients, rent, and wages cost $300, their profit is $100.

2. The Economists' View of Costs and Profit

This is where Economics diverges from standard Accounting. Accountants only look at the money that physically leaves the bank account, but economists are interested in opportunity cost.

2.1. Accounting vs. Economic Costs

For economists, Total Cost (TC) is made up of two types of costs:

• 1. Explicit Costs (Accounting Costs): These are the obvious, physical cash payments made by the firm to external parties.
  Examples: wages, rent, utility bills, raw materials.
• 2. Implicit Costs (Opportunity Costs): These are the hidden costs. They represent the income the firm sacrifices by using its factors of production (land, labour, capital, enterprise) for its current purpose instead of their next best alternative use.
  Example: If the entrepreneur owns the factory building, the implicit cost is the rent they could have earned by leasing it to someone else.

Total Economic Cost is therefore:
\[\text{Total Economic Cost} = \text{Explicit Costs} + \text{Implicit Costs}\]

2.2. Defining Economic Profit

Economists use Total Economic Cost when calculating profit. This gives us the true picture of whether a business is actually succeeding relative to all other options available in the economy.

• Accounting Profit: \(\text{TR} - \text{Explicit Costs}\)
• Economic Profit: \(\text{TR} - \text{Total Economic Costs (Explicit + Implicit)}\)

Analogy: Imagine you run a shoe store. Your Accounting Profit is $50,000. But if you had instead worked as a manager at a large corporation, you could have earned a salary (your implicit cost) of $60,000. Economically, you made a loss of $10,000!

3. The Two Types of Economic Profit (3.3.2.5)

The syllabus requires you to distinguish between two key types of profit:

3.1. Normal Profit

Normal Profit is the minimum level of profit required to keep the factors of production (especially enterprise/the entrepreneur) in their current use in the long run.

• It is considered part of the firm's Total Economic Costs.
• It represents the reward for the risk-taking and management skills of the owner, equal to what the entrepreneur could earn in their next best alternative job (their implicit cost).
• It occurs when Economic Profit = 0 (meaning TR is just enough to cover ALL economic costs, both explicit and implicit).

Normal Profit Condition: \(\text{TR} = \text{Total Economic Costs}\)

3.2. Abnormal (Supernormal) Profit

Abnormal Profit (also called supernormal profit or sometimes economic profit) is any profit earned above the level of normal profit.

• It occurs when Economic Profit > 0 (meaning TR is greater than Total Economic Costs).
• It is a signal that the firm is earning more than the minimum required to keep it in business.

Example: If a mobile phone app developer covers all their explicit costs AND pays themselves an implicit salary equivalent to a top software engineer (Normal Profit), and *still* has $10 million left over, that $10 million is Abnormal Profit.

3.3. Subnormal Profit (Economic Loss)

If a firm fails to cover its Total Economic Costs (TR < Total Economic Costs), it is making an Economic Loss, or Subnormal Profit.

• In this situation, the entrepreneur is earning less than they could in their next best job.
• In the long run, this firm will likely exit the industry, seeking a higher return elsewhere.

4. The Role of Profit in a Market Economy (3.3.2.5)

Profit is much more than just a number on a balance sheet; it is the fundamental mechanism that coordinates the millions of decisions made by firms and consumers, acting as the economy’s "invisible hand."

4.1. The Signalling Function

• High (Abnormal) profit acts as a powerful signal that resources should move into that industry. Consumers are clearly demanding this good/service, so more firms will enter to capture a share of that profit.
• Conversely, losses (Subnormal profit) signal that resources should leave the industry because consumer demand is low or costs are too high.

4.2. The Incentive Function

The potential for abnormal profit provides the main incentive for entrepreneurs to take risks, innovate, and work hard.

• It encourages cost minimisation: To maximise profit (TR – TC), firms are incentivised to find the cheapest, most efficient way to produce goods.
• It encourages innovation: Firms developing new technologies or products are often rewarded with a temporary period of high abnormal profit before competitors catch up.

4.3. Rewarding Enterprise and Investment

• Profit is the reward for the factor of production, enterprise. Without this reward, entrepreneurs would not undertake risky ventures.
• Source of Investment: Retained profits (profits kept by the firm rather than paid out to owners/shareholders) are a crucial source of funds for research and development (R&D) and new capital investment, leading to long-run economic growth.
• Allocation of Resources: By signaling where profits are highest, profit helps allocate resources (land, labour, capital) to their most valued use, promoting allocative efficiency (producing what society wants most).