Firm profitability

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In economics, profit in the accounting sense of the excess of revenue over cost is the sum of two components: normal profit and economic profit. The enterprise component of normal profit is the profit that a business owner considers necessary to make running the business worth his or her while, i. Only in the short run can a firm in a perfectly competitive market make an economic profit. 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. 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. Economic profit is, however, much more prevalent in uncompetitive markets such as in a perfect monopoly or oligopoly situation.

The existence of economic profits depends on the prevalence of barriers to entry: these stop other firms from entering into the industry and sapping away profits, like they would in a more competitive market. However, some economists, for instance Steve Keen, a professor at the University of Western Sydney, argue that even an infinitesimal amount of market power can allow a firm to produce a profit and that the absence of economic profit in an industry, or even merely that some production occurs at a loss, in and of itself constitutes a barrier to entry. In a single-goods case, a positive economic profit happens when the firm’s average cost is less than the price of the product or service at the profit-maximizing output. The economic profit is equal to the quantity of output multiplied by the difference between the average cost and the price.

Often, governments will try to intervene in uncompetitive markets to make them more competitive. 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 monopoly profit. The social profit from a firm’s activities is the normal profit plus or minus any externalities or consumer surpluses that occur in its activity. A firm may report relatively large monetary profits, but by creating negative externalities their social profit could be relatively small.

Profitability is a term of economic efficiency. Given that profit is defined as the difference in total revenue and total cost, a firm achieves a maximum by operating at the point where the difference between the two is at its greatest. Another significant factor for profit maximization is market fractionation. A company may sell goods in several regions or in several countries. Profit is maximized by treating each location as a separate market.