Have you ever thought about what it means for a firm to generate profit? How do you find out if an enterprise is profitable? Most importantly, what is profit? Confused? Don't worry! This article will help you learn everything you need to know about profit.
What is profit?
Students often confuse profit and revenue and use them mistakenly as synonyms. Actually, profit and revenue have different meanings.
Revenue is the total amount of income that a firm generates when selling the goods and services it produces.
Profit is the difference between the sales revenue the firm receives when selling the goods or services it produces and the costs it incurs when producing these goods or services.
The formula for profit is:
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Total profit = Total revenue – Total costs
It cost £20,000 for a bakery to produce different types of breads, cookies, and cakes. After selling all of its products, the bakery generated a £35,000 annual revenue. How much profit did the bakery make?
£35,000 (total revenues) - £20,000 (total costs) = £15,000 (profit)
If the total costs of production a firm incurs are higher than the total sales revenue, the firm will incur a loss.
Think of a loss as a negative profit.
Profit maximisation
In economics, we assume that maximising profit is the main objective of firms. In other words, firms aim for the maximum positive difference between costs and revenue.
A basic economic assumption is that entrepreneurs will take the risk of starting trading their firms in the stock market if they believe there is profit to be made.
Making large profits can enable firms to:
- Reinvest funds into the development of new products that will gain them new customers.
- Pay higher returns to the shareholders. This may encourage more people to buy shares in the company or help boost the shares price. This, in turn, would raise more capital for the firm.
Profit maximisation occurs when a firm’s total revenue (TR) exceeds total costs (TC) by the greatest amount.
A firm maximises its profit at the point where its Marginal Cost=Marginal Revenue.
Fig. 1 - Profit maximisation
This means that the cost of producing the last unit is equal to the revenue gained from selling that last unit.
Figure 1 shows the point at which a firm in a perfect competition maximises its profit. Keep in mind that it is conditional for a firm to maximise profit where its marginal cost equals marginal revenue.
The point where MC=MR determines the amount of output a firm has to produce and the price it needs to sell in order to maximise profit. In the figure above, a firm maximises profit by producing quantity Q* and selling it at price P*.
Normal vs abnormal profit
When explaining profit maximisation, there are two concepts to keep in mind: normal profit and abnormal profit.
Normal profit is the minimum level of profit necessary to keep firms in the market. That minimum profit would reward the time, decision-making and entrepreneurial risk-taking ‘invested’ into production.
Normal profit, which is also referred to as 'zero economic profit' occurs at the level of revenue at which the firm just covers its total costs, including opportunity costs.
Normal profit occurs when a firm is producing at a point where average revenue (AR) = average total cost (ATC).
However, normal profit made by incumbent firms or firms already established in the market is insufficient to attract new firms to the market. Only abnormal profits attract new entrants to enter and compete in an industry.
In the long run, firms that are unable to make normal profits leave the market. Normal profit varies from one industry to another, depending on the various risks facing firms.
Abnormal profit, or supernormal profit, by contrast, is extra profit over and above normal profit.
The importance of profit in a market economy
Firms generating high profits can indicate that they have been successful in lowering the total costs of production by eliminating unnecessary costs and by using the most effective and efficient production processes.
Thus, we can say that profit itself can be an indicator of economic efficiency. Furthermore, profit can have other positive effects in a market economy:
Creation of worker incentives
There are many companies that use profit-related pay models to incentivize their employees to work harder. It works by having workers get higher payments as the company's profit increases. This is very common in real estate agencies or in sales.
Additionally, to provide incentives for employees to become more productive, companies give higher salaries relative to the employees' performance.
Creation of shareholder incentives
When a company makes high profits, it is able to pay more dividends to shareholders. This also provides the incentive for the current shareholders to keep their shares and buy new ones.
Additionally, companies often use high dividends to attract new shareholders to buy shares and invest in the company. This enables the firm to have additional money coming into it that could be used for further expansion.
Profits and resource allocation
An industry that is growing and is associated with high profits becomes very attractive for new and existing firms. New firms will have the incentive to join the industry and start providing goods and services in that market. Existing firms will also increase the quantity supplied in order to capture more profits.
Profit as a reward for innovation and risk-taking
Innovation is an improvement on something that has already been invented; it turns the results of an invention into a useful product. If entrepreneurs believe that innovation can result in high profits in the future, the incentive to innovate increases.
As we can never be sure of future profits, there are risks involved. However, successful risk-taking leads to high profits.
Profit as a source of business finance
Instead of being distributed to the business’s owners as a form of income, profit can be retained in the business. Retained profits are perhaps the most important source of financing for firms undertaking investment projects.
High profits also make it easier and cheaper for firms to use borrowed funds as an important source of business finance.
Profit - Key takeaways
- Profit and revenue are not the same.
- Revenue refers to the total amount of income that a firm generates when selling the goods and services it produces.
- Profit is the difference between the sales revenue the firm receives when selling the goods or services it produces and the costs it incurs when producing these goods or services.
- The formula for profit is: Total profit = Total revenue – Total costs
- Profit maximisation occurs when a firm’s total revenue (TR) exceeds its total costs (TC) by the greatest amount.
- The profit-maximising rule for firms in all market structures is where marginal cost (MC) = marginal revenue (MR).
- Normal profit is the minimum level of profit necessary to keep incumbent firms in the market.
- Profit can have other positive effects in a market economy: it can create worker and shareholder incentives, better resource allocation, rewards for innovation and risk-taking, and financing for the business.
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