role of profits in a market economy

Profit measures the return to risk when making an investment (I.e. committing resources to a particular market or industry).

Entrepreneurs take risks for which they require an adequate expected rate of return The higher the risk and the longer they expect to have to wait to earn a positive return, the greater the minimum required return that an entrepreneur is likely to demand.

One important concept to consider briefly is that of the hurdle-rate. This is the expected real rate of return on capital employed that an entrepreneur requires before going ahead with an investment project.

The profitability of companies is cyclical in nature. We expect to see fluctuations in profit according to the strength of demand in the economy (reflected in the annual rate of growth of real GDP) and the level of demand in particular industries.

Company profits are also affected by factors such as 

(1) The strength of the exchange rate (a strong pound puts increased competitive pressure on domestic exporters and firms that face competition from imports. This can lead to a squeeze on profits as companies seek to protect their market share in home and overseas markets).

(2) The rate of growth of wages and other costs

Changes in factor productivity.

Higher productivity reduces unit costs and provides a boost to the profitability of companies

Profits and the Allocation of Resources

Profits are the life-blood of most commercial companies.

(1) Retained profits (i.e. those profits not distributed to shareholders) are the most important source of internal finance for companies wanting to go ahead with major capital investment projects.

(2 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. In contestable markets, we would expect to see an influx of new suppliers leading to a rise in market supply and downward pressure on prices.

(3) Scarce economic resources tend to flow where the expected rate of return is highest. In an industry where demand is growing strongly, the rate of return rises, and land, labour and capital are then committed to that sector. Equally in a recession, output, employment, incomes and investment all fall.