We now put costs and revenues together and look at profits. Economists have different interpretations of what profit is, we look at this together with the roles that profit plays in a market-based economy.

The meaning of profit and different profit concepts

Profit measures the return to risk when committing scarce resources to a market or industry. Entrepreneurs take risks for which they require an adequate expected rate of return. The higher the market risk and the longer they expect to have to wait to earn a positive return, the greater will be the minimum required return that an entrepreneur is likely to demand.

1. Normal profit - is defined as the minimum level of profit required to keep the factors of production in their current use in the long run. Normal profits reflect the opportunity cost of using funds to finance a business. If you decide to put £200,000 of your personal savings into a new business, then those funds could easily have earned a fairly risk-free rate of return by being saved in a bank or building society deposit account. You might therefore use the rate of interest on that £200,000 as the minimum rate of return that you need to make from your business investment in order to keep going in the long run!

Of course we are ignoring here differences in risk and also the non-financial (or non-pecuniary) benefits of running and building your own business or investing funds in someone else’s project.
Because we treat normal profit as an opportunity cost of investing financial capital in a business, we normally include an estimate for normal profit in the average total cost curve, thus, if the firm covers its ATC (where AR meets AC) then it is making normal profits.

2. Sub-normal profit - is any profit less than normal profit (where price < average total cost)
3. Abnormal profit - is any profit achieved in excess of normal profit - also known as supernormal profit. When firms are making abnormal profits, there is an incentive for other producers to enter the market to try to acquire some of this profit. Abnormal profit persists in the long run in imperfectly competitive markets such as oligopoly and monopoly where firms can successfully block the entry of new firms. We will come to this later when we consider barriers to entry in monopoly.

Price Per Unit (£)	Demand / Output (units)	Total Revenue (£)	Marginal Revenue (£)	Total Cost (£)	Marginal Cost (£)	Profit (£)
50	33	1650		2000		-350
48	39	1872	37	2120	20	-248
46	45	2070	33	2222	17	-152
44	51	2244	29	2312	15	-68
42	57	2394	25	2384	12	10
40	63	2520	21	2444	10	76
38	69	2622	17	2480	6	142
36	75	2700	13	2534	9	166
34	81	2754	9	2612	13	142

 

Consider the example in the table above. As price per unit (average revenue) declines, so demand expands. Total revenue rises but at a decreasing rate (as shown by column 4 – marginal revenue). Initially the firm is making a loss because total cost exceeds total revenue. The firm moves into profit at an output level of 57 units. Thereafter profit is increasing because the marginal revenue from selling units is greater than the marginal cost of producing them. Consider the rise in output from 69 to 75 units. The MR is £13 per unit, whereas the marginal cost is £9 per unit. Profits increase from £142 to £166.

But once marginal cost is greater than marginal revenue, total profits are falling. Indeed the firm makes a loss if it increases output to 93 units.

As long as marginal revenue is greater than marginal cost, then total profits will be increasing (or losses decreasing). The profit maximisation output occurs when marginal revenue = marginal cost.

In the next diagram we introduce average revenue and average cost curves into the diagram so that, having found the profit maximising output (where MR=MC) we can then find (i) the profit maximising price (using the demand curve) and then (ii) the cost per unit. The difference between price and average cost marks the profit margin per unit of output.

Total profit is shown by the shaded area and equals the profit margin multiplied by output

Changes in demand and the profit maximising price and output

A change in demand and/or production costs (supply) will lead to a change in the profit maximising price and output. In exams you may often be asked to analyse how changes in demand and costs affect the equilibrium output for a business. Make sure that you are confident in drawing these diagrams and you can produce them quickly and accurately under exam conditions.

In the diagram below we see the effects of an outward shift of demand from AR1 to AR2 (assuming that short run costs of production remain unchanged). The increase in demand causes a rise in the market price from P1 to P2 (consumers are now willing and able to buy more at a given price perhaps because of a rise in their real incomes or a fall in interest rates which has increased their purchasing power) and an expansion of supply (the shift in AR and MR is a signal to firms to move along their marginal cost curve and raise output). Total profits have increased.

Roles of profit in a market economy

Profits serve a variety of purposes to businesses in a market-based economic system

• Finance for investment Retained profits remain the most important source of finance for companies undertaking new capital investment projects. The alternatives such as issuing new shares (equity) or bonds may not be attractive depending on the state of the financial markets. It is easier for companies to raise fresh capital when stock markets are performing strongly or when the demand for corporate bonds is high (reflected in a high price) and correspondingly, bond interest rates are low.
• Market entry: Rising profits send signals to other producers within a market. When the existing firms are earning supernormal profits, this sends a signal that profitable entry may be possible. In contestable markets, we would see a rise in market supply and downward pressure on prices. But in a monopoly, the existing dominant firm(s) may be able to protect their market position in the long run.
• Demand for factor resources: Scarce factor resources tend to flow where the expected rate of return or profit is highest. In an industry where demand is strong more land, labour and capital are then committed to that sector. Equally in a recession, national output, employment, incomes and investment all fall leading to a squeeze on profit margins and attempts by businesses large and small to cut costs and preserve their market position. In a flexible labour market, a fall in demand can quickly lead to a reduction in planned investment and cut-backs in labour demand

Two steps to higher profits!

In an ideal world, running a business would be easy! You come up with an innovative idea, create a new product or service so popular you can’t stop people from buying it. Word spreads and, before you know it, sales and profits are growing rapidly. If only. In reality, few businesses are able to sit back and watch the profits roll in. Creating and subsequently increasing profitability depends on doing a hundred little things better than the existing competition. So what are the best ways for a business to increase its profitability?

Method 1: Grow the “Top Line”

Every business and every market is different. But for most businesses, the best long-term way to improve profitability is to increase sales (also known as “turnover”). This is for four main reasons:

• If a business has a high gross profit margin, every extra sale is highly profitable. Once your turnover reaches the break-even level (i.e. where price = average cost) then each additional sale adds to profits. Cutting your prices may reduce profit margins, but the extra sales should still add to total profits.
• Acquiring new customers is made easier by greater market presence and reputation. As you grow, unit costs are reduced through economies of scale.
• If your customers tend to be loyal, the value of each new customer lays not just in the immediate sale, but in future sales as well. The cost of selling to existing customers is almost always lower than the cost of acquiring new customers. Loyal customers also tend to be your best promotional tool, because they recommend the business via “word-of mouth”. Behavioural economists have lots to say about this aspect of business growth. From popular restaurants to emerging technologies, there is often a tipping point in a market where sales surge partly on the back of recommendations from satisfied customers.
• Defending a high market share against competitors is easier than defending high profit margins. Businesses can happily depart from a narrow profit maximization objective in order to protect their existing demand.

However, not every business can increase their turnover easily. Many businesses operate in what are called “low growth” markets - where expansion only comes by taking a bigger share of the available demand. That usually requires investment in marketing and possibly increased production capacity. Low growth markets tend to be where the income elasticity of demand is low, so that as the real incomes of consumers increase, there is little positive effect on total market demand.

Method 2: Keep Costs under Control

If a business has a low gross profit margin, reducing direct costs dramatically increases the profit on each sale. Eliminating unnecessary overheads has an immediate impact on profit. Every business can increase profitability by reducing hidden costs. Hidden costs include the costs of employing inappropriate people since poor recruitment can lead to lower quality, increased training costs and ultimately redundancy costs.