Profit | tutor2u Economics
Study notes

Profit

  • Levels: A Level
  • Exam boards: AQA, Edexcel, OCR, IB

Profit measures the return to risk when committing scarce resources to a market or industry

Types of Profit - revision video

Supernormal and Subnormal Profit - Key Diagrams for A Level Economics - revision video

The Nature of Profit

Entrepreneurs organise factors of production and take risks for which they require an adequate 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 will demand to participate in the market

There are different types of profit

Normal profit

  • Normal profit is the minimum profit required to keep factors of production in their current use in the long run
  • Normal profit is when a business is making just enough profit to keep resources/firms in their current use
  • Normal profits reflect the opportunity cost of using funds to finance a business. If you put £200,000 of savings into a new business, those funds could have earned a low-risk rate of return by being saved in a bank account. You might use the rate of interest on that £200,000 as the minimum rate of return that you need to make from your investment
  • Because we treat normal profit as an opportunity cost of investing financial capital in a business, we include an estimate for normal profit in the average total cost curve, thus, if the firm covers its AC then it is making normal profit

Sub-normal profit - this is profit which is less than normal (P < average cost)

Abnormal profit

  • Profit achieved in excess of normal profit (also known as supernormal profit). When firms are making abnormal profits, there is incentive for other producers to enter a market to acquire some of this profit.
  • Abnormal profit persists in the long run in imperfectly competitive markets where firms successfully block the entry of new firms
World's most profitable airlines in 2013
Accounting profit and economic profit

Calculating Economic Profit

The data below is for an owner-managed firm for a given year

  • Total revenue £320,000
  • Raw material costs £30,000
  • Wages and salaries £85,000
  • Interest paid on bank loan £30,000
  • Salary the owner could have earned elsewhere £32,000
  • Interest forgone on capital invested £20,000

In a simple accounting sense, the business has total revenue of £320,000 and costs of £145,000 giving an accounting profit of £175,000. But profit according to an economist should take into account the opportunity cost of the capital invested and the income that the owner could have earned elsewhere. Taking these two items into account we find that the economic profit is £123,000.

Functions of Profit - revision video

Functions of Profit - revision video

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