Whether economic profit exists or not depends how competitive the
market is, and the time horizon that is being considered.
LEARNING OBJECTIVE [ edit ]
Describe sources of economic profit
KEY POINTS [ edit ]
Economic profit = total revenue - (explicit costs + implicit costs). Accounting profit = total
revenue - explicit costs.
Economic profit can be positive, negative, or zero. If economic profit is positive, there
is incentive for firms to enter the market. If profit is negative, there is incentive for firms to exit
the market. If profit is zero, there is no incentive to enter or exit.
For a competitive market, economic profit can be positive in theshort run. In the long run,
economic profit must be zero, which is also known as normal profit. Economic profit is zero in the
long run because of the entry of new firms, which drives down the market price.
For an uncompetitive market, economic profit can be positive. Uncompetitive markets can earn
positive profits due to barriers to entry, market power of the firms, and a general lack of
competition.
TERM [ edit ]
normal profit
The opportunity cost of an entrepreneur to operate a firm; the next best amount the entrepreneur
could earn doing another job.
EXAMPLE [ edit ]
Consider a shoe production firm that is in a competitive market. In one year, the firm earns a
total revenue of $50,000, while spending $15,000 on production (explicit costs) and having
$10,000 in foregone wages, rent, and interest (opportunity costs). Consequently, the firm earns
$25,000 in economic profit. Attracted by the potential to earn profit, other firms enter the
market. Eventually, the firm's revenue will fall as market price decreases, until the total revenue
just covers production costs and opportunity costs, and economic profit equals zero.
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Economic profit is total revenue minus
explicit and implicit (opportunity) costs.
In contrast, accounting profit is the
difference between total revenue and
explicit costs- it does not take opportunity
costs into consideration, and is generally
higher than economic profit.
Economic profits may be positive, zero, or
negative. If economic profit is positive,
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other firms have an incentive to enter the
market. If profit is zero, other firms have no incentive to enter or exit. When economic profit
is zero, a firm is earning the same as it would if its resources were employed in the next best
alternative. If the economic profit is negative, firms have the incentive to leave the market
because their resources would be more profitable elsewhere. The amount of economic profit a
firm earns is largely dependent on the degree of market competition and the time span under
consideration.
Competitive Markets
In competitive markets, where there are many firms and no single firm can affect the price of
a good or service, economic profit can differ in the short-run and in the long-run.
In the short run, a firm can make an economic profit. However, if there is economic profit,
other firms will want to enter the market. If the market has no barriers to entry, new firms
will enter, increase the supply of the commodity, and decrease the price. This decrease in
price leads to a decrease in the firm's revenue, so in the long-run, economic profit is zero . An
economic profit of zero is also known as a normal profit. Despite earning an economic profit
of zero, the firm may still be earning a positive accounting profit.
Price
MC
ATC
P
D=AR=MR
Q
Quantity
Long-Run Profit for Perfect Competition
In the long run for a firm in a competitive market, there is zero economic profit. Graphically, this is seen
at the intersection of the price level with the minimum point of the average total cost (ATC) curve. If the
price level were set above ATC's minimum point, there would be positive economic profit; if the price
level were set below ATC's minimum, there would be negative economic profit.
Uncompetitive Markets
Unlike competitive markets, uncompetitive markets - characterized by firms with market
power or barriers to entry - can make positive economic profits. The reasons for the positive
economic profit are barriers to entry, market power, and a lack of competition.
Barriers to entry prevent new firms from easily entering the market, and sapping shortrun economic profits.
Market power, or the ability to affect market prices, allows firms to set a price that is
higher than the equilibrium price of a competitive market. This allows them to make
profits in the short run and in the long run. This situation can occur if the market is
dominated by a monopoly (a single firm),oligopoly (a few firms with significant market
control), ormonopolistic competition (firms have market power due to having
differentiated products). .
Lack of competition keeps prices higher than the competitive market equilibrium price.
For example, firms can collude and work together to restrict supply to artificially keep
prices high.
Price
MC
P
ATC
Economic
profit
D=AR=P
MR
Q
Quantity
Long-Run Profit for Monopoly
In the long run, a monopoly, because of its market power, can set a price above the competitive
equilibrium and earn economic profit. If price were set equal to the minimum point of the average total
cost (ATC) curve, the monopoly would earn zero economic profit. If the price were set lower than the
minimum of ATC, the firm would earn negative economic profit.