profits, theories of

The early classical economists believed that profits would eventually decline.

The Scottish economist Adam Smith (1723-1790) viewed the growth rate of capital accumulation (which took place at a rate higher than total output) as the cause.

The English economist David Ricardo (1772-1823) argued that a decline in the general rate of profit was caused by the diminishing marginal productivity of land.

The German political economist Karl Marx (1818-1883) believed that the rate of profit was influenced by the growth of competition between capitalists.

A Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (London, 1776);
D Ricardo, On the Principles of Political Economy and Taxation (London, 1817);
K Marx, Capital, i-ni (Harmondsworth, ,1976-81)

An economic profit is the difference between the revenue a business has received from its outputs and the opportunity costs of its inputs.[1] An economic profit differs from an accounting profit as it considers both the firms implicit and explicit costs, where as an accounting profit only considers the explicit costs which appear on a firms financial statements. Due to the additional implicit costs being considered, the economic profit usually differs from the accounting profit.[2]

From an economic standpoint, we often view economic profits in conjunction with normal profits, as both consider a firm’s implicit costs. A normal profit is the profit that is necessary to cover both the implicit and explicit costs of a firm and the owner-manager or investors who fund it. In the absence of this profit, these parties would withdraw their time and funds from the firm and use them to better advantage elsewhere, as to not forgo a better opportunity. In contrast, an economic profit sometimes called an excess profit, is the profit remaining after both the implicit and explicit costs are covered.[2]

The enterprise component of normal profit is the profit that a business owner considers necessary to make running the business worth his or her time, i.e., it is comparable to the next-best amount the entrepreneur could earn doing another job.[3] In particular, if enterprise is not included as a factor of production, it can also be viewed as a return to capital for investors including the entrepreneur, equivalent to the return the capital owner could have expected (in a safe investment), plus compensation for risk.[4] Normal profit varies both within and across industries; it is commensurate with the riskiness associated with each type of investment, per the risk-return spectrum.

Economic profits arise in markets which are non-competitive and have significant barriers to entry, such as Monopolies and Oligopolies. The inefficiencies and lack of competition in these markets creates an environment where firms can set prices or quantities, instead of being a price-taker, which occurs in a perfectly competitive market.[5] In a perfectly competitive market when long-run economic equilibrium is reached, an economic profit becomes non-existent. This is because there is no incentive for firms to either enter or leave the industry.

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