Economic Profit

Definition

Economic profit is the difference between total revenue and total costs, including both explicit and implicit costs. It goes beyond simple accounting profit by considering opportunity costs, which are the benefits missed when choosing one alternative over another. This measure helps understand how well resources are being utilized in an economy, affecting decisions in various market structures, including the dynamics of competition and monopoly.

5 Must Know Facts For Your Next Test

1. In monopolistic competition, firms can earn economic profit in the short run, but due to the entry of new firms in the long run, these profits typically diminish to zero.
2. In perfect competition, economic profit can exist in the short run but will also trend towards zero in the long run as new firms enter the market and drive prices down.
3. Economic profit is an important indicator of market efficiency, as it signals that resources could be better allocated elsewhere if profits are consistently positive.
4. Firms experiencing economic losses will eventually exit the market, while those with sustained economic profits may attract new entrants seeking similar returns.
5. The existence of economic profit can indicate market power or inefficiencies, especially in monopolistic or oligopolistic markets where firms may manipulate prices above marginal cost.

Review Questions

• How does economic profit differ from accounting profit, and why is this distinction important for understanding market behavior?
  • Economic profit differs from accounting profit in that it takes into account both explicit costs and implicit costs, including opportunity costs. This distinction is important because while accounting profit might indicate a firm is profitable based on financial statements, economic profit reveals whether a firm is truly maximizing its resources. In competitive markets, understanding this difference helps explain why firms may exit or enter a market based on potential profitability.
• Discuss how economic profit influences firm behavior and market dynamics in both monopolistic competition and perfect competition.
  • Economic profit significantly influences firm behavior by affecting their decisions to enter or exit a market. In monopolistic competition, firms can earn short-run economic profits, which attracts new entrants, ultimately driving profits down in the long run. In perfect competition, firms initially experience economic profits or losses, but as new firms enter or exit based on these signals, the market naturally moves towards zero economic profit in the long run. This dynamic showcases how firms react to profitability indicators within different competitive environments.
• Evaluate the implications of sustained economic profits in a market and how they can impact resource allocation and competition.
  • Sustained economic profits in a market suggest that resources are not being allocated efficiently, as it indicates some firms have market power or face little competition. This can lead to inefficient production levels and potentially higher prices for consumers. Over time, high economic profits attract new entrants who seek similar returns, increasing competition and ideally leading to a more efficient allocation of resources. However, if barriers to entry exist, these profits could persist longer, distorting the market equilibrium and potentially leading to negative welfare outcomes.

Related terms

Accounting Profit: The total revenue minus the explicit costs of production; it does not account for opportunity costs.

Opportunity Cost: The potential benefits that an individual or business misses out on when choosing one alternative over another.

Normal Profit: The minimum level of profit needed for a company to remain competitive in the market, considered the same as zero economic profit.