A Simple Break Down of Economic Profit

Economic profit can be interpreted in two ways. Some conflate the definition of this term with “accounting profit,” which simply refers to the occasion when a business’s earnings exceed its costs. In reality, however, it not only takes into account the tangible costs and expenses, but also the opportunity cost—or potential for profit—that is involved.

Perfect Competition

A free market in which all buyers and sellers have equal access to resources, and no single company holds control over prices, is otherwise known as a state of perfect competition. A business cannot make an economic profit in long-running states of perfect competition, as new firms will always be entering the market and forcing the competition to lower prices until finally no profit is possible. Businesses can, however, make profits in the short run, while prices temporarily remain above the cost of production.

Extended Profit

Though businesses are usually unable to maintain steady economic profit over the long term in either perfect competition markets or contested monopolies, it is possible to do so in some cases. A company that is able to sustain profits over a lengthy period of time in a free market economy has probably cut costs to match competition, while also improving product performance and production processes so price does not dip below production costs.

Market Monopolies

Long-term versions of these profits are most often found in a perfect monopoly system, in which certain businesses hold power over a particular product or market area. Because these monopolies are able to set prices without much competition, they can ensure sustained profit over time. This can go on so long as there are economic “barriers to entry,” which prevent the monopoly system from transitioning into a competitive market.

The Role of Government

Governments have a hand in determining the existence and sustainability of economic profit on the market. For example, the United States government implemented the antitrust law to ensure constant market competition and to discourage monopolies. In fact, the Microsoft Corporation was taken to court in 1998 under accusations of breaking the antitrust law, and has since been forced to adopt strict oversight measures to ensure that no barriers to entry are set up in the future.

Social Profit

Though the aforementioned examples have dealt largely with economic profit as a source of revenue, these profits can also be discussed in terms of economic efficiency. In other words, profitability can include social profit—social capital that does not hold a monetary value—as well as monetary gains. In these cases, profit calculations must take into account consumer value placed on goods and services in addition to the revenue.

Profit Maximization and Game Theory

While some people assume that a free market economy boasts a level playing field in which every firm has a chance to profit in the short term by ensuring that proceeds outweigh expenses, in actuality the success of most businesses is often dependent on the actions of other firms in the market. Therefore, business must often employ game theory, or strategic tactics assuming an interdependent market, in order to economically profit.

For most companies, economic profit in a competitive free market economy like the United States is in a constant state of flux. Prices and production procedures must be constantly altered and improved to achieve repeated short-term profits and efficiency while avoiding anti-competitive behavior.