Normal profit versus economic profit

PROFIT

Unit 7

In a perfectly competitive system, economic profits are merely temporary rewards for innovations and for those entrepreneurs who anticipate changes in the pattern of consumer demand. When monopoly exists or when barriers to entry prevent new firms from entering markets, profits can be maintained over longer periods.

In the United States, corporate profits account for about 10 percent of the national income. The income earned by owners of proprietorships and partnerships comprises an additional 5 percent of national income. It therefore appears as though business profits account for 15 percent of national income. Beware, however: that appearance can be misleading!

Recall that normal profit is a cost of production that equals the opportunity cost of all owner-supplied inputs. An important component of normal profit is the opportu­nity cost of owner-supplied funds used to acquire physical capital. This cost represents the interest income that stockholders and proprietors of business firms forgo by tying their own funds up in their business. When market interest rates are high, the normal profit is also high.

The problem with the official statistics on profit is that they include both normal and economic profits. Much of the profit earned by corporations is really normal profit. Similarly, much of the income earned by owners of sole proprietorships includes wages of owner-supplied labor and the opportunity cost of owner-supplied funds invested in the firm. Actual profits, as a percentage of national income, are therefore significantly lower than 15 percent. Official statistics on labor income and interest income may understate the amounts actually earned because these statistics don’t include imputed wages and interest earned by owners of business enterprises. The following sources of economic profit can be identified:

Innovations and anticipation of consumer demands. This is a source of short-term profit even under perfect competition. Those who market new products and are shrewd enough to predict changes in the pattern of consumer demand will earn temporary economic profits. Of course, under perfect competition, free entry will reduce these profits to zero in the long run. However, shrewd entrepreneurs continually shift their funds around to support expansion of growing industries while removing their funds from declining industries. This is what playing the stock market is all about! Investors with the skills to supply funds to finance expansion of industries with the right ideas at the right time can turn temporary profits into a permanent source of income. Financial support of those who innovate represents the drive that keeps the capitalist system moving.

Risk taking. Innovations more often than not involve risks. Profit can be regarded as a payment to entrepreneurs for taking risks. As you’re well aware, not everyone who plays the stock market succeeds. Only a few shrewd or lucky investors strike it rich by always buying the stock of the right company just as that company begins to earn economic profits, and then selling it just when those profits fall to zero. There are thousands of other investors who make little profit or lose money by taking risks. In effect, investing and starting new enterprises are a bit like gambling. The rewards can be viewed as profits.

Exercise of monopoly power. The exercise of monopoly power can be a source of long-term profits in an industry. For this to be the case there must be a barrier to entry that prevents the market from becoming contestable. In monopolis­tic markets, barriers to entry result in profits that are more than temporary rewards for innovation. They are a source of concern to consumers and policymakers because they stem from prices that are higher than the marginal cost of producing goods. Increased competition can eliminate monopoly profits and result in net gains in well-being as production increases and prices fall to the minimum possible average cost. Often governments cooperate with firms to allow monopoly profits to be earned by granting exclusive franchises and enacting policies that set up barriers to entry in industries.

Economic profit is the difference between total revenue and the cost of all inputs a firm uses over a given period. The equation for a firm’s economic profit over a certain period can be written as

Economic profit = Total revenue — Total cost

The total revenue for a single-product firm would be the total units of output sold over the period multiplied by the price per unit:

Total revenue = Price x Quantity sold

Total cost is the economic cost of inputs used over the period. Total profit is therefore the difference between total revenue and the sum of accounting cost and the implicit cost of owner-supplied inputs. Throughout this book when a firm is said to be earning profits, it will mean that its revenues exceed the sum of its accounting cost and the implicit costs of owner-supplied inputs.

Normal profit is a term economists use to indicate that portion of a firm’s cost that isn’t included in accounting costs. Normal profit is therefore a measure of the implicit costs of owner-supplied resources in a firm over a given period. When a firm earns zero economic profit it will cover both its accounting costs and its implicit costs. If a firm therefore takes in enough revenue to pay all its accounting costs during the period and still has enough left over to cover its implicit costs, it will be earning a normal profit.

For example, suppose the only owner-supplied input to a corporation is $1 million worth of capital net of debt. If the owners of the firm can earn 10 percent by investing that $1 million elsewhere, normal profit would be $100,000. If total revenue exceeds accounting costs by $100,000, the owners of the firm would be earning zero economic profit. However, since they took in enough revenue to cover their implicit costs, they can also be said to just be earning the normal profit. A firm earning zero economic profit is said to be earning the normal profit. This means that the firm earns just enough to cover the opportunity cost of remaining in business.

When earning a normal profit in a business, the owners of the business cannot improve their well-being by using the resources they supply to the firm in another activity. It follows that when a firm earns zero economic profit, its owners can do no better in any other activity so their best alternative is to keep the firm operating.

If a firm is earning negative economic profit, it will be incurring an economic loss. Under such circumstances its owners can’t cover their implicit costs. They will therefore earn less than the normal profit, which implies that they can do better by transferring the resources they own to another activity.

Because current accounting practice doesn’t include implicit costs of owner- supplied inputs, accounting costs, as we’ve shown, underestimate economic costs. As a result, accounting profits based on accounting costs overestimate profits by underestimating costs. For example, suppose Melissa’s annual sales revenues in the preceding example were $200,000. Because annual accounting cost was $90,000, the accountant would report an annual profit of $110,000! Melissa, being shrewd, would realize that her actual economic profit was only $27,000 that year. The normal profit for Melissa’s store is $83,000, the opportunity cost of her owner- supplied inputs. Suppose her annual sales revenues were instead only $100,000. The accountant would report a $10,000 annual profit. However, Melissa would realize that she actually lost $73,000 based on her economic costs that year! She would go out of business as soon as possible if she didn’t expect an improvement in sales.

FOR-PROFIT COLLEGE STUDENTS END UP WITH LOWER EARNINGS

By Kay Steiger, July 3, 2012

In a new working paper filed with the National Bureau of Economic research, a statistical analysis of for-profit college students show that earnings are significantly less than students who attend comparable nonprofit schools. The study found that “income in 2009 is approximately $5,500 lower for students starting at for-profit institutions than for students starting at not-for-profit/public institutions.”

Kevin Lang, the lead researcher on the study and a professor at Boston University, told Raw Story: “I’d certainly be very cautious about putting a lot of my eggs in the for-profit basket as a policy tool for improving labor market outcomes for disadvantaged workers. At this point the case has not been made.”

Other research has found that for-profit students make up about half of all student loan defaults, even though they make up about 12 percent of the general student population. The default rate among students at for-profit schools is 15 percent, more than double that of student who attend public universities and more than triple that of students who attend private, nonprofit schools. “At this point, the case for the effectiveness even equaling the effectiveness of more traditional postsecondary sector is not there,” Lang said.

The one exception was for-profit students who earned a certificate in health care fields. Lang said this could be because the study was conducted in 2009 during an economic recession, when the one field that still did well in earnings was the health care industry.

Though the study looked at earnings outcomes, there are many possible explanations. One is that students who attend for-profit colleges are less prepared for higher education than their nonprofit peers. Another is that employers simply don’t view for-profit colleges as desirable as a nonprofit degree when evaluating potential employees. Regardless, data so far show that for-profit students aren’t doing as well as their nonprofit peers.

This study also confirms the findings of a previous NBER report that found for-profit students in 2004 were earning $1,800 to $2,000 less than their nonprofit peers.

The U.S. Department of Education issued regulations that would have restricted for-profit colleges’ access to federal student aid if they couldn’t meet student debt requirements, but a federal judge gutted one of the key aspects of the regulation in a ruling this weekend.

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