Profitability is the most important concept in the theory of the firm. Indeed, profit is such a key element in the market economy that the market system would fail to operate without profit and the profit motive. It is a measure of a firm s performance in the market and it is often cited by both economists and managers as the primary objective of the firm. The rate of profit differs from industry to industry according to the production system, technology availability of raw materials, competitive market situation, tax and subsidy situation, etc. Thus, profits and the profit motive play an important and growing role in the efficient allocation of economic resources.
Economists have developed a number of theories that are used to determine profit levels. The main theories are as follows:
Compensatory Profit Theory
The theory explains profit as the economic rewards an entrepreneur receives for undertaking the risk to invest, and maintaining efficient operations. This theory also recognizes economic profit as an important reward for the entrepreneurial function of owners and managers.
Frictional Profit Theory
The theory states that markets are sometimes in disequilibrium because of unanticipated changes in product demand or cost conditions. A shock occurs in the. economy, producing
disequilibrium conditions that lead to either positive or negative economic profits for the
Monopoly Theory of Profits
The theory considers some factors like location, huge capital requirements, patents, economies of scale, etc. that allow existing firms to exercise monopoly power and economic profits.
Innovation Theory Of Profits
The theory stated that profit is mainly the result of technological change and innovations in a competitive market. Firms that are able to adopt new technologies that improve their products and/ or methods of production enjoy higher economic profits.
Functions of Profit
Profit plays a very crucial role in the determination of investment, production, distribution, and other economic activities related to the production system in a free market economy. High profit provides the incentiVe for firms to expand output and other firms will enter that industry in long run. Profit is the signal of efficiency in production and also acts as a signal for the reallocation of society’s resources to reflect changes in consumers’ tastes and demands over time.
If the economy is not operating under perfect competition, it should deduct the number of social costs, contributions,s and other policies of the government from the total profit. Therefore, in case of imperfect competition, the profit system is the most efficient form of resource allocation available. Generally, in the case of socialistic economies like Cuba, North Korea, etc. profits are not allowed.
The main significances of profits are as follows:
(1) Profit is a measure of performance.
(2) It is a premium to cover the cost of staying in business.
(3) It ensures the supply of future capital.
(4) It acts as a single resource allocation.
(5) It encourages organizing factors of production.
(6) It performs a useful social function.
(7) It is the Heart of the free enterprise system (make investments in business)
Peterson and Lewis, “No one will play the game if there is no chance of winning the price in the form of profit, “
Joel Dean, a business firm is an organization designed to make profits, and profits are the primary measure of its success. “
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This blog post provides an insightful overview of the nature and functions of profit in managerial economics, which is essential for businesses to understand their financial performance and make informed decisions about resource allocation and growth strategies.
I completely agree with the blog post’s assertion that profit is a crucial aspect of managerial economics. Profits serve as an incentive for businesses to engage in production and investment, thus promoting economic growth and development. However, profit can also lead to market failures if it is not properly managed. For instance, excessive profits can lead to overproduction and overexploitation of resources, causing market imbalances and inefficiencies. As a reader, I found this post to be informative and thought-provoking, and I look forward to exploring these issues further in future posts.
Great post! I never thought about the nature and functions of profit from a managerial perspective. You’ve really clarified the concept for me. Can you elaborate more on how profit maximization is related to the shareholder wealth maximization approach?
Great post! I found the explanation of profit as a residual concept to be particularly insightful. It helped me understand the relationship between revenue, costs, and profit in a clearer manner. Would love to see more examples of how profit functions in different industries and market structures in future posts!