Profit (AQA A-Level Economics): Revision Notes
Profit
What is profit?
Profit represents the financial reward a business receives after accounting for all its costs. Many students mistakenly think profit and revenue are the same thing, but they are distinctly different concepts.
Profit is the difference between the sales revenue a firm receives when selling its goods or services and the costs it incurs when producing these goods or services.
The formula for calculating profit is straightforward:
It's important to understand that profit can be negative. When a firm's total costs exceed its total revenue, the business makes a loss rather than a profit. Economists refer to this situation as negative profit.
Normal and abnormal profit
When analyzing how firms make decisions about production, economists use two key profit concepts that are essential for understanding business behaviour in different market structures.
Normal profit
Normal profit is the minimum level of profit a firm must make to remain in business. This profit level rewards the time, decision making, and entrepreneurial risk taking that has been 'invested' into production.
However, normal profit is insufficient to attract new firms into the market. Economists treat normal profit as an opportunity cost—the return that could be earned in the next best alternative use of resources. This is why normal profit is included in a firm's average cost curves.
The level of normal profit varies between industries, depending on the risks facing firms in each sector. In the long run, firms that cannot make at least normal profit will leave the market.
Abnormal profit
Abnormal profit (also known as supernormal profit or above-normal profit) is any profit earned over and above normal profit.
This distinction is crucial for understanding firm behaviour and market dynamics. When firms make abnormal profit, this signals that the industry is particularly profitable and may attract new competitors to enter the market.
Study note: Don't confuse normal profit with the term "normal good" from consumer demand theory. Normal goods are products that experience increased demand as consumer incomes rise—a completely different concept.
Calculating profit: worked example
Let's work through a practical example to understand how firms calculate different types of profit and identify the profit-maximising level of output.
The table below shows information about a firm's short-run output, costs, and revenue:
| Output per week | Total revenue (£000s) | Total cost (£000s) |
|---|---|---|
| 0 | 0 | 10 |
| 1 | 20 | 14 |
| 2 | 38 | 19 |
| 3 | 54 | 28 |
| 4 | 68 | 44 |
| 5 | 80 | 80 |
| 6 | 90 | 93 |
Worked Example: Calculating Marginal Revenue
Marginal revenue is the change in total revenue resulting from selling one additional unit.
When output increases from 4 to 5 units per week:
The marginal revenue equals £12,000.
Worked Example: Identifying the Normal Profit Level
The firm makes normal profit when total revenue equals total cost.
Looking at the table, this occurs at an output level of 5 units per week, where:
At this point, the firm is covering all its costs including the opportunity cost of the resources used, but it's not making any abnormal profit. This represents the break-even point where the firm makes just enough to stay in business.
Worked Example: Finding the Profit-Maximising Output
Profit maximisation occurs at the level of output where total profit is greatest.
Examining each output level:
- At 3 units: Total profit =
- At 4 units: Total profit =
- At 5 units: Total profit =
The firm maximises profit at an output of 3 units per week, earning £26,000 in total profit. This represents abnormal profit since it exceeds the normal profit level (which equals zero in monetary terms when ).
The role of profit in a market economy
Traditional economic theory assumes that firms have a single business objective: profit maximisation. This means firms aim to produce at the output level where profit (revenue minus costs) is greatest. While firms may have other objectives such as survival, growth, or increasing market share, profit maximisation remains a central assumption in microeconomic analysis.
Profit performs several crucial functions in a market economy, influencing business behaviour and the allocation of resources throughout the economy.
Attracting new firms to the market
In the long run, and where there are no significant entry barriers, abnormal profit performs an important economic function by attracting new firms into the market.
When existing firms make high profits, this signals to potential entrepreneurs that the market offers attractive opportunities. The hope of earning higher profits in the future provides two types of incentives:
- Internal incentive: Managers within existing firms work harder to make their businesses even more profitable
- External incentive: Other firms are encouraged to enter the market
Abnormal profit acts as a "magnet," pulling new entrants into a market or industry. As we'll explore in later chapters, if market entry is easy and relatively costless, new firms joining the market increase market supply. In competitive markets, the entry of new firms triggers a process that reduces both abnormal profit and prices, ultimately benefiting consumers.
However, the story changes when entry barriers are high or when monopoly or highly imperfect competition exists. In these situations, profit may simply reward inefficient producers. This represents a form of market failure where the producer rules the market rather than the consumer—a situation of "producer sovereignty" rather than "consumer sovereignty."
Economic efficiency and profit
Except when monopolies make large profits by exploiting their consumers, profit can indicate economic efficiency. Large profits might mean that firms have succeeded in:
- Eliminating unnecessary costs of production
- Using the most efficient production processes available
- Responding effectively to consumer demand
In this sense, profit serves as a signal of how well a firm is performing relative to its competitors.
Creating worker incentives
Some companies use profit-related pay and performance-related pay to increase worker motivation. The idea is that workers will work harder and share the objectives of the business's managers and owners if they benefit directly from the firm's success.
However, this approach can be counterproductive if ordinary workers see higher management and company directors enjoying huge profit-related bonuses while they receive relatively low wages. This disparity can damage morale and reduce the effectiveness of incentive schemes.
Creating shareholder incentives
High profit generally leads to high dividends or distributed profit being paid out to shareholders who own companies. This creates an incentive for more people to want to buy the company's shares, which drives up the share price.
A rising share price makes it cheaper and easier for a business to raise finance by issuing new shares. Companies with strong profit records find it easier to attract investment capital for expansion and new projects.
Profits and resource allocation
High profits made by incumbent firms in a market create incentives for:
- New producers to enter the market
- Existing firms to supply more of a good or service
Conversely, loss making (or a failure to make abnormal profits) creates incentives for firms to:
- Leave markets where they're unprofitable
- Deploy their resources in more profitable markets
This process helps ensure that resources flow toward their most valued uses in the economy, improving overall economic efficiency and welfare. Profit acts as a signaling mechanism, guiding the allocation of scarce resources to where they're most productive.
Profit as a reward for innovation and risk taking
Innovation represents an improvement on something that has already been invented, turning the results of invention into a useful product.
If entrepreneurs believe that innovation can result in high profits in the future, they have an incentive to innovate and develop new products or processes. However, we can never be certain of future profits—risks are always involved. Successful risk taking leads to high profits, rewarding those who correctly identify opportunities and invest in innovation.
This role of profit is particularly important for long-term economic growth and development. Without the prospect of profit, firms would have little incentive to invest in research and development or to take the risks associated with bringing new products to market.
Profit as a source of business finance
Instead of being distributed to the business's owners as a form of income, profit can be retained within the business. Retained profits are perhaps the most important source of finance for firms undertaking investment projects.
When firms retain their profits, they can:
- Fund expansion without borrowing
- Avoid the interest costs associated with loans
- Maintain control without issuing new shares to external investors
High profits also make it easier and cheaper for firms to use borrowed funds as an additional source of business finance, since profitable firms are seen as lower-risk borrowers.
Real-world application: the John Lewis economy
Real-World Example: Profit Sharing in Practice
John Lewis PLC provides an interesting example of how profit can be shared with workers in practice.
John Lewis is a generally successful retailing company that shares its profits with all its workers, making them part-owners of the business through the John Lewis Partnership. The letters PLC stand for public limited company, meaning the company's shares can usually be bought and sold on the stock market. However, John Lewis operates differently—it doesn't have external shareholders. Instead, the Partnership offers its employees indirect ownership of the company.
Employees don't directly own shares in the business, but they are granted some voting rights at board level plus a share of the profits, which are added to their salaries each year. The John Lewis Partnership is the largest employee-owned business in the UK.
Government ministers have claimed that employee share ownership is key to improving company profits and productivity. However, the employee-owned sector is not currently large enough to bring about a major change in the character of the British business model.
In recent years, John Lewis has been less successful than it was previously. Profits have fallen, which means worker pay has also fallen. Plans for a "John Lewis economy" that would inspire businesses to share ownership with their staff have been undermined by the removal of government support services offered to such businesses.
This example illustrates both the potential benefits and challenges of profit-sharing schemes. When times are good, workers benefit from high profits. When profits fall, workers may see their income decline, which can affect morale and retention.
Remember!
Key Points to Remember:
-
Profit is revenue minus costs. It's not the same as revenue—don't confuse these two concepts in exam answers.
-
Normal profit is the minimum needed to stay in business, but it's insufficient to attract new firms. Abnormal (supernormal) profit is extra profit above this level.
-
Profit maximisation occurs where total profit is greatest, which is found by calculating at each output level.
-
Profit serves multiple roles in a market economy: it attracts new firms, creates incentives for workers and shareholders, guides resource allocation, rewards innovation and risk taking, and provides business finance.
-
In competitive markets, abnormal profit attracts new entrants, which increases supply and reduces prices, benefiting consumers. However, in markets with high entry barriers or monopoly power, profit may reward inefficient producers rather than promoting efficiency.