Economic Profits

Definition

Economic profits refer to the surplus revenue a firm earns above and beyond the opportunity costs of all inputs used in production, including the normal return to capital. This concept is crucial in understanding a firm's entry and exit decisions in the long run, as well as the behavior of firms operating in monopolistic competition markets.

5 Must Know Facts For Your Next Test

1. Economic profits are the surplus revenue a firm earns above the opportunity costs of all inputs, including the normal return to capital.
2. Firms will continue to enter a market as long as there are positive economic profits, and will exit a market if economic profits are negative.
3. In monopolistic competition, firms will continue to enter the market until economic profits are driven down to zero in the long run.
4. Economic profits provide the incentive for firms to innovate, invest, and expand their operations in the long run.
5. Firms must consider both accounting profits and economic profits when making production and investment decisions.

Review Questions

• Explain how the concept of economic profits relates to a firm's entry and exit decisions in the long run.
  • In the long run, firms will continue to enter a market as long as there are positive economic profits, as this indicates that the market is earning returns above the opportunity cost of the resources used. Conversely, firms will exit a market if economic profits are negative, as this means the firm is not earning enough to cover the full opportunity cost of its inputs. The entry and exit of firms in response to economic profits drives the market towards a long-run equilibrium where economic profits are driven down to zero.
• Describe how the concept of economic profits influences the behavior of firms operating in monopolistic competition.
  • In a monopolistically competitive market, firms will continue to enter the market as long as there are positive economic profits. This entry of new firms increases the level of competition, driving down each firm's market share and reducing their ability to charge higher prices. Firms will continue to enter until economic profits are driven down to zero in the long run, at which point the market reaches a long-run equilibrium. The presence of economic profits thus provides the incentive for firms to innovate, invest, and expand their operations in an effort to differentiate themselves from competitors and maintain some degree of market power.
• Analyze the differences between accounting profits and economic profits, and explain why firms must consider both when making production and investment decisions.
  • Accounting profits only consider the explicit, or stated, costs of production, while economic profits also include the opportunity costs of the firm's resources. Firms must consider both when making decisions, as accounting profits may indicate the firm is profitable, while economic profits could be negative, indicating the firm is not earning enough to cover the full opportunity cost of its inputs. This is particularly important in the long run, as firms will only continue to operate if they are earning at least normal profits (the minimum level required to keep the firm in business). Firms that fail to consider economic profits may make suboptimal decisions that lead to losses in the long run.

Related terms

Accounting Profits: Accounting profits are the total revenues a firm earns minus the explicit costs of production, without considering the opportunity costs of the firm's resources.

Normal Profits: Normal profits are the minimum level of profits required to keep a firm in business in the long run, equal to the opportunity cost of the firm's resources.

Marginal Revenue: Marginal revenue is the additional revenue a firm earns from selling one more unit of output, and is a key determinant of a firm's economic profits.