Profit Maximization and Economic Profit

Maximizing Profits

  • Firms must behave as if their primary goal is to maximize profits for survival.
  • Even with goals like providing high-quality products or enabling dreams, firms must prioritize profit maximization.
  • If a firm doesn't maximize profits, competitors will, potentially leading to the firm's failure.

Defining Profit

  • Two types of profit: Accounting profit and economic profit.
  • Accounting profit is commonly reported and discussed (e.g., Wall Street Journal, small business conversations).

Accounting Profit

  • Calculated as revenue minus explicit costs.

    Accounting\ Profit = Revenue - Explicit\ Costs

  • Revenue: Money brought into the firm from selling goods/services.

  • Explicit costs: Money used to acquire factors of production and raw materials.

  • If revenue exceeds explicit costs, accounting profit is positive; otherwise, it's negative.

Economic Profit

  • Considers revenue, explicit costs, and implicit costs (opportunity costs).

    Economic\ Profit = Revenue - Explicit\ Costs - Implicit\ Costs

  • Implicit costs: Opportunity costs of running the business.

Example: Knitting Scarves

  • Roommate knits scarves all summer, sells them for $100, with $80 in material costs.
  • Accounting profit: 100 - 80 = $20.
  • However, there's an opportunity cost: the value of time given up knitting scarves instead of other activities (vacations, other work, etc.).
  • Even with accounting profit, economic profit might be negative if opportunity costs are high.

Sam's Smoothies: A Detailed Example

  • Sam runs a smoothie business and seeks help evaluating her profit after a year.
Financial Data
  • Revenue: 100,000
  • Explicit Costs:
    • Rent: 13,000
    • Labor: 22,000
    • Ingredients: 20,000
  • Accounting Profit: 100,000 - (13,000 + 22,000 + 20,000) = $45,000
Implicit Costs (Opportunity Costs)
  • Sam invested 10,000 of savings in the business that could have been invested elsewhere.
  • Potential return on investment (e.g., stock market): 1,000
  • Sam turned down a job offer from Starbucks as a manager with a 70,000 salary.
  • Total Implicit Costs: 1,000 + 70,000 = $71,000
  • Economic Profit: 100,000 - 55,000 - 71,000 = -$26,000
Analysis
  • Accountant Perspective: Congratulates Sam on a 45,000 profit.
  • Economist Perspective: Sam lost money, as she would have been better off working at Starbucks.
Implications
  • Firms with negative economic profit may eventually shut down because resources could be used more productively elsewhere.
  • Potential actions for Sam: Raise prices, lower costs, or shut down the business and take the Starbucks job.

Positive Economic Profit Scenario

  • If Sam didn't have the Starbucks job offer, the economic profit would be:
    • Economic Profit = 100,000 - 55,000 - 1,000 = $44,000

Creating Value

  • Firms with positive economic profit create value.
  • The resources used (rent, ingredients, labor, opportunity cost) are turned into something more valuable.

Competition and Market Dynamics

  • Positive economic profits attract new firms to the market like "Steve's Smoothies"
  • New firms compete through:
    • Lower prices.
    • Better products (higher quality, variety).
    • Better marketing

Benefits of Competition

  • Consumers benefit as firms compete for their dollars by offering better value.
  • Increased competition puts downward pressure on economic profits.

Market Equilibrium

  • New entrants continue joining until economic profit is driven to zero.
  • Normal rate of profit in a competitive market is zero (economic profit).
  • When economic profit equals zero, there is no incentive to enter the market.

Accounting Profit vs. Economic Profit at Equilibrium

  • Even when economic profit is zero, accounting profit can be positive.
  • Reports in the Wall Street Journal typically refer to accounting profit.

Challenges in Calculation

  • Explicit costs are easily tracked, but implicit costs are hidden and difficult to quantify.
  • Impossible to know the real opportunity cost of running a business.

Key Takeaways

  • Goal is to maximize economic profit which is different than accounting profit.
  • Economic profits are rewards for creating value.
  • Creating value attracts new firms, and this competition drives economic profit to zero (normal rate of profit).