Profit
In the United States, all the major soda brands have their own versions of cherry soda, such as Cherry Coke, Wild Cherry Pepsi, Dr. Pepper Cherry, and Cherry Sprite. Raspberry soda, however, is nearly impossible to find. Why is this? Why do so many producers make cherry soda, but not raspberry soda?
The answer, of course, is simple. As a whole, consumers are more likely to buy cherry soda than raspberry soda. Producers can make all the raspberry soda they like, but they won't sell very much of it. And because they won't sell very much of it, they won't make much of a profit.
As we learned earlier in the course, a profit motive is a primary characteristic of a market economy. It's the main driver of all decisions that producers make; it's the incentive for the effort they put into making a quality product.
Calculating Profit
So we know profit is important for producers, but how exactly do we determine a company's profit? At its core, the calculation is very simple. We take the company's revenue—the income generated by the sale of goods and services—and subtract the total cost of everything used in the production of those goods and services. Some examples of these production costs are labor, raw materials, transportation, and electricity. Profit is the amount of money remaining when all costs are subtracted from revenues.
Profit = Total Revenue – Total Cost
Let's pretend we own a soda company called Charlie's, and we sell bottles of cherry soda for $2.00 apiece. In our first month of business, we sold 500 bottles of soda. This means our revenue was $1,000 (500 sales times $2.00 per sale). Our total cost for producing those 500 bottles was $900. This means that our profit for the month was $100.
$1,000 Total Revenue
– $900 Total Cost
= $100 Profit
Production Costs
Because a company's profit is calculated by subtracting its costs from its revenue, those costs play a vital role in the decisions they make. The production costs of a particular good or service play a large role in the pricing of that product—and whether it will even be produced at all. When the production costs of a good or service become greater than the revenue a company generates for selling it, it no longer makes sense to continue producing that product. Remember that this is why price ceilings result in shortages. When the revenue for selling a product is capped by the government, companies have no way to offset rising production costs.
In a normal market economy, companies have two choices when production costs rise. They can either accept lower profits, or they can increase their prices. What would happen if the flavoring we use for our soda suddenly rises from $0.10 a bottle to $0.20 a bottle? If we continue selling bottles of Charlie's Cherry for $2.00 each, we'll be earning $0.10 less profit on each unit. Ten cents might not sound like a lot, but if you multiply that by a million bottles, that's a lot of money.
Our second option is raising the price of Charlie's Cherry to $2.10. The ten-cent increase means we'll continue making the same amount of profit on each bottle that we sell. Sounds great! Unfortunately, if we do that, we risk losing sales to other soda brands that are still selling cherry soda for $2.00 a bottle. Will we lose more profit by keeping the price the same, or will we lose more profit by raising the price (due to the lower number of units sold)? It will take a good research team to help Charlie's make the right decision.
Now, what do you think would happen if the cost of our cherry flavoring went down instead of up? If it only cost us $0.05 a bottle instead of $0.10 a bottle, we could keep the price at $2.00 and make $0.05 more profit on each unit. Alternatively, we could lower the price to $1.95 to keep the same level of profit we had before. We would do this with the hope that more customers would buy our soda at the lower price.
Thus, when production costs fall, there are two potential outcomes. One is that the company's profits on each unit will rise. The other outcome is that the prices of their products will decrease. The decline in price could lead to increased sales. This could make the company's total profit increase, even though its profit per unit would decrease.
"The Function of Profits"
Opponents of capitalism criticize the system by saying it creates a nation of companies that will commit atrocities just to gain a few extra bucks. They argue that, when companies only care about profit, they hurt consumers by cutting the production of unprofitable goods. As you read Chapter 21 of Economics in One Lesson, pay attention to Hazlitt's argument that a profit motive is essential to a functional market economy.
READ: Hazlitt, Economics in One Lesson, Chapter 21: "The Function of Profits." [This may be Chapter 22 in some newer editions.] When you've finished, click below to continue with the rest of the lesson.
In "The Function of Profits," Hazlitt pointed out that profits made up only a small portion of America's total income, and that remains true today. According to the Federal Reserve Bank of St. Louis, corporate profits still only make up 6.6 percent of the nation's total income. Most of the revenue companies generate goes to pay their employees, their suppliers, and the government (in the form of taxes).
Review of Key Terms
revenue: the income generated by the sale of goods and services
profit: the amount of money remaining when all costs are subtracted from revenues
Without a profit motive, producers would have no incentive to increase the quality and efficiency of their production, and they would have no need to make the products that consumers want.