Economic Profit

A company’s primary objective is to maximize profit.  This post shows how economic profit is calculated and how it relates to the basic decisions companies make in a perfectly competitive market.

To make a profit, companies must produce a good or service to meet a demand.  Companies demand input and transform it into some sort of output.  Companies want to minimize the cost of inputs and production, to maximize profits.  Households and government may also produce, but for different reasons.

It is always important to do the maths before you spend money on a new venture.  To calculate economic profit, you need to know:

  1. The market price of output
  2. Techniques and technology available for production
  3. Input prices

Market price determines potential revenue.  Input prices and techniques/technology determines cost.

Calculating Economic Profit

Economic Profit can be calculated as the difference between total revenue and total economic cost

Economic Profit = Total Revenue - Total Economic Cost

Economic Profit Formula where total revenue is the amount received from the sale of products/service

Total Revenue = Quantity X Price

Total Revenue = Quantity X Price
Total Revenue Formula

Total Economic cost includes Out-of-pocket cost, Opportunity Cost  and Normal rate of return.

Total Economic Cost = Out of pocket Cost+ Opportunity Cost+ Normal Return

Total Economic Cost = Out-of-pocket Cost+ Opportunity Cost + Normal Return
Total Economic Cost Formula

Out-of-Pocket costs are explicit costs.

Opportunity cost is included to take into account things that does not cost anything but you forfeit something.  For example, your spouse may provide labor for free, but could have earned something elsewhere.

Normal Return represents the opportunity cost of capital.  It does not make sense to invest capital in the company if you can get a higher return on risk free or low risk government bonds.

If economic profit as positive, it makes sense to invest in the company.  If economic profit is negative, you need a better plan.  This brings us to the decisions companies make to maximize profits.

Basic Decisions Companies make

For the purpose of this post, we assume an industry with perfect competition where products are identical, prices are determined by supply and demand and a company’s primary objective is to maximize profits.  Profit maximizing companies make 3 basic decisions.

  1. Quantity output supplied
  2. How to produce that output (production technique or technology)
  3. Input needed (labor, electricity, equipment, raw materials etc.)

If your economic profit calculation worked out negative, you can revisit the three basic decisions.  Maybe you can find a different production technique, cheaper raw materials or increase the quantity output to take advantage of economies of scale.

If we relax the assumption of perfect competition, it could be possible to increase the price.  This could work if for example, your products are not identical to those of competitors and the market price is not elastic.

Production Decisions
Production Decisions

Generally the technology or production techniques used will affect the inputs needed.  Likewise, available inputs options may also affect the production techniques used.  Companies will try to minimize the cost of production.

For example, if the cost of labor is cheap or the product can be made most efficiently by hand, the company may choose labor-intensive production technology.  In countries where labor is expensive or production can be automated, the company may choose capital-intensive production technology.  Capital-intensive technology may require more electricity.

Companies often move production facilities to countries or areas where labor is cheaper or resources are readily available.

Production Function

To maximize profit, we need to know how additional input affects output.  Production Function is a mathematical expression of the relationship between input and output.  

Let’s say for example we produce pancakes.  We have more than enough flour and eggs, but we only have one stove.  A single employee can bake 10 pancakes per hour.  A second employee may be able to bake 15 pancakes per hour, because he can concentrate on baking pancakes (he does not need to answer the phone or take orders like the first employee).  When we add a third employee, it gets a bit crowded and they get in each other’s way, so he can add only 10 pancakes per hour.  A fourth employee can only add 5 pancakes per hour, because they now need to literally take turns at the stove.  A fifth employee will not add any output.

Production functions
Labor for our pancake store

You can plot these production functions on a graph.  We looked at the effect of changes in labor on the output.  You can do the same with all the input variables.

Production Function: Total Product
Production Function: Total Product

The important thing to see on these graphs is that an additional unit of input does not always add the same level of additional output.  This brings us to the law of diminishing returns.

Marginal v.s. Average product of labor
Marginal v.s. Average product of labor

Law of Diminishing Return

When additional units of variable input is added to fixed input, the marginal product of the variable input declines after a certain point.

In our example we added variable input (labor) to fixed input (the stove).  After a certain point, our output (pancakes) no longer increased to the same extend in response to the increase in labor.

Short term v.s. long term decisions

Unfortunately things take time.  So you need to think about the day to day operations as things stand.  Over the short term, you can make small adjustments.  But you also need do long term strategic planning.  It takes time to expand or change technology used.

Monitor the environment

Things change.  New companies may enter the industry, others may exit, the market may become saturated, input cost may increase.  Technology also change all the time.  You need to constantly monitor the environment.  Unfortunately even your long term strategy may need to change sometimes.

References

Karl E. Case, Ray C.Fair, Principles of economics.  Seventh Edition, Pearson Prentice Hall, 2004, Chapter 6




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