Question

What is the role of economic profits in a competitive market? How does it presence of lack impact resources allocation?

Answer 1

Profit is the revenue surplus after a company has paid all its expenses. Profit can be seen as the monetary reward for a firm's shareholders and owners. Profit plays an important role in providing incentives for businesses and entrepreneurs in a capitalist economy. The reward of higher profit for an incumbent company will encourage them to try and cut costs and develop new products. If a business becomes competitive, otherwise new companies will be motivated to join. If a company becomes unprofitable, it will have to either adapt and change, or close. This profit motive will help enhance productivity, increase consumer choice and allocate resources according to consumer preferences.

Behavioral economists argue that the position of benefit can often be overemphasised in economics. Individuals, for example, are driven by many reasons other than income, such as job pride, the desire to work in a larger company, the desire to be competitive and the commitment to concepts–though unprofitable. The increased profit allows a company to spend more on research and development. This can lead to improved technology, reduced costs and dynamic efficiency. For some sectors, such as oil exploration, drug research, and car manufacturing, this benefit is particularly important–which require significant risky investment to grow.

Shareholders get dividends. Higher profit results in higher dividends and allows people to purchase shares. Shareholders are an important source of corporate finance. Profit is necessary because shareholders can be remunerated. It is the expectation of future profit that will allow companies to raise shareholder funds to fund expansion. Low profit can be the target of a takeover bid for a firm. Should a company appear to be under-performing, shareholders may feel better off selling to a company that wants to take over.

Profit can be saved, and compensation can be offered for an unforeseen decline, such as recession or rapid exchange rate appreciation. With volatile industries, such as luxury products, this is significant. In boom years, luxury goods may be very profitable but in recession they make a loss. Higher profits act as an incentive to start a business. There would be less innovation without the income incentive and fewer people willing to take risks. There is no incentive for profit in a command economy but this can easily lead to a lack of incentives.