Economic profit is the difference between the money a business earns and the cost of the inputs it uses to produce its product or service. In a perfectly competitive market, firms face the market price for their output and their input costs are equal to average input prices.
When a firm faces a decline in its average cost of production, it means that it is producing more output at a lower cost. This is because it has invested in better resources or technologies to produce its product or service.
A firm that increases its productivity will earn economic profit. A firm that does not invest in improving its productivity will suffer economic losses. These two facts about economic profit drive an important consequence of perfect competition: there is no such thing as long-term economic profit in a perfectly competitive industry.
This article explores what happens to firms, industries, and economies when there is no long-term economic profit.
Economic profit is not unique to the competitive industry
In a perfectly competitive market, economic profit is the difference between the price a company receives for its product and the price it costs to produce that product.
If a company can produce a good or service at a lower cost than its competitors, then it will earn economic profit. That’s because it will be able to sell its product at a lower price and still make a reasonable profit.
Of course, if every company could do this, then nobody would make a profit. That’s why there are constant pressures on companies to reduce costs in order to stay competitive.
Economic profits motivate companies to be more efficient so that they can stay in business and keep making money. When economic profits go down, companies have two options: cut costs or increase sales.
Consumers benefit from economic profit
A firm producing a product in a perfectly competitive market can make economic profit. This means the firm can sell its product for more than it costs to produce and market it.
Economic profit is a good thing in a free market. It motivates firms to stay in the industry and keep competing to provide the best product at the best price.
Consumers benefit from lower prices due to this competition. A common question is, “If all firms in an industry are earning economic profit, then who is paying for it?” The answer is other firms that are not!
In economics, there is a principle called the “fallacy of misplaced cost.” This principle says that you can’t just look at what someone pays for a good or service, you also have to look at what they receive in return. In other words, what value they get out of the good or service they purchase.
Producers benefit from economic profit
A producer’s ability to charge a price that is higher than the cost of producing the good or service is what economic profit is. When a producer can produce a good or service at a lower cost than other producers, they have an advantage.
They can then sell their product at a lower price and still earn a profit. Consumers benefit because they can acquire the good or service at a lower price.
When all producers in an industry cannot lower their costs, then none of them have an economic profit. All of their profits are just normal returns on investment, investment being money that they invested in production. Investment can be in things like machinery, buildings, raw materials, etc.
The market adjusts to eliminate economic profit
As we discussed earlier, a firm that is earning economic profit is getting an advantage over its competitors. This advantage comes in the form of extra revenue from sales of its product.
However, as firms in a perfectly competitive market are producing identical goods, then any advantage one firm has over another is negligible.
Thus, the market as a whole is producing the minimum economic profit. Any firm that attempts to earn more than the minimum will soon be out-competed by other firms and forced to lower their prices.
How does the market eliminate economic profit, you ask? By new firms entering the industry or existing firms lowering their prices to return to average economic profits.
Consumers tend to buy more of the product that has economic profit
A firm can maintain a positive economic profit if it keeps producing and selling more product. This is hard to do, however, as other firms are also trying to do the same thing.
There is constant competition to offer the best product at the best price. As mentioned before, this means that all firms must invest in the same inputs that cost money: labor and raw materials.
Economic profit motivates firms to keep producing and investing in their business. This is a good thing for society because it encourages continued production and investment in new technologies, better products, and more efficient processes.
When economic profit is zero, producers may decide to stop investing in their business. This could lead to reduced production down the road, which would hurt consumers. Preventing this from happening is another reason why governments impose anti-monopoly laws.