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Profit (Economic definition)

It is important to distinguish clearly between the definition of profit used in accounting calculations in firms and the definition of profit made in economic theory. In many ways, the distinction reflects that made between accounting and economic definitions of costs.

The economic concept of profit need not quite correspond to that of the accountant, because the economist would deduct imputed costs as well as money outlays. If the firm owned its own land and buildings, the rent which the firm would have had to pay if it had to lease them will be part of the accountant’s profit figure and would not be seperately identifiable, whereas the economist would deduct a sum equal to the rent which could be obtained if the land and buildings were let out to the highest bidder, i.e. he would deduct the ‘imputed’ rent.

Economics distinguishes between two types of profit.

Normal profit: Profit is regarded as the income which accures to the entrepreneur, i.e. the residual left after payment of all opportunity costs to the inputs he employs. The entrepreneur need not devote his energies to the particular line of business he is in: he could just as well devote them to som other activity, and the best return he could obtain in some alternative line of business is the opportunity cost to him of remaining in the activity he is in. Then normal profit is defined as that profit which is just sufficient to induce the entrepreneur to remain in his present activity: it is the opportunity cost of remaining in that activity. It follows that if actual profits are less than normal profits, the entrepreneur will switch to a more profitable activity; on the other hand, if profits exceed normal profits, we would exprect entrepreneurs in other activities to move into the one in question. The essential point about normal profit is that it is not a surplus over all costs, but rather the cost of the service which the entrepreneur provides. Super-normal profit: Profit over and above normal profit, also referred to as excess profit. If entry into an activity is prefectly free, then in the long run super-normal profit would be zero, du to the competition of entrepreneurs attracted to the activity by the prospect of higher income than they are currently earning. This super-normal profits are either a short-run disequilibrium phenomnon, or the result of barriers to entry. This suggests the role of super-normal profits in the process of adjustment of a free market economy as being an indicator of ‘resource deficiency’ – they indicate that resources are realtively more scarce than in tiher areas in the economy which are just earning normal profits, and at the same time provide the attraction which, in the abcence of entry barriers, leads to the apporpriate expansion in scale of resources devoted to that particular activity. Reference: The Penguin Dictionary of Economics, 3rd edt.