Economic profit and a desire to change the world are fundamental motives for entrepreneurs who establish firms to innovate new products and technologies in a capitalist economy. Most people misunderstand this role of profit and substantially overestimate average profit, both per sales dollar and as a return on invested capital. You know that a firm's accounting profit is the difference between total revenue and explicit costs, which pay for the use of resources not owned by the firm. Only after subtracting implicit costs (opportunity costs of resources owners provide to operate a firm) from accounting profit do we have pure economic profit, which is also a pure rent to the firm's owners.
Economic profit is revenue exceeding all opportunity costs for resources.
In a purely competitive and unchanging economy in which transaction costs were zero, economic profit would always be zero; implicit payments to sustain owner-provided resources would absorb all accounting profits. In reality, transaction costs are significant, and the future is uncertain. Many changes are wrought by entrepreneurial quests for profits. Moreover, monopoly power is commonplace. This leads to the major sources of pure economic profits: (a) monopoly power, (b) innovation, and (c) uncertainty.
Monopoly power enables some firms to generate total revenue far in excess of the opportunity costs of the resources used. But can a monopolist continually enjoy economic profit? Transaction costs, uncertainty, and entry barriers create short-run profit opportunities. Monopoly profit may persist into the long run if barriers prevent entry by competitors, but profits will stimulate resource flows that eliminate monopoly profit in markets where there is a threat of potential new entry (contestable markets). If so, profit will have served its function by signaling where society desired greater production. If barriers preclude entry in the long run, economy-wide efficiency will not occur, but the drive for monopoly profit does encourage least-cost production.
The capitalization processes described in a moment suggest that profit is realized primarily by the owners when a firm secures a monopoly position. Predictable profits are capitalized in the long run into a higher market value (and thus higher opportunity costs) for ownership of the monopoly; subsequent owners can expect only normal profits.
Rewards for Innovation
Innovation is another source of profit.
Innovation involves the development and implementation of a new product or production process or the opening of a new market.
A firm is likely to profit if it is among the first to introduce a successful good or a more efficient technology. Profits fall when competitors mimic successful innovators. Thomas Edison, for example, became rich when he established General Electric as the outlet for his genius, but GE now faces hordes of competitors and realizes only normal profits.
Invention and innovation are not synonymous; each is a part of the process of change. Some highly successful inventions have been innovated by firms not directly associated with the inventor. You may never have heard of Gilbert Hyatt, but in 1990, the courts and the U.S. Patent Office recognized him as a primary inventor of modern computer chips. The microchip makers who launched a revolution in how we live by innovating his chips wound up paying him royalties only after extended bouts in court. Sam Walton pioneered discount stores in small communities, propelling his company, Wal-Mart, to the top and making himself a billionaire in the process. On a smaller scale, one Colorado sixth-grader recently developed and marketed biodegradable golf tees.
Joseph Schumpeter first expressed the innovation theory of profits to help explain the business cycle. Entrepreneurs will attempt to capitalize on new profit opportunities created by a significant innovation, and their collective investments fuel economic booms. Once the advantages from the innovation are fully absorbed, however, investment declines, pushing the economy into a downturn to await another major innovation.
Risk Bearing and Uncertainty
If the likelihood of some occurrence is fairly predictable, many people will adjust in similar ways, so only normal rates of return can be expected. Buying insurance is one adjustment against life's possible hazards, or you might take your chances and self-insure. Some aspects of the future, however, seem totally unpredictable. If fortune smiles, unexpected profit may be your reward for bearing the risk of just being in a line of business, or you may be clobbered if disaster unexpectedly strikes your industry.
Risk and uncertainty exist because the range of things that will occur is a subset of the things that could conceivably occur. The economist Frank Knight first distinguished risk from uncertainty.
Risk exists when the probability of a given event can be estimated.
For example, if a firm can reliably predict that, on average, a production process will yield 3 defective units out of 100, it can adjust for these risks by considering "losses due to defects" as a normal cost of doing business. Similarly, the probabilities of fire, certain accidents, or the death of a key executive can be fairly reliably predicted, and insurance is available. Again, these risks will be reflected in production costs and output prices.
Uncertainty, on the other hand, forces entrepreneurs to weigh imperfect information and base their decisions on subjective judgments.
Uncertainty occurs when a potential occurrence is so unpredictable that forecasts are unavoidably almost pure guesswork.
According to Frank Knight, profits are rewards for bearing uncertainty. Entrepreneurs invest in an expectation of generating sufficient revenues to cover all costs, including allowances for all risks, but the unfolding of time may yield events beyond any entrepreneur's wildest hopes or fears. Uncertainty makes it impossible to predict economic profits or losses.
The Economic Role of Profits
Uncertainty, innovation, and monopoly power are major sources of economic profit, but what functions do profits perform? Economic profits signal that prices exceed average costs and indicate that social welfare can be improved by shifting resources from unprofitable to profitable endeavors. Conversely, industry-wide economic losses signal that too many resources are devoted to particular forms of production and could beneficially be shifted elsewhere.
Profits are also a stimulus for efficiency. Entrepreneurs' desires for profits cause costs to be cut wherever possible, freeing resources for other uses. Competition forces profits down to normal levels as imitators mimic successful firms, whether success is derived from being in a certain product line or from using a more efficient technology. Competition also punishes relatively inefficient high-cost firms with economic losses.
Profits also reward the entrepreneurs who innovate new products and technologies in an uncertain business environment. The drive for entrepreneurial profit propels society along a path of economic growth and progress. Predictable rents, interest, or profits are translated into wealth through capitalization processes when resources that generate these income flows can be sold. In the next section, we examine the mechanics of how competition for income streams determines the market values of income-generating assets.