Profit and Loss in Economics
In this article, we will be familiar with revenue, cost, loss, and profit from an economic point of view. Let's dig deeper into different theories of profit.
Risk-Bearing Theories of Profit:
This theory asserts that profit is a reward for bearing risk. The entrepreneur who takes risks is rewarded with profit. Risk is the possibility of loss and uncertainty associated with the outcome of a decision. The greater the risk, the greater the potential profit.
Frictional Theory of Profit:
According to this theory, profit is the result of market imperfections and frictions. Imperfections such as imperfect information, transaction costs, and search costs create inefficiencies in the market, which lead to the existence of profit. Profit arises because entrepreneurs are better at dealing with these frictions than others.
Monopoly Theory of Profit:
The monopoly theory of profit suggests that profit is a result of market power. In a monopoly, a firm has the power to set prices and restrict output, resulting in higher profits. Monopolies can arise from barriers to entry, such as patents, economies of scale, or control over resources.
Innovation Theory of Profit:
The innovation theory of profit states that profit is a reward for innovation. Innovation involves introducing new products, services, or production methods that are more efficient or effective than existing ones. Innovators are rewarded with profit because their innovation leads to increased productivity and lower costs.
Managerial Efficiency Theory of Profit:
The managerial efficiency theory of profit suggests that profit is a result of efficient management. Firms that are well-managed can produce goods and services at a lower cost than their competitors, resulting in higher profits. This theory emphasizes the role of management in achieving efficiency and productivity.
Revenue:
Revenue is the money that a government or business makes from its economic activities. In economics, revenue is a business or government's income from its economic activities. Therefore, it’s the money that a business or government makes from producing goods and services for sale. It’s also the total amount of income that a business or government receives from all sources.
Mathematically, Revenue is the product of the number of units sold and the cost price of each unit(Average cost)
TR = P x Q
Graphically,
Area of rectangle = length x breadth. If we have to find the revenue at point A of a demand curve then we take the rectangle OPAQ. The area of the rectangle gives revenue.
Cost:
The concept of cost is essential to economics. In economics, the term cost refers to the amount of money spent on purchasing goods or services. Many factors affect the price of any goods and services, and prices are affected by the amount of time it takes to produce them. Taxes also affect costs, which are additional payments made to government bodies to purchase goods or services. Therefore, understanding how costs affect economics is beneficial for everyone.
In the figure, the rectangle POQB represents the cost of production.
Profit:
Profits are essential to any business. It gives a company a reason to work and an incentive to produce quality products or services. Businesses can only operate if someone makes money from running them. Most organizations have to balance the need for profits with other factors such as growth and sustainability. They also have to ensure that they don’t over-extract their resources or endanger the environment with their activities. Additional ethical considerations must also be taken into account when creating and managing profits for a business. Advertising is the only way for most businesses to make a profit. Most companies spend considerable sums on advertising their products or services to make sales. This helps them reach potential customers and generate income from their work. It can also create brand awareness which leads to more sales overall. Companies that produce quality goods usually have an easier time advertising them successfully since consumers trust what they sell after buying something from an advertisement. Conversely, less ethical companies can make less income from advertising since consumers may still buy from them if they know what’s wrong with their product beforehand. The consumer is always the number one priority for a business. Companies exist so that people can buy goods and services— not the other way around. People will always spend money on things they want or need if they believe it will lead to better outcomes for them in some way. Businesses run by unsavory individuals may prey on consumers’ fears or greed without any issue as long as they are making money from it.
Mathematically,
Profit is total sales minus total costs.
Profit = TR − TC
Profit = (TR/Q − TC/Q) x Q
Profit = (P − ATC) x Q
In the graph, there is profit when the demand curve is above the average total cost.
The red-colored rectangle(ABPC = AQOC - OQBP) is the difference between revenue and cost of production.
Loss in Economics
Loss is an economic term that describes when something is taken away from a person or group of people such as money or physical assets like food or property values etc. The severity of the problem can vary depending on what has been lost; however, there always needs to be an immediate solution to prevent further losses from occurring. To prevent future losses from occurring; people must recognize what they are losing when they experience it and take action immediately to stop it before creating any more potential losses
Mathematically it is the difference between the revenue received from sales and the cost of producing output.
Loss = TC - TR
When the cost of production exceeds sales, a loss is visually possible. ATC curve is hence above the TR line. Only when there is a need for products and services can revenue be generated.
Nature of Profit
The nature of profit can be described in the following ways:
Uncertain: Profit is an uncertain income, and there is no guarantee that a business will make a profit.
Residual: Profit is what remains after all expenses have been paid. It is the excess of revenue over costs.
Dynamic: Profit is dynamic and can change over time, depending on various factors such as market conditions, competition, and technological advancements.
Relative: Profit is relative to the level of investment and risk involved in a particular business venture.
The reward for entrepreneurship: Profit is considered a reward for entrepreneurs who take risks and invest their resources to create and manage businesses.
Motivational: Profit is a motivator for entrepreneurs, and it encourages them to innovate and improve their business practices to increase profits.
Socially beneficial: Profit helps businesses to generate income, create jobs, and contribute to the economy's growth and development.
Competitive: Profit is a competitive factor that drives businesses to strive for efficiency, quality, and customer satisfaction to increase profits.
Subjective: The measurement of profit is subjective and can vary depending on the accounting methods used and the interpretation of financial data.
Conclusion
Profit is a term that holds different meanings for various people, including businessmen, accountants, policymakers, workers, and economists. Essentially, profit is the positive gain realized from business operations or investments after deducting all costs or expenses. In economic terms, profit is the reward received by an entrepreneur for combining all factors of production to meet the needs of individuals in an economy facing uncertainties. Profit can be classified into two types: accounting profit and economic profit. Accounting profit is the total earnings of an organization, calculated by subtracting explicit costs from total revenue. Economic profit considers both explicit and implicit costs or opportunity costs. Theories of profit suggest that it is the reward for entrepreneurial functions and the successful management of risks and uncertainties by entrepreneurs.
