Variations in Profits Across Industries and Firms

The important thing to note about Equation (1.9) is that a firm that breaks even in an economic sense in fact is earning an operating profit equal to its normal rate of return.The reason for this,of course,is that normal profits are considered to be an implicit cost.Put differently,a firm that is earning zero economic profit is earning a rate of return that is equal to the rate of return on the next best alternative investment of equivalent risk.A firm that is earning zero economic profit is earning an amount that is just sufficient to keep people from pulling their investments in search of a higher rate of return.When economic profits are positive (i.e.,when operating profits are greater than normal profits),the firm is said to be earning an above-normal rate of return.When firms are earning above-normal profits,investment capital will be attracted into the business.These distinctions will be discussed in greater detail in Chapter 8 when we consider short-run and long-run competitive equilibrium.

VARIATIONS IN PROFITS ACROSS INDUSTRIES AND FIRMS

It was pointed out earlier that profit is the mechanism whereby society signals resource owners and entrepreneurs where goods and services are in greatest demand.If market economies are dynamic and efficient,this would imply that profits tend to be equal across industries and among firms.Yet, this is hardly the case.Established industries,such as textiles and basic metals,tend to generate a lower rate of return than such high-technology industries as computer hardware and software,telecommunications,health care,and biotechnology.There are several theories that help to explain these profit differences.

Although free-market economies tend to be relatively efficient and dynamic,it is this very dynamism that often gives rise to above-normal and below-normal profits.In general,we would expect risk-adjusted rates of return to be the same across all industries and firms.The frictional theory of profit,however,helps explain why this is rarely the case.To see this,we make a distinction between short-run and long-run competitive equilibrium.If we assume that firms are profit maximizers,then a firm is in shortrun equilibrium if it is earning an above-normal rate of return.The existence of above-normal rates of return tends to attract investment capital,thereby resulting in an increase in industry output,falling product prices,and lower profits.If a firm is earning below-normal rates of return,then investment capital will tend to exit the industry,resulting in lower output,rising product prices,higher prices,and increased profits.

Firms that are just earning a normal rate of return are said to be in longrun equilibrium.When firms are in long-run equilibrium,investment capital will neither enter nor exit the industry.In this case,output neither expands

nor contracts,and product prices and profits remain unchanged.In reality, industries are rarely in long-run competitive equilibrium because of recurring supply-side and demand-side “shocks”to the economic system. Examples of supply-side shocks may result from changes in production technology or changes in resource prices,such as fluctuations in energy prices brought about by recurrent changes in OPEC production policies. On the demand side of the market,these shocks may result from the introduction of new products and changing consumer preferences,such as was the case with the introduction of personal computers in 1980s.

The risk-bearing theory of profit suggests that above-normal profits are required to attract productive resources into industries with above-average risk,such as petroleum exploration.This line of reasoning is quite analogous to the idea that the rate of return on corporate equities should be higher than that for corporate bonds to compensate the investor for the increased uncertainty associated with the returns on these financial assets.

Sometimes a firm will earn above-normal profits because it is in a position to exercise market power.Market power relates to the ability of a firm or an industry to raise the selling price of its product by restricting output. The degree of a firm’s market power is usually related to the level of competition.If a firm has many competitors,each selling essentially the same good or service,then that firm’s ability to raise price will be severely limited. To raise prices in the face of stiff competition would result in a dramatic decline in sales.As we will discuss in Chapter 8,this is characteristic of firms operating in perfectly competitive industries.At the other extreme,a firm that produces output for the entire industry has a great deal of discretion over its selling price through adjustments in output.This is the extreme case of a monopoly.Such a dominant position in the market may be achieved through patent protection,government restrictions that limit competition, or through cost advantages associated with large scale production.

An extension to the competitive theory of firm behavior is the marginal efficiency theory of profit.According to this theory,the firm’s ability to extract above-normal profits in the long-run stems from being a more efficient (least-cost) producer.In this case,a firm is able to generate high profits by staying ahead of the competition by adopting the most efficient methods of production and management techniques.Above-normal profits might also be generated through the introduction of a new product or production technique.The innovation theory of profit postulates that above-average profits are the rewards associated with being the first to introduce a new product or technology.Steve Jobs,cofounder of Apple Computer,became a multimillionaire after pioneering the desktop personal computer.Such above-normal profits,however,invite a host of imitators and thus are usually short-lived.Usually within a relative short period of time,abovenormal profits will be competed away,and some individual producers may be forced to drop out of the industry.