Definition, Nature and Sources of Firm Profit

1. Definition of Profit

Profit, in economics, is the portion of assets that investors gain through investment after deducting related costs, including opportunity costs. It is the difference between total revenue gained and total costs incurred in the transaction. In classical and Marxian economics, profit is a return to the owner of (i) production materials or natural resources used in productive activity involving labor, or (ii) income from bonds, stocks, and investments in the financial market.

For a firm, profit is the difference between the selling price and the total business costs (including both explicit and implicit costs) when the firm provides its products or services to the market (Rumelt, 1987). In practice, the firm has to pay explicit costs such as rent, purchasing cost of assets, and necessary resources (such as employees, raw materials, etc.), as well as legislative costs (such as taxes, insurance, etc). In a perfectly competitive market where risks are eliminated, firm profits will be positive in the short term. This positive profit attracts investments or the entry of new firms into the industry, ultimately leading to a reduction in profits for all firms operating within that industry. Specifically, when a new firm enters an industry, it increases the supply and tends to offer lower prices than other existing firms to attract customers to buy its products. Consequently, existing firms in this industry that are losing customers will have to lower their prices to compete with the new entrant. Other new entrants continue to enter the industry until the price of the product is reduced to the average social cost of production, at which point, profit will be zero. Thus, in the long run, the entry of new firms gradually reduces profit to zero, and the market reaches a long-term equilibrium. This is the ideology suggesting that capitalism will collapse.

However, business environments are often not perfect; some special ownership rights consistently provide firms with a market position against competition from other rivals in the short term. Similarly, firms only realize the differentials from their implicit investment costs, such as research and development expenses, brand building, reputation, etc. As a result, firms can achieve sustainable profits in the long term.

2. Sources of Profit

In general, there are five sources of firm profit. Firstly, profit gained from market failure: In an imperfectly competitive market, firms within an industry are protected by barriers against new entrants, ensuring profits for these firms. This is referred to as “monopoly profit”, which arises from a deliberate restriction of outputs (at the level of product supply) rather than inputs (at the level of resources); they rely on the ability to offer differentiated products, erect barriers to entry into the industry, or leverage a first-mover advantage. In other words, this profit originates from the firm’s ability to obtain certain resources at a lower price compared to what other firms would have to pay in a perfectly competitive market.

Secondly, in Ricardian perspective, profit can be derived from scarcity. Resources of a firm are not always in abundance; some resources are very limited in comparison to needs in the market. Ricardian rents arise from the superior efficiency of resources involved in the business process, as well as from the scarcity of these resources; control over scarce resources enables firms to generate profit.

The third source of firm profit comes from risks, which comprise two types (Knight, 1921). Firstly, measurable risks, which can be calculated using probability formulas, can have both positive and negative impacts on firm profit as they may result in losses but also in benefits and opportunities for the firm. Profits are calculated based on the prioritized assessments or experiential judgments of the firm and/or decision-makers within the firm. The second type is true risk, which cannot be calculated or estimated, resulting in misfortune, loss of assets, or decreasing profits compared to the expected profits of the firm. This risk is related to uncertainties that occur unintentionally in the firm’s activities, affecting its existence and development.

However, such risk represents “true net profit sources”, providing “windfall profits” to the firm because it cannot be accurately predicted; for example, changes in customer behavior, technological changes, or sometime because of fire accident, natural disaster, disease outbreak …. Profit originating from these true risks is considered a reward for the risks undertaken by the firm. Although there is still debate over the source of profit from risks, in practice, high-risk investments often yield greater profits than safe ones.

The fourth source of profits is derived from innovation. Economists, such as Schumpeter (1912), argue that “innovation is the pure source of profit”. In business activities, innovation serves as a driver for firm growth. Schumpeter, the pioneer in innovation literature, believed that industries must continuously revolutionize their internal structure and innovate their production processes to create better products or achieve better performance. Firms also need to continuously research and apply new methods, ideas, and technologies to better meet customer needs regarding product quality, associated services, and competitive prices. These inventions and innovative applications not only reduce costs but also increase firm revenue as optimized production technologies and processes are adopted, and new products are introduced to the market. So, Schumpeterian rents are associated with the development of new resources or their utilization in new forms, which can be seen as rewards for the firm’s efforts in implementing a special function of innovation.

Finally, quasi-rents arise from the difference between the acquisition value of a resource and the value generated by its utilization. Not all firms derive identical value from the same resource; therefore, resource scarcity is not the sole source of rent. Quasi-rents are associated with the specificity of resources, which may therefore have higher value to a particular firm compared to others. They arise when resources have a higher value when combined together than when separate. Quasi-rents also arise from the imperfect mobility of resources, which cannot always be freely traded and acquired due to property rights, their specificity with the owning firm, high transaction costs, or complexity preventing transfer.

3. Firm profitability

Regarding firm profitability, it depends on two factors: the attractiveness of the chosen industry and the competitive advantage over rivals (Grant, 1991, p.117). Industrial organization economics emphasizes industry attractiveness as the primary basis for the high profitability of the firm. It implies that the mission of strategic management consists of seeking favorable industry environments, positioning segments, and regulating competitive pressures by influencing market structure and the behavior of competitors (Grant, 1991; Schmalensee, 1988).

Figure 1: Resources as the basis for profitability

Source: Grant (1991, p.118)

However, the inter-firm profit within a specific industry is determined by each firm’s competitive advantage. This implies that the mission of strategic management consists of allocating resources to choose between differentiation or cost advantage and deciding the firm’s market scope (Grant, 1991). Differentiation advantage allows firms to create differentiated products or services compared to competitors through expanding distribution channels, service networks, applying technology to assert superior characteristics, and branding products; thereby achieving high profits due to the high prices accepted by customers. In contrast, cost advantage requires possession of scale-efficient plants, superior process technology, ownership of low-cost sources of raw materials, or access to low-wage labor; these factors allow the firm to produce goods, supply services at low costs, thereby achieving high profit.