Economy over time
Profit being a form of return from risk-taking and entrepreneurship, plays a significant role in allocating limited factors of production (land, capital, entrepreneur, labour) in the economy over time. It acts as a signaling mechanism in the free market system and funds capital investment so as to generate more returns in the future. Furthermore, it serve as an indicator to producers on what and how much to produce, how to produce and for whom to produce. This allows them to allocate scarce resources effectively and hence, maximize profits. Traditionally, the objective of every firm is to maximize their profit.
This can be done by producing at the output level where marginal revenue=marginal cost (MR=MC). At this point, the additional revenue that a firm would earn by selling one more unit of good would be equivalent to the additional cost required to produce it. Hence, firms would allocate their resources to increase output till this point as reflected in the diagram A. As shown in Diagram A, producing at output level, Q1 would result in a profit earned reflected by the blue border box. However, the firm is not producing at the optimal output level of Q2 which generate the highest possible profit as reflected by the red border box.
Hence, profit-driven firms would be motivated allocate more scarce resources to increase their output level to Q2 to maximize profits. Therefore, this shows that potential profit is able to drive allocation of scarce resources to achieve profits maximisation. Profits also encourage capital investment in an economy. It is the most important source of funding for major capital projects, research and development. If business conditions improve and the expected post-tax rate of return on an investment rises, then the marginal efficiency of capital increases leading to a higher capital investment at each rate of interest.
This would allow output expansion and employ more factors of production if the expected demand would increase over time. Moreover, it would also allow firms to undergo research and development to generate higher rate of returns in the future by improving quality of good and production method. For example, Apple Company uses supernormal profits earned from selling its products for research and development such as improving of IPhone 3 to IPhone 4. Hence, this would allow better allocation of scarce resources and allow firms to achieve dynamic efficiency.
Profits also serve as a signaling mechanism in the free market system. In economy, some good may generate subnormal profits while others may generate supernormal profits. When faced with such situation, firms in the economy could shift their resources from producing the subnormal profits goods to producing the supernormal profits goods. This is because these firms hope to acquire the highest rate of returns. For example, in the disk industry, consumers’ preferences have changed from VCDs to DVDs and Blu-ray due to the higher definition and greater memory space.
As such, over the years, the number of VCDs produced has reduced while the number DVDs and Blu-ray has increased. Below is graphical representation of the market system of VCDs as well as DVDs and Blu-ray. As shown by the graphs, the demand curve for VCDs have shift to the left while the demand curve for DVDs and Blu-ray have shift to the right. This is due to a change in consumers’ preferences from VCDs to DVDs. As seen by the new equilibriums, the output levels have changed. Disk suppliers, hence would shift their resources from producing VCDs to DVDs and Blu-ray.
Profits, therefore act as a signaling mechanism in the free market mechanism signaling to suppliers the need of shifting resources. Thus, profits serve as an indicator for firms and suppliers to allocate their scarce resources. In addition, when a market is offering supernormal profits, there is an incentive for new suppliers to enter the market in the long run – providing that barriers to entry are not prohibitive. This leads to an increase in market supply. The addition of new suppliers would cause an increase in demand of limited factors of production (labour and capital).
This shows that supernormal profits would affect the allocation of resources due to the entry of new suppliers. However, not all firms seek to maximize profits and the assumption of profit maximization is not always applicable. Other objectives of firms include market dominance, survival, efficiency, revenue maximisation and satisfacing behavior depending on the type of market structure they are in. An example of such sector is the Family Travel Agency which hopes to ensure its survival in this highly competitive sector.
Therefore, they are less concern with the profits made in the short run and focus more on attracting and retaining customers. (this point maybe can expand and drawn some diagram to have some analysis) It is also an assumption that there is perfect information in the economy about the costs of production and revenue conditions. However, this is not possible due to the presence of imperfect information in real world market structure. Furthermore, there are other players that play a role in resource allocation in the economy such as the government.
Decisions about resource allocation taken by the government are rarely driven by the profit motive as public sector capital projects may be undertaken on the basis of a cost-benefit analysis of the social costs and social benefits of a particular project. In conclusion, profits act as a signaling mechanism in the free market system and funds capital investment so as to generate more returns in the future. Thus, profits play a significant role in allocating limited factors of production in the economy over time.