Main page
   
   
   

PROFITS

 

 

by Valentino Piana (2004)

 
     
 
 

Contents


 
 
1. Significance
 
 
2. Determinants
 
 
3. Impact on other variables
 
 
4. Long-term trends
 
 
5. Behaviour during the business cycle
 
 
6. Formal models
 
 
7. Data
 
 
8. Related papers
 
 
 
 
 
 

Significance

Profits are the difference between revenues and costs. In a trade transaction, profit is the difference between the price at which you sell a good and the price at which you bought it. Running a business, net profit is what is left out of turn-over after paying suppliers, workers, financing institution, and the state. In insurance companies, it's the difference between the sums of the premiums collected and the total claims resulting from insured negative shocks.

Distributed profits are the income source of the owners of business. As a social group, they are called "owners" or "capitalists". The part of the value added not distributed as wages, interests, and taxes, remain within the firm to finance investments.

Determinants

Maximising profits is said to be the objective of all firms. Indeed, it's not always easy for the management to find out which are the right decisions that would maximise them. For instance, short-run profits can be easily pumped up by avoiding maintenance, discretionary costs, investments, that however are necessary of on-going competitiveness, as you can experiment with this free business game.

Moreover, what maximises the "overall profits" is not necessary what allows to attain the maximum of "profitability", i.e. the percentage of profits to turn-over, as you can better understand by using this model of monopoly and comparing two policies: (i) extremely high prices (= high profitability), (ii) a price set from a mark-up of 15% on costs.

In reality, firms do have profits targets, and sometimes they pay managers for reaching them, but the goals of firms are broader than profits alone.

Proceeding with other determinants of profits, rising prices of competitors, better sales conditions and skills, a higher overall price level allow for higher prices of the considered firm's products, thus increase nominal profits to the extent that costs are inelastic, i.e. they rise less than proportionally to revenues.

Cost structure and its general elasticity to production level is thus relevant to profits. Economies of scale increase profits more than proportionally when sales grow. Conversely, a recession with falling sales levels will hit profits particularly hard in industries where there are economies of scales and high fixed costs.

Rising wages directly reduce profits. If, however, on a macro-economic level, these wages will be spent on domestic goods, higher consumption will boost business revenues, partially counteracting the previous dynamics. Depending on the dynamics of exports and other GDP components, higher wages are compatible with higher profits, as you can see in these real data.

In other terms, productivity gains determine rising profits.

High trade profits can prompt other people to entry the market and begin to compete with current traders. In manufacture, this effect, although still present, crucially depends on the easy of imitation of product features and production processes. It's often difficult to enter into highly profitable markets.

If markets were all perfectly competitive in their long run equilibrium, all firms in the economy would have the same constant level of profits: zero. By contrast, in the real world, firms have different profits with certain sectors and certain firms systematically reaching better profits than others.

This is due to ubiquitous imperfect competition, barriers to entry, innovation and product differentiation.

Profits from process innovation

Consider the case of a competitive market where many firms sell basically the same product at the same price. If they had the same technology and faced the same input prices (e.g. wages), they would enjoy similar profit levels. Let's assume that one specialized supplier introduce a new machine that is better than the state-of-art, say a faster machine. The suppler sells it to one of the firms on the market. This will result in lower costs per unit of output, thus higher profits. These profits are used, retrospectively, to pay for the investment in the new machine but after the pay-back period they can be distributed to firm's owners.

The specialized supplier would like to sell again the new machine, either to its first adopter or to its competitors. If not legally restrained, earlier or later, in fact, the competitors will pay attention to the innovation and would like to imitate the first adopter. Slower or faster, innovation will diffuse throughout the market. Possibly some of the reduced costs will reach the consumers in terms of lower prices. If demand is elastic and there are economies of scale a self-sustained positive feedback loop enlarges production capacity, production levels, profits and consumption. If labour is not too weak, also wages will rise.

In a certain point on time, firms that did not adopt the new machine will see their profits seriously hit by competition and will have to choose whether to exit the market, to adopt, or to find other competitive advantages. Pressure to reduce wages in failing firms can be an example of these short-term defensive strategy.

Profits from product innovation

Consider a market with product differentiation, as this. An R&D investment over the years leads to an improvement of one product features and the management decides to substitute this new model to the existing one. Let's imagine for simplicity's sake that costs of product are the same as the previous version.

Three main effects will increase sales:

1. consumers who did not buy the good because it did not satisfied their minimum requirements on this feature can now buy, to the extend the improvement is sufficient at their eyes;

2. consumers who decides by a "top-quality" rule and positively value the feature could switch from their current provider, to the extend the overall quality of the new good becomes superior;

3. consumers who decides by a "value-for-money" rule could switch from their current provider, to the extend the price / quality relationships of the new good becomes more convenient.

At the same time, the price of this new version could be set higher than before, so that sales would be braken, unit profits boosted. Overall profits would soar.

Try all this - and the consequences of competitors' reaction - by playing this business game.


Impact on other variables

Distributed profits go into the income flows of the owner, directly or as dividends. The expected and actual rise in dividends boost the stock exchange quotations. Since shares are concentrated, in their majority, in few hands, and the more so the ownership of private firms, the rich get richer.

The demand pattern for consumption goods changes, with a more convex shape. There is an increase in overall consumption quantities, especially of luxury goods, often leading to a more than proportional growth of imports. In certain market segments prices rise.

Undistributed profits allows, and high rentability incentives, a new wave of investments, partially funded by banks in this "euphoria tide" of positive animal spirits.

Employment in capital goods sectors, as well as in some correlated industries, rise as well. Actual workers can ask for higher wages, credibly manacing strikes that would hurt profits, thus can encounter less-than-usual resistance.

Taxation from profits and capital gains soars to give more funds to the State for spending and balancing the budget. However, the rich and the very rich employ a vast array of sophisticated techniques to exploit any loophole in the tax code to minimize their burden. In certain countries, their interests are so protected by lobbies and political parties that the same tax code is written to open such loopholes.

Taxes on capital gains and profits can be lower than on labour; since the rich have a disproportionally high share of income coming from the former, the effect is a violation of "vertical equity" which requires that taxation be related to contribution capability.

Long-term trends

There is no long-term trend in profitability. Absolute profits rise with GDP. The share of profits on value added depends on social groups compromises and conflicts. A certain tendence to a rise of this share can be noticed in Western countries, without being an automatical consequence of development or technology.

Behaviour during the business cycle

Profits are extremely pro-cyclical. At the early stages of recovery, inventories go down, with sales surpassing production and injecting new liquidity to the business. The following increase in production is obtained by a higher production utilization of plants and employment. Productivity steeply rise and profits as well.

During recovery and boom, employment and capital accumulation (investments) can go hand in hand, increasing absolute profits if not profitability.

At the end of the boom phase, high interest rates on loans (taken for funding investment and discretionary costs) hurt profits, as well as higher wages can do.

Often unexpected, the demand downturn make inventories piling up, freezing resources and forcing a fall in production. Before this adjustment takes place, profits plunge even into negative values.

Experiment by yourself the inventory dynamics and how profits react to business cycle through this dynamic monopoly model.

For the dynamics of profits during the industry life-cycle see these data.

Formal models

Profits in competitive markets with product differentiation

Profits in a dynamic monopoly

Cost structures and profits: a software

Profits from exports: a dynamic model to play

Profits in the insurance market: a computational model

Data

Income sources (profits, labour) by income level of household (2012)

Aggregate profits in manufacture (1983-1996), from simplified balance sheets covering value added, wages, financial costs, taxes, and employment

Profits during the industry life cycle

Corporation profits and other incomes (1926-1976)

International comparisons of profitability (2000)

International comparisons of profitability (2002)

Related papers

Innovation, firm profitability and growth

Profits and market exit

Profits, competition and opportunity costs: two introductory papers on the flaws in neoclassical approach

Exchange Rates and Profit Margins: The Case of Japanese Exporters

Executive compensation and firm performance in Korea

 

 

 
 
Main page
 
 
Key concepts
 
 
 
 

Download in just one click all key concepts and the website 2012 compressed
[353 MB]

Please be patient - it may take long but it's worth downloading!


 
 
Copyright