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Much economic theory begins with the assumption that firms maximize profit. This assumption has been a source of controversy, in part simply because the word profit is a bit nebulous. One might think that it is well defined because each year thousands of firms announce to the public exactly what their profits are. Firms compute these profits by subtracting from their total receipts most cash outlays plus an allowance for depreciation of capital.1 Profit emerges as a residual--something left over after costs have been paid.

The problem that economists have with this definition is that it ignores implicit returns. The ma-and-pa grocery or restaurant may seem to have a profit when costs are subtracted from revenues, but this may be only because the owners do not pay themselves a wage. When their time is valued at even low levels, the "profit" may disappear. Or the family farm may have a profit, but only because it neglects to take into account a return on the land. If this return is computed on the basis of what rent could be obtained on the land, and if an allowance is made for the value of the farmer's labor, there may be little or no profit.

Much of corporate profit can reflect an implicit return on investment. If the corporation has a large investment in capital and this entire investment was financed by borrowing, then the return on capital is captured in the interest payments the firm makes. But if the investment is not financed by borrowing, then the return on it will be reported as profit in the income statement.

The economic definition of profit is the difference between revenue and the opportunity cost of all resources used to produce the items sold. This definition includes implicit returns as costs. Because profit is a surplus in this definition, it should not persist in industries in which entry is easy. Whenever this surplus exists, new firms have an incentive to enter an industry, bidding up the price of resources and bidding down the price of output until profit in the economic definition is eliminated. Profit should not exist in long-run equilibrium.

Economic profit exists in the real world for several reasons. The argument that economic profit should be zero in the long run rests on the assumption that new firms can enter any industry. If there are barriers to entry, short-run profits can persist into the long run. To some economists profit indicates that the economic system is in perpetual disequilibrium. Joseph Schumpeter, for example, saw profit as a return to a successful entrepreneur. The entrepreneur who finds an opportunity where no one before him saw one and takes advantage of this opportunity will make a profit. This profit will be temporary because, as time goes on, others will follow him and erode his profit, but in a dynamic economy there are always new entrepreneurs upsetting the status quo. Other economists have argued that profit is a special sort of implicit return, a return for bearing risk. Those who are willing to take more risk will, on the average, earn higher returns.

After one includes implicit costs as part of costs, an accurate measurement of profit is impossible, which is a major reason why accountants do not try to measure the economic concept of profit. This obviously causes problems if one wants to test whether or not firms try to maximize profits. An alternative way to approach the measurement problem begins with the Schumpeterian notion of profit, which is that it comes from the discovery of opportunity. A discovery of an opportunity should increase the discoverer's wealth. Thus, a way to measure profit is to try to measure unexpected changes in wealth--wealth increasing faster than a normal rate of return. If one sees people whose wealth is increasing more rapidly than it would if their assets were entirely in the form of high-grade, short-term bonds, one could conclude that they had found a profitable opportunity. There are measurement problems here as well, however. Much of people's assets are in the form of investment in themselves--human capital--and is not easily measured.

Do firms try to maximize profits? If profit is defined as accountants measure it, it seems unlikely that firms do. However, if costs are defined broadly enough, it must be maximized if the decision-maker is rational because profit is good for the firm. For example, suppose a humanitarian opened a business with a goal of helping the poor. He might keep prices below a level at which accounting profits are maximized. Yet one can argue that if the humanitarian raises prices, his (opportunity) costs increase because he must partially forgo the goal of helping the poor. Thus, with a loose enough definition of cost, one can argue that a very wide assortment of observed results are consistent with the assumption of profit maximization. (However, with a very loose definition of costs, the hypothesis will cease being a scientific hypothesis because it will not be open to refutation.)

The assumption of profit maximization is also subject to criticism because of the incentives that agents have.

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1This is the accounting definition of profit greatly simplified. There are in fact many technicalities that complicate this computation, but they need not concern us here.

Copyright Robert Schenk