Accounting profit is the difference between a firm's revenue and its explicit expenses. It differs from economic profit, which is the difference between revenue and the sum of the firm's explicit and implicit costs. Normal profit is the difference between accounting profit and economic profit. It is the opportunity cost of the resources supplied to a business by its owners.
The quest for economic profit is the invisible hand that drives resource allocation in market economies. Markets in which businesses earn an economic profit tend to attract additional resources, whereas markets in which businesses experience an economic loss tend to lose resources. If new firms enter a market with economic profits, that market's supply curve shifts to the right, causing a reduction in the price of the product. Prices will continue to fall until economic profits are eliminated. By contrast, the departure of firms from markets with economic losses causes the supply curve in such markets to shift left, increasing the price of the product. Prices will continue to rise until economic losses are eliminated. In the long run, market forces drive economic profits and losses toward zero.
When market supply and demand curves reflect the underlying costs and benefits to society of the production of a good or service, the quest for economic profit ensures not only that existing supplies are allocated efficiently among individual buyers, but also that resources are allocated across markets in the most efficient way possible. In any allocation other than the one generated by the market, resources could be rearranged to benefit some people without harming others.
Economic rent is the portion of the payment for an input that exceeds the reservation price for that input. If a professional baseball player who is willing to play for as little as $100,000 per year is paid $15 million, he earns an economic rent of $14,900,000 per year. Whereas the invisible hand drives economic profit toward zero over the long run, economic rent can persist indefinitely, because replicating the services of players like Derek Jeter is impossible. Talented individuals who are responsible for the superior performance of a business will tend to capture the resulting financial gains as economic rents.
When a payment is to be received in the future, it has a lower current value than an equivalent payment received today. This idea is known as present value. The present value (PV) of a future payment is lower because if the money were received today, instead of in the future, it could earn interest over time. Thus, PV – M/r, where M is a perpetual payment and r is the interest rate.
Failure to understand the logic of Adam Smith's invisible hand often compromises the design of regulatory programs. For instance, when regulation prevents firms from lowering prices to capture business from rivals, firms generally find other ways in which to compete. Thus, if airline regulators set passenger fares above cost, air carriers will try to capture additional business by offering extra amenities and more frequent service. Likewise, many antipoverty programs have been compromised by failure to consider how incentives change people's behavior.
A share of stock in a company is a claim to a share of the current and future accounting profits of that company. The price of a share of stock depends not only on its accounting profits, but on the market rate of interest, since the interest rate affects the present value of future costs and benefits. When the annual interest rate is r, the present value (PV) of a payment M to be received (or paid) T years from now is the amount that would have to be deposited in an account today at interest rate r to generate a balance of M after T years: PV = M/(1 + r)T.
According to the efficient markets hypothesis, the market price of a stock incorporates all currently available information that is relevant to that company's earnings. If this hypothesis were untrue, people could earn large sums of money without working hard, having talent, or being lucky.
The no-cash-on-the-table principle implies that if someone owns a valuable resource, the market price of that resource will fully reflect its economic value. The implication of this principle is not that lucrative opportunities never exist, but rather that such opportunities cannot exist when markets are in equilibrium.
The benefit of an investment to an individual sometimes differs from its benefit to society as a whole. Such conflicting incentives may give rise to behavior that is smart for one but dumb for all. Despite such exceptions, the invisible hand of the market works remarkably well much of the time. One of the market system's most important contributions to social well-being is the pressure it creates to adopt cost-saving innovations. Competition among firms ensures that the resulting cost savings get passed along to consumers in the long run.
