At first sight profit appears to be a simple concept that is defined as the residual of revenues from the cost of production; the related concept of profitability is defined as the ratio of profits to some basis, with the most commonly employed basis being invested capital. The simple concept of profitability is of great significance for understanding the motion of the capitalist system because the desire for and promise of profit motivate entrepreneurs to initiate productive activity and because the level of profitability is the measure of the success or failure of an endeavor. Consequently, measuring current and past profitability as well as projecting future profitability is crucial for entrepreneurial decisions with regard to the expansion or contraction of investment in the current activity or alternative activities, the possibility of takeovers, and the like.
In spite of the fact that profitability appears to be easy to define, a closer examination reveals that in reality costs, which are crucial for the determination of profits, are difficult to define in a generally accepted way. The usual textbook discussion of costs refers to the definitions of costs by accountants and economists. Definitions by accountants record only explicit costs, that is, all monetary expenses incurred in the production and sale of goods and services, whereas those by economists include additional costs called the implicit or opportunity cost: the compensation for not exploiting the best alternative opportunity. Clearly, the notion of profits of the economist includes that of the accountant, and this implies that profits in the economist’s sense exist if the revenues from sales exceed both the explicit and the implicit costs. Economic profit sometimes is referred to as supernormal or excess profit, and the normal profit (rate) is the part of the cost that usually is identified with the interest (rate).
In light of these distinctions, it is clear that there is no single definition of profitability even for accountants because costs and therefore profits depend on various accounting practices and the purposes they serve. For example, accountants usually convey different pictures of a firm’s profitability to the government and to the stockholders. Similarly, economists use different measures of profitability, such as profits over invested capital and profits over equity, among a host of others. However, the Cambridge capital controversies show that it is difficult to deal with profitability because it involves the evaluation of capital goods, which requires the prior knowledge of equilibrium prices. Those prices can be estimated only if one knows the average rate of profit of the economy. That estimation, however, requires the evaluation of invested capital, among other things, creating a vicious cycle from which there seems to be no exit.
Thus, economists have further difficulties in the estimation of the proper notion of profitability, which usually is identified with the internal rate of return (IRR): the discount rate that equalizes the value of the investment project with the present value of the future stream of expected profits that will result from the lifetime of the investment project. The IRR concept has certain limitations that, among other things, have to do with the idea that only the short-term horizon is relevant for investment decisions. This is why economists make use of the economic rate of return (ERR), which is the IRR over a specific, much shorter period of the firm’s life. Even this notion of profitability, however, is hard to measure with actual data, and so economists revert to the accounting rate of profit (ARP): the ratio of the value of a flow of profit in a specific period to the value of the stock of capital.
It is true that in any particular instance the ARP for firms and industries will be different from the respective ERR. More specifically, in 1983 Fisher and McGowan showed that as a result of depreciation methods, the projected cash profiles over time and the growth rate of a firm make ARPs fall short of a good approximation to the ERP. The problem with these experiments is that they were performed with numerical examples, not with actual data. By contrast, in 1990 Duménil and Lévy, using actual data from the U.S. economy over a long period, contended that for all practical purposes and under certain conditions and for certain types of economic problems the ARP can serve as a reliable approximation of the ERR.
In spite of criticisms economists use the notion of the ARP in many applications, such as industrial organization studies; if a particular industry makes an ARP above the economy’s average ARP for a considerable period, economists say that this may be evidence of economic (sometimes called excess or even supernormal) profit that accrues to a firm or an industry. This may be due to the exercise of monopoly power or the presence of barriers to entry, which prevent new firms from seizing such profit opportunities. Economic profit is viewed as a departure from the ideal of perfect competition, and the government must take action to correct the situation in its effort to make economic life look more like the perfectly competitive model, in which economic profit in the long run is zero. Furthermore, the ARP has been used, along with other variables, in econometric specifications as a determinant of investment behavior and capital accumulation. The idea is that excess profits attract investment, and therefore capital accumulation accelerates to the point where excess profits are competed away; the opposite is true in the cases of losses.
ARP also has been used in historical studies as an indicator of the expansion or contraction of an economy. In fact, it has been shown that the contraction phase of an economy is associated with a protracted falling ARP that leads to stagnant or even falling total real profits, giving rise to pessimistic expectations and thus discouraging aggregate investment and increasing the rate of unemployment. The opposite is true with a rising rate of profit, which creates an atmosphere of optimism, encouraging investment spending, lowering unemployment, and setting the stage for prosperity.
SEE ALSO Average and Marginal Cost; Cambridge Capital Controversy; Capital; Profits; Rate of Profit; Revenue
Duménil, Gérard, and Dominique Lévy. 1990. Post Depression Trends in the Economic Rate of Return for U.S. Manufacturing. Review of Economics and Statistics 72 (3): 406–413.
Fisher, Franklin M., and John J. McGowan. 1983. On the Misuse of Accounting Rates of Return to Infer Monopoly Profits. American Economic Review 73: 82–97.