Profit & Loss

Generally speaking, activities with high monetary profits will attract more entrepreneurs than those that cause losses. In a market economy with open competition, there is a tendency for monetary profits and losses to be whittled away over time, as entrepreneurs adjust to the situation.

When more entrepreneurs do a highly profitable activity, their efforts to buy the necessary inputs cause their prices to rise, while the increased output of the finished good causes the price to the consumer to fall. The gap between the two sets of prices tends to shrink, so that the monetary profits disappear as well.

The reverse occurs when an activity is plagued by recurring losses. New entrepreneurs will shy away from the industry, and entrepreneurs who are already in the industry will either scale back their operations or abandon them and move to a different industry. The entrepreneur’s total demand for the necessary inputs drops, leading to lower prices for workers, materials and other items used in this activity, while the diminished supply of the finished good or service tends to raise the price that the consumer must pay. This process continues until the finished price has risen enough, and the input prices have fallen enough, so that the remaining entrepreneurs no longer suffer losses from producing the good in question.

People usually attach a higher value to current dollars over future dollars, meaning interest rates are positive. We need to keep this in mind when discussing competition and its impacts on profit margins. In the long run, it is not true that competition will completely whittle away the gap between the revenues an entrepreneurs receives from selling his product, versus the out-of-pocket expenditures on inputs such as labor and materials. This is because a portion of gross profit must go to pay interest on the financial capital invested in the business. When we say that a high profit attracts more entrepreneurs into the industry, we mean high net (or economic) profit, i.e. the profit when an implicit interest payment on invested capital has been included as one of the “inputs” into the operation.

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