Profit as a form of return from risky businesses and entrepreneurship plays an important role in allocating scarce factors of production, which are land, entrepreneurship, labor, and capital. It acts as a signaling instrument in the liberalized economy and finances capital investment to create extra returns in the future. Additionally, it functions as a pointer to manufacturers on what and how much to invest, ways of production and for the market to produce. This lets them allot scarce resources efficiently and hereafter, make the most profits (Arrow).
Customarily, the main objective of each firm is to exploit its profit. This is made possible by manufacturing at the productivity level where marginal cost equals the marginal revenue (MC=MR). At this point, the extra income that a company would get by marketing an extra unit of a good would be equal to the extra cost needed to create it. Hereafter, companies would apportion their capitals to raise output up to this point. This means that when MC is greater than the MR, the company operates at a loss and vice versa. If the opposite happens, a firm is able to get enough profits, and can decide to retain some for expanding the business. Here, profits play a crucial role in determining the value of the firm. A firm which has a steady profitability rate is considered ‘healthy’, and its value goes up. This way the firms can woe investors who will have no fear of dangers resulting from obsolesce or bankruptcy of the firm (Garcia).
Profits measure the return to risks when making capital investments (that’s conferring assets to a specific business sector or industry). Ambitious people go for risky ventures with the hope of getting high returns. The higher the risk, the higher the profitability and this tends to disrupt allocation of resources in the market. One imperative idea to think about is the hurdle rate, which is the expected real rate of return on investment that an investor requires before making the investment.
The productivity of organizations is cyclical in nature. We expect to see variances in profitability as per the strength of demand in the economy (reflected in the twelve-month rate of development of real GDP) and the level of demand in particular industries. Organization profitability is influenced by variables such as the strength of the exchange rate, the growth of wages and other costs, as well as efficiency in the allocation of resources.
The strength of the exchange rate increases pressure on domestic exporters, which creates competition between domestic and imported products. This makes it hard for domestic companies to protect their market share. In addition, domestic companies continue to record low profitability. Here, profits play a critical role in shaping competition between locally manufactured products and imported ones. Due to this, local producers learn how to position themselves in both the local and international markets. If the exchange rate favors domestic firms, those firms can easily improve their profitability and work towards improving the value of the firm. High profitability brings stability and predictability in the firm. This in turn makes the company attractive to potential shareholders who consider it worth to do business with that firm.
Retained benefits (that is, those profits not circulated to shareholders) are the most significant source of internal money for organizations needing to continue with real capital financing tasks. This is considered as cheap capital because it does not attract any interest. Retained earnings do not involve costs that are borne while applying for loans. Firms with high amounts of retained earnings find it easy to compete in the free market. This is because when it comes to making capital investments, those firms will always find it easy to raise funds. A firm that uses retained earnings does not encounter risks such as, bankruptcy and default on loans. This means that profits help to mitigate
business risks. They also make it possible for the firms to obtain cheap finance, which can be used to make capital investments.
Rising profits additionally send significant indicators within a business or industry. The point when the existing firms in a business sector are acquiring supernormal benefits sends a sign to different firms that profitable entrance may be conceivable. This is a very important concept because when firms are making super profits, it means that there the market has been flooded with demand for goods and services. This makes additional firms to enter the market, especially if there are no barriers to entry, in the market.
The biggest question is whether the existing firms will continue enjoying abnormal profits. The answer depends on two circumstances. First, if there are barriers of entry to the market, the firms will continue making high profits. This happens in case of a monopoly market, where the market is only controlled by a single seller. Second, if the market is highly contested, there will be a very high influx of new suppliers, which leads to increase in market supply. Increased market supply puts pressure on prices to go down. When prices go down, the abnormal profits fade away, and firms start to realize normal profits. From this analysis, it is clear that profits help suppliers to know when to enter into a market, and when to keep off from a certain industry (Chan).
Scarce economic resources have a tendency to stream where the expected rate of return is most elevated. In an industry where the demand is increasing, the rate of return ascents, and land, labor and capital are then dedicated to that area. Similarly, in a depression, yield, vocation, livelihoods and capital investments all fall. This means that scarce economic resources tend to be employed in sectors where expected profits are high. This has serious implications in economic policy. First, when governments are certain that a given sector is going to yield the highest returns, they commit resources to that sector. When a resource is limited, it means that there are only a few numbers of people holding that resource. A rational investor will invest in projects that have high returns. Even if the resources are limited, people end up releasing them with the hope of doubling their returns (Akytiz).
- Akyüz, Yilmaz, and Charles Gore. “The investment-profits nexus in East Asian industrialization.” World Development 24.3 (1996): 461-470.
- Arrow, Kenneth. “Economic welfare and the allocation of resources for invention.” The rate and direction of inventive activity: Economic and social factors. Nber, 1962. 609-626.
- Chan, Yuk?Shee. “On the positive role of financial intermediation in allocation of venture capital in a market with imperfect information.” The Journal of Finance 38.5 (1983): 1543-1568.
- Garcia, Rosanna. “The role of knowledge in resource allocation to exploration versus exploitation in technologically oriented organizations*.” Decision Sciences 34.2 (2003): 323-349.