The Economic Function of Profit and Loss

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Economics examines the ways in which households, firms and societies allocate scarce resources and set priorities to satisfy needs and wants. In capitalist economies based on free enterprise, individuals and businesses are free to invest their money as they wish, without direction from government-planning committees. Under this system, the free market acts as a coordinating mechanism, guiding investment capital toward profitable activities and away from failing enterprises.

Function

Capitalist economies rely on markets rather than government planners or other planning bodies to coordinate economic activities. The market is a mechanism that brings together buyers and sellers of goods. In this market system, profits and losses provide signals of what activities and enterprises yield the greatest prosperity. Investors, seeking maximum return for their money, will invest their resources in profitable industries and withdraw from businesses and activities that show losses. In short, profit and loss guide societies in how to allocate resources.

Identification

In economics, companies earn profits when revenues earned from the sale of products and services exceed costs. Losses occur when the costs of production outweigh revenues. However, economists’ definitions of profit and loss differ from the conventional definitions used by accountants.

Features

The accounting definition of profit and loss considers only explicit costs of production, subtracting them from revenues to determine if a firm earned a profit or a loss. Economists consider implicit costs as well, such as the opportunity cost of allocating resources to one use instead of another. For example, the opportunity cost of using savings to open a small business is the loss of interest income. If the business’ earnings exceed the explicit operating costs and implicit opportunity costs, then the venture is profitable. If not, the business has a negative economic profit or loss.

Considerations

Some societal needs, such as national defense and public safety, will not be provided for on their own in a market economy because these activities can't be conducted profitably while still ensuring the provisions of these services to all citizens. Economists call these services public goods, which the government provides.

References

  • "Principles of Economics" (3rd ed.); N. Gregory Mankiw; 2004

Resources

About the Author

Shane Hall is a writer and research analyst with more than 20 years of experience. His work has appeared in "Brookings Papers on Education Policy," "Population and Development" and various Texas newspapers. Hall has a Doctor of Philosophy in political economy and is a former college instructor of economics and political science.

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