ECO 6010B

Assignment 1.
John Waweru
ID 629166

Question 1.
Define and differentiate normal profit and Economic profit.

Answer:
Normal profit = TR TC
It is total revenue less total costs. It is the excess of sales receipts over operational costs over a
given year.
TR = Total revenue
TC = total cost ( includes wages and salaries, rent, interest, cost of materials).

Economic profit is the difference between a firm's total revenue and total economic cost( all costs,
including normal profit)
Economic Profit = Total Revenue Total economic cost.
Total economic cost is all the costs in production process including normal profit as a return to
financial resources. So it includes both explicit and implicit costs.

Unlike normal profit, economic profit takes into account both the explicit costs and
Implicit or imputed costs. The implicit or opportunity cost can be defined as the payment

that would be necessary to draw forth the factors of production from their most
remunerative alternative use or employment. Opportunity cost is the
income foregone which the business could expect from the second best alternative use of
resources. The foregone incomes referred to here include interest, salary, and rent, often
called transfer costs.
Economic profit also makes provision for (a) insurable risks, (b) depreciation, (c)
necessary minimum payment to shareholders to prevent them from withdrawing their
capital investments. Economic profit may therefore be defined as residual left after all
contractual costs, including the transfer costs of management, insurable risks, depreciation, and
payments to shareholders
have been met. Thus,
Economic or Pure Profit = e = TR EC IC
where EC = Explicit Costs; and, IC = Implicit Costs.
Note that economic profit as defined by the above equation may necessarily not be Positive. It may
be negative since it may be difficult to decide beforehand the best way
of using the business resources. Pure profit is a short-term phenomenon. It does not exist
in the long-run under perfectly competitive conditions.

Q2. Give a short brief and classification of theories of profit.

Theories of Profit
There are various theories of profit in economics. The following discussions summarise the main
theories.

1. Dynamic equilibrium (Friction) Theory of profit

According to this theory of profit, there exists long run equilibrium normal rate of profit (adjusted
for risk) that all firms should tend to earn. However at any point in time individual firms in specific
industries may earn a rate of return above or below this normal rate of return. This can occur
because of temporary dislocations or shocks in various sectors of the economy. This dynamism of
the market provides opportunities for firms to make profits.
This theory is of the opinion that profits arise in a dynamic economy, not in a
static economy. A static economy is defined as the one in which there is absolute
freedom of competition; population and capital are stationary; production process
remains unchanged over time; goods continue to remain homogeneous; there is freedom
of factor mobility; there is no uncertainty and no risk; and if risk exists, it is insurable. In
a static economy therefore, firms make only the normal profit or the wages of
management.
A dynamic economy on the other hand, is characterized by the following generic
changes:
(i) population increases;
(ii) increase in capital;
(iii) improvement in production technique;
(iv) changes in the forms of business organizations; and,
(v) multiplication of consumer wants.
The major functions of entrepreneurs or managers in a dynamic environment are in
taking advantage of the generic changes and promoting their businesses, expanding sales,
and reducing costs. The entrepreneurs who successfully take advantage of changing

conditions in a dynamic economy make pure profit.

From this theorys point of view, pure profit exist only in the short-run. In the long-run,
competition forces other firms to imitate changes made by the leading firms, leading to a
rise in demand for factors of production. Consequently, production costs rise, thus
reducing profits, especially when revenue remains unchanged.
2 Risk bearing Theory of Profit
This theory holds that economic profits above normal rate of return are necessary to compensate the
owners of the firm for the risk they assume when making their investments. Since they are not
guaranteed of a fixed rate of return, they take a risk and they need to be compensated for this risk in
the form of a higher rate of return.
Risk in business may arise due to such reasons as obsolescence of a product, sudden fall in the
market prices, non-availability of crucial raw materials, introduction of better
substitutes by competitors, risk due to fire, war and the like. Risk taking is regarded as an
inevitable accompaniment of dynamic production, and those who take risk have a sound
claim of a separate reward, referred to as profit.
3. Innovation Theory of Profit
The innovation theory of profit suggests that above normal profits are the rewards for successful
innovations.
The innovation theory of profit was developed by Joseph A. Schumpeter. According to the
Schumpeters theory, profit can be made only by introducing innovations in manufacturing
technique, as well as in the methods of supplying the goods. Sources of innovation include:
1. Introduction of new commodity or a better quality good;
2. Introduction of new method of production;
3. Opening of a new market;
4. Discovery of new sources of raw material; and,

5. Organising the industry in an innovative manner with the new techniques.

4. Monopoly Theory of Profit
In some industries one firm is effectively able to dominate the market and potentially above normal
rates of return for a long period of time.
Monopoly arises due to such factors as:
(i) economies of scale;
(ii) sole ownership;
(iii) legal sanction and protection; and,
(iv) mergers and acquisition.
A monopolist can earn above normal rates of return and maintain it in the long run by using its
monopoly powers, including:
(i) powers to control price and supply;
(ii) powers to prevent entry of competitors by price cutting
5. Managerial Efficiency Theory of Profit
This theory is closely related to the innovation theory. It holds that above normal profits can be
realized because of exceptional managerial skills of well managed firms.

Q3. With help of a demand curve define a shift in demand and discuss the reasons behind d1
and d2.

If changes occur in of the independent variables in the demand function there may be a shift in the
demand curve to the right or to the left as the quantity demanded increases or decreases at a given
price.
In the graph above d1 indicates the demand curve when a oarticular factor like consumer disposable
income is at a particular level. If consumer disposable income increases then the demand curve
would shift to the right to d2 as the demand for the product at each price increases.

Q4.
With the help of the data given
i)

Draw the demand curve

ii)

Give the demand function

Price
20
40
60
80

Quantity Demand
110
90
78
68

100
120

63
60

Answer:
Demand curve

Demand function:
Quantity Demanded, QD = f( P, Ps, Pc, Y, A, Ac, N, Cp,PE TA T/S)

Where QD

Quantity demanded of the good or service

P = Price of the good or service

Ps = Price of substitute goods or services
Pc = Price of complimentary goods or services
Y = Income of consumers

A = Advertising and other marketing expenditures

, Ac

Competitors advertising expenditures on the good or service

N= Population and other demographic factors

Cp =

Consumers preferences and tastes for the good or service

PE = Expected future changes in price

TA = Adjustment time period
T/S = taxes or subsidies