Profits and Resource Allocation
If all firms in some industry are earning economic profits, the owners of
factors of production will want to move resources into that industry
because the earnings available to them are greater there than in
alternative uses. If, in some other industry, firms are incurring economic
losses, some or all of this industry’s resources are more highly valued in
other uses, and owners of the resources will want to move them to those
other uses.
Economic profits and losses play a crucial signalling role in the workings of a free-market
system.Economic profits in an industry are the signal that resources moved into
that industry will earn more than if they remain in their current use.
Losses are the signal that resources will earn more if they are moved
elsewhere. Only if there are zero economic profits (which means that
revenues exactly cover opportunity costs) is there no incentive for
resources to move into or out of an industry. We will examine the role of
profits and losses in determining industry entry and exit in Chapters
and 10.
2 Depreciation is also among the firm’s explicit costs, even though it does not involve a market
transaction. Depreciation is a cost to the firm that arises because of the wearing out of its physical
capital.
3 For larger firms, this element of implicit costs is not relevant because the owners usually do not
work at the firm. In these cases, the salaries to the firm’s managers appear in the firm’s accounts as
explicit costs.