Role and Functions of Profits

Profits play an important role in a free market economy or in a mixed economic system also. First, profits serve as a single to change the rate of output or for the firms to enter or leave the industry. Second, profits play a critical role in providing incentive to introduce innovations and increase productive efficiency and take risks.
Thus, high economic profits beings being earned in an industry serve as a signal for the consumers who want more of the commodity being produced by that industry. These profits indicate to the firm to expand output of the commodity and for the new firms to enter the industry to gain a share of economic profits that exist in the industry. As a result, more resources will be allocated to the output of that industry. On the other hand, below normal profits in an industry serve as a signal that either less output of the industry is demanded by the consumers or inefficient production methods are being used by the firms. In response to the lower demand for the product the firms will reduce their output and also some firms will leave the industry. As a result, some productive resources will be released from that industry and made available for the production of other goods. If the lower profits are due to the inefficient production and organization, this will induce firm to improve efficiency by changing the production methods or make organizational changes to reduce costs.

In a free market economy, in the first standpoint profit motive drives a free-market economy. Although it has been observed that sometimes managers and entrepreneurs in a free market system are influenced by greed and desire for wealth, and break laws to make money or profits by exploiting the consumers or workers, profits, in general, perform useful function of sending signals for changing levels of output of various products and for reallocation of resources among them.

Secondly, above normal rate of profits in a free enterprise system is an essential reward for introducing innovations and taking risks. No entrepreneur will introduce new products or more efficient production methods or undertake investment in risky projects unless there is chance of making profits. Some firms continue to earn above-normal rate of profit year after year as they continually introducing new products, new production methods and providing good customer services.

And finally, in market economy changes in demand for the product often occur due to cyclical and structural changes. Besides, new strategies of rival firms also affect the demand for the product of a firm. All these uncertain and unanticipated changes involve a good deal of risk. An important function of economic profits is to reward entrepreneurs for taking these risks involved in making investment and organizing factors for the production of products.

However, in some cases firms are also able to make super normal profits by virtue of their having monopoly power may be due to some legal patent and license obtained from the government, the economies of large scale production, exclusive control over essential raw materials which prevent the other firms from producing the same product or service. These enable the
monopoly firms to charges higher prices and thereby make large economic profits. Therefore, even in free market economies steps are taken to prevent the emergence of monopolies through anti-trust laws.

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