Frictional Profit Theory and Innovation Profit Theory - Coursework Example

Managerial Economics Table of Contents Managerial Economics 1 Table of Contents 1 Introduction 2 Theories of Profit 2 Frictional Theory of Profit 3 Innovation Theory of Profit 5 Conclusion 8 References 9 Carbaugh, R. J. (2010) Contemporary Economics: An Application Approach (6th Edition). New York: M. E. Sharpe. 9 Fogiel, M. & Rycroft, R. S. (1992) The Economics problem solver. USA: research and Education Association. 9 Hirschey, M. (2009) Fundamentals of Managerial Economics (9th Edition). New York, USA: Cengage Learning. 9 Nadar, E. N. & Vijayan, S. (2009) Managerial Economics. New Delhi, India: PHI Learning 9 Bibliography 9 Cowan, R., Rizzo, M. J. (1995) Profits and morality. London: University of Chicago Press. 9 Introduction Profit motives might be regarded as one of the most important elements instigating business operations. Better the possibilities of reaping profit in an industry, the more crowded will it be with prospective manufacturers and investors. However, prior to taking the plunge it is important to assess the aspects which lie beneath the published profit statement. There are a few theories of profit, each of which defines the element from a diverse angle. It is necessary to figure them all out before arriving at an investment decision. While some put a greater emphasis on short term gains, there are others which stress upon long run figures. Hence, the significance to be paid on any particular type wholly depends upon the investor and manufacturer’s choice of short term or long term prospects. The present paper deals with two variants of profit theory, viz., frictional profit theory and innovation profit theory. Each of these concepts define or explain economic profit in their own discreet ways and hence, are relevant in deciding various aspects of the underlying business, for the benefit of investors as well as manufacturers to some extent. Furthermore, the economy gains as well if economic units sort out the most efficient avenues of production or investment, since that would mean a speedier progress towards national growth. Theories of Profit Broadly speaking, there are two different explanations to economic profit, namely, disequilibrium theories of profit and compensatory theories of profit. While the previous theory explains the logic behind an industry earning super-normal profits despite the presence of market disequilibria or discrepancies, the latter accomplishes how innovative activities taking place in a firm can assure super-normal profits to the same. Nonetheless, both these theories encompass many others within themselves (Hirschey, 2009, p. 12). Of them, only two belonging to each type, will be discussed underneath, namely, frictional profit theory and innovation profit theory. The discussion will involve comparison between the two concepts inclusive of evidences in support of the logics underlying them. Frictional Theory of Profit Frictional theory of profit, as the name suggests, is the generation of super-normal profits due to frictions present in the economy. These are untimely events, leading to shocks in the market and thus confusing the normal state of the market. An industry is often characterised by a large number of buyers and sellers, so that there is no scope to earn super-normal profit. However, a sudden shock might shift the position of the demand or supply curves or even change their slopes in a manner which is conducive for reaping abnormally high profits. Changes in these conditions do not occur due to any deliberate regulations, but are caused completely due to exogenous factors (Fogiel & Rycroft, 1992, p. 848). The adjoining diagram shows how a negative supply shock, can lead to a hike in equilibrium prices from P1 to P2, while reducing the equilibrium quantity demanded from Q1 to Q2. Given that the margin of difference is higher between per unit prices than that between the quantities demanded, it could readily be said that the profit margin for sellers, has definitely soared up. A similar explanation could be provided to rise in profit margin owing to a positive demand shock, as the diagram depicts. These shocks however, are abnormal conditions which have a temporary existence in an economy. In most of the cases, these shocks recede in magnitude eventually. Market conditions return back to their normal state, with sellers beginning to earn super-normal profits once again. Either increases in the demand or supply conditions are absorbed into the system through the inflow of more sellers in the industry, or they are brought back to their original positions. Usually in cases where both demand and supply conditions are subjected to shocks, the equilibrium quantities and prices traverse back to their old positions, though much of it depends upon the slopes of the demand and supply schedules. In a few cases, any further shift from the new positions might give rise to a perpetual disequilibrium. Frictional profits are generally regarded to be short lived in nature since, in the absence of barriers to entry, scopes of any supernormal profit is welcomed by swarms of prospective sellers. They enter the industry to taste the profit margin, but end up earning normal profit given their behaviour is mirrored by many others belonging to their lot. In fact, it is often found that more number of sellers than the industry can sustain, enter the scenario so that the profit margin being earned becomes negative. In such situations, some sellers leave the market hence adjusting it to normal profit conditions. Such an explanation, of course must be supported by the absence of stringent barriers to entry in the form of artificial regulations (Carbaugh, 2010, p. 192). There is still another point that needs to be covered while assessing that frictional profit is only a short term phenomenon. The market in question must be characterised by the features of monopolistic competition where no two producers produce homogeneous products. This homogeneity however, might not always be in terms of quality; many a times, they also mean to perceived differences amounting even to brand names. In case, the market is governed by a monopolist, the possibilities of frictional profit turning out to be a short term event are lean. Given that they frame market conditions according to their own benefits and there is an absence of any rival firm, consumer surplus in a monopoly market is barely found, implying an indefinite period of earning supernormal profit (Fogiel & Rycroft, 1992, p. 848). A suitable instance could be sought from the financial market of USA. The nation had been rather proud of its robustness prior to the global meltdown following the subprime financial crisis. The financial market had been one of the largest channels generating revenue for the economy. However, a negative demand shock arising in the housing sector owing to rise in the market rates of interest, led to a fall in the demand for home loans as well. Investment banks which had invested in mortgage backed securities with high face-values tumbled down due to a sharp fall in these prices. Profits turned negative and many firms were compelled to walk out of the market. Eventually, the market for investment banks when left out with a few number of players succeeded in standing up once again. Hence, frictional theory of profit could be applied here where the profit conditions in the market have been retained to its normal state in the long run, though at the cost of a few influential sellers. Innovation Theory of Profit Innovation theory of profit, as the name implies, is profit arising due to the application of innovative technologies to the production process. Such a step, if successfully implemented, helps to reduce the cost per unit of production through a hike in the marginal productivity of the factors of production. The firms which indulge in innovative practices are generally concerned about consumer needs and thus, those which emerge with cost efficient techniques of production are the ones which can actually meet their requirements (Hirschey, 2009, p. 13). Innovative profits however, are both the reasons and consequences of profit generation. A firm that is able to earn innovative profit retains a part of it to indulge in future innovative practices (Nadar & Vijayan, 2009, p. 192). From such a perspective thus, innovative profit could be regarded as a continuous process, though its success depends upon the extent to which any firm can retain its innovative efficiencies. If the effort put by the researchers hired by a company dilutes with time, its chances of earning innovative profits get slimmer. Hence, it might also be considered as a subjective phenomenon, though it cannot be classified under short-term profits. Firms which involve themselves in innovative activities might not be a part of an industry featured by barriers to entry, but their invented technologies could serve a similar purpose. In most of the cases, any modern technology being invented is patented by the founding firm so as to avoid chances of duplication by their rivals. Any attempt of replication by a rival firm is considered to be a crime once a patent is granted to a firm. Causes for the application for patents might range from introducing goods featured with better parts, the discovery of new sources for factors of production or that of a market, efficient ways to advertise, etc. (Nadar & Vijayan, 2009, p. 192). Unless the rivals discover alternatives to the former avenues, possibilities of the firm of earning a normal profit are low; in some cases, such a firm is found to be earning supernormal profit perpetually. Nature of innovative profit, thus, might not be a short term phenomenon like frictional profit. Even though the firms operate in a monopolistically competitive framework, chances are that their profits are retained in the long run, so that they actually turn out to be monopolists in their own small ways. Moreover, it had been found in the case of frictional profit that consumers stand a chance of facing a loss, in situations when they are subjected to a positive demand shock or negative supply shock. In such instances, they have to pay a higher price per unit of good demanded, even though the quality of the latter remains unchanged. However, if the added benefits to the consumer due to a product’s ability to attend to their needs are quantified, possibilities of an innovative profit raise the chances of a hike in consumer surplus as well. The demand schedule for a product improvised due to the inclusion of salient features in it, apparently seem to have shifted above. Such a shift symbolises the fact that the consumers are now prepared to pay a greater price for former quantities of goods demanded, due to the added facilities. Innovation theory of profit is a type of compensatory profit which realises profits arising out of innovative or extraordinary activities. Such activities might not only arise from the application of modern technologies to the production process, but also due to entrepreneurial skills which help reduce marginal cost of production, in contrast to a hike in marginal productivity (Fogiel & Rycroft, 1992, p. 848). Generally firms earning innovative profits are regarded as efficient ones than those who do not earn the same. A suitable example of innovative profit being earned by a firm is that of Microsoft Inc. which pioneered the invention of user-friendly software. Microsoft was the first firm in the industry of software manufacturers who paid attention to the innovation of graphical user interfaces for the benefit of common people. The company has maintained its position at the peak despite the entry of many new players in the market. The only reason behind its success is not only that the company maintains an efficient line of researchers, but also because it had been successful in realising customer needs. Conclusion The purpose of the paper had been to distinguish between two theories of profit viz., frictional and innovative profits. While the former forms part of profits arising out of market disequilibrium, the latter occurs due to a firm’s capabilities of making successful innovations. Though disequilibrium conditions are corrected with time, restriction of innovative activities solely depend upon the efficiency of the researchers employed by a firm. This is the reason why the former could be earned only in the short run as chances of profit get reduced with the inflow of new entrants, in the absence of barriers to entry. On the other hand, innovative profit might not be a short term phenomenon given that the firms which indulge in making innovations, usually patent their products before rivals can duplicate them. Given that the former does not retain producer surplus throughout, earning innovative profits are usually preferred by able managers, than earning the uncertain frictional ones. References Carbaugh, R. J. (2010) Contemporary Economics: An Application Approach (6th Edition). New York: M. E. Sharpe. Fogiel, M. & Rycroft, R. S. (1992) The Economics problem solver. USA: research and Education Association. Hirschey, M. (2009) Fundamentals of Managerial Economics (9th Edition). New York, USA: Cengage Learning. Nadar, E. N. & Vijayan, S. (2009) Managerial Economics. New Delhi, India: PHI Learning Bibliography Cowan, R., Rizzo, M. J. (1995) Profits and morality. London: University of Chicago Press. Read More