Compensatory Theory of Economic Profits - Managerial Economics

Describes above-normal rates of return that reward firms for extraordinary success in meeting customer needs, maintaining efficient operations, and so forth. If firms that operate at the industry’s average level of efficiency receive normal rates of return, it is reasonable to expect firms operating at above-average levels of efficiency to earn above-normal rates of return. Inefficient firms can be expected to earn unsatisfactory, below normal rates of return.

Compensatory Profit Theory

Compensatory profit theory also recognizes economic profit as an important reward to the entrepreneurial function of owners and managers. Every firm and product starts as an idea for better serving some established or perceived need of existing or potential customers.

This need remains unmet until an individual takes the initiative to design, plan, and implement a solution. The opportunity for economic profits is an important motivation for such entrepreneurial activity.

Role of Profits in the Economy

Each of the preceding theories describes economic profits obtained for different reasons. In some cases, several reasons might apply. For example, an efficient manufacturer may earn an above normal rate of return in accordance with compensatory theory, but, during a strike by a competitor’s employees, these above-average profits may be augmented by frictional profits.

Similarly, Microsoft’s profit position might be partly explained by all four theories: The company has earned high frictional profits while Adobe Systems, Computer Associates, Oracle, Veritas, and a host of other software companies tool up in response to the rapid growth in demand for user-friendly software; it has earned monopoly profits because it has some patent protection; it has certainly benefited from successful innovation; and it is well managed and thus has earned compensatory profits.

Economic profits play an important role in a market-based economy. Above-normal profits serve as a valuable signal that firm or industry output should be increased. Expansion by established firms or entry by new competitors often occurs quickly during high profit periods. Just as above-normal profits provide a signal for expansion and entry, below-normal profits provide a signal for contraction and exit. Economic profits are one of the most important factors affecting the allocation of scarce economic resources. Above-normal profits can also constitute an important reward for innovation and efficiency, just as below-normal profits can serve as a penalty for stagnation and inefficiency. Profits play a vital role in providing incentives for innovation and productive efficiency and in allocating scarce resources.

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