Profits and Economic Efficiency Explained

In this revision video we explore the extent to which business profits and different types of economic efficiency are linked.

Analysing possible links between economic efficiency and the level of business profits is often the focus of an exam question. Strong evaluation considers the extent to which other(internal and external) factors also impact on business profits.

What external factors not linked to economic efficiency can affect the level of business profits?

1. Unexpected events can affect profitability (including pandemics / lockdowns, environmental events, terrorism) which affect profits beyond the control of the firm’s management
2. Impact of government intervention such as changes to taxation (direct and indirect) and alsogovernment spending (such as the furlough)
3. Changing consumer tastes and preferences
4. Impact of regulatory intervention such as price caps and possible liberalisation of the market which encourages new entrants

In theory, profits and efficiency can be positively linked when profits are the reward to achieving internal economies of scale which lowers long run unit costs and allows firms to lower prices whilst making higher profits at the same time.

But profits are also linked to the market power enjoyed by a business. When market concentration is high and PED is low, then a firm can raise and keep prices well above marginal and average cost. Profits increase but there is a loss of allocative efficiency and a loss of consumer welfare.

The profits made by a business also depend on their objectives (consider the difference between profit maximising and satisficing aims as an example). And many external factors – independent of efficiency – impact on the level of profitability.