Profits as well as losses are critical in ensuring both the market and economy’s allocative-efficiency. Firms organize productive resources in the hope of meeting the needs of the market, and if those needs are efficiently met, the firms earn profits (O'keeffe & Cohen, 2011). Normal profits, where the total production costs are completely offset by the realized revenues, imply the firm is competitive and is sustainably meeting the needs of the market.
Normal or super profits mean that the firms are organizing productive resources in the best possible way than could be used for other purposes, effectively, the opportunity costs of the employed resources is less than the value attained from the current employment. Losses on the other hand, imply inefficiency i.e. the value attained from the current use of resources is lower that the opportunity costs (Heyne, Boettke & Prychitko, 2002). Naturally, in a free market economy, profitable firms will remain in the market, but if firms’ losses fall below the average variable production costs; then they must shut down. This effectively removes inefficient firms and productive resources are freed up to be used for more efficient purposes.
A further, critical role of profits/losses is to encourage sustainable risk taking, innovation and investment, which boosts economic growth as well as development. Existence of profits will ensure that economic agents efficiently invest their resources, clearly understanding the risks involved, and thus avoiding losses (Lee, Johnson & Joyce, 2008). This has a tremendous positive effect on the macro-economy. In this case, profits/losses are used an instrument of measuring sustainability of firms, which in turn fosters the reorganization of the productive resources to meet the profitability and efficiency needs.
Heyne, P., Boettke, P. & Prychitko, D. N. (2002). The Economic Way of Thinking. Upper Saddle
River, N.J.: Prentice Hall.
Lee, R., Johnson, R. W. & Joyce, P. (2008). Public Budgeting Systems. London: Jones & Bartlett
O'keeffe, K & Cohen, S. (2011). Robust Profits Face Hurdles . Retrieved on 20th Sept, 2011