“I learned in economics that in ‘perfect competition’ profits are zero, so any actual profits come from some kind of monopoly power. So how could profits be good?”

This question was asked of me by a student at a recent economics seminar hosted by the Institute for Humane Studies. Supposing other readers of this blog have the same question, I offer my answer here. The simple explanation is that while the model of perfect competition is helpful for understanding certain economic phenomena, its simplifying assumptions make it useless for understanding profit and loss in a real economy.

My in-depth explanation is below.

The Source of Profit and Loss in the Real World

In its broadest definition, profit (or loss) is the difference between yield and cost, between what one gets out of some project and what one puts into it. We call that profit if it’s positive and loss if it’s negative.

A business’s yield is the total revenue it receives from its customers. The size of that revenue indicates how much the business’s customers value the good or service it produces. (The value to customers is actually almost always greater than the business’s revenue, because some of the customers value the good at more than the price they pay for it.) The business’s cost is the market value of all the inputs it uses to produce that good or service.

Hence profit or loss = total revenue – total cost.

Think what this simple equation means about the nature of profit as such, where it comes from, what it represents: Profit occurs when an enterprise takes inputs worth a certain amount and transforms them into a good or service worth more. That means profit-making in free and voluntary exchange is profoundly creative; it comes from creating new value for other people.

Loss, on the other hand, comes from destroying value, from taking inputs worth more in other possible uses (as indicated by the market prices an entrepreneur must pay to bid them away from other users) and turning them into a good or service worth…less. What a shame. It’s a minor tragedy, really.

It follows that those who make profits in free and voluntary exchange—and that proviso is crucial—are benefactors of their fellows, deserving congratulations and thanks along with their profits.

How can we reconcile this positive view of profit with that of the model of perfect competition, in which profit indicates monopoly power in an imperfectly competitive market?

The key is to recognize that the model of perfect competition is a tool of thought—a very useful one—for understanding one key aspect of competition, namely price competition, in which businesses compete by offering the (identical) product at a lower price than their competitors offer it. In order to highlight the role of price competition, the model ignores another more important aspect of competition, namely innovation.

In the real world, profit is a signal of and reward for innovation. But innovation has no place in the model of perfect competition. Therefore, there is no room for profit in the model.

What the Perfect Competition Model Ignores

Here is a quick review of the perfect competition model: It assumes:

  • In a market for some particular product, there are many buyers and many sellers.
  • It is costless for a seller to get into (or out of) the industry.
  • Each seller has access to the best available technology and thus faces the same costs.

Let’s say a seller in such a market wanted to make a profit by setting the price of its items above the costs of production. Other sellers would have an incentive to undercut that first seller’s price by a little. This would allow them to take the first seller’s customers away and make a bit of profit for themselves. In that way, the competing sellers would bid down the market price to where they all are charging a price that just covers their costs…and thereby eliminates profits.

The insight this gives us is valid and important: profit from any source does tend to get competed away.

But at the same time, new sources of profit tend to get created. Entrepreneurs innovate; they strive to do better than their competitors, not just undersell them. This kind of competition is absent from the model of “perfect competition.”

Consider the model’s assumptions again:

  • The market is for a particular product. That means every seller is selling the identical product. This rules out new features, styles, accessories, and locations, better packaging, longer hours of availability and the like—all the ways in which entrepreneurs improve their products in real competition so as to create more value for their customers and thereby earn profit.
  • Each seller has access to the best available technology and thus faces the same costs. That means that the perfect competition model fails to include all the improvements sellers constantly try to make in their production processes and thereby earn profit. An economic model that excludes things like improving transportation, developing higher-capacity production machinery, streamlining factories, improving worker training, etc. is not true to the real-world.

In the model of “perfect competition,” all the most interesting ways in which entrepreneurs compete with one another—thinking, struggling, striving to do what they do better—are absent.

“Perfect competition,” as my former colleague Jerry Ellig taught me, is therefore way inferior to actual competition, because in “perfect competition” nothing changes. Nothing gets better.

Profit and Loss in the Real World

Economist Joseph Schumpeter addressed the incessant change of free markets in his book Capitalism, Socialism, and Democracy:

Capitalism, then, is by nature a form or method of economic change and not only never is but never can be stationary…The fundamental impulse that sets and keeps the capitalist engine in motion comes from the new consumers, new goods, the new methods of production or transportation, the new markets, the new forms of industrial organization that capitalist enterprise creates. (emphasis added)

Back to profits: Profits are an entrepreneur’s reward for innovating, for making things better, for improving a product or process. Every particular instance of profit is fleeting because competing sellers eventually imitate every profitable innovation and thereby compete away the profit the innovation creates. But as long as human ingenuity lasts, there will always be more innovations and hence new profits which will be competed away in their turn.

We might think of every enterprise currently making profit (in a free market) as a kind of temporary monopolist in that it offers a combination of product features or uses a novel production process others have not yet matched. It’s as if every entrepreneur is vying for a never-ending series of temporary little monopolies, each with its own temporary profits. The company that first put a camera in a cell phone, for example, had a monopoly on that product, but only for as long as it took its competitors to do the same.

The temporary “monopoly profits” people earn by creating new value for others both incentivize innovation and signal what innovations customers value. They are an essential part of the real-world process of competition, in which people use their creativity to find new ways to satisfy the wants and needs of others.