Profits: Understanding the Why and How of Cyclical Variation

As a residual between two moving objects—revenues and costs—profits can be quite volatile in the short run. Yet, corporate profits are one of the clearest examples that we have of the principals of dynamic adjustment and the role of information over the economic cycle.

Output growth and price fluctuations both contribute to the change in revenues. Revenues will rise in response to an increase in economic output driven by a rise in aggregate demand in the economy. However, aggregate demand in the economy fluctuates over the business cycle. In the early phase of the economic recovery, an increase in demand will lead to an increase in output and, thereby, revenues. At the same time, prices are slow to respond to an increase in aggregate demand as prices lag economic growth. These observations reflect the dynamic, partial adjustment process in the economy. While output responds to an increase in demand, prices are slower to respond. As a result, the actual day-to-day operations of output markets are not consistent with a frictionless, perfectly competitive view of output markets—particularly manufacturing. As a result, our modeling of the profits process should reflect that imperfection.

Meanwhile, on the cost side, the short-run supply curve for any product is upward sloping because some factors of production (land and business structures) are fixed in the short run and other factors (labor) are subject to diminishing returns. That is, an increase in the application of the variable factor, labor, applied to the other factors of production (land, business structures and equipment) generates a diminishing return in terms of output per unit of labor.