The earning of profit is a necessary element in the operation of a free enterprise economy. It enhances the efficiency of a free market system in the following ways:
• Normal profit is a cost of production; it is the cost of the entrepreneurship factor of production. It is the minimum amount that the entrepreneur must earn if he/she is to remain in that particular line of business in the long run.
• Supernormal profit is a reward to the entrepreneur for successful innovation, for introducing new commodities for which the public is prepared to pay an economic price.
• Supernormal profit acts as a signalling system from the market to producers indicating those goods the supply of which might profitably be increased.
• The existence of supernormal profits stimulates the desire for entry into an industry.
• Profits provide the funds that enable a firm to expand and increase its level of production.
• Where price competition exists, the actions of competitors constrain the ability of rival firms to increase their selling prices. In these circumstances the firms earning the most profits will be the firms with lowest cost. In this way production is concentrated in the hands of the most efficient firms