Firms enter an industry when they can earn an economic profit. Economic profit equals total gains minus total losses. If a firm earns more than it spends, that particular firm earns a economic profit. In contrast, when a firm loses more money than it gains, the business incurs an economic loss. Here’s an example to demonstrate just how industries shrink and stretch depending on profit opportunity.
Application of Economic Profit/Loss Principles
Let’s use the up and coming Blogosphere as our example. As more and more individuals create blogs, the demand for blog hosting, services, and networks increases. To satisfy this stretch in demand, firms enter the industry with their own blogging services. These firms generate an economic profit as long as the market has room to grow as it approaches saturation. Once the demand equals supply, firms no longer earn economic profit and resort to normal profit (when your gains equal your expenses).
If investors understand how supply and demand correlates with economic profit and/or loss, they can sequester fast growing industries from slow growing industries. Blogging, video on demand, and health care are all good examples of rapid growth opportunities.