What is 'Normal Profit'
Normal profit is an economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero. Simply put, normal profit is the minimum level of profit needed for a company to remain competitive in the market.
BREAKING DOWN 'Normal Profit'
A business will be in a state of normal profit when its economic profit is equal to zero, which is why normal profit is also often called “zero economic profit.” When total revenues are equal to total costs, “normal profit” and “economic profit” are the same. Unlike accounting profit, economic profit (and thus normal profit as well) takes into account the opportunity cost of a particular enterprise. As such, normal profit calculations divide “total cost” into two categories, explicit costs and implicit costs.
The method of determining whether a firm is in a state of normal profit can be represented in the following way:
Total Revenue - (Explicit Expense + Implicit Expenses) = 0
If the difference between total revenue and total expenses is not equal to zero, the business in question is not in a state of normal profit. If total revenue exceeds total expenses, it is called economic profit or, alternatively, “super-normal profit” or “abnormal profit.” If total expenses exceed revenue, it is called economic loss.
The term normal profit may also be used in macroeconomics to refer to broader economic areas than a single business.
Normal profit occurs at the point at which the resources available to the firm are being efficiently used and could not be put to better use elsewhere. It is often considered the minimum amount of earnings needed in order to justify an enterprise. It is important to note that zero economic profit does not mean that the company is not earning any money (accounting profit). It is simply a measure of how well resources are being used relative to all possible options.
When attempting to determine whether or not a business is in a state of normal profit, it is important to understand the components of total cost. Total cost is divided into explicit costs and implicit costs. Explicit costs are easily quantifiable and generally involve a transaction that is tied to an exchange of cost. Examples of explicit costs include raw materials, labor and wages, rent and owner compensation. Implicit costs, on the other hand, are costs associated with not taking an action, called the opportunity cost, and are therefore much more difficult to quantify. Usually, analysts or economists calculate implicit costs. Examples of implicit costs include entrepreneurship or cost of capital.
To better understand normal profit, suppose that Suzie owns a bagel shop called Suzie’s Bagels that generates an average of $150,000 each year. Also suppose that Suzie has two employees, each of whom she pays $20,000 per year, and that Suzie takes an annual salary of $40,000. Suzie also pays $20,000 annually in rent and $30,000 annually for ingredients and other supplies. After meeting with her financial advisor, Suzie learns that, based on her skills, the estimated opportunity cost of operating Suzie’s Bagels full-time is $20,000 each year. Based on this information, Suzie calculates that her average annual explicit costs are $130,000 ($20,000 + $20,000 + $40,000 + $20,000 + $30,000) and that her average annual implicit costs are $20,000, making her average annual total costs $150,000. She observes that her total costs are equal to her total revenues and determines that her bagel shop is in a state of normal profit.
Yet, while traveling in Europe Suzie has an idea to start selling sandwiches. She realizes that she can sell sandwiches at a higher price point than the one at which she has been selling bagels, and also that she can make a higher profit margin while doing so. Suzie meets with her financial advisor and unveils her idea, and her financial advisor informs Suzie that her normal profit calculations have changed. With the advent of Suzie’s new idea and the accompanying potential for increased earnings, Suzie’s financial advisor determines that Suzie’s opportunity cost of running Suzie’s Bagels has risen to $50,000 per year and that Suzie’s Bagels is no longer in a state of normal profit but is rather in a state of economic loss. Seeking greater earnings, Suzie decides to close down Suzie’s Bagels and reopen as Suzie’s Sandwiches.
In addition to a single business, as in the example, normal profit may also be used in more macroeconomic terms to refer to an entire industry or market. In macroeconomic theory, normal profit may occur only in conditions of perfect competition and economic equilibrium.
On the other hand, economic profit only occurs when these conditions are not met. When economic profit does occur, it encourages other firms to enter the market because of their potential to gain a share of the profit. The new company will then be contributing more of the product to the market, which has the effect of lowering the market price of the good to account for increased supply. Eventually, the industry will reach a state of normal profit as prices stabilize and profits decline. In the mean time, firms may achieve short-term economic profit through reaching a prominent market position, as well as by improving performance, cutting costs and through other means allowing goods to be sold for less than market price.
A similar yet inverse case can be said to apply in cases of economic loss. In theory, conditions of economic loss within an industry or sector will drive companies to begin leaving that industry or sector. Eventually, competition will be sufficiently reduced so as to allow remaining companies to achieve normal profit or short-term economic profit.
Economic profit is more likely to occur in the case of a monopoly, as the company in question has the power to determine the pricing and quantity of goods sold. Such a state of affairs is largely dependent on the presence of significant barriers to entry, which prevent other firms from easily entering the market and driving costs down, thereby disrupting the prominent company’s monopoly. In this case, however, governments will often attempt to intervene in order to increase market competition, often through antitrust laws or similar regulations. Such laws are meant to prevent large and well-established companies from using their foothold on the market to reduce prices and drive out new competition. Some high-profile cases wherein such laws were used against companies occurred in the late 19th and early 20th century involving Standard Oil, U.S. Steel (X), and more recently Microsoft (MSFT).
Uses of 'Normal Profit'
Normal profit allows business owners to compare the profitability of their work with that of other possible business ventures, as in the Suzie’s Bagels example. Because normal profit, economic profit and economic loss assign a business with a neutral, positive or negative value, respectively, they can be used to compare a variety of business opportunities with one another.
Normal profit and related terms can also be used in macroeconomics to help determine whether an industry or sector is improving or declining. It may also be used to determine whether or not there is room within an industry for new companies, or if an industry is in a state of monopoly or oligopoly.
Things to Consider
As demonstrated in the Suzie’s Bagels example, normal profit does not indicate that a business is not earning money. Because normal profit accounts for opportunity cost, it is theoretically possible for a business to be operating at normal profit, develop a new idea that will improve earnings but was not accounted for in previous opportunity cost calculations, implement the idea and subsequently exist in a state of improved earnings while maintaining its normal profit status.
It is also important to consider that “implicit cost” is an important element of normal profit calculations, but is also one that is estimated and difficult to determine with accuracy. As such, it has the potential to be unreliable, which affects the reliability of the entire calculation. Because of this, it is crucial to take the utmost care when determining implicit cost.
One should also note that the cost of normal profit can vary between companies and industries in accordance with the risk of the investment in question.
For more on profit and cash flows, check out What is the difference between revenue and profit? and Understanding The Income Statement.