What Is Normal Profit?
Normal profit is a profit metric that takes into consideration both explicit and implicit costs. It may be viewed in conjunction with economic profit. Normal profit occurs when the difference between a company’s total revenue and combined explicit and implicit costs are equal to zero.
- Normal profit is often viewed in conjunction with economic profit.
- Normal profit is a condition that exists when a company or industry's economic profit is equal to zero.
- Normal and economic profits differ from accounting profit, which does not take into consideration implicit costs.
- A company may report high accounting profit but still be in a state of normal profit if the opportunity costs of maintaining business operations are high.
- In macroeconomics, an industry is expected to experience normal profit during times of perfect competition.
Understanding Normal Profit
Normal profit is often viewed in conjunction with economic profit. Normal profit and economic profit are economic considerations while accounting profit refers to the profit a company reports on its financial statements each period. Normal profit and economic profit can be metrics an entity may choose to consider when it faces substantial implicit costs.
Economic and Normal Profit
Economic profit is the profit an entity achieves after accounting for both explicit and implicit costs.
Economic Profit = Revenues - Explicit costs – Implicit costs
Normal profit occurs when economic profit is zero or alternatively when revenues equal explicit and implicit costs.
Total Revenue - Explicit Cost - Implicit Cost = 0
Total Revenue = Explicit + Implicit Costs
Implicit costs, also known as opportunity costs, are costs that will influence economic and 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 called “zero economic profit.” Normal profit occurs at the point where all resources are being efficiently used and could not be put to better use elsewhere. When substantial implicit costs are involved, normal profit can be considered the minimum amount of earnings needed to justify an enterprise. Unlike accounting profit, normal profit and economic profit take into consideration implicit or opportunity costs of a particular enterprise.
When attempting to calculate economic and normal profit, it is important to understand the two components of total cost. Explicit costs are easily quantifiable and generally involve a transaction that is tied to an expense. 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. Implicit costs come into consideration when an entity is foregoing other types of income and choosing to take a different path. Some examples of implicit costs may include rental income foregone for the sake of business property utilization, base salary income foregone by an entrepreneur choosing to run a business rather than work in another job, or the difference in projected gain from investing at one rate of return level vs. another. Businesses may analyze economic and normal profit metrics when determining whether to remain in business or when considering new types of costs.
Example of Normal Profit
To better understand normal profit, suppose that Suzie owns a bagel shop called Suzie’s Bagels, which generates an average of $150,000 revenue each year. Also suppose that Suzie has two employees, each of whom she pays $20,000 per year, and 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 business and her individual 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 $20,000 + $20,000 + $40,000 + $20,000 + $30,000 = $130,000. This results in an accounting profit before taxes of $20,000. Because her average annual implicit costs are $20,000, her average annual total costs will be $130,000 + $20,000 = $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.
Normal Profit in Macroeconomics
The term normal profit may also be used in macroeconomics to refer to economic areas broader than a single business. In addition to a single business, as in the example above, normal profit may refer to an entire industry or market. In macroeconomic theory, normal profit should occur in conditions of perfect competition and economic equilibrium. Conceptually this is because competition eliminates economic profit. Moreover, economic profit can serve as a key metric for understanding the state of profits comprehensively within an industry. When a company or companies are achieving economic profit, it may encourage other firms to enter the market because there is profit potential. New entrants contribute more of the product to the market, which lowers the market price of goods and has an equalizing effect on profits. Eventually, the industry reaches a state of normal profit as prices stabilize and profits decline. In the meantime, firms managing for economic profit may take action to obtain a more prominent market position, improve operational performance to lower direct costs, or cut costs to decrease indirect costs.
Collectively actions from all industry participants can contribute to the level of revenue and total costs required for the normal profit level.
A similar yet inverse case can be said to apply in cases of economic loss. In theory, conditions of economic loss within an industry will drive companies to begin leaving that industry. Eventually, competition will be sufficiently reduced so as to allow the remaining companies within the industry to move toward and potentially achieve a normal 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. Generally, governments will often attempt to intervene in order to increase market competition in industries where monopolies occur, often through antitrust laws or similar regulations. Such laws are meant to prevent large and well established companies from using their foothold in the market to reduce prices and drive out new competition.
Applications of Normal Profit
Normal profit allows business owners to compare the profitability of their work with that of other possible business ventures. For example if Suzie from Suzie’s Bagels would like to expand her business to include sandwiches she could return to her financial advisor to obtain estimates on how her revenue and cost structure would change including any changes to her opportunity costs. After assessing her projected accounting, normal, and economic profits she can make a more informed decision on whether to expand her business.
Normal profit can be used in macroeconomics to help determine whether an industry or sector is improving or declining. As discussed, economists may choose to follow economic and normal profit projection balances of an industry when exploring macroeconomic metrics and antitrust issues. Normal profit metrics may also be used to determine whether a state of monopoly or oligopoly is occurring and appropriate steps for legislative actions in developing an industry toward more equalized competition.
Examples of implicit costs used in normal profit calculations may include foregone rental income, foregone salary income, or foregone investment gains from investing at one projected rate of return vs. another.
As demonstrated with Suzie’s Bagels, normal profit does not indicate that a business is not earning money. Because normal profit includes opportunity costs, it is theoretically possible for a business to be operating at zero economic profit and a normal profit with a substantial accounting profit.
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, when looking at business expansion prospects, new opportunity costs have the potential to be unreliable or involve new risks previously unaccounted for, which affects the reliability of a normal profit calculation comprehensively.