What is Normal Profit?
Normal Profit is an economic term that when the profit is zero after taking into consideration both the implicit cost and the explicit cost as well as the overall opportunity costs. It occurs when all the resources are efficiently utilized and could not be used for a better purpose. If the residual gain is non-zero then it is called supernormal profit.
Normal vs Economic Profit
It is said to have occurred when the firm earns from the revenue after accounting for explicit costExplicit CostExplicit cost refers to the business expenses that impact the organization's profitability and are recorded in the general ledger. Such costs are the expenses that appear in the income statement. and implicit costsImplicit CostsImplicit cost is the opportunity cost of the organization's resources where the organization calculates what the business would have earned if the resource had been employed for some other purpose instead of the business activity..
However, it is said to have occurred when economic profitEconomic ProfitEconomic profit refers to the income acquired after deducting the opportunity and explicit costs from the business revenue (i.e., total income minus overall expenses). It is an internal analysis metric used by the organizations along with the accounting profits. is zero or in other words, the revenue is equal to implicit cost and explicit costs.
Total Revenue – (Implicit Costs + Explicit Costs) = 0
Or Total Revenue = Implicit Costs + Explicit Costs
- Implicit cost is also called as the opportunity cost of a particular enterprise. It is not easily quantifiable.
- Explicit costs are easily quantifiable as it denotes the actual expenses made by the firm towards raw material, labor wages, rent, owner remuneration, and other expenses for running the business.
Example of Normal Profit
Consider Elvis running a corporation with a revenue of $100,000. He has to pay rent for the office at $25,000 and the wages of the staff and other office expenses equal to $ 40,000. He met with an expert who assumes that the time and capital spent by Elvis should be equal to $ 35,000 annually.
Calculation of Total Cost
Here, the total costs (including the opportunity costsOpportunity CostsThe difference between the chosen plan of action and the next best plan is known as the opportunity cost. It's essentially the cost of the next best alternative that has been forgiven.) = 25000 + 40000 + 35000 = 100,000
Thus, total costs = total revenue
Hence, the firm can be said to working at a normal profit.
Normal Profit in Macro Economics
When an industry is said to be earning normal profit it is considered that the industry is in a state of perfect competition and all the resources are utilized efficiently further there is no economic profit in the industry.
This can be considered as an ideal situation for both the producers and the consumers as the consumers receive goods at competitive prices and all the goods produced by the producers are consumed.
However, whenever an industry has an economic profit, more entrepreneurs and firms will try to enter the industry thus raising competition and putting price pressures. This makes the industry highly competitive and will reach a stage of normal profit.
The above concept can be reversed in case of the industry having economic losses. The companies will tend to close down and leave the industry because there is no profit. The industry will remain with few companies thus reaching a state of normal profit.
- It can be used by firms to compare their business performance and profit with businesses in other sectors and learn about opportunity costs.
- It can be used in macroeconomicsMacroeconomicsMacroeconomics aims at studying aspects and phenomena important to the national economy and world economy at large like GDP, inflation, fiscal policies, monetary policies, unemployment rates. to understand various sectors if they are declining or improving.
- It can be used to determine if an industry is moving towards monopoly or oligopolyOligopolyAn oligopoly in economics refers to a market structure comprising multiple big companies that dominate a particular sector through restrictive trade practices, such as collusion and market sharing. Oligopolists seek to maximize market profits while minimizing market competition through non-price competition and product differentiation. and thus helping in better governance and legislation so to improve competition in the industry.
Disadvantages and Limitations
It includes the opportunity cost of the firm. This opportunity cost is difficult to measure since it is a subjective measure. If the opportunity cost is not measured accurately or by taking appropriate assumptions the calculation of normal profit may lead to different and wrong decisions. Due to this limitation, this is also a disadvantage of using this measure since it may lead to wrong decision making.
It is linked to the economic profit of the company or industry. If it is zero then it is considered as the ideal situation of perfect competition in the industry. However, if this profit changes positive to negative then:
- If it is positive more firms will open up in the same industry to earn money. This will lead to more competition in the industry and thereby decreasing the profit.
- If it is negative, it means that there are too many firms competing in the industry and some of them will close down due to unbearable losses. This will make the profit zero.
Normal profit is said to occur when the company earns revenue equal to the implicit and explicit cost of the company. It includes the opportunity costs of the company. The situation in macroeconomics occurs when the industry experiences perfect competitionPerfect CompetitionPerfect competition is a market in which there are a large number of buyers and sellers, all of whom initiate the buying and selling mechanism. Furthermore, no restrictions apply in such markets, and there is no direct competition. It is assumed that all of the sellers sell identical or homogenous products.. In such a scenario the economic profit of the firm is zero.
This has been a guide to Normal Profit and its definition. Here we discuss the difference between normal profit and economic profit along with examples, advantages, and disadvantages. You can learn more about accounting from following articles –