What Is Normal Profit?
Let me explain normal profit directly to you: it's a profit metric that accounts for both explicit and implicit costs, often considered alongside economic profit. You see normal profit when a company's total revenue minus its combined explicit and implicit costs equals zero.
Key Takeaways
- 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
I want you to understand that normal profit ties in with economic profit, while accounting profit is what you see on financial statements. When your business faces significant implicit costs, you should look at normal and economic profit metrics. Economic profit is what you get after subtracting both explicit and implicit costs from revenues. Normal profit happens when that economic profit hits zero, or when revenues equal explicit plus implicit costs.
Implicit costs are opportunity costs that affect these calculations. Your business is at normal profit when resources are used efficiently and can't be better allocated elsewhere. This is the minimum earnings to justify staying in business, factoring in those opportunity costs unlike plain accounting profit.
Economic and Normal Profit
When calculating these, remember total costs have two parts: explicit costs, which are straightforward like materials, wages, and rent, and implicit costs, which are trickier as they're opportunity costs from foregone alternatives. You might analyze these when deciding to stay in business or add new costs.
Example of Normal Profit
Take Suzie's Bagels as an example: she pulls in $150,000 revenue yearly. Her explicit costs total $130,000 including salaries, rent, and supplies, giving her $20,000 accounting profit. But her implicit cost is $20,000 from opportunity costs, so total costs hit $150,000, matching revenue—that's normal profit.
Normal Profit in Macroeconomics
On a broader scale, normal profit applies to industries in perfect competition, where it signals equilibrium and zero economic profit. Competition drives this by encouraging new entrants when profits are high, lowering prices until normal profit is reached. If losses occur, firms exit until equilibrium returns. Monopolies, however, can sustain economic profits due to barriers, which governments may counter with antitrust laws.
Applications of Normal Profit
You can use normal profit to compare your business against other ventures. For instance, if Suzie considers adding sandwiches, she'd assess changes in revenues, costs, and opportunities to decide. In macroeconomics, it helps gauge if industries are improving or declining, or if monopolies need intervention for fair competition.
Special Considerations
Remember, normal profit doesn't mean no money is made; a business can have substantial accounting profit but still be at normal profit due to opportunity costs. Implicit costs are estimates, so they're not always precise, which can affect reliability when planning expansions or new risks.
Other articles for you
A trademark legally protects a company's brand by identifying its products or services and preventing unauthorized use by others.
A trading house acts as an intermediary facilitating international trade by buying and selling goods, providing expertise, and managing risks for businesses.
Tax-exempt interest is income from sources like municipal bonds that isn't taxed at federal, state, or local levels, with variations depending on the investment and location.
Overextension in finance means having more debt than one can afford to repay, often leading to risks for borrowers and lenders alike.
A tax treaty is a bilateral agreement between countries to prevent double taxation on income.
Life-cycle funds automatically adjust asset allocations to reduce risk as retirement approaches, offering a passive investment option with benefits and criticisms.
A financial index tracks the performance of a group of assets like stocks and bonds to benchmark specific market sectors or the broader market.
The operating cash flow ratio measures a company's ability to cover short-term liabilities using cash generated from its operations.
Workers' compensation is a state-mandated insurance program that provides financial support for employees injured or ill due to work-related activities.
Backtesting evaluates trading strategies using historical data to assess risks and profitability without real capital risk.