What is Normal Profit?

Normal Profit is an economic term that when the profit is zero after considering both the implicit cost and the direct cost and the overall opportunity costs. It occurs when all the resources are efficiently utilized and cannot be used for a better purpose. If the residual gain is non-zero, then it is called supernormal profit.

Normal vs Economic Profit

Economic Profit

It is said to occur when the firm earns from the revenue after accounting for explicit costExplicit CostExplicit costs are the culmination of all direct and indirect expenses recorded in a company’s ledger. read more 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.read more.

Normal Profit

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.read more is zero or in other words, the revenue is equal to implicit cost and 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.

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Total Revenue – (Implicit Costs + Explicit Costs) = 0

Or Total Revenue = Implicit Costs + Explicit Costs

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 staff’s wages and other office expenses equal $ 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.read more) = 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 a normal profit, it is considered that the industry is in a state of perfect competition. All the resources are utilized efficiently. Further, there is no economic profit in the industry.

It can be considered an ideal situation for both the producers and the consumers. 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 enter the industry, thus raising competition and putting price pressures. It makes the industry highly competitive and will reach a stage of normal profit.

The above concept can be reversed in case the industry has 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.

Advantages 

  • Firms can use it 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.read more 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.
  • read more thus helping in better governance and legislation 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. This limitation is also a disadvantage of using this measure since it may lead to bad decision-making.

Important Points

It is linked to the economic profit of the company or industry. If it is zero, then it is considered the ideal situation of perfect competition in the industry. However, if this profit changes positive to negative, then:

  • More firms will open up in the same industry if it is positive to earn money. It will lead to more competition in the industry and decrease profit.If it is negative, too many firms are competing in the industry, and some will close down due to unbearable losses. It will make the profit zero.

Conclusion

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.read more. 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 and economic profit along with examples, advantages, and disadvantages. You can learn more about accounting from the following articles –

  • Accounting ProfitFormula of Marginal RevenueExamples of Opportunity CostSunk Cost