Above normal profits refer to the level of profit earned by a firm that exceeds the minimum return necessary to keep its resources employed in their current use. This concept is central to microeconomics and industrial organization, distinguishing between accounting profitability and true economic performance. When a company achieves above normal profits, it means its total revenue surpasses all costs, including both explicit costs (such as wages, rent, and raw materials) and implicit costs (the opportunity cost of the capital and entrepreneurship employed).
History and Origin
The concept of economic profit, which underpins the notion of above normal profits, evolved significantly with the development of modern economic thought. Early economists debated the nature of profit, often conflating it with interest, rent, or even wages for entrepreneurial effort. A pivotal contribution came from Frank H. Knight, whose 1921 work, Risk, Uncertainty, and Profit, distinguished between insurable risk and true uncertainty. Knight argued that profits arise not from bearing insurable risks, but from dealing with uninsurable uncertainty—the unpredictable elements of the future that cannot be quantified or transferred. Entrepreneurs who successfully navigate this true uncertainty are able to earn returns beyond what is required to compensate for their time, capital, and manageable risks, thus generating economic profits.
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Key Takeaways
- Above normal profits represent an economic return that exceeds all costs, including the opportunity cost of resources.
- They are typically associated with market imperfections, such as monopoly power or significant barriers to entry.
- In theory, perfect competition drives economic profits to zero in the long run, leaving only normal profits.
- Achieving above normal profits indicates a firm is efficiently allocating resources and creating value beyond its minimum required return.
Formula and Calculation
Above normal profits are fundamentally represented by a positive economic profit. While not a standalone formula, economic profit is calculated by subtracting both explicit and implicit costs from total revenue.
The formula for economic profit is:
Alternatively, since accounting profit considers only explicit costs, economic profit can also be expressed as:
Where:
- Total Revenue is the total income a firm generates from its sales.
- Explicit Costs are the direct, out-of-pocket expenses for a firm (e.g., fixed costs, variable costs, wages, rent, raw materials).
- Implicit Costs are the opportunity costs of using resources already owned by the firm, for which no direct payment is made. This includes the return that could have been earned on capital invested elsewhere or the entrepreneur's alternative earnings.
- Accounting Profit is Total Revenue minus Explicit Costs.
A firm earns above normal profits when its calculated economic profit is greater than zero.
Interpreting Above Normal Profits
Interpreting above normal profits goes beyond simply looking at a company's reported accounting profit. A company can show a substantial accounting profit but still not be earning above normal profits if its implicit costs (like the forgone returns on its capital investment) are higher.
A positive economic profit, signifying above normal profits, indicates that a business is generating a return that exceeds the market rate for the capital and risk involved, effectively outperforming its best alternative use of resources. This suggests the firm possesses some form of competitive advantage, whether through superior technology, efficient operations, brand loyalty, or a unique market structure. Such profits often attract new competitors, leading to a dynamic process where these excess returns may eventually diminish unless the firm can maintain or strengthen its advantages.
Hypothetical Example
Consider "InnovateTech Inc.", a software development firm that specializes in niche AI solutions. In its first year of operation, InnovateTech reports total revenue of $5 million. Its explicit costs, including salaries, office rent, and operational expenses, amount to $3 million. This gives InnovateTech an accounting profit of $2 million.
However, the founder, a highly skilled AI engineer, sacrificed a job offer from a leading tech company that would have paid $500,000 annually. Additionally, the $1 million the founder invested in InnovateTech could have earned a 10% return in a diversified index fund, representing an opportunity cost of $100,000.
In this scenario, InnovateTech's implicit costs are $500,000 (foregone salary) + $100,000 (foregone investment return) = $600,000.
To calculate InnovateTech's economic profit:
Economic Profit = Accounting Profit - Implicit Costs
Economic Profit = $2,000,000 - $600,000 = $1,400,000
Since InnovateTech's economic profit is $1.4 million, it is indeed earning above normal profits. This indicates that the company is not only covering all its explicit expenses but also generating a substantial return beyond what the owner could have earned from their next best alternatives.
Practical Applications
The concept of above normal profits is critical in various areas of finance and economics:
- Investment Analysis: Investors often seek companies with the potential to generate sustained above normal profits, as these indicate strong competitive positions and potential for superior shareholder returns. Metrics like Economic Profit (EP) are used by firms to assess their true value creation, going beyond traditional accounting measures. Companies that consistently deliver growth in economic profit tend to maximize company value.
4* Market Structure Analysis: Above normal profits serve as an indicator of market power. Industries characterized by sustained above normal profits, such as certain segments of Big Tech or pharmaceuticals, often operate under conditions of oligopoly or near-monopoly, where significant barriers to entry prevent new competitors from eroding these profits.
3* Antitrust and Regulation: Regulatory bodies, such as the Federal Trade Commission (FTC), scrutinize firms earning persistent above normal profits, particularly when combined with high market share, as this may signal monopolistic practices or anti-competitive behavior. For example, the FTC has sued major online retailers, alleging they illegally maintain monopoly power and hike prices, leading to excessive profits. 2Regulators aim to foster competition, which, in theory, drives economic profits towards normal levels. - Business Strategy: Firms constantly strive for strategies that yield above normal profits. This involves developing unique products, achieving cost leadership, building strong brands, or innovating production methods to secure a temporary economic rent that can lead to such profits. This pursuit aligns with the principle of profit maximization.
Limitations and Criticisms
While above normal profits are a desirable outcome for firms, the concept and their persistence face several limitations and criticisms:
- Theoretical vs. Real-World: The existence of sustained above normal profits challenges the classical economic model of perfect competition, where it is posited that competition would quickly erode any economic profits to zero in the long run. Critics argue that this model's assumptions (e.g., perfect information, homogenous products, free entry and exit) are rarely met in the real world, leading to persistent "supernormal profits" in many sectors.
1* Measurement Challenges: Accurately measuring implicit costs, particularly the opportunity cost of entrepreneurial talent or unique assets, can be subjective and difficult. This makes the precise calculation of economic profit challenging in practice. - Dynamic Nature of Markets: In dynamic markets, what appears as above normal profits might simply be a temporary reward for innovation, risk-taking, or a unique competitive advantage. Over time, as competitors imitate innovations or new technologies emerge, these profits tend to diminish.
- Regulatory Scrutiny: Highly visible and sustained above normal profits can attract significant regulatory attention, potentially leading to antitrust investigations, increased taxes, or other interventions aimed at fostering competition or redistributing wealth.
Above Normal Profits vs. Economic Profit
The terms "above normal profits" and "economic profit" are closely related and often used interchangeably, but it's important to clarify their distinction.
- Economic Profit is a specific financial metric that calculates a firm's total revenue minus all its costs, both explicit and implicit (including opportunity costs). It can be positive, negative (economic loss), or zero (normal profit).
- Above Normal Profits is the state or condition where a firm's economic profit is positive. It signifies that the firm is earning more than the minimum required return to keep its resources in their current use. It is a qualitative description of a specific quantitative outcome (a positive economic profit).
In essence, "above normal profits" describes the desirable outcome when the calculation of "economic profit" yields a positive value. When economic profit is zero, the firm is said to be earning "normal profit," which covers all explicit and implicit costs, but yields no additional surplus beyond the opportunity cost.
FAQs
What causes a company to earn above normal profits?
A company typically earns above normal profits due to market imperfections or advantages like strong barriers to entry, unique products, superior efficiency, patents, brand loyalty, or a lack of intense competition. These factors allow the company to charge prices significantly higher than its average total cost, including implicit costs.
Are above normal profits sustainable in the long run?
In highly competitive markets, above normal profits are generally not sustainable in the long run. The existence of such profits acts as an incentive for new firms to enter the market, increasing supply and driving down prices until only normal profits are earned. However, in markets with strong barriers to entry or unique competitive advantages, firms may sustain above normal profits for extended periods.
How do above normal profits relate to consumer welfare?
While beneficial for the firm, sustained above normal profits can sometimes indicate a lack of competition, which may negatively impact consumer welfare through higher prices, reduced product choice, or less innovation. This is often the focus of antitrust regulation.
What is the difference between normal profit and above normal profit?
Normal profit occurs when a firm's total revenue equals its total economic costs (explicit + implicit), resulting in zero economic profit. It represents the minimum return needed to keep a firm in business. Above normal profit (positive economic profit) means the firm's revenue exceeds all economic costs, generating a surplus beyond this minimum required return.
Do all companies aim for above normal profits?
Yes, every profit-seeking company aims to earn above normal profits. This drives innovation, efficiency improvements, and the pursuit of competitive advantage, as these are the mechanisms through which above normal profits are generated and sustained.