Normal profit

What Is Normal Profit?

Normal profit is an economic concept representing the minimum level of profit necessary for a firm to remain in operation in the long run. It is the accounting profit that covers all explicit costs and the implicit costs of doing business, including the opportunity cost of the entrepreneur's time and capital. This concept is fundamental to microeconomics and helps explain firm behavior within various market structures. A firm earning normal profit is said to be covering all its costs, meaning it is generating enough revenue to compensate for the resources used and the alternative returns that could have been earned. It signifies a breakeven point from an economic perspective, where resources are being allocated efficiently, but no "supernormal" or "economic" profit is being earned.

History and Origin

The concept of normal profit has its roots in classical and neoclassical economic thought, particularly in the work of Alfred Marshall. Marshall, in his seminal work Principles of Economics, first published in 1890, explored how firms determine their output and pricing in competitive markets. He recognized that for a business to continue operating, it must not only cover its direct expenses but also account for the return its owners could have received by deploying their capital and effort elsewhere. Marshall’s analysis of costs, supply and demand, and market equilibrium laid the groundwork for understanding this necessary level of profit. His work emphasized that in the long run under perfect competition, firms would tend to earn only normal profit, as any higher profits would attract new entrants, driving prices down until only this minimum profit level remained.

⁶, ⁷, ⁸## Key Takeaways

• Normal profit is the minimum profit a firm needs to stay in business, covering both explicit and implicit costs.
• It signifies that the firm is earning just enough to compensate for the resources used, including the owner's capital and time, at their next best alternative use.
• In perfectly competitive markets, firms tend to earn only normal profit in the long run.
• Normal profit is a component of total cost from an economic perspective.
• Firms earning normal profit are economically breaking even; they are not making "economic profit."

Formula and Calculation

Normal profit is not calculated as a separate line item but rather as the difference between accounting profit and economic profit. However, it can be understood as the level of accounting profit where economic profit is zero.

The formula can be expressed as:

Alternatively, since economic profit is defined as Total Revenue minus (Explicit Costs + Implicit Costs), normal profit is the situation where:

This implies that:

Where:

• Total Revenue refers to the total income generated from the sale of goods or services.
• Explicit Costs are the direct, out-of-pocket expenses incurred by a business, such as wages, rent, utilities, and raw materials. These are typically the costs that accountants track.
• Implicit Costs are the opportunity costs of using resources already owned by the firm that do not involve a direct cash outlay. This includes the income foregone by using the owner's capital in the business rather than investing it elsewhere, or the salary the entrepreneur could have earned working for someone else.

Interpreting Normal Profit

Interpreting normal profit involves understanding that a firm earning this level of profit is economically viable and sustainable in the long term, even though it may not appear to be "making money" beyond its operational expenses from a purely accounting standpoint. For economists, normal profit represents the cost of staying in business, as it includes the necessary return on capital and labor provided by the owners. If a firm earns less than normal profit, it suggests that its resources could be better utilized elsewhere, leading to a potential exit from the market in the long run. Conversely, if a firm earns more than normal profit (i.e., economic profit), it attracts new entrants, increasing competition and eventually driving profits down to the normal level in industries characterized by perfect competition. This interpretation highlights the dynamic nature of markets and the constant push toward efficiency.

Hypothetical Example

Consider "Green Thumb Landscaping," a small business owned and operated by Jane. In a given year, Green Thumb Landscaping generates $150,000 in revenue from its services.

Her explicit costs include:

• Wages for employees: $60,000
• Equipment maintenance and fuel: $20,000
• Rent for a small office and storage: $12,000
• Insurance and supplies: $8,000
  Total Explicit Costs = $60,000 + $20,000 + $12,000 + $8,000 = $100,000

Jane also incurs implicit costs:

• Opportunity cost of her own labor: If Jane worked as a landscape designer for another company, she could earn $40,000 per year.
• Opportunity cost of her capital: Jane invested $50,000 of her savings into the business. If she had invested it elsewhere, she could have earned a 4% return, or $2,000.
  Total Implicit Costs = $40,000 + $2,000 = $42,000

Now, let's calculate her accounting profit and economic profit:

• Accounting Profit = Total Revenue - Explicit Costs = $150,000 - $100,000 = $50,000
• Economic Profit = Accounting Profit - Implicit Costs = $50,000 - $42,000 = $8,000

In this scenario, Green Thumb Landscaping is earning an economic profit of $8,000. This means Jane is earning more than normal profit; she is covering all her explicit costs and receiving a return on her time and capital that exceeds their next best alternative use. If, however, her economic profit were $0, she would be earning normal profit.

Practical Applications

Normal profit is a key consideration in several practical business and economic contexts:

• Market Entry and Exit: Businesses considering entering a new market will assess whether they can realistically achieve at least a normal profit. If existing firms are only earning normal profit, it suggests the market is competitive and may not offer "extra" returns. Conversely, firms consistently unable to achieve normal profit may consider exiting the market, reallocating resources to more profitable ventures.
• Pricing Decisions: Companies, particularly in competitive industries, must set prices that allow them to cover all costs, including the implicit costs represented by normal profit. Failure to do so leads to economic losses, which are unsustainable in the long run.
• Resource Allocation: From a broader economic perspective, the concept of normal profit guides efficient resource allocation. Industries where firms consistently earn above-normal profits attract new investment and resources, while those earning below-normal profits see resources reallocated elsewhere.
• Taxation and Business Expenses: While normal profit itself isn't directly taxed, its components (explicit costs) are crucial for determining taxable income. Businesses often deduct various business expenses to lower their taxable income, which aligns with accounting for explicit costs. T⁴, ⁵hese deductions, which the IRS defines as "ordinary and necessary" for the business, reduce the gap between revenue and taxable income, impacting the final accounting profit figure.

³## Limitations and Criticisms

While a crucial concept in economic theory, normal profit has limitations and faces criticisms. One challenge is the difficulty in precisely quantifying implicit costs, especially the opportunity cost of an entrepreneur's time and capital. Unlike explicit costs, which are recorded transactions, implicit costs are subjective estimates of forgone opportunities. Determining the exact value of the "next best alternative" for an owner's labor or capital can be challenging and may vary depending on individual perceptions and market conditions.

¹, ²Another criticism arises in dynamic and imperfect markets. The idea that firms gravitate towards earning only normal profit is most strictly applicable under conditions of perfect competition, where there are many small firms, homogenous products, perfect information, and free entry and exit. In reality, most markets are characterized by elements of monopoly or oligopoly, product differentiation, barriers to entry, and imperfect information. In such markets, firms may be able to sustain economic profits (i.e., profits above normal profit) in the long run.

Furthermore, the concept can sometimes be misinterpreted by non-economists. When a business owner states they are making a "normal profit," it can sound as though they are not doing well or only barely surviving. However, from an economic standpoint, achieving normal profit means the business is successfully covering all its costs, including the opportunity cost of the owner's investment and effort, and is therefore a sustainable enterprise.

Normal Profit vs. Economic Profit

The distinction between normal profit and economic profit is fundamental in economic analysis and often a source of confusion.

The key difference lies in the inclusion of implicit costs. Accounting profit, which most businesses report, only considers explicit costs. Therefore, an accounting profit can still mask an economic loss if the implicit costs (like the entrepreneur's forgone salary or capital returns) are not covered. Normal profit is the specific point where the accounting profit is exactly equal to the implicit costs, resulting in zero economic profit. It means the entrepreneur is earning just enough to make staying in the current business worthwhile, given other opportunities.

FAQs

Is normal profit considered a "good" profit?

From an economic perspective, earning normal profit means a business is sustainable and its resources are being allocated efficiently. It is not a "supernormal" or "extra" profit, but it indicates that the firm is covering all its costs, including the opportunity costs of the capital and labor employed.

What is the relationship between normal profit and opportunity cost?

Normal profit is directly tied to opportunity cost. The implicit costs component of normal profit represents the income or return that the business owner could have earned by using their time and capital in their next best alternative venture. For a business to achieve normal profit, it must cover these foregone opportunities.

Can a business earn normal profit in the short run?

Yes, a business can earn normal profit in the short run. However, the concept is more commonly discussed in the context of the long run equilibrium under perfect competition, where firms are expected to gravitate towards earning only normal profit due to the free entry and exit of firms.

Why do economists care about normal profit?

Economists care about normal profit because it helps them understand resource allocation and market efficiency. If firms in an industry are earning more than normal profit, it signals that resources in that industry are generating higher returns than elsewhere, attracting new capital and labor. Conversely, if firms earn less than normal profit, it suggests an inefficient allocation of resources, which may then move to more productive uses. This concept is vital for analyzing profit maximization strategies.

Does normal profit mean the business is not making money?

No, normal profit does not mean the business is not making money. It means the business is earning enough accounting profit to cover all its explicit expenses and to adequately compensate the owners for the capital they have invested and the time and effort they have put into the business, at a rate comparable to what they could earn in their next best alternative. From an economic viewpoint, it's a break-even point where resources are earning their market rate of return.