Normal profits

What Are Normal Profits?

Normal profits refer to an economic condition where a firm's total revenues are exactly equal to its total costs, including both explicit costs and implicit costs. Within the broader field of microeconomics, this concept is crucial for understanding how firms operate and achieve stability, particularly in competitive markets. When a company achieves normal profits, it means it is covering all its expenses, including the opportunity cost of the capital and entrepreneurship employed in the business. This state is often described as zero economic profit, signifying that the firm is earning just enough to remain in its current line of business without any incentive for new firms to enter or existing firms to exit the market.¹⁶, ¹⁷

History and Origin

The concept of profit itself has evolved significantly over economic thought. Early economists, such as Adam Smith, discussed "profits on stock," often lumping together various returns to capital. It was later, notably with Alfred Marshall in the late 19th and early 20th centuries, that a clearer distinction began to emerge between different types of profit. Marshall's work helped formalize the idea of "normal profits" as the minimum return necessary to keep a firm operating in a competitive environment, contrasting it with "abnormal profit" (which is synonymous with economic profit). This distinction became fundamental to the theory of the firm and understanding market equilibrium, especially in models of perfect competition.¹⁵

Key Takeaways

• Normal profits occur when a firm's total revenue precisely covers its total costs, encompassing both explicit and implicit costs.
• This state implies zero economic profit, meaning the firm is earning a sufficient return to justify its continued operation but no more.
• The inclusion of opportunity cost in the calculation of normal profits highlights that resources used in one venture could have yielded returns elsewhere.
• In a perfectly competitive market, firms are expected to earn only normal profits in the long-run equilibrium due to the free entry and exit of firms.
• Achieving normal profits indicates efficient resource allocation within an industry, as there are no excessive returns to attract new competition or losses to drive out existing players.

Formula and Calculation

Normal profits are calculated by comparing a firm's total revenue to its total costs, which critically include both explicit and implicit costs. The formula can be expressed as:

Alternatively, normal profits are achieved when the average revenue (price) is equal to the average total costs (ATC). This means that for every unit sold, the revenue generated covers the average cost of producing that unit, including the implicit costs associated with the entrepreneur's time and capital.¹⁴

Interpreting the Normal Profits

Interpreting normal profits involves understanding that this is the minimum level of profitability required for a business to stay operational and competitive in the long run. If a firm earns normal profits, it indicates that its business operations are viable, covering all its expenses, including the implicit costs of the resources employed. This condition signals a state of market equilibrium, particularly in industries characterized by perfect competition. It suggests that there are no incentives for new entrants to join the market, nor for existing firms to exit, as all are earning a "normal" return on their investment and entrepreneurial effort. Conversely, if a firm earns less than normal profits, it incurs economic losses, which would eventually lead to its exit from the industry.¹², ¹³

Hypothetical Example

Consider a small, independent coffee shop operating in a bustling urban area. In a given year, the coffee shop generates $500,000 in total revenue from selling coffee and pastries. Its explicit costs, which include rent, employee wages, raw materials (coffee beans, milk, sugar), utilities, and marketing, amount to $400,000.

However, the owner, who also works full-time managing the shop, could have earned a salary of $70,000 working as a manager for a larger chain. This forgone salary represents an implicit cost. Additionally, the owner invested $100,000 of personal savings into the business; if this money had been invested elsewhere, it could have generated an opportunity cost of $10,000 in investment returns.

To calculate the normal profits, we first determine the total implicit costs:
Implicit Costs = Owner's Forgone Salary + Opportunity Cost of Capital
Implicit Costs = $70,000 + $10,000 = $80,000

Next, we calculate total costs:
Total Costs = Explicit Costs + Implicit Costs
Total Costs = $400,000 + $80,000 = $480,000

Finally, we find the normal profit:
Normal Profit = Total Revenue - Total Costs
Normal Profit = $500,000 - $480,000 = $20,000

In this scenario, the coffee shop is making a positive accounting profit of $100,000 ($500,000 - $400,000). However, once implicit costs are considered, it is earning a $20,000 economic profit. If the result was zero economic profit, it would mean the business achieved normal profits. This means the owner is being compensated for their time and capital at the market rate, but no excess profits are being generated beyond what is necessary to keep the resources employed in this particular business.

Practical Applications

Normal profits are a foundational concept in analyzing various aspects of economic and financial markets. They are particularly relevant in the study of market structure, especially perfect competition, where the long-run equilibrium dictates that firms will only earn normal profits. This principle helps economists understand industry dynamics, explaining why industries with low barriers to entry and homogenous products tend to see profit margins driven down over time.

The concept also informs discussions around resource allocation, as the pursuit of profits (and the eventual normalization of those profits) guides capital and labor towards their most efficient uses. Regulatory bodies, such as the Federal Trade Commission (FTC), indirectly consider the dynamics that lead to normal profits when evaluating market competitiveness and antitrust issues, aiming to prevent monopolies that could earn sustained supernormal profit by restricting competition.⁷, ⁸, ⁹, ¹⁰, ¹¹

Limitations and Criticisms

While the concept of normal profits is a valuable analytical tool in microeconomics, it faces several limitations and criticisms. One significant challenge lies in accurately measuring implicit costs, particularly the opportunity cost of entrepreneurship and owner-supplied capital. These costs are often subjective and not easily quantifiable, making precise calculation difficult and potentially leading to inaccurate assessments of true profitability.⁶

Furthermore, the theory often assumes perfect knowledge and rational firm behavior, which may not hold true in real-world scenarios. Firms rarely have complete information about their demand curves or all potential costs, operating instead under various degrees of uncertainty.⁵ The assumption of profit maximization, which underpins the idea of firms striving towards normal profits, has also been critiqued. Some economists argue that firms may pursue other objectives, such as sales maximization or growth, especially when there are agency problems between owners and managers. These alternative objectives can deviate from the strict pursuit of normal profits.⁴

Normal Profits vs. Economic Profit

The distinction between normal profits and economic profit is fundamental in economic analysis. Normal profits, as discussed, represent the total revenue equal to total costs, where total costs include both explicit (out-of-pocket) and implicit (opportunity) costs. It is the minimum profit necessary to keep a firm in operation in the long run, compensating the entrepreneur and capital for their commitment. When a firm earns normal profits, its economic profit is precisely zero.², ³

In contrast, economic profit, often referred to as supernormal profit or abnormal profit, occurs when a firm's total revenue exceeds its total costs, including implicit costs. This means the firm is earning more than the minimum required to keep its resources in their current use. The presence of economic profit acts as a strong signal, attracting new firms to enter the competitive markets. This entry increases supply, drives down prices, and ultimately erodes economic profits until only normal profits remain in the long-run equilibrium. Conversely, if a firm experiences negative economic profit (an economic loss), it is not even covering its implicit costs, leading to an incentive for resources to exit that industry.¹