What is Normal Profit?
Definition: Normal profits in business refer to a situation where a company generates revenue that is equal to the total costs incurred in its operation, thus allowing it to remain operational in a competitive industry.
Normal profit is considered an important factor in a business’s production process because it is the minimum profit level that a company can achieve to justify its continued operation in the market where there is competition. Normal profit also means that the revenue the company manages to generate is higher than the opportunities that the company foregoes when it uses its resources to make the product it sells to the market.
If a company incurs losses, then there is not much incentive to remain in the market and so it has to achieve the minimum threshold for it to remain operational. In other words, it has to achieve a normal profit level for it to remain in business. Since normal profit means that the company’s total cost is equivalent to its total revenue, then the normal profit level is zero. This is not to say that the company is not profitable.
Normal Profit Formula Calculation
How to calculate normal profit.
The calculation is rather simple where you subtract the total costs from the total revenues as shown below.
Normal profit = total revenue – total costs
The total costs are both implicit and explicit costs. Implicit costs represent the opportunity cost of working elsewhere and also in regards to capital (foregone opportunity to use that capital in other projects that would have generated revenue). This means that implicit costs are not easily quantifiable but are rather taken as the revenue that the company would have earned if it had not foregone that opportunity. The implicit costs include quantifiable costs such as raw materials, labor, rent, and others.
A chart demonstrating normal profit.
Why do normal profits occur in a perfect competition?
Perfect competition means that there is freedom of entry into the market. Usually, when a few firms in the industry are enjoying supernormal profits,the favorable profits encourage other companies to join the market.
Since there is little friction to market entry, the firms can enter freely to get a piece of the pie until the market starts making normal profit. This tends to happen in the long-run in a perfect competition market.
Normal Profit vs Economic Profit
Normal profit usually goes hand in hand with economic profit. The latter refers to the profit that a company realizes after accounting for the implicit and explicit costs. Normal profit happens when the revenue realized is equal to the explicit and implicit costs combined or when the economic profit equates to zero. This also explains why normal profit is also referred to as zero economic profit.
Economic Profit = Revenues – Explicit costs – Implicit costs.
Normal Profit Examples
What happens when the market reaches normal profit?
Normal profit means that the companies are not really generating meaningful profit levels and this will obviously have an impact on the industry. In a perfect competition market, the free entry and exit conditions encourage more competition which brings down the supernormal profits to normal profit levels.
There are numerous situations where normal profits can be used to help make useful adjustments that help businesses or industries to perform better. Normal profits are important especially in macroeconomics because they help economists to identify whether an industry is doing well or whether it is tanking. Economists may also use normal profits to determine whether there is an oligopoly or monopoly in a market. If the results are positive, then the right legislative measures are taken to ensure that equal competition is fostered.
Business owners can also use normal profit to gauge the performance of their businesses relative to others in the same industry. This helps them to determine whether or not they should take extra steps to improve their businesses such as expanding their business mostly through product diversification.