What is a Normal Profit?

What is a Normal Profit?

Definition

In economics, the term normal profit refers to a situation where total costs equal total revenues. It’s important to remember that here the costs include the amount that needs to be paid for the entrepreneur’s time and effort in running the business.

This payment to the business owner includes the implicit cost of not taking up any other activity. This is also referred to as an opportunity cost.

What does normal profit mean?

When a business is making a normal profit, its economic profit is said to be zero. Remember that the terms “normal profit” and “economic profit” convey the same meaning and can be used interchangeably.

When normal profit is zero, it doesn’t mean that the firm is not making an accounting profit. Accounting profit is equal to total revenues minus total costs.

Accounting profit = Total revenues – total costs

Where,

Costs refer to explicit costs. These are represented by:

⇨ Material costs

⇨ Labor costs

⇨ Other costs related to the business

⇨ Compensation payable to the owner

NOTE – this cost element of compensation payable to the owner excludes the opportunity cost of the owner not taking up any other activity.

If the opportunity cost is included in the cost calculation, the total cost required to calculate economic profit will be obtained.

The following formula will illustrate the difference between accounting profit mentioned above and normal profit:

Normal profit = 0 = Total revenues – total costs (explicit costs and implicit costs)

What if the normal profit is greater than zero? In that case, the firm is said to be earning a super-normal profit. However, in a competitive market, this situation cannot last very long. Other firms will enter the fray and drive prices down. As a result of this, a situation where there is normal profit will prevail once again.

Example of normal profit

Gordon Ackerman runs an auto parts distribution business. His total revenues are $3 million and his costs are:

⇨ Purchase of goods: $2.2 million.

⇨ Employee costs: $300,000.

⇨ Other costs: $400,000.

⇨ Salary paid to Gordon Ackerman: $80,000.

The total revenues exceed total costs by $20,000. ($3,000,000 – $2,200,000 – $300,000 – $400,000 – $80,000)

The business is making an accounting profit of $20,000. However, it is making an economic loss since the opportunity cost of Gordon’s abilities is far in excess of $20,000.

Summary

Entrepreneurship carries an opportunity cost. If this cost element is built into a firm’s costs, the economic profit can be calculated. When economic profit is zero, the firm is said to be making a normal profit.