Normal Profit

Minimum profit necessary to attract and retain suppliers in a perfectly competitive market (see
perfect competition). Only normal profit could be earned in such marketsbecause, if profit was
abnormally high, more competitorswould appear and drive prices and profit down. If profit was
abnormally low, firms would leave the market and the remaining ones would drive the prices and
profit up. Markets where suppliers are making normal profits will neither expand nor shrink and
will, therefore, be in a state of long-term equilibrium.

What is 'Normal Profit'

Normal profit is an economic condition occurring when the difference between
a firms total revenue and total cost is equal to zero. Simply put, normal profit is the
minimum level of profit needed for a company to remaincompetitive in the market.

BREAKING DOWN 'Normal Profit'

A business will be in a state of normal profit when its economic profit is equal to zero,
which is why normal profit is also often called zero economic profit. When total
revenues are equal to total costs, normal profit and economic profit are the same.
Unlike accounting profit, economic profit (and thus normal profit as well) takes into
account the opportunity cost of a particular enterprise. As such, normal profit calculations
divide total cost into two categories, explicit costs and implicit costs.
The method of determining whether a firm is in a state of normal profit can be
represented in the following way:
Total Revenue - (Explicit Expense + Implicit Expenses) = 0
If the difference between total revenue and total expenses is not equal to zero, the
business in question is not in a state of normal profit. If total revenue exceeds total
expenses, it is calledeconomic profit or, alternatively, super-normal profit or abnormal
profit. If total expenses exceed revenue, it is called economic loss.
The term normal profit may also be used in macroeconomics to refer to broader economic
areas than a single business.
Normal profit occurs at the point at which the resources available to the firm are being
efficiently used and could not be put to better use elsewhere. It is often considered the
minimum amount of earnings needed in order to justify an enterprise. It is important to
note that zero economic profit does not mean that the company is not earning any money
(accounting profit). It is simply a measure of how well resources are being used relative
to all possible options.
When attempting to determine whether or not a business is in a state of normal profit, it is
important to understand the components of total cost. Total cost is divided into explicit
costs andimplicit costs. Explicit costs are easily quantifiable and generally involve a
transaction that is tied to an exchange of cost. Examples of explicit costs include raw
materials, labor and wages, rent and owner compensation. Implicit costs, on the other
hand, are costs associated with not taking an action, called the opportunity cost, and are

therefore much more difficult to quantify. Usually,analysts or economists calculate

implicit costs. Examples of implicit costs include entrepreneurshipor cost of capital.
To better understand normal profit, suppose that Suzie owns a bagel shop called Suzies
Bagels that generates an average of $150,000 each year. Also suppose that Suzie has two
employees, each of whom she pays $20,000 per year, and that Suzie takes
an annual salary of $40,000. Suzie also pays $20,000 annually in rent and $30,000
annually for ingredients and other supplies. After meeting with her financial advisor,
Suzie learns that, based on her skills, the estimated opportunity cost of operating Suzies
Bagels full-time is $20,000 each year. Based on this information, Suzie calculates that her
average annual explicit costs are $130,000 ($20,000 + $20,000 + $40,000 + $20,000 +
$30,000) and that her average annual implicit costs are $20,000, making her average
annual total costs $150,000. She observes that her total costs are equal to her total
revenues and determines that her bagel shop is in a state of normal profit.
Yet, while traveling in Europe Suzie has an idea to start selling sandwiches. She realizes
that she can sell sandwiches at a higher price point than the one at which she has been
selling bagels, and also that she can make a higher profit margin while doing so. Suzie
meets with her financial advisor and unveils her idea, and her financial advisor informs
Suzie that her normal profit calculations have changed. With the advent of Suzies new
idea and the accompanying potential for increased earnings, Suzies financial advisor
determines that Suzies opportunity cost of running Suzies Bagels has risen to $50,000
per year and that Suzies Bagels is no longer in a state of normal profit but is rather in a
state of economic loss. Seeking greater earnings, Suzie decides to close down Suzies
Bagels and reopen as Suzies Sandwiches.
In addition to a single business, as in the example, normal profit may also be used in
more macroeconomic terms to refer to an entire industry or market. In macroeconomic
theory, normal profit may occur only in conditions of perfect competition and economic
equilibrium.
On the other hand, economic profit only occurs when these conditions are not met. When
economic profit does occur, it encourages other firms to enter the market because of their
potential to gain ashare of the profit. The new company will then be contributing more of
the product to the market, which has the effect of lowering the market price of the good
to account for increased supply. Eventually, the industry will reach a state of normal
profit as prices stabilize and profits decline. In the mean time, firms may achieve shortterm economic profit through reaching a prominent market position, as well as by
improving performance, cutting costs and through other means allowing goods to be sold
for less than market price.
A similar yet inverse case can be said to apply in cases of economic loss. In theory,
conditions of economic loss within an industry or sector will drive companies to begin
leaving that industry or sector. Eventually, competition will be sufficiently reduced so as
to allow remaining companies to achieve normal profit or short-term economic profit.

Economic profit is more likely to occur in the case of a monopoly, as the company in
question has the power to determine the pricing and quantity of goods sold. Such a state
of affairs is largely dependent on the presence of significant barriers to entry, which
prevent other firms from easily entering the market and driving costs down, thereby
disrupting the prominent companys monopoly. In this case, however, governments will
often attempt to intervene in order to increase market competition, often
through antitrust laws or similar regulations. Such laws are meant to prevent large and
well-established companies from using their foothold on the market to reduce prices and
drive out new competition. Some high-profile cases wherein such laws were used against
companies occurred in the late 19th and early 20th century involving Standard Oil, U.S.
Steel (X), and more recently Microsoft (MSFT).

Uses of 'Normal Profit'

Normal profit allows business owners to compare the profitability of their work with that
of other possible business ventures, as in the Suzies Bagels example. Because normal
profit, economic profit and economic loss assign a business with a neutral, positive or
negative value, respectively, they can be used to compare a variety of business
opportunities with one another.
Normal profit and related terms can also be used in macroeconomics to help determine
whether an industry or sector is improving or declining. It may also be used to determine
whether or not there is room within an industry for new companies, or if an industry is in
a state of monopoly or oligopoly.

Things to Consider
As demonstrated in the Suzies Bagels example, normal profit does not indicate that a
business is not earning money. Because normal profit accounts for opportunity cost, it is
theoretically possible for a business to be operating at normal profit, develop a new idea
that will improve earnings but was not accounted for in previous opportunity cost
calculations, implement the idea and subsequently exist in a state of improved earnings
while maintaining its normal profit status.
It is also important to consider that implicit cost is an important element of normal
profit calculations, but is also one that is estimated and difficult to determine with
accuracy. As such, it has the potential to be unreliable, which affects the reliability of the
entire calculation. Because of this, it is crucial to take the utmost care when determining
implicit cost.
One should also note that the cost of normal profit can vary between companies and
industries in accordance with the risk of the investment in question.