Normal Profit Is Also Known As Economic Profit

Normal Profit: Understanding the Difference Between Accounting and Economic Profit

Meta Description: This article clarifies the often-misunderstood concept of normal profit, explaining its relationship to economic profit and highlighting the crucial difference between accounting and economic profits. Learn how opportunity cost shapes the understanding of business profitability.

The terms "normal profit" and "economic profit" are often used interchangeably, leading to confusion. While they are related, they represent distinct concepts in economics. Understanding this difference is crucial for accurately assessing the financial health and success of a business. This article will delve into the nuances of normal profit and its relationship to economic profit.

What is Normal Profit?

Normal profit refers to the minimum amount of profit necessary to keep a business operating in its current market. It's the return that an entrepreneur needs to receive in order to stay in business, covering all explicit and implicit costs. Think of it as the compensation for the entrepreneur's time, effort, and risk. It's the amount that makes the business just as attractive as investing that capital and time elsewhere. This is also commonly referred to as zero economic profit.

This concept is fundamentally linked to the idea of opportunity cost. Opportunity cost represents the potential benefits an individual, investor, or business misses out on when choosing one alternative over another. If a business isn't making at least a normal profit, it means the entrepreneur could earn more elsewhere, leading them to exit the market.

Explicit vs. Implicit Costs

To grasp normal profit fully, it's essential to understand the difference between explicit and implicit costs:

• Explicit Costs: These are the direct, out-of-pocket payments a business makes. Examples include wages, rent, materials, and utilities. These are readily apparent in a company's accounting statements.

• Implicit Costs: These are the opportunity costs associated with using resources already owned by the business. This includes the forgone salary the owner could have earned elsewhere, the return on capital invested in the business, or the potential rental income from business-owned property. These costs are often overlooked in simple accounting but are essential for calculating economic profit.

The Role of Opportunity Cost

Opportunity cost is the cornerstone of understanding normal profit. If a business owner could earn $100,000 a year working elsewhere, and their business only generates $90,000 in accounting profit (after covering explicit costs), they are actually experiencing a loss. The $10,000 difference represents the implicit cost – the opportunity cost of running their business instead of pursuing another employment option. The normal profit in this scenario would be at least $100,000.

Normal Profit and Economic Profit: The Key Difference

Economic profit, unlike normal profit, considers both explicit and implicit costs. It represents the difference between total revenue and the total of both explicit and implicit costs. A business earning a normal profit is essentially earning zero economic profit. It is making enough to cover all costs, including the opportunity cost of the resources used.

A positive economic profit indicates a business is performing exceptionally well, exceeding the minimum required to remain competitive. This suggests that the business is creating value above and beyond what is necessary to simply stay afloat. Conversely, a negative economic profit means the business isn't covering all its costs, including opportunity costs, and should reconsider its strategy.

In Summary

Normal profit and economic profit are interconnected but distinct concepts. Normal profit is the minimum profit needed to keep a business operational, covering all costs, including the opportunity cost of the resources used. Economic profit considers both explicit and implicit costs. A business achieving normal profit is essentially making zero economic profit. Understanding this distinction is vital for a comprehensive assessment of business performance and profitability. Ignoring implicit costs provides an incomplete picture of a business's true financial health.