Profit in Economics: Definition, Calculation, and Critical Elements
Economic profit and abnormal profit are essential concepts in understanding a company's financial performance. Economic profit, also known as abnormal profit or supernormal profit, represents a firm's total revenue minus both explicit (out-of-pocket) and implicit (opportunity) costs. This figure reflects the true profitability, including alternative uses of resources. On the other hand, abnormal profit denotes profit above the normal profit level, meaning it is excess earnings over the total costs, including opportunity costs.
In terms of market structure and sustainability factors:
- In perfect competition, firms are price takers with many sellers, and freedom of entry and exit ensures that abnormal profits cannot persist in the long run. New firms enter when existing firms earn abnormal profits, increasing supply and driving prices down until only normal profit (zero economic profit) remains sustainable. If firms incur losses, some exit, reducing supply and raising prices back to normal profit levels.
- In monopolies, monopolistic competition, and oligopolies, firms have some market power (price-making ability or product differentiation), enabling them to earn and potentially sustain abnormal profits for longer periods. Barriers to entry (like high startup costs or legal restrictions) prevent easy entry by competitors, reducing competitive pressures that would otherwise erode abnormal profits.
Here's a comparison of economic profit and abnormal profit:
| Aspect | Economic Profit | Abnormal Profit | |------------------------|------------------------------------------------|---------------------------------------------| | Definition | Total revenue minus explicit + implicit costs | Profit above normal profit (excess profit) | | Related to | True profitability considering opportunity costs | Same concept; often synonymous with supernormal profit | | Market structures | Applies in all markets | Typically referenced in imperfect markets (monopoly, oligopoly, monopolistic competition) | | Sustainability factors | Limited by competition and entry/exit freedom | Sustained by barriers to entry, market power | | Long-run outcome in PC | Zero economic profit (normal profit) only | Abnormal profits erode due to free entry |
To calculate economic profit, you can use the formula: Economic profit = Total revenue - Explicit costs - Implicit costs. It's essential to note that economic profit is not found in the income statement, and the company has no obligation to disclose it to external parties. However, the net operating profit after tax (NOPAT) can be found in the company's income statement, which is one of the explicit costs in the economic profit calculation.
In summary, economic profit measures actual profit including opportunity costs, while abnormal profit denotes profit beyond normal profit. Under perfect competition, abnormal profits are temporary due to free market entry and exit, whereas in imperfect markets, barriers allow abnormal profits to be sustained longer.
- When considering personal-finance and wealth-management, understanding economic profit and abnormal profit is crucial to identify investment opportunities, as these concepts reflect the true profitability of businesses, taking into account both explicit and implicit costs.
- In the realm of business and finance, companies operating in imperfect markets such as monopolies, monopolistic competition, and oligopolies may potentially sustain higher profit levels due to their market power, unlike companies in perfect competition where barriers to entry erode abnormal profits over time.
