Unusual Earnings: Definition, Mathematical Representation
In the world of business, the concept of abnormal profits, also known as supernormal or economic profits, can be a subject of great interest. These profits occur when a company's economic profit is positive, exceeding the normal returns expected in a given market.
To calculate economic profit, one must consider both explicit and implicit costs. Explicit costs include total variable costs and total fixed costs, while implicit costs represent the opportunity costs of using the firm's current resources. Opportunity costs can be the cost of buying a production machine (if rented) or the cost of renting it (if bought). Total revenue minus explicit costs equals accounting profit, which is the profit listed in the company's financial statements. However, economic profit is calculated by subtracting implicit costs from the accounting profit.
In a perfectly competitive market, firms may earn abnormal profits in the short run, but these will not last due to new entrants bringing in new supplies and lowering prices. This is because in a perfectly competitive market, there are many buyers and sellers, and no single entity has the power to influence the market price.
On the other hand, abnormal profits persist in monopoly and oligopoly markets in the long run. In a monopoly, the company is the sole purchaser of inputs in the industry, and its production function is often unique due to the absence of competition. Monopolists can preserve abnormal profit due to no competition, high barriers to entry, and absolute power over quantity and quality.
In oligopoly markets, companies may have significant market power due to controlling a significant share of the market. They can generate positive economic profit through differentiation and high market share, combined with high barriers to entry. Tech giants like Apple, Google, and Amazon, for example, have earned abnormal profits in oligopolistic markets, often using complex tax structures and offshore subsidiaries to obscure these gains.
Companies that book economic benefits often try to hide this fact, aiming to reduce competitive pressure and avoid government anti-competitive investigations. However, it's important to note that monopolists and oligopolists can face scrutiny for their business practices, as their market power can lead to higher prices and reduced consumer choice.
In conclusion, understanding abnormal profits is crucial in analysing a company's financial health and its competitive position in the market. Whether in a perfectly competitive, monopolistic, or oligopolistic market, the presence of abnormal profits can signal market power and potential for further growth or regulatory intervention.
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