What’s it: Abnormal profit occurs when the firm earns a higher than normal profit. It occurs when total revenue exceeds total economic costs (implicit costs plus explicit costs). Also known as supernormal profit or economic profit.
When a company in the market posts an abnormal profit, it attracts new entrants to the market. They increase supply, lower market prices, and reduce profits. Long story short, entry barriers are among the critical factors for sustaining supernormal profit in the long run.
Calculating abnormal profit
Abnormal profit is when economic profit is positive. Firms earn higher revenues than explicit costs and implicit costs (or opportunity costs). The economic profit formula is as follows:
Economic profit = Total revenue – Explicit costs – Implicit costs
Explicit costs include total variable costs and total fixed costs. You can find these costs on the income statement, along with total revenue.
Meanwhile, implicit costs represent the opportunity costs of using the firm’s current resources. For example, to use a production machine, the company has two best options: buy it or rent it. If the company chooses to rent a machine, the opportunity cost is the same as the machine purchase cost. Conversely, if you buy a machine, the rental costs represent implicit costs.
Of course, you won’t find costs implicit in the income statement.
Furthermore, total revenue minus explicit costs equal accounting profit, which is the profit listed in the company’s financial statements. And, we can rewrite the above formula to be:
Economic profit = Accounting profit – Implicit costs
Meanwhile, the relationship between economic profit, normal profit, and accounting profit is presented in the following equation:
Accounting profit = Economic profit + Normal profit
Normal profit refers to the level of accounting profit needed to cover implicit costs. It will equal accounting profit when economic profit equals zero. And, if accounting profit is higher than normal profit, economic profit is positive.
Relationship between market structure and abnormal profit
In the long run, abnormal profits are likely to persist only in monopoly and oligopoly markets. The monopolist can preserve it because there is no competition and high barriers to entry. Also, the company has absolute power over quantity and quality as it is the sole producer.
Furthermore, as the sole purchaser of inputs in the industry, the monopolist also has strong bargaining power against suppliers. The monopolist can use this power to get a lower price input.
Meanwhile, companies in the oligopoly market face few competitors, so the competitive pressure is relatively low. Some companies may have significant market power because they control a significant share of the market. They can generate positive economic profit in several ways, including through differentiation. Combined with the high barriers to entry, it allows them to maintain abnormal profit over time.
If companies book economic benefits, they will usually try to hide this fact. Its aim is to reduce competitive pressure from new entrants and government anti-competitive investigations.
Furthermore, in a perfectly competitive market, some firms may earn abnormal profits in the short run. However, it will not last in the long term as it will attract newcomers to enter. New arrivals bring in new supplies, forcing prices down and lowering profits.