2.1.2. Economic Profit and Normal Profit
Economic profit (also known as abnormal profit or supernormal profit ) may be defined broadly as accounting profit less the implicit opportunity costs not included in total accounting costs.
Economic profit = Accounting profit – Total implicit opportunity costs
We can define a term, economic cost , equal to the sum of total accounting costs and implicit opportunity costs. Economic profit is therefore equivalently defined as:
Economic profit = Total revenue – Total economic costs
For publicly traded corporations, the focus of investment analysts’ work, the cost of equity capital is the largest and most readily identified implicit opportunity cost omitted in calculating total accounting cost. Consequently, economic profit can be defined for publicly traded corporations as accounting profit less the required return on equity capital.
Examples will make these concepts clearer. Consider the start-up company for which we calculated an accounting profit of €300,000 and suppose that the entrepreneurial executive who launched the start-up took a salary reduction of €100,000 per year relative to the job he left. That €100,000 is an opportunity cost of involving him in running the start-up. Besides labor, financial capital is a resource. Suppose that the executive, as sole owner, makes an investment of €1,500,000 to launch the enterprise and that he might otherwise expect to earn €200,000 per year on that amount in a similar risk investment. Total implicit opportunity costs are €100,000 + €200,000 = €300,000 per year and economic profit is zero: €300,000 – €300,000 = €0. For the publicly traded corporation, we consider the cost of equity capital as the only implicit opportunity cost identifiable. Suppose that equity investment is $18,750,000 and shareholders’ required rate of return is 8 percent so that the dollar cost of equity capital is $1,500,000. Economic profit for the publicly traded corporation is therefore $2,000,000 (accounting profit) less $1,500,000 (cost of equity capital) or $500,000.
For the start-up company, economic profit was zero. Total economic costs were just covered by revenues and the company was not earning a euro more nor less than the amount that meets the opportunity costs of the resources used in the business. Economists would say the company was earning a normal profit (economic profit of zero). In simple terms, normal profit is the level of accounting profit needed to just cover the implicit opportunity costs ignored in accounting costs. For the publicly traded corporation, normal profit was $1,500,000: normal profit can be taken to be the cost of equity capital (in money terms) for such a company or the dollar return required on an equal investment by equity holders in an equivalently risky alternative investment opportunity. The publicly traded corporation actually earned $500,000 in excess of normal profit, which should be reflected in the common shares’ market price.
Thus, the following expression links accounting profit to economic profit and normal profit:
Accounting profit = Economic profit + Normal profit
When accounting profit equals normal profit, economic profit is zero. Further, when accounting profit is greater than normal profit, economic profit is positive; and when accounting profit is less than normal profit, economic profit is negative (the firm has an economic loss ).
Economic profit for a firm can originate from sources such as:
exceptional managerial efficiency or skill;
difficult to copy technology or innovation (e.g., patents, trademarks, and copyrights);
exclusive access to less-expensive inputs;
fixed supply of an output, commodity, or resource;
preferential treatment under governmental policy;
large increases in demand where supply is unable to respond fully over time;
exertion of monopoly power (price control) in the market; and
market barriers to entry that limit competition.
Any of the above factors may lead the firm to have positive net present value investment (NPV) opportunities. Access to positive NPV opportunities and therefore profit in excess of normal profits in the short run may or may not exist in the long run, depending on the potential strength of competition. In highly competitive market situations, firms tend to earn the normal profit level over time because ease of market entry allows for other competing firms to compete away any economic profit over the long run. Economic profit that exists over the long run is usually found where competitive conditions persistently are less than perfect in the market.