Difference between Normal and Abnormal Profits:
Normal Profits: Normal profits, also known as zero economic profits, refer to the minimum level of profits necessary to keep a business operating in the long run.
Normal profits are the amount of profit that covers all costs, including both explicit costs (such as wages, rent, and materials) and implicit costs (opportunity costs of using the resources).
When a firm earns normal profits, it means it is earning a return that is just sufficient to keep the owners or shareholders satisfied and willing to continue investing in the business.
In this case, the firm is neither making above-average profits nor incurring losses. It is essentially covering all costs and earning a reasonable return on investment.
Abnormal Profits: Abnormal profits, also known as economic profits or supernormal profits, occur when a firm earns more than the normal level of profits.
Abnormal profits represent a situation where a business is earning revenue that exceeds both explicit and implicit costs.
In other words, abnormal profits are above and beyond what is required to cover all costs and provide a normal return on investment.
Abnormal profits indicate that the firm has a competitive advantage, such as unique products, innovative processes, or significant market power, allowing it to generate higher revenues and outperform its competitors.
Example: Let's consider a hypothetical bakery. In a competitive market, several bakeries are operating, and each bakery is earning normal profits. They are covering their explicit costs (wages, ingredients, rent) and implicit costs (such as the opportunity cost of the owner's time and capital invested) while earning a reasonable return.
However, one particular bakery introduces a new and highly popular line of pastries that quickly becomes a favorite among customers. Due to the high demand for these pastries, this bakery starts generating significantly higher revenue compared to its competitors. As a result, it earns abnormal profits.
The bakery's abnormal profits indicate that it is earning more than the minimum necessary to cover all costs and provide a normal return. This exceptional performance could be attributed to its unique product offering or its ability to capture a significant market share. The abnormal profits act as an incentive for the bakery to continue investing in its business and potentially expand operations.Difference between Accounting Profit and Economic Profit:
Accounting Profit: Accounting profit refers to the profit calculated using traditional accounting methods. It is the revenue generated minus explicit costs, such as wages, rent, materials, and other operating expenses.
Accounting profit does not consider implicit costs, which are the opportunity costs associated with using the resources, including the owner's time and capital invested.
Accounting profit provides a financial measure of a firm's performance according to the accepted accounting principles and is primarily used for financial reporting and tax purposes.
Economic Profit: Economic profit is a broader measure of profit that considers both explicit and implicit costs, providing a more comprehensive view of a firm's profitability.
Economic profit subtracts both explicit and implicit costs from total revenue to calculate the true economic benefit or return on investment.
Implicit costs include the opportunity costs of resources, such as the foregone earnings from alternative uses of capital or the owner's time.
Economic profit represents the net benefit of using resources in a particular business venture compared to their next best alternative use.
Example: Let's say an entrepreneur starts a business and calculates an accounting profit of $100,000 per year. This profit is derived by subtracting explicit costs, such as $300,000 in operating expenses (wages, rent, materials), from total revenue of $400,000.
However, when considering economic profit, the entrepreneur realizes that the implicit costs of the business are significant. They estimate that if they were not running their own business, they could earn an annual salary of $80,000 in a similar industry. This opportunity cost of their time and potential earnings is an implicit cost that must be factored in.
Therefore, the economic profit would be calculated as total revenue ($400,000) minus both explicit costs ($300,000) and implicit costs ($80,000), resulting in an economic profit of $20,000.
In this example, the accounting profit is $100,000, reflecting the revenue left after deducting explicit costs. However, when considering the implicit costs or the opportunity cost of the entrepreneur's time, the economic profit becomes $20,000, indicating the true net benefit of running the business compared to the next best alternative use of resources.