Meaning and Computation of Normal Profits
Normal profit is an economic term that describes when a company’s total revenues are equal to its total costs in a perfectly competitive market. NP is included in the costs of production because it is the minimum amount that justifies why the firm is still in business.
In economics, normal profit is the minimum compensation that a firm receives for operating. The compensation is higher than the opportunity cost that the firm loses for using its resources effectively and producing a given product. If a firm’s profits are lower than its revenues, the firm incurs losses. It must meet a minimum threshold to stay in business.
Furthermore, because the normal profit is equal to zero, it doesn’t mean that the firm is not profitable. The NP compares the effective use of the firm’s resources to its revenues.
Let’s look at an example.
Karry is a financial analyst working for an esteemed securities firm. She wants to check the companies in a client’s portfolio to see which one realizes a NP. Karen thinks that at least one of the companies in the portfolio should not stay in business as it incurs losses for two years in a row.
Karen creates an Excel file with the five companies that she follows in the particular portfolio, and she adds the total revenues, and fixed costs, variable costs, and opportunity costs to calculate the total costs of each firm.
Karen assumes that all firms have the same opportunity cost, equal to $100,000 million. Total revenues range between $235,650 and $285,440 as the firms compete in the same industry.
Of the five companies, company A and company C incur losses of $4,070 million and $4,980 million, respectively. Company B and company E realize a gain of $41,421 million and $48,878 million, respectively. Company D has a NP because the difference of the total revenues minus the total costs is zero.