3.1.4.7 - Profit and its role
Learn how economists measure profit, including the opportunity cost of keeping resources in a business. Calculate normal and supernormal profit and explain how profit and loss influence production, investment and entry.
Normal profit and opportunity cost
Economic profit compares revenue with the full opportunity cost of the resources used. Costs include explicit payments, such as wages and materials, and relevant implicit costs, such as the income an owner gives up by running the business instead of taking the next best alternative.
Normal profit is the minimum reward needed to keep an entrepreneur's resources in their current use. Economists include it in total economic cost because using those resources here sacrifices an alternative return. Abnormal or supernormal profit is revenue above total economic cost, including normal profit.
Consider an original illustrative business earning £100,000 a year. Explicit costs are £70,000, while the owner's next best use of their labour and capital would earn £30,000. Accounting profit, on this simplified explicit-cost basis, is £30,000. Economic cost is £100,000, so economic profit is zero. The owner earns normal profit: the business rewards their resources as well as the relevant alternative.
If revenue rises to £115,000 with both cost categories unchanged, accounting profit is £45,000 and supernormal economic profit is £15,000. The normal return of £30,000 is still covered; only the extra £15,000 is supernormal profit.
Zero economic profit therefore does not mean zero income for the owner, and normal profit is not an arbitrary percentage of sales. The relevant alternative use determines the opportunity cost. A reported accounting profit cannot establish supernormal profit unless the necessary opportunity costs are known.
Calculating total and per-unit profit
Profit is the difference between total revenue and total cost measured over the same period and for the same output. Specify whether cost is explicit accounting cost or full economic cost before interpreting the result.
Economic profit
The per-unit difference must be multiplied by output to obtain total profit. It is not itself a total money amount. In these expressions, and include normal profit unless the task states otherwise.
An illustrative firm sells 2,000 units per month at £12 each. Its full economic cost is £20,000. TR is £24,000, so supernormal profit is £4,000. Equivalently, AC is £10 and AR is £12; the £2 surplus per unit multiplied by 2,000 gives £4,000. If AC were £12 at this output, the firm would earn normal profit. If AC were £13, it would make an economic loss of £2,000.
The following original comparison shows why higher revenue alone does not imply higher profit:
| Firm, same annual period | TR | Full economic TC | Economic profit |
|---|---|---|---|
| Cedar | £300,000 | £270,000 | £30,000 |
| Maple | £250,000 | £200,000 | £50,000 |
Maple has £50,000 less revenue but £70,000 less cost, so its profit is £20,000 higher. This is evidence about the difference between revenues and costs, not proof that small firms are always more profitable. The table says nothing about the resources invested, risk or percentage return on capital.
Continue this lesson.
You’re previewing NovaLearn without an account. Create a free account to read the rest.
Create free account