key term - Normal Profit

Definition

Normal profit is the minimum level of profit that a firm must earn in the long run to stay in business. It represents the opportunity cost of the firm's resources, including the implicit costs of using the owner's own labor and capital, and is the minimum level of return required to keep the firm operating in its current industry and production method.

5 Must Know Facts For Your Next Test

1. Normal profit is the minimum level of profit a firm must earn to remain in business in the long run.
2. Normal profit includes the opportunity cost of the firm's own resources, such as the owner's labor and capital.
3. In perfect competition, firms earn normal profit in the long run because economic profit is driven to zero.
4. Firms that earn less than normal profit in the long run will eventually exit the industry.
5. The concept of normal profit is important for understanding the differences between accounting and economic profit.

Review Questions

• Explain how normal profit differs from accounting profit and the importance of this distinction.
  • Normal profit includes the opportunity cost of the firm's own resources, such as the owner's labor and capital, while accounting profit only considers the explicit costs the firm pays out. This distinction is important because it reflects the true economic cost of operating the business, not just the monetary payments. Firms must earn at least normal profit to remain in business in the long run, even if they are reporting positive accounting profit.
• Describe the role of normal profit in the context of perfect competition and why it is a key concept in this market structure.
  • In a perfectly competitive market, firms are price takers and must earn at least normal profit in the long run to remain in business. If firms earn more than normal profit, new firms will enter the market, driving down prices and profits until they reach the normal profit level. Conversely, if firms earn less than normal profit, they will eventually exit the industry. This ensures that in the long run, firms in perfect competition will earn only normal profit, which is the minimum level required to keep them operating in their current industry and production method.
• Analyze how the concept of normal profit relates to the distinction between explicit and implicit costs, and explain the importance of this relationship.
  • The concept of normal profit is closely tied to the distinction between explicit and implicit costs. Explicit costs are the actual monetary payments a firm makes to acquire resources, while implicit costs represent the opportunity cost of the firm's own resources, such as the owner's labor and capital. Normal profit includes these implicit costs, which are not accounted for in the firm's accounting profit. Understanding this relationship is crucial because it highlights that a firm must earn at least the normal profit level to remain in business in the long run, even if it is reporting positive accounting profit. This is because the firm must cover both its explicit and implicit costs to continue operating.

Related terms

Explicit Costs:

The actual monetary payments a firm makes to acquire resources, such as wages, rent, and the cost of raw materials.

Implicit Costs:

The opportunity costs of using the firm's own resources, such as the value of the owner's time and the use of the owner's capital.

Accounting Profit:

The difference between a firm's total revenue and its explicit costs, not including implicit costs.