Abnormal profit refers to the unusual profit generated by a business due to an added advantage or market structure.
Businesses can generate abnormal profits due to several reasons including an economic monopoly or imperfect competition.
Let us discuss what abnormal profit is, how it exists, and what are its advantages and disadvantages.
Abnormal Profit – Definition
By definition, any profit generated by a firm above its normal profit is called abnormal profit or economic profit.
Abnormal profit is also called economic profit, supernormal profit, or excessive profit. It’s an economic term associated with irregular profits generated by an entity.
Abnormal profit is achieved at a point where the firm generates sufficient revenue to cover all costs including explicit and implicit costs.
Explicit costs are the regular expenses incurred to generate revenue like raw materials, wages, taxes, utilities, and so on.
Implicit costs are usually difficult to quantify. For instance, the opportunity cost of buying a machine over leasing it for 10 years.
In economics, abnormal profit may exist in an imperfect market only. It exists in a perfect market only when the entity enjoys a monopoly.
There are several variations of the economic or abnormal profit formula. The most widely used formula is:
Abnormal Profit = Revenue – Explicit Costs – Implicit Costs
Further, we can see that the formula above includes accounting profit.
Accounting Profit = Revenue – Explicit Costs
Abnormal Profit = Accounting Profit – Implicit Costs
Since implicit costs are the level of revenue where the entity covers normal profit. Here, we can create a relationship between normal, abnormal, and accounting profits.
Accounting Profit = Abnormal Profit + Normal Profit
So, if there is no abnormal profit, accounting profit will be the same as normal profit.
What is Abnormal Profit in Economics?
Accounting profit is the profit an entity reports on its income statement. It is simply the surplus revenue over all costs (fixed + variable).
Contrarily, the economic profit figure is not recorded in the income statement. It includes the opportunity costs of undertaking a business as well. Therefore, it covers both the explicit and implicit costs of doing business.
Economic or abnormal profit is often analyzed to compare different investment options by individuals and businesses.
It helps entities to determine what they would earn if they had invested the same resources in another opportunity.
Simply put, if we deduct the opportunity costs (implicit costs) from normal profit, we’ll get the abnormal profit. So, when there is no opportunity cost, the normal profit is equal to the abnormal profit.
A major concern while calculating abnormal profit is the calculation of implicit costs. Opportunity costs are integral in this calculation.
For instance, undertaking another business produces a higher (or lower) normal profit utilizing the same resources.
Many of the top global firms enjoying monopoly shares in specific markets earn supernormal or abnormal profits in the short term.
For instance, Google has the largest share in the search engine industry and it has no real competitor. Similarly, Facebook enjoyed gigantic profits for years before new entrants in the social media market.
Similarly, Apple posted aggressive economic profits for several years mainly because they enjoy a significant share of the smartphone market in the US.
In the last few years, the pharmaceutical industry has seen a surge in abnormal prices due to increased demand for their products during the Pandemic.
Abnormal Profit in a Perfect Market
The theory of the perfect market states no barriers to entry or exit for entities competing in a market.
It applies, if there are abnormal profits available to one entity, more entrants will enter the perfect market. Thus, the profits of the first entity will reduce to normal levels.
Therefore, the theory of the perfect market states that abnormal profits for entities may exist only in the short term.
Conversely, when entities leave a congested or competitive market, it will make room for new entrants or increase the profits of the existing entities.
Either way, supernormal profits (and losses) do not continue in a competitive market for long. However, a perfect market hardly exists in practice.
There are several types of entry and exit barriers like access to technology, finance, human resources, language barriers, taxation, and so on.
Abnormal Profit in a Monopoly
Another market structure where abnormal profits exist is a monopoly. It is the market structure where one seller enjoys a significantly larger share of the market and controls it.
For example, Google enjoys a monopoly search engine market although there are several other competitors but their market shares are significantly lower or marginal.
A seller can increase prices due to excessive demand for its products/services to generate supernormal or abnormal profits. In such situations, customers will be willing to pay any price as no alternative will be available to them.
A similar market structure where companies generate abnormal profits is an oligopoly. It is a market structure where very few market competitors exist.
For example, Apple and Samsung compete in an oligopoly market in the US and several other parts of the world as there are a few other competitors in the smartphone market globally.
Abnormal Profit Vs. Normal Profit
Normal profit is also called “zero economic” profit. It is a point where an entity generates revenues equaling its total costs.
The total costs here include the explicit costs plus the business’s opportunity cost (rate of return). It includes a profit margin required by shareholders at which they’ll be willing to continue the business.
Therefore, normal profits will include the amount of accounting profit reported in a company’s income statement. In other words, it is the sum of a business’s total explicit and implicit costs.
On the other hand, when an entity generates profits above normal profit, it is called abnormal or supernormal profit.
As mentioned above, it exists only in special market conditions like a monopoly, oligopoly, or imperfect market.
For most businesses, when there is no economic or abnormal profit, their normal profit will be equal to the accounting profit reported in the income statement.
Advantages of Abnormal Profit
Abnormal or economic profits provide several advantages to the market and the earning company:
- It can be used to recover previous losses or future investment opportunities.
- Businesses can invest in research and development programs.
- Governments can collect more taxes or highly profitable entities.
- Shareholders can receive higher dividends and also see business growth.
- Abnormal profits attract new entrants and offer incentives for developing new products/technology.
Disadvantages of Abnormal Profit
Supernormal or abnormal profits are not always beneficial to the market as they also come with some disadvantages.
- Abnormal profits are often generated through market monopolies. It means businesses take unfair advantage of low competition at the cost of customers’ wealth.
- Most large companies enjoying abnormal profits stash their wealth in low-tax heavens and often avoid taxes too.
- Large corporate and wealthy shareholders take the larger chunk of these profits.
- Companies with abnormal profits do not invest in research and development and often accumulate cash indicating unused reserves for years.
- Abnormal profit indicates a company does not have a net positive value (+NPV) project to invest in.