CFA CFA Level 1 Economic profit vs normal profit

Economic profit vs normal profit

  • This topic has 4 replies, 4 voices, and was last updated May-17 by edulima.
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    • cmah
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      If economic profit is accounting profit less total implicit opportunity cost, and normal profit is accounting profit less implicit opportunity cost, what is the difference between economic and normal profit? Isn’t the formula Acct profit= ec profit + normal profit double counting implicit opportunity cost?

    • christine
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      Hi @cmah – welcome to the forum! 🙂

      The formulae may be the same, but the concept and definition is different.

      Economic profit is a number is as you mention, accounting profit less total implicit opportunity costs.

      Normal profit is a concept that arises in perfect competition, when economic profit is zero. i.e. accounting profit = total implicit opportunity costs, meaning that the business is just making enough to continue operating (which is how things are supposed to be in perfect competition).

    • Sascha
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      @cmah

      Normal Profit is the difference between Accounting profit and Economic Profit. So not Accounting profit less implicit opportunity cost, but Accounting profit less Economic profit.

      In other words, the profit that is necessary to cover the opportunity costs. So if Accounting profit equals Normal Profit, your Economic Profit will be 0.

      It is very accessible if you write the equation down and rearrange:

      AP = EP + NP
      EP = AP – NP
      NP= AP – EP

      I hope this helps 🙂

    • Sascha
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      To give an example: A firm has AP of 1,000,000 and implicit opportunity cost of 500,000. In this case, NP would be 500,000 (equalling the opportunity cost) and Economic Profit would be the difference between the two, 500,000.

    • edulima
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      Agree with @Sascha: the formula in the very first post was incorrect. Normal Profit numerically equals Opportunity Cost (since it is the amount required to cover opportunity costs).

      An important point is that for a publicly traded company, the main component of the opportunity cost is the return required by investors on their equity capital (a fixed cost), so if the company earns just enough to cover all its explicit costs (like what they need to pay for labor and other inputs, or the “accounting” costs) plus the amount for these “normal” (or required) returns, then they are only earning the “normal” profit but nothing more: the economic profit is zero.

      If they are making more money than that, then that’s when they start earning positive economic profit. If they make less money than that (i.e. they don’t cover the required return), then they suffer an economic loss (negative economic profit).

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