Readers Question: When will firms be able to make supernormal profit rather than normal profit?
- Normal profit is defined as the minimum level of profit necessary to keep a firm in that line of business. This level of normal profit enables the firm to pay a reasonable salary to its workers and managers. The definition of normal profit occurs when Average Revenue AR=ATC (average total cost)
- Supernormal profit is defined as extra profit above that level of normal profit. Supernormal profit occurs where AR>ATC. Supernormal profit is also known as abnormal profit. Abnormal profit means there is an incentive for other firms to enter the industry (if they can)
The theory of perfect competition suggests that supernormal profit can only be earned in the short term. Perfect Competition involves
- Perfect information
- Freedom of Entry and exit
Therefore, if a firm is able to make supernormal profits. Other firms will be aware of this fact. Because there is no barriers to entry, firms will be encouraged to enter the market until price falls. Firms will enter and prices will fall until normal profits are made.
This is why only normal profits will be made in the long run.
However, most markets don’t have these features of perfect information and freedom of entry and exit. Most markets have a degree of barriers to entry and exit. There are sunk costs which deter entry. Therefore, even if firms are making supernormal profit, new firms may not be able to enter and compete.
Diagram showing supernormal profit in imperfect competition
For example, Tesco is making supernormal profits £3.54bn (BBC) in 2011. But, it is difficult for a new firm to compete in the supermarket industry. Tesco’s has significant economies of scale and strong brand loyalty. Therefore it is very difficult for other firms to enter. Therefore, in the long run, firms like Tesco are able to continue making supernormal profits.
Other industries may have even greater barriers to entry. Shell make profits in the region of $27bn (most profitable company). This is clearly supernormal profit. But, there are strong barriers to entry in this market.