- Supernormal profit is all the excess profit a firm makes above the minimum return necessary to keep a firm in business.
- Supernormal profit is calculated by Total Revenue – Total Costs (where total cost includes all fixed and variable costs, plus minimum income necessary for the owner to be happy in that business.)
- 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 AR=ATC (average revenue = average total cost)
- Supernormal profit is defined as extra profit above that level of normal profit.
- 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)
Supernormal profit in perfect competition
The theory of perfect competition suggests that supernormal profit can only be earned in the short term. In the long-term firms will make normal profit.
Perfect competition is a market structure which involves:
- Perfect information
- Freedom of Entry and exit
Suppose there is a rise in demand, price rises and a firm can make supernormal profit in the short-term.
The supernormal profit is (AR – AC) * Q2. Other firms will be aware of this fact. Because there are no barriers to entry, firms will be encouraged to enter the market until price falls back down to P1 and normal profits are made.
Perfect competition in the long-run
This is why only normal profits will be made in the long run. At Q1 – AR=ATC.
Supernormal profit in monopoly
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 monopoly. It is the red shaded area.
Examples of supernormal profit in the real world
- Apple. In 2015, Apple was the world’s most profitable company with profits of $53.4 billion. It also had cash reserves of $216bn. This is accumulated profit saved in their bank accounts. The supernormal profit of Apple comes from its very strong brand loyalty and products which have sold well, despite high prices.
- JP Morgan Chase & Co. In 2015, J P Morgan Chase made profits of $24.4 billion.
- Berkshire Hathaway. An investment trust owned by Warren Buffet. Berkshire Hathaway made profits of $24.1 billion.
- In the Shell is the most profitable firm with profits in the region of $27bn (most profitable company). This is clearly supernormal profit. There are strong barriers to entry in the oil/petroleum market.
- In 2011, Tesco was making supernormal profits of £3.54bn (BBC) in 2011. At the time it was difficult for new firms to compete in the supermarket industry. Tesco’s has significant economies of scale and strong brand loyalty. However, since 2011, its profitability has faltered because new European supermarkets Lidl and Netto) have entered the market – making UK supermarkets more competitive and less profitable.