Supernormal profits

Definition

Supernormal profits are the profits that exceed the normal profit level, which is the minimum profit necessary for a firm to remain in business in a competitive market. They occur when total revenue is greater than total costs, including both explicit and implicit costs. Supernormal profits indicate that a firm is earning more than enough to cover its opportunity costs, which can attract new firms into the market, affecting supply and competition.

5 Must Know Facts For Your Next Test

1. Supernormal profits can attract new competitors to the market as they signal potential profitability, increasing overall market supply.
2. In the long run, supernormal profits tend to diminish as new firms enter the market, driving prices down and eventually leading to normal profits.
3. Firms with supernormal profits may invest in innovation or expansion to maintain their competitive advantage.
4. Regulation or taxation may be implemented by governments to limit supernormal profits in certain industries deemed essential or monopolistic.
5. Supernormal profits are often associated with monopolies or firms with significant pricing power due to barriers to entry for competitors.

Review Questions

• How do supernormal profits influence market competition and firm behavior?
  • Supernormal profits play a significant role in shaping market competition because they indicate that a firm is earning more than its normal profit level. This excess profitability attracts new entrants into the market, which increases competition and often leads to a reduction in prices. Existing firms may also respond by innovating or improving efficiency to maintain their market position and profitability.
• Analyze the long-term effects of supernormal profits on an industry and its market structure.
  • In the long term, supernormal profits tend to diminish due to increased competition as new firms enter the industry seeking their share of the excess profit. This influx of competitors raises supply, leading to a decrease in prices until firms earn only normal profits. As a result, industries characterized by supernormal profits may shift from monopoly or oligopoly structures towards more competitive environments.
• Evaluate the implications of government intervention on markets with persistent supernormal profits.
  • Government intervention in markets with persistent supernormal profits can have varied implications. Regulations or taxes aimed at reducing these profits might encourage fair competition and protect consumers from exploitation. However, such interventions could also dissuade investment and innovation if firms perceive that their potential returns are being unfairly limited. The challenge lies in balancing the need for competitive markets while fostering an environment conducive to growth and innovation.

Related terms

Normal profit: The minimum level of profit needed for a company to remain competitive in the market, covering both explicit and implicit costs.

Economic profit:

Another term for supernormal profit, representing the difference between total revenue and total costs, including opportunity costs.

Market entry: The process by which new firms enter a market, often triggered by the presence of supernormal profits in an industry.