The Truth About Zero Economic Profit

Zero economic profit is also known as normal profit, a term which is a bit counterintuitive as it is not actually reflective of a “profit” at all. Normal profit or zero profit is the revenue needed for a company to break even and meet operating costs without a loss. Zero profit is not a fixed number, but varies by market, risk-return, and competition level.

Perfect Competition

Zero economic profit most often arises in perfect competition, as it is typically a result of competitive businesses driving down profits and preventing a firm from earning more money than it spends in production costs. In fact, a zero profit margin is almost guaranteed for any business functioning in a state of pure competition, as only short term profits are possible in competitive markets. This is because the perpetual influx and departure of businesses causes market prices—and company revenues—to ebb and flow.

Pure Competition Allowances

In a state of perfect competition, when all businesses have equal access to information and to the market, profit itself is theoretically disallowed. In this system, zero profit is considered the goal, as actual profits are undermined by new firms entering the market and introducing competitive pricing. The kind of market economy present in the United States might be more accurately described as an imperfect competition, in which states of zero profit are achieved, but not on a long-term basis since businesses do actually see profits in the short term.

Long-Run Equilibrium

Long-run equilibrium is achieved when the revenue for all firms in a market is normal. In other words, this occurs when every business is making zero profit (thus only breaking even), and when no businesses are disrupting prices by either leaving or entering the market. The state of long-run equilibrium in a competitive market, otherwise known as “perfect competition in the long run,” is quite similar to a long-term competitive monopoly. In the latter case, demand for a product eventually increases along with the cost, which also levels a firm’s revenue to zero profit margins.

Infrequency

Long-run equilibrium at normal profit levels is considered to be a theoretical ideal by many economists. That is, it is almost never practicable, since there are too many other factors at play ensuring that one or more firms will always be making a profit. In fact, a state of pure competition itself is often viewed as an unattainable construct itself, as it suggests a market free of imperfections. Instead, an equilibrium based on normal profits in a state of perfect competition serves as a model against which the actual economy is measured.

Temporary and Permanent Options

Companies that find themselves in a situation of zero economic profit should not see this as a sign that the business is failing; on the contrary, this is an expected market trend in the long run. A firm at normal profit level should continue to produce products as long as it breaks even, even if it is planning to temporarily shut down. A permanent shut down—when a firm leaves the market—is recommended after periods of sustained losses, since at this point it is no longer rational or practical to continue production.

Despite negative associations with the term “zero profit,” this particular economic stage is inevitable in a free market system, which is why it is also deemed “normal”. When a firm reaches normal profit levels, however, it should take extra precautions and exercise strategic planning to ensure that no losses are incurred.