Economic Profit

When an accountant examines a business, he concerns himself with production costs and how they affect the firm's profitability. However, when an economist looks at costs, she is more interested in why the firm's founders have decided to do this particular type of business or why they decided to do it in particular way and what economic impact those decisions have on the rest of the economy.

The simplest accounting of a business is to consider total revenue, total cost, and profit. Total revenue is simply the total amount of money that the firm receives for its production. Total costs are the cost of all the inputs that were necessary to produce the products. Profit, then, equals total revenue minus total costs.

An accountant is mainly concerned with cash flow, and, thus, costs are anything that requires the payment of money. However, economists also consider opportunity cost as a cost of doing business, since this yields greater insight into the selection of a particular type of business.

Opportunity costs do not require an outlay of cash —they are not explicit costs. Opportunity costs are implicit costs because no payment is required, but simply represents what is forgone in doing a particular thing. So if a surgeon who makes $400 per hour doing surgery takes 2 hours to mow her own lawn instead of hiring a lawn service at $40 per hour, then the surgeon forgoes the $720 that she could have netted doing surgery and paying $80 to the lawn service to do the job.

The cost of capital also has an opportunity cost, in that it can be invested in many different enterprises, some earning a higher profit than others. Or the money can just be deposited in a bank account, where it can earn interest. By investing the money in a firm, the interest that could have been earned in a bank account is forgone — this represents the opportunity cost of capital.

Accounting Profit = Revenue – Explicit Costs

Economic Profit = Revenue – Explicit Costs – Implicit Costs

Economic Profit = Accounting Profit – Implicit Costs

Sometimes economic profit is presented as total revenue minus economic costs, which yields the same result, since economic costs include all explicit and implicit costs.

Economic Costs = Explicit Costs + Implicit Costs

Economic Profit = Revenue – Economic Costs

To better see the difference between economic and accounting profit, consider a carpenter who earns $30 per hour working for someone else. However, he decides that he can make more money working for himself, so he starts his own business, and eventually makes $40 per hour after subtracting all his expenses. In this case, his accounting profit is $40 per hour, but his economic profit is only $10 per hour, since the opportunity cost of his time is $30 per hour, which is what he can make as an employee. But what if he only makes $20 per hour? Then he still has an accounting profit of $20 per hour, but his economic profit is now -$10 per hour, since he is making $10 per hour less than he would if he worked as an employee. So for each hour that he works at his business, he is forgoing $10. Hence, if there is no economic profit, then it is unlikely that an individual would continue in a business when more money can be made doing something else.

In this way, economic profit helps to determine the allocation of economic resources, since people and businesses will seek those projects that yield the greatest economic profit, thus minimizing opportunity costs and maximizing allocative efficiency. In the long run, however, economic profits tend to 0.

Normal Profits Are Earned, When Economic Profits = 0

Because economic profit includes the opportunity costs of the entrepreneur or the business owners, economists say that a normal profit is earned when the economic profit = 0. In other words, the difference between the economic profit of 0 and the accounting profit is enough to compensate the business owners to continue the business. If economic profits exceed 0, then other firms will enter the industry, until the increased supply reduces prices enough so that economic profits again = 0. However, if normal profits are not earned, then firms will exit the industry, until lower supply raises prices high enough for the remaining firms to earn a normal profit. Thus, economic profits = 0, when the market reaches equilibrium.

Note that accounting profit is easily measured, but not economic profit, because opportunity costs are hard to measure. Hence, economic profit is more of a heuristic concept than a practical one.