Economic economic profit

What Is Economic Profit?

Economic profit represents the residual gain a business achieves after accounting for both its explicit and implicit costs, including the crucial element of opportunity cost. Unlike accounting profit, which typically focuses only on explicit, out-of-pocket expenses, economic profit provides a more comprehensive view of a firm's profitability by considering what an entrepreneur or firm could have earned by deploying their resources in their next best alternative use. This concept is fundamental to microeconomics and decision-making, helping firms determine the true viability and efficiency of their operations. When a firm earns positive economic profit, it signifies that its current use of resources is superior to all alternative uses, thereby justifying its continued operation in that specific industry.

History and Origin

The concept of profit, and the distinction between different forms of cost and return, has evolved through economic thought. While rudimentary ideas of profit existed earlier, the systematic distinction that underpins modern economic profit can be traced back to the development of neoclassical economics. Alfred Marshall, a pivotal figure in this school of thought, extensively discussed various forms of cost and return in his seminal work, Principles of Economics, first published in 1890. Marshall's work laid much of the groundwork for understanding how price and quantity are determined by the interplay of supply and demand, and how firms make decisions in various market structures. His analysis, building on earlier classical economists, helped formalize the idea that true profit must account for the full cost of all inputs, including the implicit returns to the owner's capital and labor. An online version of Marshall's Principles of Economics is available through the Online Library of Liberty, a project of Liberty Fund.⁴

Key Takeaways

• Economic profit is calculated by subtracting both explicit and implicit costs, including opportunity costs, from total revenue.
• A positive economic profit indicates that a business is earning more than it could in its next best alternative, signifying a truly efficient allocation of resources.
• In conditions of perfect competition, economic profit tends towards zero in the long run as new firms enter the market.
• Positive economic profits can persist in markets with significant barriers to entry, such as a monopoly.
• The concept of economic profit is crucial for evaluating long-term business viability and efficient resource allocation, rather than just short-term financial performance.

Formula and Calculation

The formula for economic profit is:

Where:

• Total Revenue: The total income generated from sales of goods or services.
• Explicit Costs: Direct, out-of-pocket expenses paid to others (e.g., wages, rent, raw materials).
• Implicit Costs: The opportunity costs of resources already owned by the firm that could have been used for an alternative purpose (e.g., the forgone salary an entrepreneur could have earned working elsewhere, or the rent that could have been collected on owned property).

This formula highlights that economic profit considers the full spectrum of costs, including those not directly involving a cash outflow but representing a missed opportunity.

Interpreting the Economic Profit

Interpreting economic profit goes beyond merely looking at a company's bottom line. A positive economic profit means that a business is not only covering all its direct expenses but also generating a return greater than what its owners or investors could have achieved by employing their capital and effort in the next best alternative. This signals that the firm is creating true economic value and that its resource allocation decisions are sound.

Conversely, a zero economic profit (also known as normal profit) indicates that the firm is covering all its costs, explicit and implicit, and is earning precisely what it could earn in its next best alternative. While a zero economic profit might sound undesirable from an accounting perspective, it implies that the business is earning a competitive return and is sustainable in the long run within a competitive market. A negative economic profit, or economic loss, suggests that the firm's resources could be more profitably employed elsewhere, indicating that it is not efficiently utilizing its assets or is operating in an unviable market. Firms experiencing economic losses are incentivized to exit the market in the long run or reallocate their resources.

Hypothetical Example

Consider "GreenGrow Farms," an organic produce farm. In a given year, GreenGrow Farms generates $500,000 in revenue from selling its produce.

Its explicit costs include:

• Wages for farmhands: $150,000
• Fertilizers and seeds: $50,000
• Equipment maintenance: $20,000
• Utilities: $10,000
• Total Explicit Costs = $150,000 + $50,000 + $20,000 + $10,000 = $230,000

The farmer, an entrepreneurship enthusiast, owns the land and equipment outright. However, these assets have implicit costs:

• The land could be rented out for $30,000 per year.
• The farmer could earn a salary of $80,000 working as an agricultural consultant.
• Total Implicit Costs = $30,000 + $80,000 = $110,000

Now, let's calculate GreenGrow Farms' accounting profit and economic profit:

• Accounting Profit = Total Revenue - Explicit Costs = $500,000 - $230,000 = $270,000

• Economic Profit = Total Revenue - (Explicit Costs + Implicit Costs)

  • Economic Profit = $500,000 - ($230,000 + $110,000)
  • Economic Profit = $500,000 - $340,000
  • Economic Profit = $160,000

In this example, GreenGrow Farms has an accounting profit of $270,000, which might seem impressive. However, its economic profit is $160,000. This positive economic profit indicates that the farm is not only covering all its operational costs but is also generating $160,000 more than the farmer could achieve by renting out the land and working as a consultant. This suggests that the farmer's decision to operate GreenGrow Farms is economically sound and achieves a high level of economic efficiency.

Practical Applications

Economic profit plays a significant role in various real-world applications within business and economic analysis:

• Market Entry and Exit Decisions: Businesses use economic profit to decide whether to enter or exit a specific market. A consistent negative economic profit suggests that resources would be better utilized elsewhere, prompting exit or reallocation. Conversely, sustained positive economic profit in an industry often attracts new firms, assuming low barriers to entry, leading towards market equilibrium.
• Investment Analysis: Investors and analysts consider economic profit when evaluating a company's true value and future prospects. A firm generating substantial economic profit is often seen as having a sustainable competitive advantage.
• Antitrust and Regulation: Regulatory bodies, such as the Federal Trade Commission (FTC) in the United States, use economic profit concepts in antitrust cases. Persistent, high economic profits in an industry can signal potential monopolistic practices or reduced competition, prompting scrutiny. The FTC's Bureau of Competition enforces antitrust laws to promote competition and protect consumers.³
• Strategic Planning: Companies utilize economic profit in their internal strategic planning. It helps them assess the profitability of different product lines, departments, or projects, guiding decisions on resource allocation and business expansion or contraction. It provides a more accurate picture of performance than accounting profit, leading to better strategic choices.

Limitations and Criticisms

While economic profit offers a more robust measure of profitability than accounting profit, it is not without limitations or criticisms. One primary challenge lies in accurately quantifying implicit costs, especially opportunity costs. These costs are often subjective and difficult to assign a precise monetary value, as they represent foregone alternatives that did not materialize. For instance, determining the exact alternative salary an entrepreneur could earn, or the exact rental income for a unique property, can involve significant estimation.

Furthermore, economic profit is a theoretical concept that relies on assumptions about perfect information and rational decision-making, which may not always hold true in the complex real world. The International Monetary Fund (IMF) has highlighted the general challenges inherent in economic measurement, especially concerning concepts like intangible capital and broader economic success, which can indirectly impact the assessment of true economic profit.² This difficulty in precise measurement can make economic profit less straightforward to apply in practical financial reporting compared to accounting profit. Critics also argue that focusing too heavily on maximizing economic profit can sometimes lead firms to overlook other important considerations, such as social welfare or long-term sustainability that might not be fully captured by immediate profit metrics. Some perspectives suggest that the focus on high profits can be misconstrued, advocating for a balanced view of competition and profitability.¹

Economic Profit vs. Accounting Profit

The distinction between economic profit and accounting profit is crucial for a complete understanding of a business's financial health and strategic viability.

The primary confusion between the two arises because accounting profit is what most people, and indeed tax authorities, consider "profit" in the everyday sense. It's the easily quantifiable gain reported on financial statements. However, economists delve deeper, recognizing that a business could be showing a positive accounting profit while simultaneously underperforming relative to its next best alternative, thereby earning a negative economic profit. In such cases, despite appearing profitable on paper, the firm is not truly maximizing its return on invested resources.

FAQs

Q1: Can a business have a positive accounting profit but a negative economic profit?

Yes, absolutely. This occurs when a business covers all its explicit, out-of-pocket costs and shows a positive accounting profit, but the implicit costs (the value of the foregone alternatives) are greater than this accounting profit. This means the resources employed in the business could generate a higher return elsewhere.

Q2: What does zero economic profit mean?

Zero economic profit, also known as normal profit, means that a firm is earning just enough to cover all its explicit and implicit costs. In essence, the business is making a competitive return on its resources; its owners and investors are earning exactly what they could earn if their capital and effort were deployed in their next best alternative. It implies market equilibrium in competitive industries.

Q3: Why is opportunity cost so important in calculating economic profit?

Opportunity cost is critical because it represents the true cost of choosing one alternative over another. By including it, economic profit provides a more accurate measure of a business's efficiency and true profitability, helping decision-makers understand if their chosen venture is truly the most beneficial use of their resources compared to other available options.

Q4: In what types of markets is economic profit most likely to persist in the long run?

Long-run positive economic profits are most likely to persist in markets with high barriers to entry, such as a monopoly or an oligopoly. These barriers, which can include high startup costs, patented technology, or government regulations, prevent new competitors from entering the market and eroding existing firms' profits. In contrast, under conditions of perfect competition, economic profits are driven to zero in the long run as free entry and exit ensure firms only earn a normal return.