Economic gross margin

What Is Economic Profit?

Economic profit is a financial metric used in managerial economics that represents the difference between a firm's total revenue and its total costs, including both explicit and implicit costs. Unlike accounting profit, which only considers explicit, out-of-pocket expenses, economic profit incorporates the concept of opportunity cost. This means it accounts for the value of the next best alternative use of a company's resources. When economic profit is zero, it indicates that a firm is earning a normal profit, meaning it is covering all its costs, including the implicit cost of capital and entrepreneurial effort.

History and Origin

The concept of economic profit is deeply rooted in classical and neoclassical economic theory, particularly in the study of market structures and firm behavior. Early economists recognized that merely covering monetary expenses wasn't enough to assess a business's true profitability or its efficient use of resources. Frank H. Knight, in his 1921 work "Risk, Uncertainty, and Profit," significantly contributed to distinguishing between different forms of profit, emphasizing the role of uncertainty and the entrepreneur's reward for bearing it. The Library of Economics and Liberty highlights that profits are a return to those who take risks and a return to organizational ability, enterprise, and entrepreneurial energy.⁹,⁸ This foundational understanding underscores that economic profit is not just about revenue minus costs, but also about the inherent value of foregone alternatives and the returns necessary to keep resources employed in their current use.

Key Takeaways

• Economic profit subtracts both explicit and implicit costs from total revenue.
• Implicit costs represent the opportunity cost of using a firm's own resources.
• A positive economic profit indicates that a firm is earning more than its next best alternative.
• Zero economic profit implies the firm is earning a normal profit, covering all explicit and implicit costs.
• Economic profit is a theoretical concept used for strategic planning and investment decisions, not for financial reporting.

Formula and Calculation

The formula for calculating economic profit involves subtracting total explicit and implicit costs from total revenue. Explicit costs are typically tangible, out-of-pocket expenses, such as wages, rent, and raw materials. Implicit costs are the non-monetary, or opportunity, costs associated with a firm's use of its own resources.

The formula is expressed as:

$\text{Economic Profit} = \text{Total Revenue} - (\text{Explicit Costs} + \text{Implicit Costs})$

Alternatively, since total cost in economic terms includes both explicit and implicit costs:

$\text{Economic Profit} = \text{Total Revenue} - \text{Total Economic Costs}$

For example, if a business owner uses their own building for operations, the explicit costs would be the utilities and maintenance, while the implicit cost would be the rent they could have earned by leasing the building to someone else. Social Sci LibreTexts emphasizes that economic profit includes the opportunity costs associated with production and is therefore lower than accounting profit.⁷

Interpreting Economic Profit

Interpreting economic profit provides critical insights into the efficiency and long-term viability of a business, especially within the field of managerial economics.

• Positive Economic Profit: If a firm earns a positive economic profit, it indicates that its current use of resources is more profitable than any alternative use. This suggests the business is highly efficient and is attracting resources, potentially drawing new competitors into the market in a perfect competition scenario.
• Zero Economic Profit: A zero economic profit means the firm is covering all its explicit costs and implicit costs. While this might sound like a lack of "profit" in the everyday sense, it means the business is earning exactly what its resources could earn in their next best alternative use. There is no incentive for resources to enter or exit the market.
• Negative Economic Profit (Economic Loss): A negative economic profit, or economic loss, indicates that the firm's resources could generate a higher return in an alternative venture. This suggests that the business is not efficiently utilizing its resources, and over time, resources may exit this market to pursue more lucrative opportunities.

This interpretation helps businesses make better resource allocation decisions.

Hypothetical Example

Consider "GreenThumb Landscaping," a small business owned and operated by Alex. In a year, GreenThumb generates $150,000 in revenue.

Her explicit costs include:

• Wages for employees: $60,000
• Supplies and equipment: $20,000
• Rent for office/storage: $10,000
• Utilities: $5,000
• Total Explicit Costs = $60,000 + $20,000 + $10,000 + $5,000 = $95,000

Now, consider Alex's implicit costs:

• Alex could earn $50,000 per year working as a landscape designer for another company (opportunity cost of her labor).
• Alex used $20,000 of her personal savings to start the business, which could have earned $2,000 in interest if invested in a low-risk bond (opportunity cost of her capital).
• Total Implicit Costs = $50,000 + $2,000 = $52,000

First, calculate the accounting profit:
Accounting Profit = Total Revenue - Explicit Costs
Accounting Profit = $150,000 - $95,000 = $55,000

Next, calculate the economic profit:
Economic Profit = Total Revenue - (Explicit Costs + Implicit Costs)
Economic Profit = $150,000 - ($95,000 + $52,000)
Economic Profit = $150,000 - $147,000 = $3,000

In this hypothetical example, GreenThumb Landscaping has an economic profit of $3,000. This positive economic profit indicates that Alex is not only covering all her out-of-pocket expenses but is also earning $3,000 more than what her labor and capital could have earned in their next best alternative uses. This suggests that her business is an economically sound venture.

Practical Applications

Economic profit is a vital analytical tool, particularly in microeconomics and strategic business decision-making, though it is not used in traditional financial accounting.

• Investment and Capital Budgeting: Businesses utilize economic profit in capital budgeting to evaluate potential projects. A project is considered economically viable if it is expected to generate a positive economic profit, meaning it will yield a return greater than the opportunity cost of the capital invested.
• Market Entry and Exit Decisions: Firms consider economic profit when deciding whether to enter or exit a market. If a market consistently yields economic losses, firms have a clear incentive to reallocate their productive resources elsewhere. Conversely, consistent positive economic profits can signal attractive opportunities for new entrants, influencing supply and demand dynamics.
• Pricing Strategy: Understanding economic profit helps businesses set prices that not only cover explicit production costs but also account for the opportunity costs of resources, ensuring long-term sustainability and optimal profit maximization.
• Competitive Analysis: In highly competitive industries, firms often operate with zero economic profit in the long run, as competition drives down prices to the point where only normal profit is earned. This concept is crucial for understanding market equilibrium in various market structures.
• Supply Chain Management: External factors such as disruptions in global supply chains can significantly impact both explicit and implicit costs, thereby affecting economic profit. Companies face pressure to control costs and manage inventories in uncertain economic environments.⁶,⁵ For example, tariffs can disrupt global supply chains, intensifying concerns over rising costs and impacting profit forecasts for companies.⁴

Limitations and Criticisms

While economic profit offers a more comprehensive view of a firm's performance than accounting profit, it has certain limitations and faces criticisms:

• Subjectivity of Implicit Costs: The most significant challenge in calculating economic profit lies in quantifying implicit costs. Determining the precise opportunity cost of an entrepreneur's time or the alternative return on invested capital can be subjective and difficult to measure accurately. This contrasts with the objective nature of explicit costs, which are easily verifiable through financial records.
• Not Used for External Reporting: Economic profit is a theoretical concept primarily for internal decision-making and academic analysis. It is not recognized by generally accepted accounting principles (GAAP) or required by regulatory bodies like the Securities and Exchange Commission (SEC) for public financial reporting.³ Financial statements reported to investors and for tax purposes only reflect accounting profit. The SEC provides investor alerts and bulletins to educate the public about financial reporting and potential investment scams, emphasizing the importance of understanding reported financial figures.²,¹
• Dynamic Nature of Markets: The opportunity costs, and thus economic profit, can change rapidly due to shifts in market conditions, technological advancements, or new investment opportunities. This dynamic nature can make long-term projections of economic profit challenging.
• Focus on the Long Run: Economic profit is often considered in the long run, where all inputs are variable. In the short run, where some inputs are fixed, the focus might shift more towards covering variable costs.

Economic Profit vs. Accounting Profit

The distinction between economic profit and accounting profit is fundamental to understanding a firm's true financial health and decision-making incentives. While both begin with a company's total revenue, their treatment of costs differs significantly.

The confusion between the two often arises because "profit" in common parlance usually refers to accounting profit, which is the figure publicly reported by companies. However, for economists and strategic managers performing cost-benefit analysis, economic profit provides a more robust measure of whether a business is truly creating value above and beyond its next best alternative.

FAQs

Q: Why is economic profit important if it's not reported by companies?

A: Economic profit is crucial for internal decision-making because it provides a more accurate picture of a business's true profitability and efficiency. It helps managers make informed choices about resource allocation, new projects, and market entry/exit by factoring in the opportunity cost of all resources, not just those with explicit monetary outlays.

Q: Can a company have a positive accounting profit but a negative economic profit?

A: Yes, absolutely. This is a common scenario. A company might be making a positive accounting profit (revenue exceeding explicit costs), but if the entrepreneur could earn significantly more by working elsewhere, or if the capital invested could generate higher returns in another venture, the implicit costs could lead to a negative economic profit. This signals that the current business is not the most efficient use of resources.

Q: What does zero economic profit mean?

A: Zero economic profit means that a firm is earning a "normal profit." This indicates that the business is covering all its explicit costs and all its implicit costs. In other words, the resources employed by the firm are earning exactly what they could earn in their next best alternative use. While it might not seem like a "profit" in the conventional sense, it signifies that the business is sustainable in the long run within a competitive market, and there's no incentive for new firms to enter or existing firms to leave.