What Is Economic Profit?
Economic profit represents the difference between the total revenue a business generates and the sum of its explicit costs and implicit costs. Unlike accounting profit, which only considers explicit, out-of-pocket expenses, economic profit incorporates the opportunity cost of resources used in production. This concept is fundamental to [microeconomics and profitability measurement], providing a comprehensive view of a firm's true profitability and its efficiency in [resource allocation]. A positive economic profit indicates that a business is earning more than it could from its next best alternative use of resources, while zero economic profit, also known as normal profit, suggests that the firm is covering all its costs, including opportunity costs, but not earning excess returns.41
History and Origin
The distinction between different forms of profit, particularly the concept that includes foregone alternatives, has roots in classical and neoclassical economics. Early economic thinkers grappled with how to define and measure the returns to capital and entrepreneurship. A pivotal figure in articulating this broader understanding of profit was Alfred Marshall, a prominent economist. In his seminal work, Principles of Economics, first published in 1890, Marshall discussed the various components of income, including returns to capital, and implicitly laid the groundwork for considering the full costs, including what today are termed opportunity costs, when assessing a business's true economic standing.37, 38, 39, 40 Marshall's insights contributed to the formalization of economic profit as a key concept for analyzing firm behavior and [market competition].
Key Takeaways
- Economic profit subtracts both explicit and implicit costs, including opportunity costs, from total revenue.36
- It offers a more complete picture of a firm's profitability compared to accounting profit.34, 35
- Positive economic profit indicates that resources are being used in their most efficient way, earning more than the next best alternative.32, 33
- In perfectly competitive markets, firms tend toward zero economic profit in the long run.31
- Economic profit is a crucial tool for businesses to make informed decisions about market entry, exit, and [profit maximization].
Formula and Calculation
The formula for economic profit is:
Alternatively, it can be expressed as:
Where:
- Total Revenue is the total income generated from sales of goods or services.
- Explicit Costs are direct, out-of-pocket expenses, such as wages, rent, raw materials, and utilities.
- Implicit Costs are the opportunity costs of using resources already owned by the firm, for which no direct payment is made. This could include the salary a business owner foregoes by working for their own company instead of elsewhere, or the rent income foregone by using owned property for business operations.
Understanding these components, especially the differentiation between explicit and implicit costs, is essential for accurate calculation.29, 30
Interpreting the Economic Profit
Interpreting economic profit goes beyond simply looking at a number; it provides critical insights into a firm's efficiency and strategic decisions. A positive [economic profit] signifies that the business is not only covering all its direct costs but is also generating a return that exceeds what could have been earned by employing its resources in their best alternative use. This indicates a strong competitive position and effective [resource allocation]. Conversely, a negative economic profit, or economic loss, suggests that the firm's resources could be generating a higher return elsewhere, even if the business is reporting an accounting profit.28 A zero economic profit means the firm is earning just enough to cover all its costs, including the opportunity cost of its capital and entrepreneurship, effectively earning a [normal profit]. This state is common in highly competitive [market structures] in the long run.27
Hypothetical Example
Consider "GreenThumb Landscaping," a small business owned by Alex. In a year, GreenThumb generates $150,000 in [total revenue]. Its explicit costs, including wages for employees, fuel, and equipment maintenance, amount to $80,000.
However, Alex previously worked as a senior landscape designer for a large firm, earning a salary of $60,000 per year. By running GreenThumb Landscaping, Alex foregoes this salary. This is an [implicit cost]. Additionally, Alex uses a piece of land owned outright for the business's nursery, which could have been leased for $5,000 annually. This is another implicit cost.
To calculate GreenThumb's economic profit:
- Total Revenue: $150,000
- Explicit Costs: $80,000
- Implicit Costs: $60,000 (foregone salary) + $5,000 (foregone rent) = $65,000
Economic Profit = $150,000 - ($80,000 + $65,000)
Economic Profit = $150,000 - $145,000
Economic Profit = $5,000
In this scenario, GreenThumb Landscaping has an economic profit of $5,000. This positive economic profit suggests that Alex's decision to run GreenThumb was economically sound, as it yielded a return slightly higher than the next best alternative use of time and capital.
Practical Applications
Economic profit serves as a vital analytical tool across various financial and economic domains. Businesses use it to evaluate the viability of new projects, assess their overall efficiency, and guide decisions regarding [capital investment] and market entry or exit. If a project is expected to yield positive economic profit, it signals an efficient use of resources relative to alternatives. For policymakers and regulators, particularly those involved with [antitrust laws], the presence of persistent economic profit in certain industries can signal a lack of [market competition] or the existence of market power, which might warrant intervention.26 The Bureau of Economic Analysis (BEA), for example, tracks various measures of corporate profits, which, while distinct from economic profit, are closely watched [economic indicators] reflecting the financial health and performance of the corporate sector.22, 23, 24, 25 Moreover, analysts and investors can use the concept of economic profit to gauge a company's true sustainable advantage and its capacity for long-term value creation, going beyond reported accounting figures.21 This broader perspective is crucial for evaluating a firm's long-term sustainability and its ability to cover its [cost of capital].20
Limitations and Criticisms
While economic profit offers a more complete view of profitability than accounting profit, it is not without limitations. One primary challenge lies in accurately estimating [implicit costs]. These costs are often subjective and difficult to quantify precisely, as they represent foregone opportunities rather than tangible expenditures. For example, determining the exact opportunity cost of an entrepreneur's time or the alternative return on invested capital can be complex and relies on assumptions.18, 19
Furthermore, the concept of economic profit assumes rational economic actors constantly seeking to maximize returns, which may not always align with real-world business decisions influenced by non-financial factors. Critics also point out that in dynamic markets, a temporary positive economic profit might simply reflect successful innovation or efficient adaptation rather than a lack of competition. Sustained economic profits, however, can indeed indicate market inefficiencies or barriers to entry.17 Some academic perspectives also highlight the broader societal implications of profit generation, suggesting that certain profits might arise from the "exploitation" of social stakeholders or nature, thus implying inherent "limits to profit" if sustainability is considered.16 This broader critique extends beyond the purely financial calculation to encompass ethical and environmental considerations.
Economic Profit vs. Accounting Profit
The primary distinction between economic profit and [accounting profit] lies in the treatment of [implicit costs].
| Feature | Economic Profit | Accounting Profit |
|---|---|---|
| Costs Included | Both [explicit costs] (direct, out-of-pocket expenses) and [implicit costs] (opportunity costs of resources).15 | Only [explicit costs] (direct monetary expenses recorded in financial statements).14 |
| Formula | Total Revenue - (Explicit Costs + Implicit Costs)13 | Total Revenue - Explicit Costs12 |
| Purpose | To determine if a business is making the most efficient use of its resources by considering foregone alternatives.10, 11 | To calculate a firm's net income for financial reporting, tax purposes, and investor relations. |
| Visibility | Not typically reported on financial statements; an analytical tool for decision-making. | Reported on a company's income statement and used for tax filings and external reporting. |
| Interpretation | Positive value suggests the business is doing better than its next best alternative. Zero implies [normal profit].8, 9 | Positive value indicates the company has generated revenue in excess of its direct expenses. |
Confusion often arises because a business can report a substantial accounting profit while simultaneously earning zero or even negative economic profit. This occurs when the explicit revenues exceed explicit costs, but the implicit costs, such as the income the business owner could have earned elsewhere, are higher than the accounting profit. Economists argue that a firm is truly profitable only if it covers all costs, explicit and implicit.7
FAQs
Q1: What is the main difference between explicit and implicit costs?
A1: [Explicit costs] are direct, tangible payments made for resources, like wages, rent, or raw materials. [Implicit costs] are the unseen opportunity costs of using resources the firm already owns, representing the income foregone by not using those resources in their next best alternative. For instance, if a business owner uses their own building, the implicit cost is the rent they could have earned by leasing it out.6
Q2: Can a company have an accounting profit but an economic loss?
A2: Yes, absolutely. A company can show a positive [accounting profit] if its [total revenue] exceeds its explicit, out-of-pocket expenses. However, if the hidden [implicit costs] (e.g., the owner's foregone salary or the return on capital if invested elsewhere) are greater than that accounting profit, the business will be experiencing an economic loss. This means the resources could have been used more profitably elsewhere.4, 5
Q3: What does "zero economic profit" mean for a business?
A3: Zero economic profit, or [normal profit], means that a business is earning just enough to cover all its explicit and implicit costs, including the opportunity cost of the entrepreneur's time and capital. It signifies that the resources employed are earning a competitive rate of return, meaning they could not earn a higher return in their next best alternative use. This state is common for firms in perfectly competitive [market structures] in the long run.3
Q4: Why is economic profit important for decision-making?
A4: Economic profit is crucial for evaluating the true efficiency of [resource allocation]. It helps businesses and investors understand whether capital and effort are being utilized optimally. By considering [opportunity cost], it provides a more accurate signal for long-term strategic decisions, such as whether to enter a new market, expand operations, or even exit an industry if better opportunities exist elsewhere.1, 2