Economic profit or loss

What Is Economic Profit (or Loss)?

Economic profit (or loss) represents the difference between the revenue a business generates and the total costs of its operations, including both explicit and Implicit Costs. Unlike traditional profit measures that appear on Financial Statements, economic profit provides a more comprehensive view by incorporating the Opportunity Cost of all resources used. This concept is fundamental in Microeconomics and Managerial Economics, helping businesses and economists understand whether a company is truly creating value beyond the minimum return required to compensate for committed resources and assumed risks. A positive economic profit indicates that a firm is earning more than it could by employing its resources in their next best alternative use, while a negative economic profit, or economic loss, suggests the opposite.

History and Origin

The foundational ideas behind economic profit can be traced back to classical economic thought, particularly the concept of opportunity cost. However, the distinction between explicit and implicit costs, crucial for defining economic profit, became more formalized with the development of neoclassical economics. Alfred Marshall played a significant role in shaping modern microeconomic theory and the understanding of various profit concepts, including Normal Profit, which is a component of implicit costs in economic profit calculations.⁴ Economists sought to develop a measure that captured the true cost of doing business, considering not just out-of-pocket expenses but also the foregone benefits of alternative uses of capital, labor, and other resources.

Key Takeaways

• Economic profit incorporates both explicit and implicit costs, including the opportunity cost of all resources.
• A positive economic profit indicates that a business is generating returns greater than the best alternative use of its resources.
• It is a theoretical concept used primarily for internal Strategic Decision-Making and resource allocation, rather than for external financial reporting.
• Economic profit serves as a key indicator of a firm's true value creation and long-term sustainability.
• In perfectly competitive markets, economic profit tends towards zero in the long run due to free entry and exit, leading to a state of Market Equilibrium.

Formula and Calculation

Economic profit is calculated by subtracting both explicit and implicit costs from Total Revenue.

The formula is:

Alternatively, since Accounting Profit is defined as Total Revenue minus Explicit Costs, the formula can also be expressed as:

Where:

• Total Revenue: The total sales generated from goods or services.
• Explicit Costs: Direct, out-of-pocket expenses incurred in running the business (e.g., wages, rent, raw materials). These are easily identifiable and appear on traditional financial statements.
• Implicit Costs: The opportunity costs of resources owned and used by the firm, for which no direct payment is made. This includes the foregone income from the next best alternative use of capital, time, or other assets. For example, the salary a business owner could earn elsewhere if not running their own company, or the return on capital if invested in a different venture.

Interpreting the Economic Profit (or Loss)

Interpreting economic profit involves understanding its implications for business performance and competitive landscapes. A positive economic profit suggests that a company is not only covering all its direct expenses but also earning more than the return available from the next best alternative use of its resources. This indicates a strong Competitive Advantage and effective Resource Allocation. Such a scenario often attracts new entrants to the market in the long run, as they seek to capture some of this excess profit.

Conversely, an economic loss (negative economic profit) means the firm's resources could earn a higher return in an alternative investment. Even if a business reports an accounting profit, it might still be experiencing an economic loss if its current operations yield less than the implicit costs. This signals that the firm may need to re-evaluate its operations, consider exiting the market, or reallocate its resources to more profitable ventures.

Hypothetical Example

Consider "GreenGrow," a small urban farm specializing in organic produce. In a year, GreenGrow generates $200,000 in Total Revenue from selling its vegetables.

Their Explicit Costs include:

• Seeds and soil: $15,000
• Farmhand wages: $60,000
• Rent for urban plot: $25,000
• Utilities and maintenance: $10,000
• Total Explicit Costs = $15,000 + $60,000 + $25,000 + $10,000 = $110,000

GreenGrow's accounting profit would be $200,000 (Total Revenue) - $110,000 (Explicit Costs) = $90,000.

Now, let's consider the Implicit Costs:
The owner, who also manages the farm, foregoes a potential salary of $70,000 per year by not working as a horticultural consultant. Additionally, the capital invested in the farm (e.g., equipment, initial setup costs) could have earned a 5% return in a diversified investment portfolio, which amounts to $20,000 per year (on $400,000 of invested capital).

• Total Implicit Costs = $70,000 (foregone salary) + $20,000 (foregone investment return) = $90,000

Using the economic profit formula:
Economic Profit = Total Revenue - (Explicit Costs + Implicit Costs)
Economic Profit = $200,000 - ($110,000 + $90,000)
Economic Profit = $200,000 - $200,000
Economic Profit = $0

In this hypothetical example, GreenGrow earns zero economic profit. While it makes a $90,000 accounting profit, this profit is exactly enough to cover the owner's foregone salary and the return on their invested capital. This scenario is also known as earning a Normal Profit, meaning the business is covering all its costs, both explicit and implicit, and the owner is earning a return equivalent to their next best alternative.

Practical Applications

Economic profit serves as a critical analytical tool across various financial and economic contexts. Businesses use it to evaluate investment opportunities and guide Capital Allocation decisions. By considering implicit costs, firms can make more informed choices about which projects to undertake, ensuring that investments yield returns above the true cost of capital.

In market analysis, understanding economic profit helps assess the competitiveness and sustainability of industries. Industries with persistent positive economic profit often indicate the presence of barriers to entry or unique competitive advantages, such as proprietary technology or strong brand loyalty. Conversely, industries with widespread economic losses signal overcapacity or declining demand, leading to exits and consolidation. For instance, the U.S. Bureau of Economic Analysis collects and reports data related to corporate profits, which, while primarily accounting-based, form the basis for further economic analysis that considers implicit costs and true value creation.³ Economic profit also plays a role in evaluating regulatory impacts, helping policymakers understand how new rules might affect the profitability and sustainability of businesses, considering all their costs.

Limitations and Criticisms

While economic profit offers a more complete picture of a firm's performance than accounting profit, it is not without limitations. A primary criticism stems from the inherent difficulty in accurately measuring Implicit Costs. Estimating the Opportunity Cost of an owner's time, or the return on capital in its "next best alternative use," often involves subjective judgments and can vary significantly depending on the assumptions made. This subjectivity can make economic profit calculations less precise and harder to verify compared to Explicit Costs, which are typically recorded in financial accounting systems.

Furthermore, the concept of economic profit can fluctuate significantly due to changing market conditions. For example, if alternative investment returns increase, the implicit cost of capital for a business also rises, potentially reducing its calculated economic profit, even if its explicit revenue and costs remain stable. Academic research has explored the "persistence" of profit, noting differences between accounting and economic profit measures and the challenges in accurately reflecting long-term competitive dynamics.² Some critiques also highlight that a focus solely on profit maximization, even economic profit, may not fully account for broader societal and environmental impacts, suggesting that a sustainable economy requires a more holistic view beyond just financial returns.¹

Economic Profit (or Loss) vs. Accounting Profit

The distinction between economic profit (or loss) and Accounting Profit is crucial for understanding a business's true financial health and efficiency. The core difference lies in the types of costs included in their calculation.

Confusion often arises because accounting profit is the more commonly reported figure on a company's Financial Statements and is used for tax purposes. However, accounting profit does not consider the alternative uses of a company's own resources. Economic profit, by incorporating Opportunity Cost, offers a more insightful perspective for management, revealing whether the business is truly generating wealth beyond what its resources could earn elsewhere. For example, a business might show a positive accounting profit, but if the owner could earn significantly more by working for another company, or if the capital could generate a higher return in a different venture, then the firm might be experiencing an economic loss.

FAQs

Q1: What is the main difference between explicit and implicit costs?
A1: Explicit Costs are direct, out-of-pocket expenses for which a firm makes a direct payment, such as wages, rent, and utility bills. Implicit Costs are the Opportunity Cost of resources owned and used by the firm, representing the foregone benefits of using those resources in their next best alternative.

Q2: Can a business have accounting profit but economic loss?
A2: Yes, absolutely. A business can have a positive Accounting Profit if its Total Revenue exceeds its explicit costs. However, if the implicit costs (like the owner's foregone salary or the return on invested capital) are higher than that accounting profit, the business will be experiencing an economic loss. This means the resources employed could generate a better return elsewhere.

Q3: Why is economic profit important for decision-making?
A3: Economic profit is crucial for Strategic Decision-Making because it provides a complete picture of a business's profitability by considering all costs, including the Opportunity Cost of resources. It helps managers determine if a business venture is truly creating value or if its resources would be better utilized in an alternative investment, guiding effective Capital Allocation.

Q4: What is "normal profit" in relation to economic profit?
A4: Normal Profit occurs when a business's economic profit is zero. This means that the total revenue generated is exactly equal to the total explicit and implicit costs. In essence, the firm is earning just enough to cover all its costs and provide the owner with a return equivalent to what they could earn from their next best alternative use of resources. It indicates that the firm is viable and efficient enough to remain in operation, but it is not earning any "excess" profit beyond that required to keep its resources employed.