Economic profits

What Is Economic Profit?

Economic profit represents the difference between total revenue and total costs, including both explicit and implicit costs. It is a key concept within microeconomics and managerial economics, providing a more comprehensive view of a firm's profitability than traditional accounting profit. Unlike accounting profit, which only considers explicit (out-of-pocket) costs, economic profit factors in the opportunity cost of resources. This means it accounts for the value of the next best alternative use of a business's capital and time. For a business to be considered truly successful from an economic standpoint, it must generate enough revenue to cover all its explicit costs and the implicit costs associated with its operations, including a normal rate of return on invested capital.

History and Origin

The concept of profit has been a central theme in economic thought for centuries, with its origins traceable to classical economists like Adam Smith and David Ricardo. However, the distinct idea of "economic profit" as separate from accounting profit gained prominence with the development of neoclassical economics. This school of thought emphasized the role of opportunity cost in economic decision-making. Early economists grappled with how to define and measure profit, with various theories emerging regarding its source, whether as a surplus in production, a return on deferred consumption, or a reward adjusted for risk¹⁸, ¹⁹.

The formalization of economic profit, specifically its inclusion of implicit costs, highlighted the idea that a business must not only cover its direct expenses but also the income it could have earned from alternative investments or activities. This distinction became crucial in understanding market efficiency and resource allocation. The notion of economic profit being driven to zero in perfectly competitive markets, due to the entry and exit of firms, is a cornerstone of this economic theory¹⁶, ¹⁷.

Key Takeaways

• Economic profit is calculated by subtracting both explicit and implicit costs (including opportunity costs) from total revenue.
• It provides a more accurate measure of a firm's true profitability and efficiency in resource allocation compared to accounting profit.
• In a perfectly competitive market, economic profit tends towards zero in the long run as new firms enter or existing firms exit.
• Positive economic profit indicates that a business is earning more than its explicit costs and the opportunity cost of its capital and entrepreneurship.
• Understanding economic profit is crucial for strategic decision-making and assessing the long-term viability of a business.

Formula and Calculation

The formula for economic profit incorporates both explicit and implicit costs.

Where:

• Total Revenue represents the total amount of money generated by a company from its sales of goods or services.
• Explicit Costs are the direct, out-of-pocket expenses incurred by a business, such as wages, rent, raw materials, and utility payments. These are easily quantifiable and appear on a company's financial statements.
• Implicit Costs represent the opportunity costs of resources owned and used by the firm. These are not direct monetary payments but are the income forgone by not using resources in their next best alternative use. Examples include the salary an entrepreneur could have earned working elsewhere or the interest income lost on capital invested in the business.

Alternatively, economic profit can be viewed in relation to accounting profit:

Accounting profit is calculated as total revenue minus explicit costs. By subtracting the implicit costs from accounting profit, we arrive at economic profit, which reflects the true economic gain or loss.

Interpreting the Economic Profit

Interpreting economic profit goes beyond simply looking at a positive or negative number; it provides insights into the true performance and strategic positioning of a firm within its industry. A positive economic profit suggests that the business is not only covering all its direct expenses but is also earning more than what its resources could have generated in their best alternative uses. This indicates a sustainable competitive advantage and signals that the firm is creating genuine economic value. In competitive markets, positive economic profit often attracts new entrants, as others seek to capture a share of these excess returns.

Conversely, zero economic profit, often referred to as normal profit, means that a firm is covering all its explicit and implicit costs. While this might appear to be a lack of profit from an accounting perspective, it implies that the business is earning exactly what its resources could earn in their next best alternative. This is a common outcome in perfectly competitive markets in the long run, where entry and exit of firms drive profits to a normal level¹⁵. A negative economic profit, or economic loss, indicates that the firm's resources could earn more if deployed elsewhere, prompting a re-evaluation of its business strategy or potential exit from the market. This framework is vital for understanding resource allocation and long-term viability in economic systems.

Hypothetical Example

Consider "GreenThumb Landscaping," a small business owned and operated by Jane. In a given year, GreenThumb generates $150,000 in total revenue from its landscaping services.

Her explicit costs are as follows:

• Wages for employees: $60,000
• Equipment rental and maintenance: $20,000
• Supplies (plants, soil, etc.): $15,000
• Rent for office space: $10,000
• Utilities and other administrative costs: $5,000

Total Explicit Costs = $60,000 + $20,000 + $15,000 + $10,000 + $5,000 = $110,000

Now, let's consider Jane's implicit costs:

• Jane could earn $50,000 annually if she worked as a landscape designer for a large corporation (her forgone salary).
• She invested $50,000 of her own savings into GreenThumb, which could have earned a 5% return ($2,500) in a low-risk savings account or certificate of deposit (CD).

Total Implicit Costs = $50,000 (forgone salary) + $2,500 (forgone interest) = $52,500

First, let's calculate GreenThumb's accounting profit:
Accounting Profit = Total Revenue - Explicit Costs
Accounting Profit = $150,000 - $110,000 = $40,000

Next, we calculate the economic profit:
Economic Profit = Accounting Profit - Implicit Costs
Economic Profit = $40,000 - $52,500 = -$12,500

Despite having an accounting profit of $40,000, GreenThumb Landscaping has an economic profit of -$12,500. This negative economic profit suggests that Jane's resources (her time and capital) could be better utilized elsewhere. If she took the corporate job and invested her savings, she would be $12,500 better off. While the business is making money on paper, it is not generating a sufficient return to cover the opportunity costs of the entrepreneur and her invested capital.

Practical Applications

Economic profit is a crucial metric with widespread practical applications across various financial and strategic domains. In business strategy, companies strive to achieve and sustain positive economic profit, as it signifies that they are generating value beyond the minimum required return on capital. This pursuit often drives innovation and competitive advantage, forcing firms to continually seek ways to differentiate themselves or operate more efficiently¹³, ¹⁴. For instance, a firm's ability to consistently deliver positive economic profit reflects the strength of its strategic choices and its capacity to defy market forces that tend to erode excess returns over time¹².

In investment analysis, analysts use economic profit to evaluate the true profitability and value creation of a company, going beyond reported accounting figures. It helps in assessing whether a company is truly adding value for its shareholders. Furthermore, economic profit plays a role in capital budgeting decisions, guiding firms in allocating capital to projects that promise returns exceeding their cost of capital, including the opportunity cost. Regulatory bodies and economists also utilize economic profit to understand market structures, competition levels, and the potential for monopolies, which can sustain positive economic profits due to high barriers to entry¹¹.

Limitations and Criticisms

While economic profit offers a more comprehensive view of profitability than accounting profit, it is not without limitations and criticisms. One significant challenge lies in the accurate estimation of implicit costs, particularly opportunity costs, which are inherently subjective and difficult to quantify precisely⁹, ¹⁰. Unlike explicit costs, which are recorded transactions, implicit costs require assumptions and estimations, introducing potential biases into the calculation. This makes comparing economic profits across different companies or industries challenging, as the assumptions regarding opportunity costs may vary significantly⁸.

Critics also point out that focusing solely on economic profit can sometimes lead to a short-term perspective, as its calculation often relies on annual data, potentially penalizing long-term investments like research and development that may not yield immediate economic returns but are crucial for future growth⁷. Furthermore, economic profit measures may not fully capture non-financial factors, such as brand reputation, customer satisfaction, or employee morale, which contribute to a company's long-term success but are not directly reflected in the financial calculations. Academic discussions, such as those found in journals exploring the persistence of profits, highlight the complexities and measurement errors associated with both accounting and economic profit measures in empirical research⁵, ⁶.

Economic Profit vs. Accounting Profit

The distinction between economic profit and accounting profit is fundamental in understanding a firm's true financial performance.

The primary difference lies in the inclusion of implicit costs in economic profit. Accounting profit provides a statutory measure of a company's earnings, crucial for financial reporting and taxation. However, economic profit offers a more economically sound assessment by acknowledging that every business decision involves a trade-off, and the value of the next best alternative must be considered. While a business might show a substantial accounting profit, its economic profit could be zero or even negative if the owner's time and capital could have earned a higher return in a different venture. This distinction is vital for internal decision-making, strategic planning, and understanding long-term viability in competitive landscapes¹, ², ³, ⁴.

FAQs

What is the difference between explicit and implicit costs?

Explicit costs are direct, tangible outlays of money, such as wages paid to employees, rent for office space, or the cost of raw materials. These are easily quantifiable and appear in a company's financial statements. Implicit costs, conversely, are the opportunity costs of using resources already owned by the firm. They represent the value of the best alternative forgone. For example, if a business owner uses their own building for their company, the implicit cost would be the rent they could have earned by leasing that building to someone else.

Why is opportunity cost important in calculating economic profit?

Opportunity cost is crucial because it accounts for the full cost of doing business. A firm might show a positive accounting profit, but if the resources (like the owner's time or invested capital) could earn more in an alternative venture, then the business is not truly maximizing its economic potential. Including opportunity cost provides a more accurate picture of whether a business is generating value above and beyond what its resources could otherwise achieve.

Can a business have positive accounting profit but zero economic profit?

Yes, a business can have a positive accounting profit but zero economic profit. This occurs when the accounting profit is exactly equal to the implicit costs. In such a scenario, the firm is covering all its explicit costs and earning just enough to compensate the owner and investors for the opportunity cost of their time and capital. This is often referred to as a "normal profit" and is a typical outcome for firms operating in perfectly competitive markets in the long run.

Does a zero economic profit mean a business is failing?

No, a zero economic profit does not mean a business is failing. It means that the business is covering all its explicit costs and all its implicit costs, including a fair return on the capital and effort invested by the owners. From an economic perspective, this is a sustainable outcome, as the resources employed are earning as much as they could in their next best alternative use. It signifies that the business is earning a "normal profit."

How does market competition affect economic profit?

In perfectly competitive markets, economic profit tends to be driven toward zero in the long run. If firms in a competitive industry are earning positive economic profits, it attracts new firms to enter the market, increasing supply and driving down prices, which eventually erodes the economic profits. Conversely, if firms are experiencing economic losses, some will exit the market, reducing supply, increasing prices, and allowing the remaining firms to eventually achieve zero economic profit. This dynamic ensures that resources are allocated efficiently across industries.