Economic returns

What Are Economic Returns?

Economic returns refer to the profit an investment or business activity generates, taking into account both explicit and implicit costs. Unlike simpler measures of profitability, economic returns consider the opportunity cost of all resources used, including capital and the owner's time and effort. This holistic perspective falls under the broader field of Economic Theory, providing a more comprehensive view of an entity's true financial performance and efficiency in resource allocation. By factoring in these hidden costs, economic returns reveal whether a venture is truly generating value above and beyond what could have been earned by employing the same resources in their next best alternative use. This concept is crucial for understanding the true profitability of a firm or investment, guiding decisions beyond just immediate gains.

History and Origin

The concept of profit, a foundational element of economic returns, has been debated by economists for centuries. Early classical economists like Adam Smith and David Ricardo discussed profit as a residual after wages and rent, often linking it to the capitalist's reward for advancing capital. The notion evolved significantly through various schools of thought, from the classical emphasis on production and distribution to the marginalist focus on utility and resource allocation. The modern understanding of economic profit, which explicitly accounts for the implicit costs of capital and entrepreneurship, solidified within neoclassical economics. The ongoing evolution of profit theories continues to be a core subject in economic discourse.⁴

Key Takeaways

• Economic returns consider both explicit (out-of-pocket) and implicit (opportunity) costs.
• They measure the true profitability of an investment or business, accounting for the value of foregone alternatives.
• A positive economic return indicates that a venture is generating more value than its next best alternative.
• Understanding economic returns helps in optimal capital allocation and strategic decision-making.
• Unlike accounting profit, economic returns provide a more comprehensive picture of long-term economic viability.

Formula and Calculation

Economic returns, often discussed in the context of economic profit, are calculated by subtracting total economic costs from total revenue. Total economic costs include both explicit costs (e.g., wages, raw materials, rent, utilities) and implicit costs (e.g., the cost of capital, the owner's foregone salary).

The formula is expressed as:

Where:

• Total Revenue represents the total money generated from sales of goods or services.
• Explicit Costs are direct, out-of-pocket expenses for a business.
• Implicit Costs are the opportunity costs of resources owned by the firm, such as the income an owner could have earned working elsewhere, or the return on capital invested in the business if it had been invested in a comparable alternative. For instance, the implicit cost of using owned machinery is the rental income that could have been earned by leasing it out.

Consider a business owner investing personal funds; the interest that money could have earned in a safe investment is an implicit cost. Similarly, if the owner works for the business instead of taking an equivalent job elsewhere, the foregone salary is an implicit cost. Calculating economic returns thus provides a more accurate picture of a venture's true profitability and efficiency.

Interpreting Economic Returns

Interpreting economic returns involves assessing whether an activity is truly value-adding when all costs, including the often-overlooked implicit costs, are considered. A positive economic return indicates that a business or investment is generating more profit than what could have been achieved by putting the same resources to their best alternative use. This implies that the venture is not only covering its operational expenses but also compensating all factors of production (labor, capital, land, entrepreneurship) at market rates, plus earning an additional surplus.

Conversely, a zero economic return means the venture is earning just enough to cover all its explicit and implicit costs, effectively earning a "normal profit" sufficient to keep resources employed in their current use, but no more. A negative economic return, or economic loss, signals that the resources employed in the venture could generate greater value elsewhere, suggesting inefficient resource allocation. This interpretation helps businesses make critical decisions, such as whether to continue operations, expand, or reallocate resources to more profitable avenues. It provides a more robust measure for strategic planning and evaluating business efficiency than measures that ignore implicit costs. Understanding supply and demand dynamics is often crucial when evaluating the sustainability of certain returns.

Hypothetical Example

Consider "GreenGrow," a small organic farm owned and operated by Sarah. In a year, GreenGrow sells produce worth $100,000 (Total Revenue). Sarah's explicit costs include $30,000 for seeds, fertilizer, and equipment maintenance, $20,000 for hired labor, and $10,000 for property taxes and utilities. Her total explicit costs are $60,000.

Now, let's consider implicit costs. Sarah could earn $40,000 annually managing another farm (foregone salary). Additionally, she invested $50,000 of her savings into GreenGrow, which could have earned a 5% return (or $2,500) in a diversified investment portfolio.

Calculation:

• Total Revenue = $100,000
• Explicit Costs = $60,000 ($30,000 + $20,000 + $10,000)
• Implicit Costs:
  • Foregone Salary = $40,000
  • Foregone Investment Return = $2,500 ($50,000 * 0.05)
  • Total Implicit Costs = $42,500

Economic Returns (Economic Profit) = Total Revenue - (Explicit Costs + Implicit Costs)
Economic Returns = $100,000 - ($60,000 + $42,500)
Economic Returns = $100,000 - $102,500
Economic Returns = -$2,500

In this hypothetical example, GreenGrow experienced an economic loss of $2,500. Although Sarah's farm generated enough cash to cover its explicit costs and some of her implicit costs, it did not provide a return that fully compensated her for her time and invested capital when considering alternative opportunities. This analysis helps Sarah determine if continuing with GreenGrow is the most financially optimal decision, or if she should consider other investing avenues.

Practical Applications

Economic returns are a fundamental concept with widespread applications across various fields of finance and economics. Governments utilize measures of aggregate economic activity, such as gross domestic product (GDP) and its real, inflation-adjusted counterpart, to gauge the overall health and growth of a national economy. The U.S. Bureau of Economic Analysis (BEA) regularly publishes data on real GDP, which reflects the inflation-adjusted value of goods and services produced, offering insights into national economic returns.³ This data helps policymakers understand economic trends, assess the effectiveness of fiscal policies, and forecast future economic performance.

In corporate strategy, businesses use the concept to evaluate potential investments and projects. By comparing the anticipated economic returns of different opportunities, firms can prioritize those that promise the greatest value creation above and beyond their true cost of resources. Investors apply the principle to evaluate the true profitability of individual companies or assets, looking beyond reported accounting profits to understand if a venture is genuinely efficient and allocating capital effectively. Furthermore, understanding economic returns is critical in assessing market efficiency and the degree of competition. In perfectly competitive markets, it is theorized that economic returns tend towards zero in the long run, as competition drives prices down to the point where they only cover all economic costs, including a normal profit. Conversely, persistent positive economic returns often indicate some form of market power or inefficiency, such as a monopoly or informational advantage.

Limitations and Criticisms

While economic returns offer a comprehensive view of profitability, they are not without limitations and criticisms. One significant challenge lies in accurately quantifying implicit costs, particularly opportunity costs. Assigning a precise monetary value to foregone alternatives, such as the owner's labor or the capital invested, can be subjective and difficult, leading to variability in economic return calculations. This subjectivity can make comparisons between different entities or across different time periods challenging.

Another criticism arises from the concept of "economic rent," which describes payment to a factor of production in excess of the minimum amount necessary to keep that factor in its current use. While often related to economic returns, economic rent specifically highlights income derived from ownership or control over a limited asset or resource without commensurate effort or expenditure, or in excess of its opportunity cost.² Some economists argue that such "unearned" income, often stemming from market imperfections or positional advantages, skews the perception of true productive economic returns and can contribute to inequality.¹ This distinguishes economic rent from the productive surplus implied by a positive economic return. The complexities in precisely identifying and measuring all implicit costs, as well as the conceptual distinctions between various forms of economic surplus, represent ongoing debates in economic analysis.

Economic Returns vs. Accounting Profit

The distinction between economic returns (specifically, economic profit) and accounting profit is fundamental to understanding a business's true financial health. Accounting profit is a straightforward calculation: it is the total revenue minus explicit costs, such as wages, rent, and materials. This is the figure typically reported on a company's income statement and is subject to generally accepted accounting principles (GAAP).

Economic returns, on the other hand, consider both explicit and implicit costs. Implicit costs are the unseen costs representing the value of the next best alternative use of a business's resources. For example, if a business owner uses their own building, the explicit costs might only include maintenance, but the implicit cost would be the rent that could have been earned by leasing the building to someone else. Similarly, the foregone salary of an entrepreneur working in their own business is an implicit cost.

The key difference lies in this inclusion of opportunity costs in economic returns. A business might show a positive accounting profit, meaning its revenues exceed its direct expenses. However, if its economic return is zero or negative, it implies that the resources—including the owner's time and capital—could have generated a higher return in an alternative venture. Confusion often arises because "profit" in everyday language typically refers to accounting profit, without considering the full spectrum of costs and opportunities. Economic returns provide a more rigorous measure of whether a business is truly adding value above what could be achieved elsewhere, guiding more rational resource allocation decisions for maximizing overall producer surplus.

FAQs

What is the primary difference between economic and financial returns?

Economic returns encompass both explicit costs (like wages and raw materials) and implicit costs (like the value of the owner's time or the return on invested capital if it were used elsewhere). Financial returns, often referred to as accounting profits, typically only consider explicit, out-of-pocket expenses. Economic returns offer a more complete picture of true profitability by including opportunity costs.

Why are implicit costs important in calculating economic returns?

Implicit costs are crucial because they represent the value of foregone alternatives. By including them, economic returns reveal whether a business is truly generating more value than if its resources were employed in their next best use. Ignoring implicit costs can lead to a misleadingly optimistic view of profitability, as it doesn't account for the true cost of all resources utilized.

Can a business have a positive accounting profit but a negative economic return?

Yes, this is common. A business might earn enough revenue to cover its explicit costs, resulting in a positive accounting profit. However, if the implicit costs (e.g., the owner's foregone salary from an alternative job, or the return on capital if invested elsewhere) are higher than this accounting profit, the economic return will be negative. This indicates that the business is not making the best use of its resources.

How do economic returns relate to investment decisions?

Economic returns are vital for sound investment decisions. Investors and businesses aim to achieve positive economic returns, meaning their chosen ventures generate more value than alternative opportunities. Evaluating economic returns helps in allocating capital efficiently and making strategic choices that maximize overall wealth, considering all costs, including the cost of not pursuing other opportunities. This analysis often involves assessing risk-adjusted return to ensure that the compensation adequately accounts for the level of risk undertaken.

What is the significance of zero economic returns?

Zero economic returns (or zero economic profit) indicate that a business is earning just enough to cover all its explicit and implicit costs. This means the resources employed are earning exactly what they could in their next best alternative use. While it doesn't suggest an incentive to exit the market, it implies that there are no "excess" profits to attract new competitors, leading to a state of market equilibrium in perfectly competitive industries over the long run.