Economic Profit vs Accounting Profit (With a Worked Example)

Economic profit and accounting profit measure the same business in two different ways, and confusing them is one of the most common mistakes on the AP Micro exam. Accounting profit is total revenue minus explicit costs, the money that actually leaves your bank account. Economic profit subtracts one more thing: implicit costs, the value of the next-best option you gave up to run the business. Because economic profit also counts opportunity cost, it is almost always smaller than accounting profit, and a firm can report a healthy accounting profit while its economic profit is zero or even negative. Getting this distinction right changes how you answer nearly every firm-theory question.

The two formulas

Both start from the same revenue and differ only in which costs you subtract.

Accounting profit = Total revenue - Explicit costs

Economic profit = Total revenue - Explicit costs - Implicit costs

Equivalently, since accounting profit already nets out explicit costs, you can write:

Economic profit = Accounting profit - Implicit costs

That last version is the fastest one to use on the exam. If a question hands you an accounting profit and then lists a forgone salary or forgone interest, you simply subtract those implicit costs to get economic profit. The interactive economic profit calculator walks the same arithmetic step by step.

Explicit costs versus implicit costs

Explicit costs are direct cash payments to other people: wages you pay staff, rent, ingredients, utilities, interest on a loan. Money physically leaves the firm. See explicit costs for the precise definition.

Implicit costs are the opportunity costs of resources the owner already owns and puts into the business, so no cash changes hands. The three that show up most often on the exam are the salary you could earn working elsewhere, the interest or return your invested savings could earn in their next-best use, and the rent you could collect on a building or equipment you own instead of using it yourself. See implicit costs and the underlying idea of opportunity cost.

The reason implicit costs matter is that resources are scarce. Every hour and every dollar the owner commits to this business is an hour or dollar not earning a return somewhere else, and a real accounting of profit has to charge the business for that.

A worked example

Suppose Maya quits a $60,000 per year office job to open a bakery. She invests $20,000 of her own savings that had been earning 5% interest in a bank account. Over her first year the bakery brings in $200,000 of revenue and Maya pays the following explicit costs: $80,000 for ingredients, $30,000 for rent, and $40,000 in wages to her staff, which totals $150,000.

Her accounting profit is a comfortable-looking $50,000: revenue of $200,000 minus explicit costs of $150,000. But her implicit costs total $61,000, the $60,000 salary she gave up plus the $1,000 of interest her savings would have earned. Subtracting those, her economic profit is $50,000 minus $61,000, which is negative $11,000.

The interpretation is the whole point. Maya is not losing money in a cash sense, she took home $50,000. But she is $11,000 worse off than her best alternative, which was keeping her job and leaving her savings in the bank. A negative economic profit is the economist's signal that resources would be better used elsewhere.

A second case: when economic profit turns positive

Now suppose Maya's second year goes better. Revenue climbs to $230,000 while her explicit costs hold steady at $150,000, so her accounting profit rises to $80,000. Her implicit costs are unchanged at $61,000, the $60,000 salary she still forgoes plus the $1,000 of interest her savings would earn. Economic profit is now $80,000 minus $61,000, a positive $19,000. This is the mirror image of year one: Maya is not merely taking home cash, she is $19,000 better off than her best alternative of returning to her old job and leaving her savings in the bank. A positive economic profit is the signal that resources are in their best use, and in a competitive market it is also the magnet that draws new firms in, a mechanism we return to below.

Normal profit: the break-even point that is not zero

There is a special case worth naming. Normal profit is the level of accounting profit that makes economic profit exactly zero. In Maya's example that would be an accounting profit of $61,000, precisely enough to cover her implicit costs. At that point she earns exactly what her time and money could earn in their next-best use, so she is indifferent between running the bakery and taking her outside options. See normal profit.

This is why economists treat normal profit as a cost, not a reward. When a firm earns zero economic profit, it is still earning normal profit and has no reason to shut down or switch. Zero economic profit is a perfectly healthy, break-even outcome, which is exactly what trips students up when they meet the long-run result below.

Why economic profit is zero in the long run under perfect competition

In a perfectly competitive market, firms are price takers, the product is identical across sellers, and there are no barriers to entry or exit. Those last two conditions drive economic profit to zero in the long run through a self-correcting cycle:

If firms earn positive economic profit, the market is more attractive than the alternatives, so new firms enter. Entry increases market supply, which pushes the market price down. Price keeps falling until the typical firm's economic profit is competed away to zero.

If firms earn negative economic profit (losses), some firms exit for better opportunities. Exit decreases market supply, which pushes the price back up until the remaining firms break even at zero economic profit.

Entry and exit stop only when there is no incentive to move, and that happens precisely at zero economic profit. At this long-run equilibrium the firm produces where price equals marginal cost equals the minimum of average total cost, so P = MR = MC = minimum ATC. The firm is both allocatively and productively efficient, and it earns exactly a normal profit. You can watch this entry-and-exit adjustment play out by dragging the curves in the perfect competition sandbox, and the full model is covered in the perfect competition module.

So the famous result that "firms earn zero economic profit in the long run" is not a claim that competitive firms make no money. It means their accounting profit has fallen to normal profit, just enough to keep their resources in the industry rather than moving them elsewhere.

Bringing it together

Accounting profit tells you whether cash is coming in. Economic profit tells you whether the business is the best use of the owner's scarce time and money once opportunity cost is included. On the exam, whenever a prompt mentions a salary the owner gave up, savings that could have earned interest, or a building the owner already owned, it is signaling an implicit cost you must subtract to find economic profit. Pair this with a solid grasp of production costs and the perfect competition model, and the whole firm-theory unit becomes far more predictable.