Economic Profit
What is Economic Profit?
Economic profit is total revenue minus both explicit and implicit costs, including opportunity costs.
Implicit costs represent the value of resources the firm owns, such as the owner's time or capital. Economic profit accounts for all costs of production, making it a better measure of true profitability. A firm earns zero economic profit when it covers all opportunity costs.
Economic Profit: a worked example
Nadia runs a tutoring company that takes in $96,000 a year. Her explicit costs are $12,000 for office rent, $4,000 for scheduling software, and $26,000 in wages for part-time tutors, totaling $42,000. Accounting profit is $96,000 minus $42,000, or $54,000. Now add the implicit costs. She turned down a teaching job paying $48,000, and she put $60,000 of her own savings into the business instead of an account paying 5 percent, giving up $3,000 in interest. Implicit costs total $51,000. Economic profit is $54,000 minus $51,000, which leaves $3,000. The positive figure says the business beats her next best alternative by $3,000 a year, so staying is the right call.
The mistake students make with economic profit
Zero economic profit gets read as failure, as though the firm earned nothing. The word profit carries everyday meaning, so zero sounds like broke. Zero economic profit means revenue covered every explicit cost plus every opportunity cost, including the owner's forgone salary and the return her money could have earned elsewhere. The owner is doing exactly as well as her best alternative, which is why economists call it normal profit and why it is the long run outcome in perfect competition. Negative economic profit, not zero, is the signal to exit.
Economic Profit questions
What does zero economic profit mean for a firm?
Zero economic profit, also called normal profit, means the firm is earning exactly enough to keep its resources where they are. Revenue covers wages, rent, materials, and the owner's opportunity costs with nothing left over and nothing missing. No firm has a reason to enter the market and none has a reason to leave, which is why perfectly competitive markets settle at zero economic profit in the long run.
What counts as an implicit cost?
Implicit costs are the value of resources the firm already owns and uses instead of selling or renting out. Common examples on AP exams include the salary an owner gives up by leaving a job, the interest forgone on personal savings invested in the business, and the rent that could have been collected on a building the owner uses for the shop. No money leaves the bank account, yet each represents a real opportunity given up.
Can a firm have positive accounting profit and negative economic profit?
Yes, and that combination is common for small owner operated businesses. A shop showing $30,000 of accounting profit while the owner passed up a $55,000 job is running an economic loss of $25,000. The books look fine and the tax return shows a gain, but the owner would be better off closing and taking the job. Negative economic profit is the exit signal, even when accounting profit is positive.
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