Accounting Profit vs Economic Profit vs Normal Profit

A bike shop owner says her shop made $55,000 last year. An economist studies the same shop and says it lost $7,000. Here's the strange part: they're both right. How can one shop make money and lose money in the same year? This is Module 3.4, Types of Profit. By the end, you'll know which of those numbers the AP exam means when it says "profit."

Every type of profit starts the same way: total revenue minus total cost. The argument is over what counts as a cost. Rosa's shop took in $150,000 last year. She paid $95,000 for rent, bike parts and a helper's wages. Those are explicit costs: costs she pays out in money. Implicit costs are different: no money changes hands. They're the value of what the owner puts in without paying for it: her own time, the interest her savings could have earned, and a reward for taking the risk.

Quick refresher from Unit 1: opportunity cost is the value of the next best thing you give up. Implicit costs are opportunity costs that never arrive as a bill.

Before opening the shop, Rosa turned down a job managing a big bike store for $58,000 a year. Running her own shop costs her that salary, so her time costs $58,000. She also put her savings into the shop's tools. Left in the bank, that money would have earned $4,000 in interest. That's the cost of her financial capital. So her implicit costs are $58,000 plus $4,000: $62,000. To keep the numbers simple, we'll leave risk out.

Accounting profit subtracts only explicit costs: $150,000 minus $95,000 is $55,000. That's Rosa's number. Your textbook may also subtract depreciation, the yearly wear on equipment like Rosa's tools, from accounting profit. To keep things simple, Rosa's numbers leave it out. Economic profit subtracts explicit and implicit costs: $150,000 minus $95,000 minus $62,000 is −$7,000. That's the economist's number: a loss. Shortcut: economic profit equals accounting profit minus implicit costs. $55,000 minus $62,000 is −$7,000 again.

So what just happened at Rosa's shop? One: revenue minus explicit costs gave an accounting profit of $55,000. Two: subtracting the $62,000 of implicit costs too gave an economic profit of −$7,000. Three: both are right, because the economist also counts what Rosa gave up.

Exam trap: when a firm has implicit costs, accounting profit is the bigger number. Economic profit is accounting profit minus implicit costs, never the reverse. The other slip is subtracting implicit costs to get accounting profit. Accounting profit never touches them. On a recent AP exam, fewer than half of students earned the point on this relationship.

Now say business picks up the next year. Revenue rises to $157,000, and every cost stays the same. Accounting profit is now $157,000 minus $95,000: $62,000. Economic profit is $62,000 minus her $62,000 of implicit costs: zero. Zero economic profit has its own name: normal profit. Normal profit isn't bad news. Revenue covers every cost, explicit and implicit, so Rosa does exactly as well as her next best option would.

So what just happened? One: revenue rose to $157,000, so accounting profit rose to $62,000. Two: implicit costs were also $62,000, so economic profit was zero. Three: zero economic profit is normal profit, even with a positive accounting profit.

Firms act on economic profit, not accounting profit. At −$7,000, Rosa's time and savings would earn more somewhere else, so in the long run she would close. At zero, no other option beats the shop, so she stays. And in the long run, with no barriers to entry, positive economic profit pulls new firms into a market, while losses push firms out. Module 3.6 shows what that does to prices. One more thing: when the AP exam says "profit," it generally means economic profit.

Now put profit on a graph. In economics, a firm's cost curves count implicit costs too, so any profit you read off the graph is economic profit. A peach orchard sells at the market price, $28 a crate, and picks 300 crates a week. At 300 crates, its average total cost, ATC, is $19. Two drawing rules. ATC sits below the price line at 300 crates, which signals a profit. And the marginal cost curve, MC, passes through the lowest point of ATC, here $16 at 150 crates.

Quick refresher: total revenue is price times quantity. $28 times 300 crates is $8,400.

For profit we also need total cost, but the graph shows only cost per crate.

Quick refresher from Module 3.2: ATC is total cost divided by quantity. Turn it around: total cost is ATC times quantity. $19 times 300 is $5,700.

Profit is total revenue minus total cost: $8,400 minus $5,700 is $2,700 a week. Faster, per crate: (P − ATC) × Q. That's ($28 − $19) × 300, or $9 × 300: $2,700 again.

Quick refresher: a rectangle's area is height times width. The height is $9, from ATC up to the price. The width is 300 crates, from zero to the quantity.

So shade that whole rectangle, not just part of it. On a recent AP exam, only about four in ten students shaded a profit area completely.

So what just happened at the orchard? One: total revenue was $28 times 300, or $8,400. Two: total cost was $19 times 300, or $5,700. Three: profit was $2,700, a rectangle $9 tall and 300 crates wide.

Now the market price falls to $12 a crate. The orchard cuts back to 100 crates, where the new price line meets MC. Module 3.5 shows why that's the best quantity. At 100 crates, ATC is $17. Now ATC sits above the price line, and that signals a loss. Same formula: (P − ATC) × Q is ($12 − $17) × 100, which is −$5 × 100: −$500. Keep the minus sign, the way AP scoring guidelines write a loss.

So what just happened when the price fell? One: the orchard made 100 crates. Two: ATC there was $17, above the $12 price, so each crate lost $5. Three: −$5 times 100 crates is −$500, the red rectangle.

Exam trap: use the quantity you already found, here 100 crates. The tempting wrong one is 150, where MC crosses ATC. ($12 − $16) × 150 is −$600: wrong quantity, wrong answer. And keep revenue first: TR − TC. Flip it to TC − TR, and the $500 loss turns into a fake $500 profit.

Exam moment: two questions the way the AP exam asks them, then one free-response part.

Theo quits a job that paid $50,000 a year to run a car-detailing business. That lost salary is his only implicit cost. This year the business takes in $125,000 and pays $40,000 in explicit costs. What are its accounting profit and economic profit, in that order? A) $35,000 and $35,000 B) $35,000 and $85,000 C) $75,000 and $35,000 D) $85,000 and $35,000 E) $85,000 and $135,000

The answer is D. Accounting profit subtracts only explicit costs: $125,000 − $40,000 = $85,000. Economic profit also subtracts the $50,000 salary Theo gave up: $35,000. B flips the two. In A, the salary comes out of both. C subtracts the salary instead of the explicit costs to get accounting profit. E adds the salary instead of subtracting it.

A firm sells 250 units at a price of $16 each. At that output, its average total cost is $12 and its average variable cost is $7. What is the firm's economic profit? A) −$1,000 B) $4 C) $1,000 D) $2,250 E) $4,000

The answer is C. Economic profit = (P − ATC) × Q = ($16 − $12) × 250 = $4 × 250 = $1,000. B stops at the profit per unit. D uses average variable cost instead of ATC. E stops at total revenue. And A: cost minus revenue, the wrong way round.

Free response. A firm sells planters at a market price of $25 and maximizes profit at 40 planters. On its graph, ATC is $31 at 40 planters and $29 at 80 planters, where MC crosses ATC. Calculate the firm's economic profit. Show your work.

To earn the point: formula, numbers, answer. Economic profit = (P − ATC) × Q = ($25 − $31) × 40 = −$240. Total revenue minus total cost works too: $1,000 − $1,240 = −$240. The costly mistake: using a different quantity. At 80 planters you'd get ($25 − $29) × 80 = −$320, and that's wrong. On a recent AP exam, fewer than half of students earned this point.

So what just happened on the free response? One: we used the quantity given, 40 planters. Two: we wrote the formula, then ($25 − $31) × 40. Three: the answer is −$240, minus sign and all.

Recap: accounting profit subtracts only explicit costs; economic profit subtracts implicit costs too. Zero economic profit is normal profit. On a graph, profit is (P − ATC) × Q, minus sign and all. Next: Module 3.5, Profit Maximization.