Definition
Economic profit is a measure that reflects the real profitability of a business by taking into account both explicit and implicit costs. It’s calculated by subtracting both the explicit costs (like salaries, rent, materials etc.) and implicit costs (like opportunity costs) from total revenue. A positive economic profit indicates that the business is generating returns above its opportunity cost, while a negative economic profit signifies the opposite.
Key Takeaways
- Economic Profit is a measure that reflects the real profitability of a business, taking into account both the explicit costs associated with business operations and the implicit opportunity costs of using resources in one way instead of the most beneficial alternative.
- Unlike accounting profit, Economic Profit provides a more comprehensive understanding of profitability as it considers not only the firm’s income and expenses but also the cost of the missed opportunities.
- A positive Economic Profit indicates that a firm’s revenue is covering all implicit and explicit costs and is surpassing the best alternative investment. In contrast, a negative Economic Profit suggests that the company would be better off if resources were allocated towards the next best alternative.
Importance
Economic Profit is an important finance term as it gives a comprehensive picture of the real profitability of a business by incorporating both the explicit and implicit costs. Unlike accounting profit which considers only explicit costs, economic profit takes into account opportunity costs or implicit costs as well.
This provides a true gauge of whether resources are being allocated in the most efficient and profitable way. A positive economic profit indicates that a business is generating a return above its opportunity cost, thus effectively contributing to wealth creation.
Conversely, a negative economic profit implies that resources could be better utilized elsewhere to generate higher returns. Understanding economic profit can thus influence strategic decision making for businesses and investors alike.
Explanation
Economic profit, a concept in microeconomics, serves a crucial purpose in the economic analysis of the efficiency and effectiveness of a business. It’s a measure that goes beyond the mere computation of accounting profit (total revenue minus explicit costs) by incorporating both explicit (out-of-pocket costs like wages, rent etc.) and implicit costs (opportunity costs like return on capital and entrepreneur’s forgone wage). This gives it a broader scope, making it a very useful indicator of overall business profitability and an excellent tool for entailing a more accurate decision-making analysis.
Moreover, economic profit is used as a theoretical tool to depict optimum resource allocation in perfectly competitive markets. A positive economic profit implies that the resources are being effectively used, providing satisfaction over and above the opportunity cost.
Conversely, a negative economic profit calls for a reassessment of operations as the revenue generated falls short of the total costs (explicit + implicit). Thus, it can guide businesses to redirect their resources and efforts where the net gains are higher and more profitable. In essence, it aids in determining whether a business is truly profitable after considering all costs and fosters efficient decision-making in resource allocation.
Examples of Economic Profit
A Furniture Manufacturer: Imagine a furniture manufacturer who invests $1,000,000 in raw materials, manufacturing, marketing, and distribution and earns $1,200,000 from the sale of its product. This gives them an accounting profit of $200,However, if the same amount of money invested could generate $250,000 if invested in a different industry (the opportunity cost), this would result in an economic profit of -$50,000, suggesting the manufacturer would have been better off by investing in a different industry.
A Local Restaurant: A local restaurant earns $500,000 annually after subtracting all its explicit costs, including ingredients, labor, rent, and utilities, indicating a positive accounting profit. However, the owners could have earned $750,000 if they had taken up corporate jobs instead of the restaurant business, which is their opportunity cost. Therefore, the economic profit here is $500,000 – $750,000 = -$250,000, indicating it would have been more profitable to work in the corporate sector.Tech Startup: Consider a tech startup that has a positive accounting profit of $2 million after deducting explicit costs such as wages, rent, and materials. But the owner, a highly skilled programmer, could make $
5 million yearly working for a prominent tech firm. This foregone wage is an implicit cost and the opportunity cost for the programmer. So, the economic profit of the startup would be $2 million – $5 million = -$500,
This means the entrepreneur is effectively losing $500,000 each year as the cost of running his own startup instead of being employed by the tech firm.
Economic Profit FAQ
What is Economic Profit?
Economic profit is a measure used in economics and business to compare the profitability and efficiency of different firms or business ventures. Different from accounting profit, economic profit considers both a company’s explicit and implicit costs.
What is the difference between Economic Profit and Accounting Profit?
Accounting profit only considers explicit costs which are direct costs like salaries, rent, and material costs. Economic profit on the other hand also includes implicit costs, which are indirect costs such as opportunity costs.
What is an example of Economic Profit?
If a shopkeeper earns $100 a day and has expenses of $30, his accounting profit is $70. However, if he could have earned $40 a day as an employee elsewhere, his economic profit is only $30 ($70 – $40) because of the opportunity cost of his decision to run his own shop instead of being an employee.
How is Economic Profit calculated?
Economic Profit is calculated by subtracting both explicit and implicit costs from the total revenue of a firm.
Why is Economic Profit important in decision making?
Economic Profit helps firms make optimal business choices. A positive economic profit indicates that a business is allocating its resources efficiently, generating more revenue than its combined explicit and implicit costs. If a firm has a negative economic profit, it may have to reconsider its business decisions.
Related Entrepreneurship Terms
- Opportunity Costs
- Explicit Costs
- Implicit Costs
- Normal Profit
- Accounting Profit
Sources for More Information
- Investopedia: Investopedia is a top source for finance and investing terms and concepts. It also provides up-to-date news and strategies related to the world of finance.
- Corporate Finance Institute (CFI): CFI provides online certification and training courses, alongside a wide variety of free resources like articles, guides, and templates, which can help in understanding various financial terms, including economic profit.
- The Library of Economics and Liberty (Econlib): Econlib is a top source for anyone wanting to read and learn about economics. The site provides articles, books, podcasts, and educational resources on various economic topics.
- The Balance: This webpage offers expertly crafted articles and advice about personal finance, career advancement and small business operations – basically covering everything from getting out of debt to planning for retirement.
