Short on time? This page is the recap. For explanations, a diagram and worked examples, use the full study guide.
Recap
- Explicit costs are money paid to others. Implicit costs are the opportunity costs of the owner’s own resources.
- Typical implicit costs: the owner’s forgone salary (their time), forgone interest on their own savings (cost of financial capital), forgone rent on property they own, and compensation for risk.
- Accounting profit ignores implicit costs. Economic profit subtracts them, so it is never larger than accounting profit.
- Normal profit is the accounting profit that exactly covers implicit costs. Economic profit is then zero.
- Firms respond to economic profit, because it compares this use of resources with the next-best one.
Key relationships
| Relationship | How to use it |
|---|---|
| TR = P × Q | Revenue from sales |
| Accounting profit = TR − explicit costs | What the firm’s books show |
| Economic profit = TR − explicit costs − implicit costs | What the owner gains over the best alternative |
| Economic profit = accounting profit − implicit costs | Quick check between the two |
| Economic profit = (P − ATC) × Q | When ATC includes implicit costs |
| Normal profit: accounting profit = implicit costs | Economic profit = 0, P = ATC |
| Economic profit | Signal | Likely response |
|---|---|---|
| Positive | Resources earn more here than elsewhere | Expansion and entry of new firms |
| Zero (normal profit) | Resources earn exactly their next-best return | No entry or exit |
| Negative (loss) | Resources would earn more elsewhere | Exit over time |
Assumptions behind the model
- Implicit costs are valued at the next-best use of the owner’s resources.
- Owners want to earn at least as much as their best alternative.
Mistakes to avoid
- Saying economic profit is larger than accounting profit.
- Calling interest on a bank loan an implicit cost (it is explicit).
- Treating zero economic profit as a loss.
- Forgetting compensation for risk or the owner’s time when listing implicit costs.
- Saying firms enter because of high accounting profit.
- Using ATC without checking whether it includes implicit costs.
Quick self-check
- TR is $50,000, explicit costs $30,000 and implicit costs $15,000. Find both profits. (Accounting $20,000; economic $5,000.)
- Accounting profit is $24,000 and implicit costs are $24,000. What kind of profit is this? (Normal profit: economic profit is zero.)
- Which is implicit: rent paid to a landlord, or rent the owner could earn on her own shop? (The rent she could earn on her own shop.)
Next: practice questions.