Why profit needs more than one definition
Profit is what is left from a firm’s revenue after costs are paid. The difficulty is deciding which costs count.
Total revenue (TR) is the money a firm receives from sales: TR = price × quantity sold.
In Topic 1.5 you met two kinds of cost:
- Explicit costs: money actually paid to others. Wages to employees, rent to a landlord, payments for materials, fuel, insurance and interest on a bank loan.
- Implicit costs: the opportunity cost of resources the owner already has and uses in the firm. No money changes hands, but something valuable is given up.
An accountant records explicit costs. An economist counts both, because both are real opportunity costs. That difference gives two measures of profit.
The implicit costs of running a firm
The most common implicit costs are:
- The entrepreneur’s time. An owner who runs the firm gives up the salary they could earn working for someone else.
- The cost of financial capital. If the owner puts their own savings into the firm, they give up the interest those savings could have earned.
- Compensation for risk. Running a firm is risky. An owner will only stay if the firm pays enough extra to make the risk worth taking, compared with a safer alternative.
- Forgone rent. If the firm uses a building or vehicle the owner already owns, the owner gives up the rent it could have earned.
Accounting profit and economic profit
Accounting profit = total revenue − explicit costs
Economic profit = total revenue − explicit costs − implicit costs
So: economic profit = accounting profit − implicit costs.
Because implicit costs are never negative, economic profit is always less than or equal to accounting profit. If economic profit is negative, the firm has an economic loss.
Both measures are useful, but for different jobs. Accounting profit is what a firm reports for tax and to its lenders. Economic profit is what an owner should look at when deciding whether to stay in business, because it asks a different question: “Am I doing better here than I could do anywhere else?”
| Result | What it means |
|---|---|
| Economic profit > 0 | The firm earns more than the owner’s resources could earn in their next-best use |
| Economic profit = 0 | Normal profit: the owner’s resources earn exactly what they could earn elsewhere |
| Economic profit < 0 (economic loss) | The owner’s resources would earn more in another use |
Normal profit
Normal profit is the level of accounting profit that just covers all implicit costs, so that economic profit is zero.
At normal profit, the owner is paid enough to keep their time, money and risk-taking in this firm, but no more. A firm earning normal profit is not failing. It is doing exactly as well as the owner’s best alternative.
Economists often treat normal profit as part of a firm’s costs. In this course, the average total cost (ATC) curves you draw include implicit costs. So when price equals ATC, the firm earns zero economic profit, which means it earns normal profit.
Profit per unit
When you know price, quantity and ATC (including implicit costs), you can find economic profit in one step:
Economic profit = (P − ATC) × Q
P − ATC is the economic profit (or loss) per unit. Multiplying by Q gives the total. On a graph, this total is a rectangle with height P − ATC and width Q; you will draw it in later topics.
How firms respond to profit
Firms and resource owners respond to economic profit, not accounting profit, because economic profit compares this use of resources with the next-best use.
- Economic profit > 0: resources earn more here than elsewhere. Existing firms have a reason to expand, and new firms have a reason to enter the industry.
- Economic profit = 0 (normal profit): there is no reason to enter or leave. Owners stay where they are.
- Economic loss: resources would earn more elsewhere. Over time, owners have a reason to exit the industry and move their time and money to a better use.
Leaving takes time: a firm may have contracts and equipment it cannot get rid of at once. In Topic 3.6 you will see when a firm should keep producing in the short run despite a loss.
Worked example 1: a food truck’s three profits
Question. Noor runs Saffron Wheels, a fictional food truck. Last year its total revenue was $180,000. She paid: assistant’s wages $50,000, ingredients $40,000, pitch fees $24,000, and fuel and insurance $6,000. Her next-best alternative was a restaurant manager’s job paying $45,000 a year. She bought the truck with $80,000 of her own savings, which could have earned 5% a year in a bank. Compared with the safe job, she needs at least $6,000 a year to make the risk of running her own business worthwhile.
(a) Calculate her accounting profit. (b) Calculate her implicit costs and her economic profit. (c) How much accounting profit would give her exactly normal profit? (d) The restaurant raises its salary offer to $52,000. What happens to her accounting and economic profit? How is she likely to respond?
(a) Explicit costs = 50,000 + 40,000 + 24,000 + 6,000 = $120,000. Accounting profit = 180,000 − 120,000 = $60,000.
(b)
- Forgone salary (owner’s time): $45,000.
- Forgone interest (cost of financial capital): 5% of $80,000 = $4,000.
- Compensation for risk: $6,000.
- Implicit costs = 45,000 + 4,000 + 6,000 = $55,000.
Economic profit = 180,000 − 120,000 − 55,000 = $5,000. Check: 60,000 − 55,000 = $5,000.
(c) Normal profit means economic profit = 0, so accounting profit must equal implicit costs: $55,000. Total revenue would then be 120,000 + 55,000 = $175,000.
(d) Accounting profit is unchanged at $60,000: the salary offer is not a payment, so it does not appear in her books. Implicit costs rise to 52,000 + 4,000 + 6,000 = $62,000. Economic profit = 60,000 − 62,000 = −$2,000, an economic loss.
Interpretation. Her accounts still show a healthy profit, but she would now be $2,000 better off taking the restaurant job. Economic profit, not accounting profit, signals that her resources have a better use, so she has a reason to sell the truck and leave. She would earn exactly normal profit at a salary offer of 60,000 − 4,000 − 6,000 = $50,000.
Worked example 2: profit from per-unit data
Question. Fennick Furniture, a fictional firm, sells 400 chairs a month at $150 each. Its average total cost, including all implicit costs, is $140 per chair. Of this, $25 per chair is implicit cost (the owner’s time and forgone interest).
(a) Calculate economic profit. (b) Calculate accounting profit. (c) Find both profits if the price falls to $140, and then to $130. Explain how the owner and other firms would respond in each case.
(a) Economic profit = (P − ATC) × Q = (150 − 140) × 400 = $4,000 per month.
(b) Explicit cost per chair = 140 − 25 = $115. Accounting profit = (150 − 115) × 400 = $14,000 per month. Check: implicit costs = 25 × 400 = $10,000, and 14,000 − 10,000 = $4,000. ✓
(c)
| Price | Economic profit | Accounting profit | Response |
|---|---|---|---|
| $150 | $4,000 | $14,000 | Resources earn more here than elsewhere: an incentive to expand, and for new firms to enter |
| $140 | (140 − 140) × 400 = $0 | (140 − 115) × 400 = $10,000 | Normal profit: no reason to enter or leave |
| $130 | (130 − 140) × 400 = −$4,000 | (130 − 115) × 400 = $6,000 | Economic loss: over time, an incentive to exit and use the resources elsewhere |
Check and interpretation. At $140 the accounting profit of $10,000 equals the implicit costs exactly, which is the definition of normal profit. At $130 the accounts still show $6,000 profit, yet the owner is losing $4,000 a month compared with the best alternative.
Common misconceptions
- “Economic profit is bigger than accounting profit.” It is the other way round. Economic profit subtracts more costs, so it is smaller (or equal).
- “Zero economic profit means the firm is losing money.” Zero economic profit is normal profit. The owner covers every cost, including their own opportunity costs.
- “Implicit costs are not real because no money is paid.” They are real opportunity costs. Ignoring them can keep an owner in a business that pays less than their alternative.
- “Interest on a bank loan is an implicit cost.” It is a payment to the bank, so it is explicit. Forgone interest on the owner’s own savings is implicit.
- “A firm with positive accounting profit should stay open.” Only if accounting profit is at least as large as implicit costs. Otherwise there is an economic loss.
- “Firms enter an industry when accounting profits are high.” Entry is driven by economic profit: by earning more than the next-best use of resources.
Where this leads
Now that you can measure profit correctly, the next step is to find the output that makes it as large as possible. In Topic 3.5, Profit Maximization, you will compare marginal revenue with marginal cost. For a reminder of how firms choose their scale, see Topic 3.3. Test yourself with the practice questions, then use the revision notes and the checklist to consolidate.
Quick questions
Is a firm earning zero economic profit doing badly?
No. Zero economic profit means normal profit: the owner earns exactly what their time, money and risk could earn in the next-best use. There is no reason to leave.
Can accounting profit be positive while economic profit is negative?
Yes. This happens whenever accounting profit is smaller than the implicit costs. The books show a profit, but the owner would be better off using their resources elsewhere.