Practice
Accounting and economic profit
Accounting profit subtracts explicit costs; economic profit also subtracts the implicit costs of what the owner gave up.
The skill
Accounting profit is revenue minus explicit costs, the payments the business actually makes. Economic profit also subtracts implicit costs: what the owner gave up, such as the salary from a former job and the interest the invested savings would have earned. Firms respond to economic profit, so a business with a healthy accounting profit can still be making an economic loss. The common errors are leaving out implicit costs entirely, or subtracting the whole amount of savings instead of the interest it would have earned.
A worked example
Lena left a job paying $57,000 a year to run a tutoring business full time, and put $38,000 of savings into it. The savings had been earning 5% interest a year. Last year the tutoring business had these results.
| Item | Amount ($) |
|---|---|
| Revenue | 262,000 |
| Rent paid for the space | 32,000 |
| Wages paid to employees | 53,000 |
| Supplies bought | 48,000 |
What was the economic profit, in dollars? Give a negative number for a loss.
Solution
- Explicit costs are payments the business made: 32,000 + 53,000 + 48,000 = $133,000.
- Accounting profit = revenue − explicit costs = 262,000 − 133,000 = $129,000.
- Implicit costs are what Lena gave up: the $57,000 salary and 5% of $38,000 in interest, $1,900.
- Economic profit = accounting profit − implicit costs = $129,000 − $58,900 = $70,100.
Answer: 70100