The economic theory of corporate behavior is based on the assumption that the objective of the firm is to maximize its profit. So we need to be clear from the start about what exactly profit means.
Difference Between Accounting Profit and Economic Profit
The economist’s understanding of profit is different from that of the accountant, and the distinction between the two is important in understanding the workings of the invisible hand.
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Accountants define a firm’s annual profit as the difference between the revenue it collects and its explicit costs (the actual payments a firm makes to its factors of production and other suppliers) for the year, which are the actual payments the firm makes to its factors of production and other suppliers. Profit so defined is called accounting profit (the difference between a firm’s total revenue and its explicit costs).
Accounting profit = total revenue – explicit costs.
Accounting profit is the most familiar concept of profit in everyday discourse. It is the one that companies use, for example, when providing statements about their earnings in press releases or annual reports.
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Economists, on the other hand, define profit as the difference between the total revenue of the firm and not only its explicit costs, but also its implicit costs (the opportunity costs of the resources provided by the owners of the firm), which are the opportunity costs of all the resources provided by the owners of the firm. Profit thus defined is called economic profit (or excess profit, the difference between a firm’s total revenue and the sum of its explicit and implicit costs).
economic profit = total income – explicit costs – implicit costs.
To illustrate the difference between accounting profit and economic profit, consider a firm with a total annual revenue of $400,000 whose only explicit costs are worker wages, totaling $250,000 per year. The owners of this business provided machinery and other capital goods with a total resale value of $1 million.
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This firm’s book profit is then $150,000, the difference between its total revenue of $400,000 per year and its explicit costs of $250,000 per year.
To calculate the economic profit of the firm, we must first calculate the opportunity cost of the resources provided by the owners of the firm. Suppose the current annual interest rate on savings accounts is 10%.
If the owners hadn’t invested in capital equipment, they could have earned an additional $100,000 in interest per year by depositing their $1 million in a savings account. The economic profit of the company is therefore $400,000 per year $250,000 per year $100,000 per year $50,000 per year.
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Note that this economic profit is less than accounting profit by exactly the amount of the firm’s implicit costs – the $100,000 per year opportunity cost of
the resources provided by the owners of the business. This difference between a firm’s accounting profit and its economic profit is called its normal profit (the opportunity cost of resources provided by the owners of a firm, equal to accounting profit minus economic profit). Normal profit is simply the opportunity cost of the resources provided to a business by its owners.
Figure 1 illustrates the difference between accounting profit and economic profit. Figure 1 (a) represents the total revenues of a company, while (b) and (c) show how these revenues are distributed among the different categories of costs and benefits.
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Accounting profit (b) is the difference between total revenue and explicit costs.
Normal profit (c) is the opportunity cost of all the resources provided by the owners of a firm. Economic profit (c) is the difference between total revenue and all costs, explicit and implicit (also equal to the difference between accounting profit and normal profit).
Examples
The following examples illustrate why the distinction between accounting profit and economic profit is so important.
Should Pudge Buffet stay in agriculture?
Pudge Buffet is a corn farmer who lives near Lincoln, Nebraska. His payments for land and equipment rentals and other supplies amount to $10,000 a year.
The only input he provides is his own labor, and he finds farming just as attractive as his only other job opportunity, running a retail store on a salary of $11,000 a year.
Apart from the question of salary, Pudge is indifferent between farming and management. Corn sells at a constant price per bushel in an international market too large to be affected by changes in a farmer’s corn production.
Pudge’s income from corn sales is $22,000 per year. What is its accounting profit? Its economic gain? Its normal benefit? Should he remain a corn farmer?
As shown in Table 1, Pudge’s book profit is $12,000 per year, the difference between his annual income of $22,000 and his annual payment of $10,000 for land, equipment, and supplies. His economic profit is that amount minus the opportunity cost of his labor.
Since the latter represents the $11,000 per year that he could have earned as a store manager, he makes an economic profit of $1,000 per year. Finally, his normal profit is the $11,000 opportunity cost of the only resource he provides, namely his labor. Since Pudge likes both jobs equally well, he will earn $1,000 a year if he stays in farming.
TABLE 1: Summary of revenues, costs and benefits
When income increases from $22,000 to $20,000, Pudge makes an economic profit of $1,000 per year. Negative economic profit is also called economic loss. If Pudge expects to suffer economic loss indefinitely, his best bet would be to give up farming in favor of running a retail store.
You might think that if Pudge could just save enough money to buy his own land and equipment, his best option would be to stay a farmer. But as the following example illustrates, this impression is based on an inability to perceive the difference between accounting profit and economic profit.
Does owning your own land make a difference?
Let’s build on the previous example. Suppose Pudge’s Uncle Warren, owner of the farmland that Pudge leased, dies and leaves Pudge with that parcel of land. If the land could be leased to another farmer for $6,000 a year, should Pudge stay in farming?
TABLE 2: Summary of revenues, costs and benefits
As shown in Table 8.2, if Pudge continues to farm his own land, his book profit will be $16,000 per year. But his economic profit will still be the same as before – that is, $1,000 a year – because Pudge has to deduct the $6,000 a year opportunity cost of farming his own land, even if he no longer has to make an explicit payment to his uncle for this.
The normal profit from owning and operating his farm will be $17,000 a year, the opportunity cost of the land and labor he provides. But since Pudge makes a book profit of just $16,000, he’d be better off giving up farming for the managerial job.
Pudge would obviously be richer as a landlord than he was as a tenant. But the question of whether to remain a farmer receives the same answer whether Pudge rents his farmland or owns it. He should only stay in agriculture if it is the option that yields the most economic profit.
SUMMARY OF THE CENTRAL ROLE OF ECONOMIC PROFIT
A firm’s accounting profit is the difference between its revenue and the sum of all the explicit costs it incurs. Economic profit is the difference between the company’s revenue and all the costs it incurs, both explicit and implicit. Normal profit is the opportunity cost of the resources provided by the owners of the firm.
When the accounting profit of a firm is exactly equal to the opportunity cost of the inputs provided by the owners of the firm, the economic profit of the firm is zero. For a business to remain in business for the long term, it must make an economic profit greater than or equal to zero.
