Accounting Profit versus Economic Profit

You’ll be able to

Distinguish explicit from implicit costs
Compute accounting and economic profit from the same data
Explain what zero economic profit means for a firm's owner

Economists count costs accountants do not

Explicit costs are payments actually made — wages, rent, materials. Implicit costs are the value of resources the owner already owns and uses in the business: the salary they gave up, the rent they could have collected on their own building, the return their invested savings could have earned. Accountants record only explicit costs. Economists count both, because opportunity cost is the correct measure of what a choice costs.

The two profits

accounting profit = revenue − explicit costs · economic profit = revenue − explicit − implicit costs

Economic profit is always smaller. Whenever implicit costs are positive, a firm can show accounting profit and economic loss simultaneously.

What zero economic profit means

Zero economic profit — the long-run outcome in perfect competition — is not failure. It means the owner is earning exactly what their resources could earn elsewhere: a normal profit. They are covering their forgone salary, the rent on their premises and a competitive return on their capital. There is simply no extra return above the next-best alternative, which is why nobody has an incentive to enter or exit.

Why this drives entry and exit

Positive economic profit means the industry pays better than the alternatives, so resources flow in. Negative economic profit means the opposite, so resources flow out. Entry and exit therefore continue until economic profit is zero — which is the mechanism behind the long-run equilibrium in Unit 3 and the reason accounting profit cannot drive it. A firm showing accounting profit but economic loss should exit, and will.

Worked example

A consultant leaves a $90,000 job to start a firm. Revenue is $260,000; she pays $110,000 in wages, $30,000 in rent and $20,000 in supplies. She also invested $50,000 of savings that would have earned 6%. Compute both profits.

1.Explicit costs = 110,000 + 30,000 + 20,000 = $160,000.
2.Accounting profit = 260,000 − 160,000 = $100,000.
3.Implicit costs = forgone salary $90,000 + forgone interest 0.06 × 50,000 = $3,000, total $93,000.
4.Economic profit = 260,000 − 160,000 − 93,000 = $7,000.

Answer: Accounting profit $100,000, economic profit $7,000. She is genuinely better off than in her old job, but only by $7,000 — the accounting figure overstates the gain by more than a factor of fourteen.

Watch out

The owner's forgone salary is a real cost even though no check is written for it. Omitting implicit costs is the single most common error in this topic, and it always overstates how well the business is doing.

Checkpoint

A firm earns $50,000 accounting profit. Its owner gave up a $65,000 salary to run it. The firm's economic profit is:

Checkpoint

Zero economic profit means the firm's owner is:

Checkpoint

Which is an implicit cost for a bakery owned and operated by its owner?

On the exam

List explicit and implicit costs in two separate columns before computing either profit. Free responses award the two figures separately, and the usual failure is a correct accounting profit followed by an economic profit missing one implicit item.

Answer the 3 checkpoints as you read.