Economic Profit: Definition, Pros, Cons & Example

What is Economic Profit

Economic profit is a term used in economics to describe the difference between a firm’s total revenue and its total cost, including both explicit and implicit costs. Explicit costs are the actual monetary expenses that a firm incurs in order to produce and sell goods or services, such as the cost of materials, labor, and rent. Implicit costs, on the other hand, are the opportunity costs of using resources that a firm already owns, such as the owner’s time and the use of the firm’s capital.

In other words, economic profit takes into account not only the explicit costs of running a business but also the opportunity costs of using resources in one way instead of another. It is a measure of a firm’s profitability that goes beyond its accounting profit, which only considers explicit costs. If a firm’s economic profit is positive, it means that the firm is earning more than its opportunity costs, and it is considered to be profitable. If the economic profit is negative, it means that the firm is not earning enough to cover its opportunity costs, and it may not be considered a viable business.

How to Calculate Economic Profit

To calculate economic profit, follow these steps:

1. Determine the total revenue earned by the firm in a given period. This is the total amount of money received from selling goods or services.
2. Determine the explicit costs incurred by the firm in that period. This includes all the monetary expenses incurred in producing and selling goods or services, such as the cost of materials, labor, rent, and marketing.
3. Determine the implicit costs incurred by the firm in that period. This includes the opportunity cost of using resources that the firm already owns, such as the owners’ time and the use of the firm’s capital.
4. Subtract the total explicit costs and implicit costs from the total revenue to obtain the economic profit.

The formula for calculating economic profit is:

Economic Profit = Total Revenue – Total Explicit Costs – Total Implicit Costs

Total Revenue is the total amount of money a firm earns from selling its goods or services.

Total Explicit Costs are the actual monetary expenses a firm incurs in producing and selling its goods or services, such as the cost of materials, labor, and rent.

Total Implicit Costs are the opportunity costs of using resources that a firm already owns, such as the owner’s time and the use of the firm’s capital.

By subtracting both explicit and implicit costs from total revenue, economic profit provides a more comprehensive measure of a firm’s profitability than accounting profit, which only considers explicit costs.

If the resulting value is positive, the firm is earning more than its opportunity costs and is considered profitable. If the resulting value is negative, the firm is not earning enough to cover its opportunity costs and may not be considered a viable business.

It is important to note that economic profit is a more comprehensive measure of profitability than accounting profit, which only considers explicit costs. Therefore, a firm may be earning a positive accounting profit but a negative economic profit if its implicit costs are too high.

Economic Profit vs. Accounting Profit

Economic profit and accounting profit are both measures of a firm’s profitability, but they differ in the way they are calculated and the information they provide.

Accounting profit is calculated by subtracting the explicit costs of a firm’s operations from its total revenue. Explicit costs are the actual monetary expenses that a firm incurs in producing and selling its goods or services, such as the cost of materials, labor, rent, and marketing. Accounting profit provides a measure of a firm’s profitability that is easy to calculate and report on financial statements.

Economic profit, on the other hand, takes into account both the explicit and implicit costs of a firm’s operations. Implicit costs are the opportunity costs of using resources that a firm already owns, such as the owner’s time and the use of the firm’s capital. Economic profit provides a more comprehensive measure of a firm’s profitability than accounting profit because it includes the opportunity costs of using resources in one way instead of another.

If a firm’s accounting profit is positive, it means that the firm is earning more revenue than its explicit costs. However, if its economic profit is negative, it means that the firm is not earning enough to cover its explicit and implicit costs, and it may not be considered a viable business. In summary, accounting profit is a simpler and more straightforward measure of profitability, while economic profit is a more comprehensive and accurate measure that takes into account both explicit and implicit costs.

Advantages of Economic Profit

The advantages of economic profit as a measure of a firm’s performance include:

1. Comprehensive: Economic profit provides a more comprehensive measure of a firm’s profitability than accounting profit because it considers both explicit and implicit costs. This makes it a more accurate reflection of a firm’s true profitability.
2. Long-term view: Economic profit encourages firms to take a long-term view of their operations. By factoring in implicit costs, firms are better able to evaluate the long-term impact of their decisions on profitability.
3. Accurate capital allocation: Economic profit helps firms allocate capital more accurately. By considering implicit costs, firms can more accurately assess the opportunity costs of different investments and allocate capital to the investments that generate the highest economic profit.
4. Better decision-making: Economic profit provides managers with a better understanding of the costs and benefits of different decisions. This helps them make more informed decisions and avoid investments that may generate a positive accounting profit but a negative economic profit.
5. Investor perspective: Economic profit is also useful from an investor perspective as it helps to determine whether the firm is generating returns that are higher than the opportunity cost of capital. Investors can use this information to make better investment decisions.

In summary, economic profit is a more comprehensive and accurate measure of a firm’s profitability than accounting profit. It encourages a long-term view, helps to allocate capital more accurately, and facilitates better decision-making by managers and investors.

Disadvantages of Economic Profit

The disadvantages of economic profit as a measure of a firm’s performance include:

1. Difficult to measure implicit costs: While explicit costs are relatively easy to measure, implicit costs such as the opportunity cost of using resources are more difficult to quantify. This makes the calculation of economic profit more complex and less reliable.
2. Subjective valuation: Implicit costs may be subject to subjective valuation, which can lead to differences in the calculation of economic profit. Different individuals may value the opportunity costs of resources differently, which can lead to different calculations of economic profit.
3. Short-term focus: Economic profit encourages a long-term view of a firm’s operations, but it may also lead to a short-term focus on profitability. Managers may prioritize short-term gains over long-term investments that generate higher economic profit.
4. Unrealistic assumptions: The calculation of economic profit is based on several assumptions, such as perfect competition, which may not hold true in the real world. This can limit the usefulness of economic profit as a measure of a firm’s performance.
5. Not widely used: While economic profit is a more comprehensive measure of a firm’s profitability than accounting profit, it is not widely used in practice. Many firms and investors still rely on accounting profit as a measure of a firm’s performance.

In summary, the disadvantages of economic profit include the difficulty in measuring implicit costs, subjective valuation, short-term focus, unrealistic assumptions, and limited use in practice.

Examples of Economic Profit

Let’s say a company named ABC Corporation produces and sells widgets. In a given year, ABC Corporation earns $1,000,000 in revenue from selling 100,000 widgets at $10 each. The company incurs $600,000 in explicit costs, which include expenses such as materials, labor, rent, and marketing. The company’s owners also have to invest their time and effort into running the business, and the opportunity cost of their time is $100,000.

Using the formula for economic profit, we can calculate ABC Corporation’s economic profit as follows:

Economic Profit = Total Revenue – Total Explicit Costs – Total Implicit Costs

Economic Profit = $1,000,000 – $600,000 – $100,000

Economic Profit = $300,000

Therefore, ABC Corporation’s economic profit for the year is $300,000. This means that the company has earned more than the explicit and implicit costs it incurred in producing and selling its widgets. The owners of ABC Corporation have earned a return on their investment, and the company can reinvest the economic profit to grow the business further.

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