3.4 Types of Profit

Introduction to the Economics of Profit

In your daily life, you probably think of "profit" as the money left over after a business pays its bills. While that is correct in the world of accounting, economists look at the world a bit differently. To an economist, profit isn't just about what you paid out; it’s also about what you could have done instead.

In this chapter, we will explore why economists distinguish between Accounting Profit and Economic Profit, and why "breaking even" in economics—what we call Normal Profit—is actually a sign of success! Understanding these differences is essential for Unit 3 and helps explain why firms choose to enter or exit markets.

The Foundation: Explicit vs. Implicit Costs

Before we can calculate profit, we have to identify all the costs involved in running a business. Economists divide costs into two main categories:

1. Explicit Costs

Explicit costs are traditional "out-of-pocket" payments. These are the costs that have a paper trail, like a receipt or an invoice. If you are writing a check or swiping a business credit card, it’s likely an explicit cost.

Examples: Paying wages to employees, buying raw materials, paying rent for a storefront, or paying the electricity bill.

2. Implicit Costs

Implicit costs are the opportunity costs of using resources the firm already owns. These do not involve a direct payment of money, but they represent a "missed opportunity." This is where many students find economics tricky at first—you have to account for what you give up to run the business.

Examples: The salary you could have earned at another job, the interest you could have earned if you hadn't spent your savings to start the firm, or the rent you could have collected if you leased your building to someone else instead of using it yourself.

Key Takeaway: Total Economic Cost = Explicit Costs + Implicit Costs.

Accounting Profit vs. Economic Profit

Now that we know the two types of costs, we can look at the two ways to measure profit. In both cases, we start with Total Revenue (TR), which is \( P \times Q \).

Accounting Profit

This is what an accountant or the IRS cares about. It only looks at the actual money flowing in and out.

\( \text{Accounting Profit} = \text{Total Revenue} - \text{Explicit Costs} \)

Economic Profit

Economists want to know if the business owner is making the best possible use of their resources. Therefore, they subtract all costs (both explicit and implicit).

\( \text{Economic Profit} = \text{Total Revenue} - (\text{Explicit Costs} + \text{Implicit Costs}) \)

Alternatively, you can think of it as: \( \text{Economic Profit} = \text{Accounting Profit} - \text{Implicit Costs} \).

Important Note: Because economic profit subtracts more costs (the implicit ones), Economic Profit will almost always be less than Accounting Profit.

What is Normal Profit?

This is a term that often confuses students. In everyday language, "zero profit" sounds like a failure. But in AP Microeconomics, Normal Profit occurs when Economic Profit is exactly zero.

If \( \text{Economic Profit} = 0 \), it means:

• The firm's total revenue is covering all explicit costs.
• The firm's total revenue is also perfectly covering all implicit costs (opportunity costs).

In other words, the business owner is doing just as well as they would in their next-best alternative job. They are making enough money to stay in business and keep themselves happy, but not so much that they are "beating" the market.

Key Takeaway: Normal Profit is the minimum level of profit needed to keep a firm in its current line of business. When \( \text{Economic Profit} = 0 \), the firm is said to be earning a Normal Profit.

Step-by-Step Example

Imagine Sarah quits her job as a software engineer where she earned \$100,000 a year to open a cat café.

• Total Revenue: Sarah sells coffee and snacks for a total of \$250,000.
• Explicit Costs: She pays \$120,000 for rent, cat food, and employee wages.
• Implicit Costs: Her foregone salary of \$100,000.

1. Calculate Accounting Profit:

\( \$250,000 (TR) - \$120,000 (\text{Explicit}) = \$130,000 \)

2. Calculate Economic Profit:

\( \$250,000 (TR) - (\$120,000 + \$100,000) (\text{Total Costs}) = \$30,000 \)

Interpretation: Sarah has an accounting profit of \$130,000, which sounds great! Her economic profit is \$30,000, which means she is making \$30,000 more than she would have made if she stayed at her old job. She has an incentive to stay in the cat café business!

Common Mistakes to Avoid

• Forgetting Implicit Costs: On the AP Exam, if a question asks for "Economic Profit," always look for hidden costs like "foregone interest" or "previous salary."
• Thinking "Zero" is Bad: Remember that Zero Economic Profit (Normal Profit) is a stable situation. It means the entrepreneur is being compensated exactly for their time and effort.
• Confusing "Profit" with "Revenue": Revenue is just the money coming in (\( P \times Q \)). Profit is what remains after costs are subtracted.

Quick Review Box

Explicit Costs: Out-of-pocket expenses (wages, rent).

Implicit Costs: Opportunity costs (foregone salary, foregone interest).

Accounting Profit: \( TR - \text{Explicit Costs} \).

Economic Profit: \( TR - (\text{Explicit} + \text{Implicit}) \).

Normal Profit: Occurs when Economic Profit is \( 0 \).

In the next chapter (3.5 Profit Maximization), we will learn the golden rule for how firms decide exactly how much output to produce to make these profits as large as possible!