Types of Profit — AP® Microeconomics Notes

A baker leaves a $45,000 job to open her own shop. At year end her accountant says the shop made $60,000 in profit, and she smiles. An economist asks a harder question: after you pay yourself what you gave up, how much is left? That second number, economic profit, is the one that decides whether firms are drawn to an industry or leave it.

Two kinds of cost, two kinds of profit

Recall from Topic 1.5 that an explicit cost is a payment of money (rent, wages, materials) and an implicit cost is the value of something the owner already has, used in the business instead of its best other use: her time, her savings, her building.

Accounting profit = total revenue - explicit costs. This is what a tax form or an income statement shows.
Economic profit = total revenue - explicit costs - implicit costs, or accounting profit - implicit costs. When it is negative, the firm has an economic loss.

Three bars: total revenue of $120 thousand; the accountant's view, $80 thousand of explicit costs and $40 thousand of accounting profit; the economist's view, the same explicit costs, $30 thousand of implicit costs and $10 thousand of economic profit. — **Figure 1.** The same revenue seen two ways: the economist subtracts implicit costs too, so economic profit is smaller than accounting profit. Invented data for practice. LevlPrep original diagram.

Worked example: the baker's year. Revenue $180,000; rent $30,000, ingredients $50,000, wages $40,000. She gave up a $45,000 salary and $2,000 of interest on the $50,000 of savings she put in.

Explicit costs: $30{,}000$ $+ 50{,}000$ $+ 40{,}000$ $= 120{,}000$ dollars.
Accounting profit: $180{,}000 - 120{,}000$ $= 60{,}000$ dollars.
Implicit costs: $45{,}000 + 2{,}000$ $= 47{,}000$ dollars. The forgone interest is $2,000, not the $50,000 she put in: the savings are still hers.
Economic profit: $60{,}000 - 47{,}000$ $= 13{,}000$ dollars. The bakery pays her $13,000 more than her best alternatives.

Normal profit

When economic profit is exactly zero, the firm earns a normal profit. That is not "no money". The firm still has an accounting profit, equal to its implicit costs, so the owner earns exactly what her time and money would earn in their next-best use. She has no reason to leave and no reason to wish she had picked something else.

	Accounting profit	Economic profit
Subtracts	explicit costs only	explicit and implicit costs
Size	larger, or equal if implicit costs are zero	smaller, or equal
At normal profit	positive, equal to implicit costs	zero
Used for	taxes, reports to owners	deciding whether a business is worth it

Why economists care about economic profit

Economic profit compares a business with its owner's best alternative, so it is the right signal for choices:

Positive economic profit: resources earn more here than elsewhere. Other entrepreneurs notice and are drawn to the industry.
Zero economic profit (normal profit): resources earn just what they would earn elsewhere. There is no pull in or out.
Economic loss: resources earn less here than elsewhere, even if the books show an accounting profit. In time, owners move their resources to better uses.

Topic 3.6 follows those moves into and out of an industry and shows how they push economic profit toward zero. On the exam, when a question says "profit" in a graph about a firm, it means economic profit, because the cost curves include the owner's opportunity costs.