Question

Which statement is true? (LO6) a) Profits are about one-quarter of GDP. b) Profits are about 1 percent of GDP. c) Accounting profits are larger than economic profits. d) None of these statements is true.

Short answer

The correct statement is (c) Accounting profits are larger than economic profits.

Step-by-step solution

Analyze Statement a)

We need to determine if profits are about one-quarter of GDP. In most economies, profits are a significant portion of GDP, but they are not as high as one-quarter. Therefore, this statement is not true.

Analyze Statement b)

We need to determine if profits are about 1 percent of GDP. Profits are an important part of the economy, and this value seems too low. Therefore, this statement is not true as well.

Analyze Statement c)

We need to determine if accounting profits are larger than economic profits. Accounting profits are the difference between total revenues and explicit costs, while economic profits consider both explicit and implicit (opportunity) costs. Therefore, since accounting profits don't account for implicit costs, they are generally larger than economic profits. So, this statement is true.

Choose the correct statement

After analyzing the given statements, it is clear that the correct statement is: c) Accounting profits are larger than economic profits.

Key concepts

Gross Domestic Product (GDP)

Gross Domestic Product, commonly known as GDP, is a key economic indicator that measures the total value of all goods and services produced in a country during a specific period. GDP is crucial because it gives a broad picture of a country's economic health and helps policymakers make informed decisions.
To calculate GDP, one can use three methods:

• The production approach, which sums up the outputs of every enterprise.
• The income approach, which calculates GDP by adding up total compensation to employees, gross profits for firms, and taxes minus subsidies.
• The expenditure approach, which is the most common and sums up consumption, investment, government spending, and net exports (exports minus imports).

GDP is used to compare economic performance between different countries and over different times. However, it does not capture unpaid work, black markets, and informal economies.

Accounting Profits

Accounting profits are a measure of a company's financial performance. This is what most people think of when they hear the word 'profit'. Accounting profit is determined by subtracting total explicit costs from total revenue. Explicit costs are the direct, out-of-pocket expenses of running a business, such as wages, rent, and materials.
To calculate accounting profit:

• Determine total revenue, which is the income a company earns from its normal business operations.
• Subtract total explicit costs, which are the costs directly tied to the production of goods or services.

The result is the accounting profit, which appears on a company's income statement and is used in assessing business performance, making it critical for investor assessments and company valuation. Accounting profit does not account for opportunity costs, which are considered in economic profits.

Economic Profits

Economic profits provide a broader perspective on profitability than accounting profits do. While accounting profits only consider explicit costs, economic profits consider both explicit and implicit costs. Implicit costs are the opportunity costs of utilizing resources for a specific purpose, which means what you give up in order to use an asset or labor elsewhere.
To calculate economic profits:

• Start with the accounting profit.
• Subtract implicit costs, which include things like potential income from other jobs the owner could pursue or returns from alternative investments.

If the economic profit is positive, it indicates that a company is using its resources wisely. However, a negative economic profit does not necessarily mean a company is losing money; it might simply be that the company could earn more in another venture. Understanding economic profit is beneficial for business owners and economists as it reflects the true economic viability of a business decision.