Question

Which of the following equalities is true? a. Economic profit \(=\) total revenue \(-\) accounting profit b. Economic profit \(=\) total revenue \(-\) explicit costs - accounting profit c. Economic profit \(=\) total revenue \(-\) implicit \(\operatorname{costs}-\) explicit costs d. Economic profit = opportunity cost \(+\) accounting cost

Short answer

The correct formula for calculating economic profit is: Economic profit = total revenue - implicit costs - explicit costs. Therefore, option c is the correct answer.

Step-by-step solution

Identifying the Correct Formula

We will now analyze each given option to see which of them represents the correct formula for calculating economic profit. a. Economic profit = total revenue - accounting profit This option takes the difference between the total revenue and accounting profit. However, accounting profit only considers explicit costs and does not include implicit costs. Therefore, this formula is incorrect. b. Economic profit = total revenue - explicit costs - accounting profit In this option, explicit costs and accounting profit are subtracted from total revenue. However, accounting profit accounts for explicit costs already; thus, this would double count explicit costs and completely ignore implicit costs. This formula is therefore incorrect. c. Economic profit = total revenue - implicit costs - explicit costs This option considers both implicit costs and explicit costs subtracted from total revenue. Since implicit costs represent opportunity cost and explicit costs represent actual out-of-pocket expenses, adding these together gives us the total cost. So, economic profit is the total revenue minus total cost (explicit + implicit costs), making this formula correct. d. Economic profit = opportunity cost + accounting cost In this option, opportunity cost (a component of implicit costs) is being added to accounting costs. However, including only one component of implicit costs while combining it with the accounting costs gives an incorrect representation of total costs. Therefore, this formula is also incorrect. #Conclusion# The correct formula for calculating economic profit is: Economic profit = total revenue - implicit costs - explicit costs Thus, option c is the correct answer.

Key concepts

Total Revenue

Understanding the flow of money in a business begins with total revenue, which is the amount a company earns from selling its goods or services before any costs are deducted. Imagine it as the total income generated from sales, often calculated as the number of units sold multiplied by the price per unit. For instance, if a toy company sells 1,000 action figures at \(10 each, the total revenue would be \)10,000.

To put this into the context of our exercise, knowing the total revenue is essential as it sets the benchmark from which we deduct costs to calculate economic profit. It represents the starting point of our profit analysis.

Accounting Profit

Accounting profit is the monetary surplus recorded in the financial statements of a company after subtracting explicit costs from total revenue. Explicit costs are tangible and direct expenses like wages, rent, and materials. If we return to our toy company example, if they spend \(6,000 on manufacturing the action figures, the accounting profit would be the total revenue (\)10,000) minus these explicit costs (\(6,000), equating to \)4,000.

This figure, however, does not reflect the completeness of a company’s profitability, as it disregards implicit costs. This is where economic profit diverges from accounting profit, by integrating these non-explicit costs into its calculation.

Explicit Costs

Let's delve deeper into explicit costs. These are the direct, clear-cut expenses that a business pays to produce its goods or services. They include payments for raw materials, labor, utilities, and rent—essentially any cost that you can see directly tied to the day-to-day operations of a business. It's what the phrase 'out-of-pocket' costs is alluding to.

From the perspective of our textbook problem, we note that explicit costs are already accounted for in the accounting profit, so they should not be subtracted again when calculating economic profit to avoid any repetition in the formula.

Implicit Costs

Implicit costs are the often-overlooked counterpart to explicit costs. These are not direct expenditures but rather represent the opportunity costs—the income a business foregoes when resources are used for one purpose over an alternative. For instance, an entrepreneur investing their own savings into their business incurs an implicit cost equal to the interest they would have earned if that money was in a savings account.

Such costs are fundamental in determining economic profit, which aims to capture the entire cost of business decisions. Unlike explicit costs, implicit costs are not recorded on financial statements but must be estimated and considered to get a holistic picture of a company’s profitability, as illustrated in option c of our exercise.