Question

A firm with explicit costs of \(\$ 2\) million, no implicit costs, and total revenue of \(\$ 3\) million would have (LO2) a) zero economic profit b) zero accounting profit c) an accounting profit and an economic profit of \$1million d) a higher economic profit than an accounting profit e) a higher accounting profit than economic profit

Short answer

Answer: c) an accounting profit and an economic profit of $1 million

Step-by-step solution

Understanding Accounting Profit and Economic Profit

Accounting profit is the total revenue minus explicit costs. Explicit costs are the actual monetary payments made by a firm to the factors of production, such as wages and rent. Economic profit is the total revenue minus both explicit and implicit costs. Implicit costs are the opportunity costs of resources owned by the firm and are not recorded as monetary payments. Given the information provided: Total revenue (TR) = $3 million Explicit costs (EC) = $2 million Implicit costs (IC) = $0

Calculate Accounting Profit

Accounting profit (AP) is calculated as total revenue minus explicit costs: AP = TR – EC AP = \(3 million – \)2 million AP = $1 million

Calculate Economic Profit

Economic profit (EP) is calculated as total revenue minus both explicit and implicit costs: EP = TR – (EC + IC) EP = \(3 million – (\)2 million + $0) EP = $1 million

Match Results to the Multiple-Choice Options

Both accounting profit and economic profit are equal to $1 million for this firm. This matches option c: c) an accounting profit and an economic profit of $1 million

Key concepts

Accounting Profit

Accounting profit is a straightforward concept in business. It refers to the difference between a company's total revenue and its explicit costs.
Explicit costs involve tangible monetary expenditures, such as payments for rent, salaries, utilities, and materials. In essence, anything that requires actual cash payments falls under explicit costs.
For our firm, with a total revenue of $3 million and explicit costs amounting to $2 million, the accounting profit is calculated by subtracting these costs from total revenue:
- Total Revenue (TR) = $3 million - Explicit Costs (EC) = $2 million Using the formula for accounting profit: - Accounting Profit (AP) = TR - EC - AP = $3 million - $2 million = $1 million So, the firm's accounting profit is $1 million. Accounting profit provides a baseline measure of a firm's financial performance. It gives insight into whether the firm's core operations are profitable, excluding any hidden or implicit costs.

Explicit Costs

Explicit costs are essential considerations for any business as they represent actual, out-of-pocket expenses.
These are the costs a company incurs directly through transactions. Examples of explicit costs include:

• Wages and salaries paid to employees
• Payments for rent of business premises
• Utilities such as electricity and water
• Cost of raw materials or inventory

Explicit costs are crucial for calculating accounting profit because they are deducted from total revenue to determine how much is left over after covering all cash expenses.
In our example, the firm had explicit costs of $2 million. These are straightforward deductions that reflect actual spending and are easy to track through financial records. Understanding and managing explicit costs is vital for maintaining the financial health of a business.

Implicit Costs

Implicit costs are sometimes less obvious as they do not involve direct cash payments. Instead,
they represent the opportunity costs of using resources that the firm already owns. These costs include the potential income from alternative uses of resources:

• The owner's time, if not drawing a salary
• The usage of the owner’s capital or real estate
• Potential earnings if assets were rented out or invested elsewhere

In our example, this firm had no implicit costs. However, understanding implicit costs is crucial for calculating economic profit, as they reflect what a firm gives up when it utilizes its resources internally rather than utilizing them elsewhere.
By incorporating implicit costs into calculations, businesses get a more comprehensive view of profitability beyond just accounting profit. It helps them evaluate whether they are using their in-house resources effectively.