Question

What is the difference between accounting and economic profit?

Short answer

The difference between accounting and economic profit lies in the inclusion of implicit costs. Accounting profit is calculated as Total Revenue - Explicit Costs, while economic profit is calculated as Total Revenue - (Explicit Costs + Implicit Costs). Accounting profit only considers actual cash payments, whereas economic profit also accounts for opportunity costs of alternative choices that were given up.

Step-by-step solution

Define Accounting Profit

Accounting profit is the difference between total revenue (money received from selling goods and services) and explicit costs (actual cash payments made for resources such as labor, materials, and rent). It represents the financial gain of a company or individual according to standard accounting principles. Accounting profit can be represented mathematically as: Accounting Profit = Total Revenue - Explicit Costs

Define Economic Profit

Economic profit takes into account both explicit costs (like accounting profit) and implicit costs (opportunity costs, or the value of the next best alternative given up in order to pursue a specific course of action). Opportunity costs can include factors such as the value of the owner's time, the expected return on alternative investments, or the forgone earnings from using one resource instead of another. The formula for economic profit is: Economic Profit = Total Revenue - (Explicit Costs + Implicit Costs)

Illustrate the Difference with an Example

Let's take an example of a business owner who starts a coffee shop. To simplify the scenario, we'll consider the following details: Total revenue from the coffee shop: $50,000 Explicit costs (rent, employee wages, coffee beans, etc.): $30,000 Implicit costs (forgone salary from another job, opportunity cost of not investing in a different venture, etc.): $10,000 Now, we'll calculate both the accounting and economic profit.

Calculate Accounting Profit

Using the formula for accounting profit, we'll subtract the explicit costs from the total revenue: Accounting Profit = Total Revenue - Explicit Costs Accounting Profit = \(50,000 - \)30,000 Accounting Profit = $20,000

Calculate Economic Profit

To calculate the economic profit, we'll need to consider both explicit and implicit costs: Economic Profit = Total Revenue - (Explicit Costs + Implicit Costs) Economic Profit = \(50,000 - (\)30,000 + $10,000) Economic Profit = \(50,000 - \)40,000 Economic Profit = $10,000

Compare Accounting and Economic Profit

Comparing the results, we can see that the accounting profit (\(20,000) is higher than the economic profit (\)10,000). This difference is due to the inclusion of implicit costs (opportunity costs) in the calculation of economic profit, which are not considered in accounting profit. This example illustrates that economic profit provides a more comprehensive understanding of the "true" profitability of a business, as it takes into account the opportunity cost of alternative choices that were given up.