Definition of Economic Profit
Economic profit is defined as total revenue minus total cost, including both explicit and implicit costs. That means apart from the general expenses that reduce the account balance (e.g., variable costs, fixed costs), it also considers costs that don’t require actual cash flow, such as opportunity costs.
To illustrate this, let’s look at an imaginary ice cream seller called John. On a sunny day, John sells 200 ice cream cones for USD 2.00 each. Thus, his revenue for that day is USD 400.00 (i.e., 200*2). Meanwhile, the ingredients to produce 200 cones add up to USD 150.00 (i.e., variable cost). In addition to that, John has to pay USD 50.00 per day to rent his ice cream truck (i.e., fixed cost). As a result, John’s explicit costs add up to USD 200.00, and his accounting profit is USD 200.00 (i.e., 400 – 200).
However, instead of selling ice cream, John could have also spent the day working at a nearby restaurant. That way, he could have earned USD 150.00 instead. In economic terms, we call this an opportunity cost. Unlike the explicit costs mentioned above, this opportunity cost does not have a direct impact on John’s cash flow. That’s why it’s considered an implicit cost. To calculate John’s economic profit, these types of costs must be included as well. As a consequence, his economic profit adds up to USD 50.00 (i.e., 400 – 200 – 150).
Why Economic Profit Matters
Economic profit is a critical concept when it comes to understanding decision-making and firm behavior. On the one hand, it shows that just because something is profitable does not always mean it is a desirable option. There may be a better – more profitable – alternative that could be taken up instead. Believe it or not, just being aware of this will help you make better decisions in various situations.
On the other hand, the difference between economic and accounting profit (i.e., explicit and implicit costs) also explains why firms in a competitive market can stay in business even though they make zero profits. Essentially an economic profit of zero states that there is no better alternative available for the firm at that time. However, as we have seen in the example above, the accounting profit can still be well above zero, and thus, the firm can still make money and be profitable in that sense.