Economic Profit
Economic Profit refers to the difference between total Revenue and total costs, including both explicit and implicit costs. Unlike Accounting Profit, which only considers direct, out-of-pocket expenses, economic profit takes into account the Opportunity Costs of all resources used in production.
Mathematically, it can be expressed as:
Economic Profit = Total Revenue – (Explicit Costs + Implicit Costs)
Example 1: A small business owner invests $100,000 in a café. The café generates $150,000 in Revenue in a year. The explicit costs (like rent, utilities, and wages) amount to $80,000. If the owner’s next best option was a job earning $50,000, the implicit cost is $50,000. Thus:
- Total Revenue: $150,000
- Explicit Costs: $80,000
- Implicit Costs: $50,000
- Economic Profit: $150,000 – ($80,000 + $50,000) = $20,000
Example 2: An Entrepreneur decides to start a tech company instead of taking a corporate job that pays $60,000 a year. The company makes $200,000 in Revenue with explicit costs of $120,000. The implicit cost of forgoing the corporate job is $60,000. Therefore:
- Total Revenue: $200,000
- Explicit Costs: $120,000
- Implicit Costs: $60,000
- Economic Profit: $200,000 – ($120,000 + $60,000) = $20,000
In both cases, the businesses generate positive economic profits, indicating that they are covering all costs, including Opportunity Costs, and are making a return greater than the next best alternative.