We generally look at profits from accounting perspective. From the perspective of an accountant, profit is the difference between total revenue and total actual expenses incurred by the firm’s actors of production. These are the explicit costs incurred by the firm. Explicit costs are the monetary payments to resource owners.
Accounting Profits = Total Revenue – Explicit Costs
Let’s say the company earned a total revenue of $100,000, and their explicit costs such as raw material cost, labour cost, etc., were $80,000. The company’s accounting profit will be:
Accounting Profit = 100,000 – 80,000 = $20,000
Economists on the other hand have a different view of what constitutes profits. They not only consider the explicit costs but also implicit costs (opportunity cost). Implicit costs are the returns foregone by not taking owners’ resources to market.
Economic Profit = Total Revenue – Explicit Costs – Implicit Costs
Let’s continue with our example. If the owners had invested this money elsewhere they would have earned $10,000 on it. This is the implicit cost. The economic profit will be calculated as follows:
Economic Profit = 100,000 – 80,000 – 10,000 = $10,000
Economic profit is also called abnormal profit.
Note that the difference between the accounting profit and economic profit is the implicit costs. This is the normal profit, i.e., the opportunity cost of the resources supplied by a firm’s owners.
Normal Profit = Accounting Profit – Economic Profit
In other words, we can say that normal profit is the accounting profit that makes economic profit zero. In our example, if accounting profit was 10,000, then economic profit would be zero.
A firm aims at earning positive economic profits. If accounting profits are greater than implicit costs, the firm would earn a positive economic profit and should stay in the business. If accounting profits are less than implicit costs, the economic profit would be negative and in such a situation the firm should exit the business.
In equilibrium we have zero economic profit, i.e., the firm is covering all implicit and explicit costs and both debt holders and equity holders are earning their required rate of return.