Economics: Finding Economic and Accounting Profit

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You want to know how your business is doing. Are you going to be around a year from now? -- two years from now? -- five? What numbers should you look at to gauge your progress? How would an economist advise a business owner to figure out whether the business is really in some long-run sense earning a profit?
Well, here's the idea: Economic profit is the difference between the revenue that a firm earns, and the sum of the opportunity costs of all the resources that are employed at that firm. As long as revenue is greater than the sum of the opportunity costs, the business owner can afford to pay all of the resources - a salary that is better than their next best alternative. That means they'll be willing to stay and work with this business as long as revenue exceeds opportunity costs. But if revenue falls below the combined opportunity costs of the employed resources, then the business is in trouble. One by one, the resources will seek alternative employment where they can earn more money. This is the notion of economic profit, and why it is that it's important that a business owner pay attention to it.
Let's consider now the difference between the way economists reckon profit and the way accountants reckon profit. It turns out that if you use accounting profit as a guide, you can sometimes get a faulty picture of how your business is doing, and that could lead you to make mistakes. Let's consider, then, the way accounting profit is calculated. Accounting profit is the difference between the revenue that a business receives and all of the expenses that the business pays out. So suppose now we are running a retail television business. You're selling television sets to people who come in off the street, you've advertised in the newspaper, you've made a name for yourself, and now customers come in, interact with your salespeople, and decide whether or not they want to buy a TV set.
Let's suppose that in one particular year, the revenue earned by this television business is $100.00. How would an accountant calculate the profits of this business for that year? Well, the first thing we'd do is make a list of all of the resources that are being - written paychecks by the manager, and we would add up the expenses. So one of the first expenses is going to be the cost of goods sold - that is, all of the television sets that we've bought from some wholesale operation that we're now selling retail. And let's suppose that the cost of goods sold for this operation is $30.00. So out of our $100.00 worth of revenue, we've got to take $30.00 of it to write checks to our wholesale provider of television sets.
Let's suppose that the other expense that we have is all of the help that we have to pay wages to. And let's suppose that for the sake of this example, our workers have combined wages of $30.00. So that's another $30.00 worth of expenses that this business has. And let's suppose that that's all the checks that we are writing out of our checking account for this TV operation. That means that $100.00 worth of revenue minus $30.00 worth of wages minus $30.00 for cost of goods sold leaves an accounting profit of $40.00 - $100.00 minus $60.00 in total expenses - so the accounting profit in this case is going to be what's leftover, and that is equal to $40.00.
Now what happens to that accounting profit? The accounting profit then is divided among other resources that are employed in this business that don't figure explicitly into the costs. Who are they? Well, for one, there's the manager. If the manager is not paying himself a salary explicitly, then he gets to take a share of the profits. Who else gets a share of the profits? Well, any investors that put their money into this TV store, maybe so that the TV store could afford to buy inventory, so they could afford to accumulate other kinds of capital that are important to their operation. Inventory is a really good tangible thing to think about why you may need to borrow money in order to run a TV retail store. So the money that's leftover - the accounting profit - is available to be divided between the manager and the stockholders.
Now, can we tell by looking at this picture whether or not our firm is going to be around a year or two? And the answer is no, because we have no idea from this reckoning how much the manager could earn somewhere else, and what the shareholders could earn somewhere else. And for that matter, what the workers could earn somewhere else. It's only when we see that all of the resources employed are earning more in this business than they could earn in their next best opportunity that we can conclude this business is going to be a going concern. That's what economic profit is about.
So what we do next is we add up the opportunity costs of all the resources that are employed, and we figure out whether this firm is earning enough revenue to cover those. Let's start with the cost of goods sold. These television sets that we are selling to our customers, what's their opportunity cost? Well, if we imagine that the wholesale television business is a very competitive business, you could turn around, and rather than sell these television sets to the public, you could sell them right back to the wholesaler, and probably get your original $30.00 back. So the opportunity cost of the televisions that we're selling to our customers is probably exactly what we paid for them - $30.00 - because we could always sell them back to the people who sold them to us.
So the opportunity cost of our cost of goods sold is probably pretty much the same number that was on our accounting books. The workers, however, probably are another story. We're paying them a total of $30.00 in wages, but their next best opportunity is surely lower than that. If the market for labor is very tight and very competitive, then the $30.00 might be their opportunity costs, but chances are, they're doing better in this operation than they would be doing at their next best alternative; that's why they've chosen to work in TV retail.
Let's suppose that the next best alternative for the workers would pay them not $30.00 but only $20.00. In that case, these workers are delighted to have the retail TV job, because their opportunity cost is lower than what they're actually being paid. Think about it, these workers are making, in some sense, a profit; they're earning $30.00 here while their next best alternative is $20.00. We call the extra $10.00 that they're earning at the TV store "economic rent." Economic rent is defined as the amount that a resource is paid in excess of its next best alternative - in excess of its opportunity cost.
So all we know here is that we've got to pay our workers at least $20.00; we happen to be paying them $30.00. But $20.00 would be enough to keep them in this employment. The big difference between economic profit and accounting profit is that economic profit includes the opportunity costs of all the resources employed, not just the ones that explicitly get paychecks. For instance, the next step in calculating economic profit is going to be to include the opportunity cost of capital. What could our investors earn if they put the money that they've presently invested in our television retail business into some alternative?
Let's suppose that a comparably risky investment would earn a 20% rate of return. That means that if our capital owners have put $50.00 into this business, say $50.00 that's lent to us so that we can acquire an inventory, if they'd put that money instead into the stock market, or into a bank account, they could earn 20% - 20% times $50.00 equals $10.00. So $10.00 in this case is the opportunity cost of capital - what our capital owners could have earned if they had invested this same amount of capital in a comparably risky investment. So let's go ahead and put $10.00 here as the opportunity cost of capital. Of course, that means that if we don't pay our capital owners at least $10.00 they're going to start looking elsewhere for investment alternatives.
Another resource that's not explicitly accounted for in accounting profit is going to be the manager, particularly if the manager is not paying himself a salary, he may not show up anywhere over here on the books. But certainly he has an opportunity cost; he could take his talent and go manage some other business. And suppose his next best alternative would allow him to earn $20.00; so $20.00, then, is his opportunity cost. If he doesn't get paid at least $20.00 for a year's worth of management expertise, then he can't be expected to stay with this firm. So what we've done here is we've added up the opportunity costs of all the resources that are employed at this business. Whether they're explicitly receiving a paycheck, or whether they're getting bonuses or dividends or whatever and not actually on the accounting books, they are considered here in this reckoning. Add up the opportunity costs, subtract the opportunity costs from the revenue that's earned, and we get what's called the economic profit. Economic profit is the amount at which the revenue exceeds the combined opportunity costs of all the resources that are employed. And this economic profit, then, will be divided among the employed resources in the form of rents.
We've already talked about how the workers are getting $10.00 worth of economic rent; they're being paid more than their opportunity costs. Maybe the manager is being paid $25.00, which would be $5.00 worth of rent for him, and maybe the shareholders are getting $15.00, which would be $5.00 worth of economic rent for them. So the economic profit, then, is going to be divided among the stakeholders in this business, whether they are capital suppliers, the managers, the workers, or anyone else. The sum of the economic rents would be equal to the firm's economic profit.
So we can conclude by saying that if the firm were not making an economic profit it wouldn't expect to be around very long, because the various resources - the manager, the workers, the capital - all these resources would go off in search of other alternatives, other opportunities, that had higher returns. But as long as the firm is making a positive economic profit, it can afford to pay all of its resources enough money to keep them interested in working for this business.
If the opportunity cost of capital is greater than the accounting profit, well, there you have it. The firm looks like they're doing okay, but in reality, they're winding down, because the economic profit will be negative. Negative economic profit means, in the long run, you're out of business. Even though the books may look good, because you haven't taken account of other factors of production that aren't being explicitly paid paychecks, you can make a mistake in management. Economic profit is a notion that helps you consider whether or not your firm is actually doing well enough to stick around.
Now there's one more point I want to make about the difference between accounting reckonings and economic reasoning, and that's the issue of sunk costs. Sunk costs are amounts of money that you pay that you will never get back - the acquisition of inputs that immediately have zero opportunity cost. Here's a parable about sunk costs that makes clear why economists are so eager to resolve the confusion about them.
Suppose you join an expensive health club, and you have to pay all of your membership dues up front. And the first day you enthusiastically go to the health club and play a vigorous game of tennis. Now, being out of shape, you're probably going to really hurt your tendons, and the next morning you wake up with tennis elbow, and you think to yourself, "You know, my arm hurts. But since I already paid my dues, I really ought to go work out again." And you do, and the arm gets worse. And the next day, and the next day, until finally you show up at the doctor, hardly able to bend your arm, and the doctor says, "Gosh, you're being really foolish. Every day when you go to that health club, you're hurting your arm worse. Why do you keep showing up?" And you say, "Because I already paid my dues."
Well, this is the problem of the fallacy of the sunk costs - you're never going to get back the money that you've paid for your membership. So every day when you wake up, you should make the decision fresh. Because the membership is prepaid, it costs you zero to go down to the health club. Are you getting enough benefit to cover that cost? Not if you're hurting yourself - in that case, the benefit is actually negative, and you are shrinking your profit by showing up. The way you should make a rational decision about costs that are sunk is, "What would it cost me to bring this project to completion?" And "What is the benefit that I can expect once the project is completed?"
If the benefit is greater than the required additional costs, go for it. But if not, it doesn't matter that you've already put money into this project. That money is sunk, you're not going to get it back anyway. It shouldn't influence the decision about whether to go forward. Even though costs show up on your accounting books, some of them that are sunk should be ignored for the sake of decisions that are forward-looking. Always consider how much it will cost to bring a project to completion, and how much benefit will be derived. If the benefit is greater than the cost, it makes rational, good, profitable sense to carry the project out. If not, don't let sunk costs become a kind of neurotic guilt that influences your actions in the present in a way that makes you do unprofitable things. What's already paid is sunk, and the economist advises you to ignore sunk costs for the sake of rational, profit-making decisions.
Perfect Competition
The Basic Assumptions of Competitve Markets
Finding Economic and Accounting Profit Page [3 of 3]