What Is a Profit in Economics vs. Accounting?

Profit represents the financial gain when revenue exceeds expenses, serving as a primary indicator of a company’s financial health and operational success. While often viewed as money left over, profit is understood differently from an accounting or economic perspective. This article explores profit through an economic lens, which provides a broader view than accounting calculations.

Accounting Profit Versus Economic Profit

Accounting profit represents a business’s financial performance over a specific period. It is calculated by subtracting all explicit costs from total revenue. Explicit costs are direct monetary expenses, such as wages, rent, raw materials, utilities, and asset depreciation. These costs appear on a company’s income statement and are used for tax and financial reporting.

Economic profit, in contrast, is a more comprehensive measure, considering both explicit and implicit costs. Implicit costs are the opportunity costs of resources a firm owns and uses in its operations, for which there is no direct monetary payment. They represent the value of the next best alternative foregone when a business decision was made.

For instance, if a business owner uses their own building, the implicit cost includes potential rental income they could have earned. Similarly, the implicit cost of an owner’s time might be the salary they could have earned working elsewhere.

For example, an individual invests $100,000 to open a business, which in a year generates $150,000 revenue and incurs $80,000 in explicit costs. Accounting profit is $150,000 – $80,000 = $70,000. If the owner could have earned $10,000 in bond interest and a $60,000 salary elsewhere, these are implicit costs. Economic profit is $150,000 – $80,000 – $10,000 – $60,000 = $0. This shows the business is not generating a return greater than alternative opportunities.

Understanding Normal Profit

Normal profit refers to the minimum profit necessary to keep a firm operating long-term. It is achieved when a firm’s total revenue precisely covers all its total costs, including both explicit and implicit costs. This means the firm earns just enough to cover operational expenses and the opportunity costs of its resources.

When economists state a firm earns “zero economic profit,” it does not mean the business is failing. Instead, it signifies the firm is earning normal profit, indicating its resources are utilized efficiently and yield a return equivalent to their next best alternative use.

For example, if a business owner earns an accounting profit of $70,000, and their total implicit costs also sum to $70,000, then economic profit is zero. The firm earns a normal profit, justifying its continued operation. The owner is compensated adequately, preventing them from seeking opportunities elsewhere.

Normal profit is the cost of staying in business, including the return to compensate entrepreneurs for risk and managerial efforts. It ensures resources remain allocated to their current use by earning a competitive rate of return. If a firm fails to achieve normal profit, its resources could generate a higher return elsewhere, prompting reevaluation.

Sources of Economic Profit

Economic profit, earned above normal profit, arises when a firm’s total revenue exceeds its total economic costs. Such profits are not sustained indefinitely in perfectly competitive markets but can occur due to factors creating temporary or prolonged advantages.

Innovation is a primary source of economic profit. Firms introducing new products, advanced processes, or novel services gain a temporary monopoly or competitive edge. This allows them to charge higher prices or operate at lower costs, leading to above-normal returns until others replicate their innovations.

Risk-taking contributes to economic profit. Entrepreneurs undertaking ventures with uncertain outcomes, especially those with substantial risks, can be rewarded with economic profits if successful. This profit compensates for bearing inherent uncertainties and potential losses.

Market power, from factors like barriers to entry, patents, and strong brand loyalty, enables firms to earn economic profits. Barriers to entry, such as high startup costs or regulatory hurdles, limit competition, allowing established firms to maintain higher prices or market shares. Patents grant exclusive rights, preventing competitors from using the technology and securing temporary monopoly profit.

Superior efficiency, achieved through optimized production, effective supply chain management, or economies of scale, leads to economic profit. Firms producing goods or services at a lower average cost than rivals gain a competitive advantage. Anticipating future market conditions, like shifts in demand or input prices, allows businesses to capitalize on emerging opportunities.

The Role of Economic Profit in Resource Allocation

Economic profit plays a key role in guiding resource allocation within a market economy. It acts as a powerful signal, directing labor, capital, and other productive resources toward industries and firms where they generate the highest value. When a firm earns economic profit, it indicates its resources create more value than their next best alternative use.

Positive economic profits attract new firms and encourage existing ones to expand, leading to an inflow of capital and labor. This increases supply, eventually driving down prices and reducing economic profits. Conversely, economic losses signal inefficient resource use, suggesting greater value could be generated elsewhere.

Economic losses prompt firms to exit or reduce operations, causing resources to flow out. This reallocation, driven by the pursuit of economic profit and avoidance of loss, ensures resources move to their most productive uses. This dynamic fosters innovation, as firms seek new ways to create value and gain a competitive edge.

The incentive of economic profit encourages businesses to innovate, improve efficiency, and respond to consumer preferences. This continuous adjustment benefits consumers through lower prices, higher quality goods, and wider choices. Economic profit thus guides optimal resource allocation and overall economic welfare.