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Overview of Types of Profit in Economics
Most firms want to make a profit, among other things. But arguably, most of these other things are aimed at increasing profit, so let’s focus on profit. So, what is profit? Profit is all the money made by the firm minus all the money spent by the firm. Let’s look at the standard definition of profit in economics.
Profit refers to the total revenue (TR) of the firm minus the total production cost (TC) of the firm.
Mathematically, this is written as:
The definition of profit mentions total revenue and total production cost. What are these? The total revenue is all the money acquired from selling the firm’s products at a given price. Total cost, on the other hand, refers to all the costs incurred during production.
Total revenue is the price (P) of a product multiplied by the quantity (Q) of that product sold.
Mathematically, this is written as:
Total cost is the sum of all costs incurred by the use of the factors of production to produce the product.
As mentioned in the definition of total revenue, price refers to the monetary value for which the product is sold, whereas quantity refers to the number of units of the product sold by the firm.
Now, you should keep in the back of your mind that there are two types of profit. These are accounting profit and economic profit. To help you understand the distinction between the two, let’s look at implicit and explicit costs, which are the two types of costs.
There are two types of costs - implicit cost and explicit cost.
Let’s explain implicit cost and explicit cost with an example.
A student graduates from the university with a degree. This student can choose to either enter the university’s master’s degree program or find a job. The student then decides to enter the master’s degree program. This decision, if acted upon, comes with an opportunity cost, and opportunity cost includes the benefits forgone by choosing an alternative.
First, there is an explicit cost, which refers to the amount of money paid directly as fees for enrolling in the master’s program.
An explicit cost is a cost that involves an outlay of money.
Second, there is an implicit cost, which refers to the amount of money the student would have made by finding a job instead of continuing school.
An implicit cost is the monetary value of the benefits that have been forgone by choosing an alternative.
Implicit cost can sometimes be even higher than explicit cost.
Types of Profit: Accounting Profit vs Economic Profit
Let’s consider the example of a coffee processing company to understand the different types of profit.
A coffee processing company made a total revenue of $20,000 this year. The company owns all its equipment and spent a total of $10,000 to produce the coffee it sold this year. Based on the explicit costs, the company made a profit of $10,000.
An accountant does not stop there. An accountant subtracts an extra amount for depreciation of the machinery and equipment. Depreciation is a real cost because the equipment are not as good as new once they are used, although it's not an explicit cost.
Depreciation is the reduction in the value of equipment as a result of being used over time.
From this, we can now see that accounting profit considers both explicit costs and depreciation.
Accounting profit refers to the total revenue minus the total explicit costs and total depreciation.
This means the accounting profit of the coffee processing company is
For economic profit, looking at the same example, if the coffee processing company contemplates whether to keep running the business or open another business, opportunity cost comes into the picture. This is because the company must consider the total revenue, the implicit costs, and the explicit costs.
Implicit costs can include opportunity cost not just of the equipment or machinery, but also of the founder's time. Implicit costs can also include the cost of incurring risk, since starting up a new company can be very risky.
When economists use the term “profit”, they are referring to economic profit.
Economic profit refers to the total revenue minus the total explicit costs and total implicit costs of the firm.
Economic profit is different from accounting profit because the accounting profit does not consider the implicit costs incurred by the business. Thus, generally speaking, the inclusion of implicit costs will make the economic costs higher than the accounting cost. As a result, economic profit is usually lower than accounting profit.
Why is implicit cost important? Because there is a limited amount of resources, and the decision to own equipment or even operate a given business means that the firm does not have enough resources to operate other businesses (where there are other benefits).
Looking at this, it becomes clear that the firm actually responds to economic profit, rather than accounting profit. This is because when there are alternatives, the company must make sure that it is putting its resources into the best alternative. Look at the example below.
A coffee processing plant can either sell processed coffee or raw coffee. processed coffee sells for $40 a bag, and raw coffee sells for $10 a bag. It costs $15 to process the coffee, which means the firm will gain $25 from this. The company is presented with two alternatives - to sell raw coffee and gain $10 or sell processed coffee and gain $25. if it sells raw coffee, that means it will miss out on the extra $15 of profit from selling processed coffee. Firms want to make as much money as they can get, therefore, the firm will respond to the economic profit of selling raw coffee. The firm will then sell processed coffee instead.
Figure 1 summarizes the types of profit.
Types of Profit: Definition of Normal Profit
There is another term that economics use, and it is normal profit. A firm makes a normal profit when the firm's economic profit is zero, and the firm is just breaking even. Economists tend to believe that in the long run, due to competitive pressures, firms can only make a normal profit and no more.
Normal profit is when the economic profit of the firm is equal to zero.
We know firms want to make more money than they spend. However, a profit of zero is not necessarily bad. This is because for the economic profit to be zero, the accounting profit is likely positive. Only when the opportunity cost of using the firm's resources elsewhere are included, does the firm have normal profit. This means that the firm is putting its resources to the best possible use at that particular time.
Types of Profit: Formula for Economic Profit
So, what is the formula for economic profit? Economic profit considers the total revenue, implicit cost, and explicit cost in the following formula:
Here's a visual illustration of the formula in Figure 2.
Types of Profit: Economic Profit Calculation
Let’s calculate economic profit from the example below using the formula:
A coffee processing company made a total revenue of $20,000 this year. The company owns all its equipment and spent a total of $10,000 to produce the coffee it sold this year. The company would have gained an extra revenue of $5,000 by renting equipment instead of owning them.
In this example, the total revenue is $20,000, explicit cost is $10,000, and implicit cost is $5,000.
Therefore,
Types of Profit: Accounting Profit Formula
Accounting profit looks at the total revenue, the explicit cost, and depreciation. So, what is the formula for accounting profit? It is as follows:
Let’s calculate accounting profit from the example below using this formula.
A coffee processing company made a total revenue of $20,000 this year. The company owns all its equipment and spent a total of $10,000 to produce the coffee it sold this year. As the company used its equipment, the machinery dropped in value by $2,000 due to wear and tear.
In this example, the total revenue is $20,000, explicit cost is $10,000, and depreciation is $2,000.
Therefore,
The accounting profit formula is illustrated in Figure 3.
Types of Profit: Economic Profit and Accounting Profit Examples
Economic profit is the total profit after taking out all costs of production and all the benefits forgone by not using the firm’s resources for alternative purposes. For example, a corn processing company subtracts the cost of processing and packing the corn as well as the benefit it would have gained by choosing to process an alternative product.
Accounting profit, on the other hand, is the total profit after taking out all costs of production and depreciation on equipment. For example, if that same corn processing company uses processing machinery that it owns, rather than rents, then those machines reduce in value after one year of use. This reduction in value is then taken into consideration as depreciation when calculating accounting profit for the corn processing company.
Congrats! You have reached the end of this article. To know the things firms spend on as part of production costs, read our article on Factor Markets.
Types of Profit - Key Takeaways
- Profit refers to the total revenue of a firm minus the total costs incurred during production.
- An explicit cost is anything that involves an outlay of money. An implicit cost is the monetary value of the benefits that have been forgone by choosing an alternative.
- There are two types of profit: accounting profit and economic profit.
- Accounting profit is total revenue minus explicit costs and depreciation.
- Economic profit is total revenue minus explicit costs and implicit costs.
- Normal profit is when economic profit equals zero.
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Frequently Asked Questions about Types of Profit
What are the types of profits?
The types of profit are accounting profit and economic profit.
How do economists view profits?
Economists view profits as including both implicit and explicit costs. Specifically, economists care about the opportunity costs of resources--the next best option. Opportunity costs are implicit costs, so they are included in economic profit but not in accounting profit, which only includes explicit costs and depreciation.
What are normal profits in economics?
Normal profit is when the economic profit equals zero.
What is the difference between accounting profit and economic profit?
Accounting profit considers explicit costs and depreciation whereas economic profit considers explicit costs and implicit costs. Since economic profit includes opportunity cost, which is an implicit cost, accounting profit is often be higher than economic profit.
What is an example of accounting and economic profit?
If you lend your friend $100 for a year and your friend pays you back $110 at the end of the year, you have an accounting profit of $10, but if you could have earned 20% by leaving this $100 in the bank, then your economic profit was a loss of $10! Economic profit includes opportunity cost which is an implicit cost.
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