Profit is the financial gain a company achieves when its revenue exceeds its costs. This straightforward calculation is what most people think of when they consider a firm’s success. The field of economics, however, employs a more detailed definition of profit. This economic perspective provides a deeper analysis of a company’s financial health and its true performance.
Accounting Profit vs Economic Profit
The most fundamental way to calculate a firm’s financial gain is by determining its accounting profit. This figure is calculated by taking a company’s total revenue and subtracting its explicit costs. Explicit costs are the direct, out-of-pocket payments a business makes to operate, including expenses such as wages, rent, raw materials, and utility bills. This is the number that companies report on their financial statements for investors and for tax purposes.
Economics, however, introduces a more comprehensive measure known as economic profit. This concept begins with the same total revenue but subtracts a broader set of costs. The formula for economic profit is total revenue minus the sum of both explicit and implicit costs. The inclusion of implicit costs is what fundamentally distinguishes economic profit from its accounting counterpart and provides a more accurate picture of a company’s efficiency and success.
Implicit costs represent the opportunity costs of the resources a business uses. An opportunity cost is the value of the next-best alternative that was given up to pursue a certain action. These are not costs that involve a direct payment, but they are real costs. For example, a business owner might use a building they personally own for their company instead of renting it out. The potential rental income they are forgoing is an implicit cost.
Consider a consultant who starts their own firm. They might generate $150,000 in revenue and have $60,000 in explicit costs for office space and supplies, resulting in an accounting profit of $90,000. However, to run this business, they had to leave a job that paid an annual salary of $100,000. This forgone salary is an implicit cost. When this is factored in, the economic profit is actually a loss of $10,000 ($150,000 revenue – $60,000 explicit costs – $100,000 implicit cost).
The Types of Economic Profit
The calculation of economic profit results in one of three outcomes that classify a firm’s performance beyond what accounting profit reveals.
When a firm’s economic profit equals zero, it is earning a normal profit, which is not a negative indicator. A normal profit means the company’s total revenues are sufficient to cover all of its explicit and implicit costs. Achieving a normal profit signifies that the venture is viable because it is doing at least as well as its owner’s next-best alternative.
A positive economic profit is a supernormal profit, which occurs when total revenue exceeds the sum of explicit and implicit costs. Earning a supernormal profit means the business is generating more than enough to cover all expenses and opportunity costs. This indicates the firm is successful and utilizing its resources more effectively than alternative ventures could.
An economic loss happens when economic profit is negative, as total revenue is not enough to cover the combination of explicit and implicit costs. A business can show a positive accounting profit while experiencing an economic loss. This arises when the accounting profit is smaller than the firm’s implicit costs, signaling that resources could be better used elsewhere.
The Role of Profit in a Market Economy
Beyond indicating a firm’s performance, profit plays a foundational role in a market economy, acting as a signaling mechanism that guides resource allocation. The presence of supernormal profits in a sector sends a message to the economy, attracting new entrepreneurs and businesses drawn by the potential for high earnings.
This influx of new firms into a profitable industry increases competition and overall supply, which drives down prices and erodes high profits. This process continues until most firms are earning only a normal profit. Conversely, economic losses signal that resources could be better used elsewhere, encouraging businesses to exit the market.
The pursuit of profit also serves as a primary driver of innovation and efficiency. To gain a competitive edge, businesses seek new ways to improve products, develop more efficient production methods, and reduce their costs. This drive for improvement leads to technological advancements and better-quality goods for consumers.
Factors That Influence Profit Levels
A firm’s ability to generate profit is shaped by various factors, one of the most significant being the structure of the market in which it operates. Market structures range from perfect competition to a monopoly. In highly competitive markets, supernormal profits are short-lived as new entrants erode them, while a monopolist may sustain high profits over the long run.
The level of consumer demand for a company’s products is another determinant of its profitability. Strong demand allows firms to charge higher prices and sell greater quantities, boosting revenues. The costs of inputs, such as labor, raw materials, and energy, also play a large part. An increase in these costs can reduce a firm’s profit margins if it cannot pass them on to consumers.
Government intervention can also have a substantial impact on profit levels. Policies such as corporate taxes directly reduce the amount of profit a company can retain. Regulations related to environmental protection or workplace safety can increase a firm’s operating costs.