Exploring Economic Profit
Economic profit is the total revenue minus all opportunity costs incurred in the production of a good or service. It is a measure of the true profitability of a business, taking into account both explicit and implicit costs. Unlike accounting profit, which does not account for opportunity costs, economic profit is a more accurate measure of the true value a business brings to the economy.
Calculating Economic Profit
Economic profit can be calculated using the following formula:
- Economic Profit = Total Revenue – Explicit Costs – Implicit Costs
Explicit Costs
Explicit costs are those that require an outlay of cash for the production of a good or service. These costs can include rent, wages, raw materials, and other costs directly related to the production of the item.
Implicit Costs
Implicit costs are those that do not require an outlay of cash, such as the opportunity cost of capital. For example, if a business were to invest in a new piece of equipment, the opportunity cost of that capital would be the potential return from investing the same money in another venture.
Example of Economic Profit
For example, a company produces a new product for $100. The company sells the product for $120. The company has no other explicit costs, but the implicit cost of the opportunity cost of capital is $20. The economic profit of the new product would be $20 ($120 sales revenue – $100 cost of production – $20 opportunity cost of capital).
Conclusion
Economic profit is an important measure of the true value of a business to the economy. It takes into account both explicit and implicit costs, such as the opportunity cost of capital, to give a more accurate measure of a business’s profitability.