PCM - Profit Lesson

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Profit LessonTypes of Profit Accounting Profit equals Total Revenue minus Explicit Costs Economic Profit equals Total Revenue minus (Explicit Costs plus Implicit Costs) Normal Profit equals Zero Economic Profit

Most people view the basic definition of profit to be the difference between total revenue and total cost. That is, total profit = total revenue - total cost. However, there are different types of profit. Most notably, economic profit and accounting profit. The difference in these two types of profit is found in the meaning of "total cost."  Total cost, as viewed by an accountant, is considered just the explicit costs of running a business (the costs of resources like labor and capital). Economists view total cost as not only the explicit costs of running the business, but the implicit costs, as well. Implicit costs include the opportunity cost incurred by the entrepreneur.

Accounting Costs vs. Economic Costs Video

View the video below to learn more. To make the video full screen, click the double arrows at the bottom right corner of the object.

Example

Suppose a teacher chooses to give up teaching (and earning a $50,000 per year salary) to open a coffee shop. The explicit costs (coffee beans, espresso machine, building, labor, etc) involved in running the coffee shop are $75,000 annually.

Examples Case 1, Case 2, and Case 3 Case 1 When total revenue (TR) equals $100,000 per year: Accounting Profit equals $100,000 minus $75,000 equals $25,000 Economic Profit equals $100,000 minus ($75,000 plus $50,000) equals negative $25,000 (this is actually a loss) The teacher would be better off to continue teaching, rather than run the coffee shop. Case 2 When total revenue (TR) equals $125,000 per year: Accounting Profit equals $125,000 minus $75,000 equals $50,000 Economic Profit equals $125,000 minus ($75,000 plus $50,000) equals zero dollars (This means the entrepreneur is earning a normal profit.) The teacher is doing as well running the coffee shop as he/she would be teaching. Case 3 When total revenue (TR) equals $150,000 per year: Accounting Profit equals $150,000 minus $75,000 equals $75,000 Economic Profit equals $150,000 minus ($75,000 plus $50,000) equals $25,000 (This is a positive profit.) The teacher is better off running the coffee shop than he/she would be teaching.

In all three cases above, an accountant would consider the business to be profitable. However, an economist would only consider operating the business worth the teacher's time in cases two and three.  

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