key term - Economic Profit

Definition

Economic profit is the difference between a firm's total revenue and its total economic costs, which include both explicit costs (out-of-pocket expenses) and implicit costs (opportunity costs of the firm's own resources). It represents the firm's net gain after accounting for all costs, including the opportunity cost of the owner's time and capital invested in the business.

5 Must Know Facts For Your Next Test

1. Economic profit is a more comprehensive measure of a firm's profitability than accounting profit, as it considers both explicit and implicit costs.
2. In the short run, a firm may earn positive accounting profit but have zero or negative economic profit if its implicit costs are not covered.
3. Perfectly competitive firms in long-run equilibrium earn zero economic profit, as their price is driven down to the minimum of their long-run average cost curve.
4. Economic profit provides the necessary incentive for firms to enter or exit an industry in the long run, as it signals the efficient allocation of resources.
5. Maximizing economic profit is the primary goal for firms operating in perfectly competitive markets, as it ensures the most efficient use of society's resources.

Review Questions

• Explain the difference between accounting profit and economic profit, and how each is calculated.
  • Accounting profit is the difference between a firm's total revenue and its explicit, out-of-pocket costs, while economic profit is the difference between total revenue and the firm's total economic costs, which include both explicit costs and implicit costs (the opportunity costs of the firm's own resources). Accounting profit does not consider the opportunity cost of the owner's time and capital invested in the business, whereas economic profit does. To calculate economic profit, you must subtract the firm's total explicit and implicit costs from its total revenue.
• Describe how the concept of economic profit relates to the firm's decision-making in the short run and long run under perfect competition.
  • In the short run, a firm may earn positive accounting profit but have zero or negative economic profit if its implicit costs are not covered. However, in the long run under perfect competition, firms will earn zero economic profit, as the price is driven down to the minimum of their long-run average cost curve. This ensures the efficient allocation of resources, as economic profit provides the necessary incentive for firms to enter or exit an industry in the long run. Maximizing economic profit is the primary goal for firms operating in perfectly competitive markets, as it ensures the most efficient use of society's resources.
• Analyze the role of economic profit in the efficient functioning of perfectly competitive markets.
  • $$\text{Economic profit} = \text{Total Revenue} - \text{Total Economic Costs}$$ In a perfectly competitive market, firms will continue to enter the industry as long as there is positive economic profit, and they will exit the industry if there is negative economic profit. This process of entry and exit will continue until economic profit is driven to zero in the long run. At this point, the market is operating at the minimum of the long-run average cost curve, which represents the most efficient allocation of resources. Economic profit, therefore, plays a crucial role in signaling to firms the optimal level of production and ensuring the efficient functioning of perfectly competitive markets.

Related terms

Explicit Costs:

The out-of-pocket expenses a firm incurs, such as payments for labor, raw materials, rent, and other inputs.

Implicit Costs:

The opportunity costs of the firm's own resources, such as the value of the owner's time and the return the owner could have earned by investing the capital elsewhere.

Accounting Profit:

The difference between a firm's total revenue and its explicit costs, excluding implicit costs.