7.1 Explicit and Implicit Costs, and Accounting and Economic Profit

Costs and Profit in Microeconomics

Every firm needs to understand its costs before it can figure out whether it's actually making money. But "costs" in economics means something broader than just the bills you pay. Economists care about all the costs of doing business, including the hidden ones. That distinction between visible and hidden costs is what separates accounting profit from economic profit.

Explicit vs. Implicit Costs

Explicit costs are the straightforward ones: actual money leaving the firm to pay for resources. Think wages, rent, raw materials, and utility bills. If there's a receipt or an invoice, it's an explicit cost.

Implicit costs are trickier. They don't involve a direct payment, but they're still real costs because they represent what you're giving up by using your resources in this business instead of somewhere else. These are opportunity costs.

For example, say you own a building and use it for your business instead of renting it out. You're not writing a rent check, but you are giving up the rental income you could have earned. That foregone rental income is an implicit cost. Other common implicit costs include:

• Foregone interest on money you invested in the business (that cash could've earned interest in a savings account)
• Foregone wages the owner could earn working for someone else
• Foregone rental income on property or equipment the owner uses in the business

One important note: sunk costs are past expenses that can't be recovered, and they should not factor into current decisions. If you already spent $50,000 on equipment you can't resell, that money is gone regardless of what you decide next.

Calculation of Profit Types

The two profit measures use the same revenue figure but differ in which costs they subtract.

Accounting Profit:

$\text{Accounting Profit} = \text{Total Revenue} - \text{Explicit Costs}$

This is the number you'd see on a firm's income statement. It only subtracts the costs that involve actual payments.

Economic Profit:

$\text{Economic Profit} = \text{Total Revenue} - (\text{Explicit Costs} + \text{Implicit Costs})$

This subtracts all costs, including opportunity costs. It tells you whether the firm is doing better than the next best alternative use of its resources.

Here's a quick example. Suppose you quit a $60,000/year job to open a bakery. Your bakery earns $200,000 in revenue and has $120,000 in explicit costs.

• Accounting profit: $200{,}000 - 120{,}000 = \$80{,}000$
• Economic profit: $200{,}000 - (120{,}000 + 60{,}000) = \$20{,}000$

The bakery looks great from an accounting standpoint, but once you factor in the salary you gave up, the economic profit is much smaller.

Key relationships between the two:

• Economic profit is always less than or equal to accounting profit (since it subtracts more costs)
• If economic profit is positive, accounting profit must also be positive
• Zero economic profit means accounting profit exactly equals implicit costs. Economists call this normal profit. The firm is earning just enough to cover all its opportunity costs, so there's no incentive to leave or enter the industry.
• Negative economic profit can still come with positive accounting profit. The firm is making money on paper, but it's not beating its next-best alternative.

Cost Structure Impact on Decisions

How a firm's costs break down between fixed and variable shapes the decisions it faces.

In the short run, at least one input is fixed (typically capital like buildings or major equipment). The firm can only adjust variable inputs such as labor and raw materials. Short-run decisions focus on things like how many workers to hire or how much output to produce given the plant size you already have.

In the long run, all inputs become variable. The firm can build new facilities, adopt new technology, or exit the market entirely. Long-run decisions are about the overall scale and structure of the business.

• Firms with high fixed costs tend to focus more on long-run planning, since those fixed costs can only be changed over time
• Firms with high variable costs have more flexibility to adjust in the short run
• Economies of scale occur when long-run average costs fall as output increases, which encourages expansion
• Diseconomies of scale occur when long-run average costs rise as output increases, signaling the firm has grown too large

Cost Analysis and Efficiency

A few more cost concepts tie this all together:

• Marginal cost (MC): The additional cost of producing one more unit. This is the cost measure firms use most when deciding how much to produce.
• Average total cost (ATC): Total cost divided by quantity produced. It tells you the per-unit cost at a given output level.
• Break-even point: Where total revenue equals total cost, meaning economic profit is zero. At this point the firm earns normal profit.
• Productive efficiency: The firm produces at the lowest possible ATC. No resources are being wasted.
• Allocative efficiency: The price of the good equals its marginal cost ($P = MC$). Society's resources are directed toward producing the goods consumers value most relative to their cost.