AP® Microeconomics · Unit 3 · Topic 3.4
Accounting Profit Versus Economic Profit
Accounting profit is revenue minus explicit costs. Economic profit goes further, subtracting implicit costs too, like the income an owner gave up by not working elsewhere.
Every firm pays explicit costs: cash out the door for rent, wages, materials. Accounting profit is just revenue minus those explicit costs, and it's what shows up on a tax form. But running a business also costs the owner something that never shows up as a payment: the next best thing they could have done instead. That forgone option, usually a salary or the return on money invested elsewhere, is an implicit cost. Economic profit subtracts both explicit and implicit costs from revenue, so it measures whether the business is actually a better use of the owner's time and money than the alternative.
This is why a business can look healthy on paper and still be a bad idea. A shop showing 40000 dollars of accounting profit sounds fine until you learn the owner turned down a 90000 dollar job to run it. Once that forgone salary is counted as a cost, economic profit is negative 50000 dollars. The accounting books never see this number, but it is the one that tells the owner whether staying open beats walking away.
This idea sets up the rest of the unit. A firm earning zero economic profit isn't failing, it's earning exactly what its resources could earn elsewhere, which is the condition that defines long-run equilibrium under perfect competition. When entry and exit drive economic profit to zero, accounting profit is usually still positive. Keeping the two profits straight is what makes the entry-exit story in later topics make sense.
Key terms
- Explicit cost
- An actual cash payment a firm makes for inputs, like wages, rent, or materials.
- Implicit cost
- The value of the best alternative given up to run the business, such as a forgone salary.
- Accounting profit
- Revenue minus explicit costs only.
- Economic profit
- Revenue minus both explicit and implicit costs.
- Opportunity cost
- The value of the next best alternative forgone, the concept behind implicit costs.
Watch it explained
- How it worksHow does subtracting implicit costs turn accounting profit into economic profit?
- Worked exampleFind both profits with 200000 revenue, 150000 explicit costs, and a 70000 salary given up.
- Common mistakeWhy isn't a positive accounting profit proof that a firm should stay in business?
- Going furtherWhat happens to economic profit when the owner's next best job starts paying more?
Check yourself
End of topic.