With reference to the following example, what is the difference between accounting profit and economic profit? John runs a small pottery firm. He hires one helper at $13,176 per year, pays annual...
With reference to the following example, what is the difference between accounting profit and economic profit?
John runs a small pottery firm. He hires one helper at $13,176 per year, pays annual rent of $5,484 for his shop, and spends $24,957 per year on materials. He has $41,174 of his own funds invested in equipment that could earn him $4,519 per year if alternatively invested. He has been offered $15,471 per year to work as a potter for a competitor. He estimates his entrepreneurial talents are worth $2,530 per year. Total annual revenue from pottery sales is $72,907.
Accounting profits simply take a firm’s total revenues and subtract from that all of the costs that it actually pays out to people. These costs are called explicit costs. In the example above, the explicit costs are the helper’s salary, the rent paid, and the materials he bought. All of these things were actually paid for.
By contrast, economic profits are the accounting profits minus all the opportunity costs of the business. These opportunity costs are things the owner of the business gives up in order to run the business. In the case given here, the implicit costs are the money that John could have earned by investing (the $4519), the $15,471 he could be making working for someone else, and the value of his entrepreneurial talents.