Defining Profit Module KRUGMAN'S MICROECONOMICS for AP* 16 52 Micro: Margaret Ray and David Anderson

What you will learn in this Module: The difference between explicit and implicit costs and their importance in decision making. The different types of profit, including economic profit, accounting profit, and normal profit. How to calculate profit. The purpose of this module is to introduce and define profit. Firms are assumed to maximize profit, but economists and accountants differ in how they define profit.

Understanding Profit Implicit versus explicit costs Accounting profit versus economic profit Normal profit All costs are opportunity costs. They can be divided into explicit costs and implicit costs.   An explicit cost is a cost that involves actually laying out money. Examples include: Rent for office space, wages to employees, interest on debt, raw materials, depreciation on equipment, and utility bills. These are referred to as “accounting costs.” An implicit cost does not require an outlay of money; it is measured by the value, in dollar terms, of the benefits that are forgone. Examples include: forgone salary, interest income given up when savings were liquidated, a building or other capital that could be rented but is self-employed. These are referred to as “economic costs.”

π = total revenue – total cost Defining Profit Profit is equal to total revenue minus total cost Economists use the symbol π to represent profit π = total revenue – total cost π = TR – TC Total revenue equals the price paid times the number sold. TR = P x Q Firms are assumed to produce the level of output that maximizes profit. Profit is equal to total revenue minus total cost.   π  = Total Revenue – Total Cost Accountants and economists both define total revenue as equal to the quantity of units sold multiplied by the price at which they were told. In other words: TR = P*Q The more difficult component of profit is the precise definition of total cost (which comes up in module 55).

Implicit versus Explicit Costs An explicit cost is a cost that involves actually laying out money. Implicit versus Explicit Costs An explicit cost is a cost that involves actually laying out money. An implicit cost does not require an outlay of money; it is measured by the value, in dollar terms, of the benefits that are forgone. Businesses can face implicit costs for two reasons. A business’s capital could have been put to use in some other way. The owner devotes time and energy to the business that could have been used elsewhere. All costs are opportunity costs. They can be divided into explicit costs and implicit costs.   An explicit cost is a cost that involves actually laying out money. Examples include: Rent for office space, wages to employees, interest on debt, raw materials, depreciation on equipment, and utility bills. These are referred to as “accounting costs.” An implicit cost does not require an outlay of money; it is measured by the value, in dollar terms, of the benefits that are forgone. Examples include: forgone salary, interest income given up when savings were liquidated, a building or other capital that could be rented but is self-employed. These are referred to as “economic costs.”

Accounting versus Economic Profit Accounting costs include only EXPLICIT costs Accounting profit equals total revenue minus total EXPLICIT costs Accounting π = TR – TC (explicit) Economic costs include BOTH explicit and implicit costs Economic profit is total revenue minus total costs (including both explicit and implicit costs) π = TR – TC (explicit + implicit) Companies report their accounting profit, which is not necessarily equal to their economic profit.   Accounting profit of a business is the business’s revenue minus the explicit costs and depreciation. π = Total Revenue – Total Explicit Costs Economic profit of a business is its revenue minus the opportunity costs of its resources; both explicit and implicit. It is usually less than the accounting profit. π = Total Revenue – Total Explicit Costs – Total Implicit Costs

Normal Profit An economic profit equal to zero is known as a “Normal profit” A normal profit means that all costs (explicit and implicit) are covered by revenues. When a firm is earning a normal profit, it can do no better using resources in the next best alternative use. When economic profit is equal to zero, or break-even, the firm is said to be earning a “normal profit”.   What’s so great about breaking even? Of course Betsy would love to have a positive economic profit, but let’s see what a normal profit means. If Betsy has zero economic profit, Betsy has sold enough clothing to: 1. Pay all of her employees, insurance company, utilities, the bank, and her clothing suppliers. And! 2. Compensate her for all of the rental income she gave up and the Macy’s salary that she gave up. If you can earn enough total revenue to cover every cost, both out of pocket and the things you gave up, a normal profit is not such a bad thing.