Economic profit

Definition

Economic profit is the difference between total revenue and total costs, including both explicit costs (direct monetary expenses) and implicit costs (opportunity costs of foregone alternatives). This concept is crucial for understanding how firms make decisions about resource allocation, production levels, and market competition. By considering opportunity costs, economic profit provides a more comprehensive view of a firm's profitability than accounting profit alone.

5 Must Know Facts For Your Next Test

1. Economic profit can be positive, negative, or zero; a positive economic profit indicates that a firm is covering all costs and generating additional income beyond its opportunity costs.
2. In perfect competition, firms earn zero economic profit in the long run as competition drives prices down to the level of average total costs.
3. When a firm earns economic profit, it signals to other firms that there are profitable opportunities in the market, often leading to new entrants.
4. A firm may continue operating at a loss in terms of accounting profit if it covers its variable costs and has not reached its shutdown point.
5. Understanding economic profit helps firms make informed decisions about entering or exiting markets based on their ability to cover both explicit and implicit costs.

Review Questions

• How does the concept of economic profit differ from accounting profit, and why is this distinction important for businesses?
  • Economic profit considers both explicit and implicit costs, while accounting profit only accounts for explicit costs. This distinction is crucial because it provides businesses with a clearer picture of their overall profitability by including opportunity costs. Firms may appear profitable when looking solely at accounting profit, but if their economic profit is negative, it indicates they are not generating sufficient returns to cover all their costs, including the potential earnings from alternative investments.
• What implications does earning zero economic profit have for firms operating in a perfectly competitive market?
  • When firms in a perfectly competitive market earn zero economic profit, it means they are just covering their total costs, including opportunity costs. This situation leads to an equilibrium where no firms have an incentive to enter or exit the market. As long as firms can cover their average total costs, they will continue to operate. However, any economic profits will attract new entrants to the market until profits are driven down to zero.
• Evaluate the role of economic profit in influencing market dynamics and firm behavior over time.
  • Economic profit plays a significant role in shaping market dynamics as it signals potential profitability to other firms. When existing firms earn positive economic profits, it encourages new entrants to join the market, increasing competition and driving prices down. Conversely, if firms consistently experience negative economic profits, it may lead to exits from the market. This cyclical nature of entry and exit based on economic profits fosters efficiency and innovation within industries as firms strive to maximize their returns while adapting to changing market conditions.

Related terms

Accounting profit: The difference between total revenue and explicit costs, not considering implicit costs or opportunity costs.

Opportunity cost: The value of the next best alternative that is foregone when a choice is made, which factors into economic profit calculations.

Normal profit: The minimum level of profit needed for a company to remain competitive in the market; it is considered a part of implicit costs.