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Course: Microeconomics > Unit 6
Lesson 4: Types of profitExplicit and implicit costs and accounting and economic profit
There are different ways of thinking about costs and profit. Read about what they are!
Key points
- Privately owned firms are motivated to earn profits. Profit is the difference between revenues and costs.
- Private enterprise is the ownership of businesses by private individuals.
- Production is the process of combining inputs to produce outputs, ideally of a value greater than the value of the inputs.
- Revenue is income from selling a firm’s product; defined as price times quantity sold.
- Accounting profit is the total revenues minus explicit costs, including depreciation.
- Economic profit is total revenues minus total costs—explicit plus implicit costs.
- Explicit costs are out-of-pocket costs for a firm—for example, payments for wages and salaries, rent, or materials.
- Implicit costs are a specific type of opportunity cost: the cost of resources already owned by the firm that could have been put to some other use. For example, an entrepreneur who owns a business could use her labor to earn income at a job.
Explicit and implicit costs and accounting and economic Profit
Private enterprise—the ownership of businesses by private individuals—is a hallmark of the US economy. When people think of businesses, often giants like Wal-Mart, Microsoft, or General Motors come to mind. But firms come in all sizes, as you can see in the table below.
The vast majority of US firms have fewer than 20 employees. As of 2010, the US Census Bureau counted 5.7 million firms with employees in the US economy. Slightly less than half of all the workers in private firms are at the 17,000 large firms, firms that employ more than 500 workers. Another 35% of workers in the US economy are at firms with fewer than 100 workers.
These small-scale businesses include everything from dentists and lawyers to businesses that mow lawns or clean houses. There are also millions of small, non-employer businesses where a single owner or a few partners are not officially paid wages or a salary but simply receive whatever they can earn—there is not a separate category in the table for these businesses.
| Number of employees | Firms, % of total firms | Number of paid employees, % of total employment |
|---|---|---|
| Total | 5,734,538 | 112.0 million |
| 0–9 | 4,543,315, 79.2% | 12.3 million, 11.0% |
| 10–19 | 617,089, 10.8% | 8.3 million, 7.4% |
| 20–99 | 475,125, 8.3% | 18.6 million, 16.6% |
| 100–499 | 81,773, 1.4% | 15.9 million, 14.2% |
| 500 or more | 17,236, 0.30% | 50.9 million, 49.8% |
Source: 2010 US Census, www.census.gov
Each of these businesses, regardless of size or complexity, tries to earn a profit.
Total revenue is the income brought into a firm from selling its products. It is calculated by multiplying the price of the product times the quantity of output sold:
We can distinguish between two types of cost: explicit and implicit. Explicit costs are out-of-pocket costs—payments that are actually made. Wages that a firm pays its employees or rent that a firm pays for its office are explicit costs.
Implicit costs are more subtle but just as important. They represent the opportunity cost of using resources already owned by the firm. Often for small businesses, they are resources contributed by the owners—for example, working in the business while not getting a formal salary or using the ground floor of a home as a retail store. Implicit costs also allow for depreciation of goods, materials, and equipment that are necessary for a company to operate.
These two definitions of cost are important for distinguishing between two conceptions of profit—accounting profit and economic profit. Accounting profit is a cash concept. It means total revenue minus explicit costs—the difference between dollars brought in and dollars paid out. Economic profit is total revenue minus total cost, which includes both explicit and implicit costs.
The difference is important. Even though a business pays income taxes based on its accounting profit, whether or not it is economically successful depends on its economic profit.
Calculating implicit costs
Let's take a look at an example in order to understand better how to calculate implicit costs.
Fred currently works for a corporate law firm. He is considering opening his own legal practice, where he expects to earn $200,000 per year once he gets established. To run his own firm, he would need an office and a law clerk. He has found the perfect office, which rents for $50,000 per year. A law clerk could be hired for $35,000 per year. If these figures are accurate, would Fred’s legal practice be profitable?
Step 1. First we'll calculate the costs. We'll use what we know about explicit costs:
Step 2. Subtracting the explicit costs from the revenue gives you the accounting profit.
But these calculations consider only the explicit costs. To open his own practice, Fred would have to quit his current job, where he is earning an annual salary of $125,000. This would be an implicit cost of opening his own firm.
Step 3. You need to subtract both the explicit and implicit costs to determine the true economic profit:
Fred would be losing $10,000 per year. That does not mean he would not want to open his own business, but it does mean he would be earning $10,000 less than if he worked for the corporate firm.
Implicit costs can include other things as well. Maybe Fred values his leisure time, and starting his own firm would require him to put in more hours than at the corporate firm. In this case, the lost leisure would also be an implicit cost that would subtract from economic profits.
Summary
- Privately owned firms are motivated to earn profits. Profit is the difference between revenues and costs.
- Private enterprise is the ownership of businesses by private individuals.
- Production is the process of combining inputs to produce outputs, ideally of a value greater than the value of the inputs.
- Revenue is income from selling a firm’s product; defined as price times quantity sold.
- Accounting profit is the total revenues minus explicit costs, including depreciation.
- Economic profit is total revenues minus total costs—explicit plus implicit costs.
- Explicit costs are out-of-pocket costs for a firm—for example, payments for wages and salaries, rent, or materials.
- Implicit costs are the opportunity cost of resources already owned by the firm and used in business—for example, expanding a factory onto land already owned.
Self-check questions
A firm had sales revenue of $1 million last year. It spent $600,000 on labor, $150,000 on capital, and $200,000 on materials. What was the firm’s accounting profit?
Review questions
- What are explicit and implicit costs?
- Would an interest payment on a loan to a firm be considered an explicit or implicit cost?
- What is the difference between accounting and economic profit?
Critical-thinking question
Small mom-and-pop firms sometimes exist even though they do not earn economic profits. How can you explain this?
Problem
A firm is considering an investment that will earn a 6% rate of return. If it were to borrow the money, it would have to pay 8% interest on the loan. The firm currently has the cash, though, so it will not need to borrow. Should the firm make the investment? Explain.
Want to join the conversation?
I could not solve the problem above. Can somebody please explain how it is solved?(8 votes)
the answer of the last problem : - no the firm will not do the investment. because if the firm borrows the money & invest it in the project then the return will be 6% but the cost is 8%. so it will lose 2%.
it also should not invest his own money on the project to get get the 6% return. because he could have loan the money to someone else & get 8% return. therefore his opportunity cost of investing the money is greater than the return.
therefore he should not make the investment .(15 votes)
in the review questions, is the interest payment of a loan an implicit or explicit cost?(6 votes)
I believe the interest payment of a loan is an explicit cost since it's a direct out of pocket expense.(9 votes)
Why are you subtracting when you say you should add when finding the implicit and accounting profit above...(7 votes)
I think you are referring to "Economic profit is total revenues minus total costs—explicit plus implicit costs." It's a little confusing.
It means to say [total revenues minus total costs] = total revenues - (explicit + implicit costs) = total revenues - explicit - implicit costs(6 votes)
Why is depreciation considered an explicit cost rather than an implicit cost?(4 votes)
The intuition here is that the cost of depreciation is paid upfront. For example, suppose a piece of equipment costs $50 and will last five years. The depreciation that you spread out over that five years represents the explicit outlay of cash you had to put up front. It's not an opportunity/implicit cost because it is not the value of something given up.(2 votes)
- for the answer of the "critical thinking", is it because that the opportunity cost is same to the revenue? so the economic profit becomes 0 and that's why that firm isn't earning any economic profit..?(1 vote)
Yeah, It is because that the Revenues equals to the Total Cost(Implicit + Explicit). Actually the economic profit might even be negative. But I think these mom-and-pop firms still exists because of two reasons: (1) Some people just want to start their own business, just like Fred in the example who wants to open his own law firm, or a baking-lover who wants to start his/her own cup-cake business, even though these people can get more money from working for a big firm. (2) The owners of these small/micro firms are expecting their revenues to gain in the following years. For the first couple of years even though they don't get much money from it they'll just think that if they can expand the business in the next years by improving the way of doing this or that.(7 votes)
For example, I am a freelacer and I work from home, this let me not to hire anyone to look after my children. For me it is implicit revenue. In this case can we say that that my economic profit is the sum of my implicit and explicit revenues minus my explicit and implicit costs?(3 votes)- I'm not sure what you mean by "implicit revenue". If you paid someone to watch your children I think that would definitely be an explicit cost. But I'm not sure you can consider not having to pay someone to watch your children as an "implicit revenue".(2 votes)
I do not understand how to explain the critical-thinking question.(1 vote)
A mom-and-pop firm uses their own money from an outside job to supply the funds necessary to the company. For example if a seamstress ( a woman who sews ) wants to sew and create hand made quilts for people, she would be running a mom-and-pop firm because she probably is using funds from an outside job to pay her expenses.🎯(5 votes)
- Is the answer to the critical thinking question, opportunity cost of happiness because they are much more happy losing money but running a business rather than making more money but joining a corporation?(2 votes)
I think you're onto something there. Opportunity cost has got to take more than just dollars into consideration.(1 vote)
- Can we also factor in subjective experiences as opportunity cost? e.g. always wanting to open a restaurant and not work as a dentist. Or are they economically unimportant?(1 vote)
- Since these factors will influence decisions, I think that they should count in our models.(1 vote)
- Would bonds and the interest payments from bonds be implicit or explicit costs?(1 vote)
