Question

Analyze the concepts of accounting profit and economic profit. How are they different, and why are there two different concepts? Why do economists focus on the “economic profit” concept? Specifically, what does a focus on economic profit tell us about decision making and when changes in behavior (or undertaking projects) occur?

Answer 1

Accounting Profit : It is the net income of a company after various costs and expenses are deducted from the revenue. Accounting Profit is net amount left after deducting Explicit costs (Amount paid outside to hire factor services. eg: wages for labourers) that are incurred while running the business.

Economic Profit : It is the profit acquired after deducting explicit costs much like accounting profit. However, economic profit includes the opportunity costs for taking up any activity done by the business. It uses Implicit costs ( Amount which is the cost of company held assets and resources such as rent of property). Economic profit is the profit from producing goods and services while considering the available alternative uses of a company's resources.

While accounting profit calculates what actually occurred and the measurable results for a given point in time , economic profit is a theoretical calculation based on the alternatives taken and the ones that could have been taken.

Economic profit seeks to calculate for a longer span of time than accounting profit. This is why economists consider the long-term economic profit to decide whether to join the industry or whether the firm to enter the market or exit from it. Economic profit can be positive, neutral or negative. If it is positive , then there is  incentive for firms to enter into market. If the profit is zero then there is no point for firms to enter or exit the market and if its negative , then firms are bound to leave the market as their resources are profitable elsewhere. The amount of economic profit highly depends on the composition , competition and time consideration of the industry and thus are highly valued by economists inorder to take decisions regarding market entry and exit.