Question

14 September 2016 15:55:15 AEST 1 year ago

Anonymous

Discussion Topic 1: Discussing Profit

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You are approached by a colleague with the following query:

“Profits seem to have a different meaning for economists. Surely it can’t be that complicated; profits equal sales revenues minus costs? I am particularly confused by the conclusions they draw about ‘normal profit’. How can you have any profit when average total cost exactly matches a business’ average total revenue? How can it be ‘normal’ to earn zero profits?”

Discuss these contentions. In your discussion, you should highlight the meaning of costs and profit used by economists and contrast it with the focus given by accountants. Give some examples of decisions you may make in business when an economist's definition of costs would be more relevant.

Answer 1

Accounting profit and economic profit are treated differently by economists. Accounting profit is revenue, less all explicit costs (those costs which have been actually incurred in course of running the business). Economic profit is revenue, less explicit costs, less implicit costs, that is, it is obtained by deducting implicit costs from accounting profit. Implicit costs are not actually incurred costs, but represent benefits foregone by choosing one alternative over another.

Economists mean economic profit when the term "Profit" is used. "Normal profit" occurs when economic profit is zero, or accounting profit equal implicit costs.

A firm can operate even while earning zero economic profit. This is because the firm's total cost includes a normal return to entrepreneurship, since "entrepreneurship" is considered a factor of production along with labor, capital and land. This return to entrepreneurship is assumed to be equal to the industry average return.

So the average cost includes an average return to entrepreneurship, and business owners get a normal return for their labor.

An example can be given to illustrate. Assume that I am earning $200,000 per year as Consultant in a company (a full time job). I decide to leave it and start my own consulting business, which earns $300,000 annual revenue and incurs $200,000 of explicit costs (Labor, rent, interest on loans and utility expenses). My accounting profit for the year is $(300,000 - 200,000) = $100,000 and so, if I act based on accounting decision-making process, I shall decide to continue my business. But my economic profit is $(100,000 - 200,000) = -$100,000, which signifies that if I stayed in my job, I could earn $100,000 net profit which I am losing by running own business. So, on basis of economic decision-making process, I will choose to exit my business and take up the full-time job.