Question

“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

There is a distinction between accounting profit and economic profit. Accounting profit is obtained by deducting all explicit costs (expenses which have been actually incurred and paid in cash) from revenue earned. Economic profit is obtained by deducting implicit (opportunity) costs from accounting profit. Implicit costs are expenses that are not actually incurred, but are benefits that are foregone by choosing one alternative over another.

By "Profit", therefore, economists mean economic profit. "Normal profit" means that economic profit is zero.

A firm continues to operate even though it earns zero economic profit (i.e. normal profit). The reason is that a normal return to entreprenureship is included in cost structure, considering "entrepreneurship" as the fourth factor of production in addition to labor, capital and land. This normal return to entrepreneurship is assumed to be at par with other firms in the industry.

Therefore, the average total cost includes an average return to entreprenureship, therefore business owners do get a return for their labor ibnvested in their business.

An example can be given to illustrate. Assume that you are earning $60,000 per year in a full-time job. You decide to leave it and start your own business, which earns $200,000 as revenue and incurs $150,000 as total explicit costs (material, labor, rent, interest on loans and utility expenses). Your accounting profit for the year is $(200,000 - 150,000) = $50,000 and so, based on accounting decision-making, ou decide to continue. But your economic profit is $(50,000 - 60,000) = -$10,000, which reflects the fact that if you stayed in your job, you could net $10,000 which you are incurring as an economic loss by running own business. So, absed on economi decision-making, you will choose to exit your business and return to the full-time job.