Question

What are explicit and implicit costs, and how do they guide the behavior of the firm? How does economic profit differ from accounting profit, and what role does it play? In your opinion should the firm base its decisions on accounting profit or upon economic profit?

Answer 1

Explicit costs refers to the accounting costs that the firm incurs in its day to day operations such as wages, rent, salaries paid , raw materials expenses etc. They are used to compute the accounting profit of the firm

Implicit cost refers to the opportunity cost of the resources which are forgone such as salary foregone, interest forgone, rent from the building forgone.They are used to compute the economic profit of the firm.

Accounting profit = Total revenue - Explicit costs

Economic profit = Total revenue-(Explicit +Implicit costs)

so, accounting profit does not include the implicit costs.The economic profit

When economic profit are used, the total profit that the firm earns would be lowered.Also the firm should base its decisions on the basis of economic profit as it shows the true picture or the state of the firm's financial situation. If the economic profit is positive, then the firm is doing well as it is able to recover its economic costs but if the firm's economic profit is negative then, it is not doing so well and should consider the alternative actions which have been given up.