Question

How can a business owner who claims to earn $20 million per year from his business claim to earn a zero economic profit? Why do we see some businesses shut down even though accounting profits are positive? Explain the distinction between accounting profit and economic profit.

Answer 1

The major difference between accounting profit and economic profit is the cost of opportunity lost. This opportunity cost are significant from economic point of view because they reflect the cost which is not directly or implicitly borne by the company but is a reflection of the cost that is incurred due to the sacrifices made in the decision making. For example there are some entrepreneurs who leave their previous jobs and start a new business. This new business may start earning revenues and profits, and accounting in general will record this profit shares accounting profit. But the lost opportunity of job which was providing a salary is not computed in accounting profit. While calculating economic profit we will deduct this salary because this represents an opportunity cost. So in general accounting profit is always less than economic profit because economic profit also deducts opportunity cost.

A business can shut down even when accounting profit are positive. This is perhaps because economic profit is negative suggesting economic loss, and that the economic loss is so high that it is not able to cover the variable cost of the firm. In such cases businesses shut down to avoid paying for the fixed cost.

Zero economic profit is a condition where a company is not able to any economic profit but it is still earning accounting profit. As mentioned before economic profit deduct opportunity costs while accounting profit does not. There can severe competition in the market so that there is no room for any company and there are no economic profit. Everyone is breaking even yet accounting profits will be positive because opportunity cost are ignored.