6.1 Explicit and Implicit Costs, and Accounting and Economic Profit
Learning Objectives
By the end of this section, you will be able to:
- Describe the difference between explicit costs and implicit costs
- Explain the relationship between cost and revenue
Each business, regardless of size or complexity, tries to earn a profit:
Profit = Total Revenue – Total Cost
Total revenue is the income the firm generates from selling its products. We calculate it by multiplying the price of the product times the quantity of output sold:
Total Revenue = Price × Quantity
We will see in the following chapters that revenue is a function of the demand for the firm’s products.
Total cost is what the firm pays for producing and selling its products. Recall that production involves the firm converting inputs to outputs. Each of those inputs has a cost to the firm. The sum of all those costs is total cost. We will learn in this chapter that short run costs are different from long run costs.
We can distinguish between two types of cost: explicit and implicit. Explicit costs are out-of-pocket costs, that is, actual payments. Wages that a firm pays its employees or rent that a firm pays for its office are explicit costs. Implicit costs are more subtle, but just as important. They represent the opportunity cost of using resources that the firm already owns. Often for small businesses, they are resources that the owners contribute. For example, working in the business while not earning a formal salary, or using the ground floor of a home as a retail store are both implicit costs. Implicit costs also include the depreciation of goods, materials, and equipment that are necessary for a company to operate. (See the Work It Out feature for an extended example.)
These two definitions of cost are important for distinguishing between two conceptions of profit, accounting profit, and economic profit. Accounting profit is a cash concept. It means total revenue minus explicit costs—the difference between dollars brought in and dollars paid out. Economic profit is total revenue minus total cost, including both explicit and implicit costs. The difference is important because even though a business pays income taxes based on its accounting profit, whether or not it is economically successful depends on its economic profit.
WORK IT OUT
Calculating Implicit Costs
Consider the following example. Fred currently works for a corporate law firm. He is considering opening his own legal practice, where he expects to earn $200,000 per year once he establishes himself. To run his own firm, he would need an office and a law clerk. He has found the perfect office, which rents for $50,000 per year. He could hire a law clerk for $35,000 per year. If these figures are accurate, would Fred’s legal practice be profitable?
Step 1. First you have to calculate the costs. You can take what you know about explicit costs and total them:
Office rental: $50,000
Law clerk’s salary: +$35,000
Total explicit costs: $85,000
Step 2. Subtracting the explicit costs from the revenue gives you the accounting profit.
Revenues: $200,000
Explicit costs: –$85,000
Accounting profit: $115,000
However, these calculations consider only the explicit costs. To open his own practice, Fred would have to quit his current job, where he is earning an annual salary of $125,000. This would be an implicit cost of opening his own firm.
Step 3. You need to subtract both the explicit and implicit costs to determine the true economic profit:
Economic profit = total revenues – explicit costs – implicit costs
= $200,000 – $85,000 – $125,000
= –$10,000 per year
Fred would be losing $10,000 per year. That does not mean he would not want to open his own business, but it does mean he would be earning $10,000 less than if he worked for the corporate firm.
Implicit costs can include other things as well. Maybe Fred values his leisure time, and starting his own firm would require him to put in more hours than at the corporate firm. In this case, the lost leisure would also be an implicit cost that would subtract from economic profits.
Now that we have an idea about the different types of costs, let’s look at cost structures. A firm’s cost structure in the long run may be different from that in the short run. We turn to that distinction in the next few sections.
SELF-CHECK QUESTIONS
- A firm had sales revenue of $1 million last year. It spent $600,000 on labor, $150,000 on capital and $200,000 on materials. What was the firm’s accounting profit?
- Continuing from Exercise 6.1.1, the firm’s factory sits on land owned by the firm that it could rent for $30,000 per year. What was the firm’s economic profit last year?