Answer to Question #101464 in Microeconomics for Lizzy

Question

Accounting rules determine a firm’s ‘‘profits’’ for tax- and dividend-paying purposes. So why any firm
should be concerned about its economic profits? Specifically, why should a firm be concerned about the
opportunity costs of the people who invest in it when those costs never enter into its accounting statements?

Answer 1

Profit is the difference between costs and revenue, but there is a difference between accounting profit and economic profit. The biggest difference between accounting and economic profit is that economic profit reflects explicit and implicit costs, while accounting profit considers only explicit costs. Explicit costs are costs that involve direct monetary payment. Wages paid to workers, rent paid to a landowner, and material costs paid to a supplier are all examples of explicit costs. In contrast, implicit costs are the opportunity costs of factors of production that a producer already owns. The implicit cost is what the firm must give up in order to use its resources; in other words, an implicit cost is any cost that results from using an asset instead of renting, selling, or lending it. Accounting profit is the difference between total monetary revenue and total monetary costs, and is computed by using generally accepted accounting principles. Put another way, accounting profit is the same as bookkeeping costs and consists of credits and debits on a firm’s balance sheet. Economic profit is the difference between total monetary revenue and total costs, but total costs include both explicit and implicit costs. Economic profit includes the opportunity costs associated with production and is therefore lower than accounting profit. Economic profit also accounts for a longer span of time than accounting profit.