Profit in Economics: Definition, Mathematical Representation, and Important Elements
In the world of business, understanding the intricacies of profit can make all the difference. Two crucial types of profit that businesses should be aware of are economic profit and accounting profit. While they may seem similar, their differences are significant, particularly in terms of decision-making and evaluating a company's true profitability.
Accounting Profit: A Financial Snapshot
Accounting profit, as the name suggests, is a financial measure that calculates a company's gain by subtracting explicit costs from total revenue. These costs typically include direct, out-of-pocket expenses such as wages, materials, rent, and taxes. It offers a snapshot of a company's financial health and performance, often used for financial reporting and short-term assessments of operational success [1][2][3].
Economic Profit: A Comprehensive Measure
Economic profit, on the other hand, goes a step further by also accounting for implicit costs, or opportunity costs. These are the value of foregone alternatives, such as the income the owner could have earned by investing capital elsewhere or by working elsewhere. This provides a more comprehensive and realistic measure of profitability, especially for long-term decisions and resource allocation [1][3][5].
The Significance of the Difference
The key significance of this difference lies in the reflection of the true economic value created by a business. A positive economic profit means the business is more profitable than its next best alternative, while a zero or negative economic profit suggests resources could be better deployed elsewhere [3][5].
Businesses primarily use accounting profit for financial reporting and tax purposes, while economic profit is crucial for strategic decisions like entering new markets or changing business models. It signals whether the venture generates more value than alternatives after including opportunity costs [1][3].
The divergence between accounting profit and economic profit is important to note. A company can show a positive accounting profit but still have zero or negative economic profit, indicating that from an economic standpoint, the resources could earn more by being invested differently [3][5].
The Role of Economic Profit in Imperfectly Competitive Markets
In imperfectly competitive markets like oligopoly and monopoly, firms are likely to get economic profit in the long run, provided they have monopoly power and higher entry barriers. A company with monopoly power can influence the market price and set the selling price above the perfectly competitive market equilibrium price, increasing the opportunity to generate and maintain an economic profit [4].
In competitive markets, a company may book short-term economic profit but may not be able to sustain it in the long term due to the threat of entry by competitors [4].
In conclusion, while accounting profit focuses on measurable cash flows and expenses recorded in company accounts, economic profit incorporates hidden costs that determine whether a business is truly adding value beyond what could be earned elsewhere. Understanding this difference helps business owners and investors make informed decisions that maximize resource efficiency and long-term profitability [1][3][4].
[1] Investopedia. (2021). Accounting Profit vs Economic Profit. [online] Available at: https://www.investopedia.com/terms/a/accountingprofit.asp [Accessed 11 Apr. 2023].
[2] Investopedia. (2021). Economic Profit. [online] Available at: https://www.investopedia.com/terms/e/economicprofit.asp [Accessed 11 Apr. 2023].
[3] Harvard Business Review. (2017). The Importance of Economic Profit. [online] Available at: https://hbr.org/2017/06/the-importance-of-economic-profit [Accessed 11 Apr. 2023].
[4] Investopedia. (2021). Imperfectly Competitive Market. [online] Available at: https://www.investopedia.com/terms/i/imperfectlycompetitivemarket.asp [Accessed 11 Apr. 2023].
[5] McKinsey & Company. (2017). The Difference Between Accounting Profit and Economic Profit. [online] Available at: https://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/the-difference-between-accounting-profit-and-economic-profit [Accessed 11 Apr. 2023].
Investing in a business requires understanding the differences between Accounting Profit and Economic Profit, as the former is a financial measure that calculates a company's gain by subtracting explicit costs from total revenue, while the latter also accounts for implicit costs, offering a more comprehensive and realistic measure of a company's profitability.
Businesses primarily use Accounting Profit for financial reporting and tax purposes, but Economic Profit is crucial for strategic decisions, as it signals whether the venture generates more value than alternatives after including opportunity costs.
