How to Distinguish between Accounting Profits and Economic Profits

To an economist, the terms profit and loss refer to whether the revenue from selling a firm’s output is bigger or smaller than the costs that must be incurred to produce that output. If the revenue exceeds the costs, the firm is running a profit, whereas if the costs exceed the revenue, the firm is running a loss. If the two are equal, the firm is breaking even.

To take a look at this economic topic, consider a business that sells lemonade. Both the accountant and the economist agree that the firm’s revenue is simply how much money the firm makes from selling its product. However, they differ on what to count as costs when calculating profit:

• Accounting profit: The accountant considers costs to be only actual monies spent in running the business: how much the firm pays its workers, how much it pays to buy supplies, and so on. Consider a business that sells lemonade. If the firm has revenues of $10,000 and it spends $9,000 to make those revenues, the accountant concludes that the firm has a profit of $1,000. This number is the firm’s accounting profit — the type of profit that is reported every day in financial statements and newspaper articles.
• Economic profit: Economic profit takes into account not just the money costs directly incurred by running a business but also the opportunity costs incurred. Think about the entrepreneur who starts this lemonade business. After paying for his materials and for his employees’ wages, his accounting profits are $1,000. But is that really a good deal?

Suppose that this person left a job as a computer programmer to open the lemonade business, and in the same amount of time that it took the lemonade business to turn a $1,000 profit, he would have made $10,000 in wages if he had stayed at his old job. That is, he gave up the opportunity to earn $10,000 in wages to open up a business that makes him only a $1,000 accounting profit. He actually sustains an economic loss of $9,000. When you know this fact, his decision to switch careers doesn’t seem like such a good idea.

Economists like to concentrate on economic profits and losses rather than accounting profits or losses because the economic profits and losses are what motivate people. By taking into account economic profits and losses, you get directly at what motivates firms to produce not only the types of goods they choose to produce but the quantities of those goods as well. In this example, you can imagine that when other computer programmers see what happened to this guy when he switched careers, they’re not going to follow him.