Explicit and Implicit Costs, and Accounting and Economic Profit

Learning Objectives

By the end of this section, you will be able to:

  • Explain the difference between explicit costs and implicit costs
  • Understand the relationship between cost and revenue

Each business, regardless of size or complexity, tries to earn a profit:

[latex]\text{Profit}=\text{Total Revenue - Total Cost}[/latex]

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:

[latex]\text{Total Revenue}=\text{Price \times Quantity}[/latex]

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:

[latex]\begin{array}{lc}\text{Office rental}:& \text{ $50,000}\\ \text{Law clerk's salary}:& \underset{\text{____________}}{\text{+$35,000}}\\ \text{Total explicit costs}:& \text{ $85,000}\end{array}[/latex]

Step 2. Subtracting the explicit costs from the revenue gives you the accounting profit.

[latex]\begin{array}{lc}\text{Revenues}:& \text{$200,000}\\ \text{Explicit costs}:& \underset{\text{____________}}{\text{-$85,000}}\\ \text{Accounting profit}:& \text{$115,000}\end{array}[/latex]

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:

[latex]\begin{array}{rcl}\text{Economic profit}& =& \text{total revenues - explicit costs - implicit costs}\\ & =& \text{$200,000 - $85,000 - $125,000}\\ & =& \text{-$10,000 per year}\end{array}[/latex]

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.

Key Concepts and Summary

Privately owned firms are motivated to earn profits. Profit is the difference between revenues and costs. While accounting profit considers only explicit costs, economic profit considers both explicit and implicit costs.

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 [link], 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?

Review Questions

What are explicit and implicit costs?

Would you consider an interest payment on a loan to a firm an explicit or implicit cost?

What is the difference between accounting and economic profit?

Critical Thinking Questions

Small “Mom and Pop firms,” like inner city grocery stores, sometimes exist even though they do not earn economic profits. How can you explain this?

Problems

A firm is considering an investment that will earn a 6% rate of return. If it were to borrow the money, it would have to pay 8% interest on the loan, but it currently has the cash, so it will not need to borrow. Should the firm make the investment? Show your work.

References

2010 U.S. Census. www.census.gov.

Glossary

accounting profit
total revenues minus explicit costs, including depreciation
economic profit
total revenues minus total costs (explicit plus implicit costs)
explicit costs
out-of-pocket costs for a firm, for example, payments for wages and salaries, rent, or materials
firm
an organization that combines inputs of labor, capital, land, and raw or finished component materials to produce outputs.
implicit costs
opportunity cost of resources already owned by the firm and used in business, for example, expanding a factory onto land already owned
private enterprise
the ownership of businesses by private individuals
production
the process of combining inputs to produce outputs, ideally of a value greater than the value of the inputs
revenue
income from selling a firm’s product; defined as price times quantity sold