Explicit and Implicit Costs, and Accounting and Economic Profit

Private enterprise, the ownership of businesses by private individuals, is a hallmark of the U.S. economy. When people think of businesses, often giants like Wal-Mart, Microsoft, or General Motors come to mind. But firms come in all sizes, as shown in Table 1. The vast majority of American firms have fewer than 20 employees. As of 2010, the U.S. Census Bureau counted 5.7 million firms with employees in the U.S. economy. Slightly less than half of all the workers in private firms are at the 17,000 large firms, meaning those firms each employ at least 500 workers. Another 35% of workers in the U.S. economy are at firms with fewer than 100 workers. These small-scale businesses include everything from dentists and lawyers to businesses that mow lawns or clean houses. Indeed, Table 1 does not include a separate category for the millions of small “non-employer” businesses where a single owner or a few partners are not officially paid wages or a salary, but simply receive whatever they can earn.

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

Profit = Total Revenue – Total Cost

Total revenue is the income brought into the firm from selling its products. It is calculated by multiplying the price of the product times the quantity of output sold:

Total Revenue = Price x Quantity

As we study the theory of the firm, it will become clear that a firm’s revenue depends on the demand for the firm’s products.

We can distinguish between two types of cost: explicit and implicit. Explicit costs are out-of-pocket costs, that is, payments that are actually made. 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 already owned by the firm. Often for small businesses, they are resources contributed by the owners; for example, working in the business while not getting a formal salary, or using the ground floor of a home as a retail store. Implicit costs also include the depreciation of goods, materials, and equipment that are necessary for a company to operate.

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.

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 section.