Economic profit is a central concept in economics that goes beyond the traditional accounting definition of profit. While accounting profit simply measures the difference between revenue and explicit costs, economic profit takes into account the full cost of all resources employed—including the opportunity cost of capital, labour, and entrepreneurship. This broader view offers a more accurate picture of whether a business is truly creating value or just breaking even compared to its best alternative use of resources. Economic profit is fundamental for understanding resource allocation, investment decisions, and long-term business sustainability.
1. Definition of Economic Profit
- Economic profit is the surplus of total revenue over both explicit and implicit costs.
- It is expressed as:Economic Profit = Total Revenue – (Explicit Costs + Implicit Costs)
- Unlike accounting profit, which considers only out-of-pocket expenses, economic profit includes the value of foregone alternatives—such as what an entrepreneur could earn by working elsewhere or investing capital in another venture.
- Economic profit can be:
- Positive: Indicates the business is more profitable than its best alternative.
- Zero: Indicates the business is covering all costs, including opportunity costs, and is economically sustainable (normal profit).
- Negative: Suggests the business is underperforming relative to other available opportunities.
2. Components of Economic Profit
- Explicit Costs: Direct payments made by a firm, including:
- Wages
- Raw materials
- Rent
- Utilities
- Interest on loans
- Implicit Costs: Opportunity costs of using resources that could have earned returns elsewhere, such as:
- The owner’s time and labour
- Capital invested that could earn interest elsewhere
- Company-owned property that could be leased out
3. Example of Economic Profit
- Suppose a business generates RM500,000 in annual revenue and incurs RM300,000 in explicit costs. Accounting profit is RM200,000.
- If the entrepreneur could have earned RM120,000 working elsewhere and RM50,000 by investing the same capital in the stock market, then implicit costs are RM170,000.
- Economic Profit = RM500,000 – (RM300,000 + RM170,000) = RM30,000
- This positive economic profit means the business is a better use of the entrepreneur’s resources than the alternatives.
4. Importance of Economic Profit
- True Indicator of Value Creation: Economic profit reveals whether a firm is truly adding value or merely covering costs.
- Efficient Resource Allocation: Resources should flow to businesses that generate economic profit, indicating high productivity and utility.
- Investment Decision-Making: Entrepreneurs and investors rely on economic profit to decide whether to enter, expand, or exit a market.
- Long-Term Viability: Businesses earning zero or negative economic profit in the long run are unsustainable and should be reevaluated.
5. Economic Profit vs. Accounting Profit
| Aspect | Accounting Profit | Economic Profit |
|---|---|---|
| Definition | Revenue minus explicit costs | Revenue minus explicit and implicit costs |
| Includes Opportunity Costs? | No | Yes |
| Reported in Financial Statements? | Yes | No |
| Used by | Accountants, tax authorities | Economists, business strategists, investors |
| Indicates | Profitability on paper | True economic value and resource efficiency |
6. Role in Competitive Markets
- In perfect competition, economic profit attracts new entrants. Over time, competition drives economic profit to zero (normal profit).
- In monopolistic competition, economic profit exists in the short run, but product differentiation and new competitors erode it in the long run.
- In oligopoly or monopoly, barriers to entry allow firms to earn economic profits even in the long run, often leading to calls for regulation or market liberalization.
7. Factors Affecting Economic Profit
- Opportunity Cost: A key factor—higher opportunity costs mean higher benchmarks for economic profit.
- Market Conditions: High demand, limited supply, or innovation increases chances of earning economic profit.
- Cost Efficiency: Firms that control costs better than competitors may enjoy positive economic profit.
- Barriers to Entry: Protect firms from competition and help preserve supernormal profits.
8. Strategic Use of Economic Profit in Business
- Performance Benchmarking: A firm earning positive accounting profit but zero economic profit is breaking even in real terms.
- Market Exit Strategy: Persistent negative economic profit indicates resources should be reallocated.
- Capital Budgeting: Firms use economic profit (often in the form of EVA – Economic Value Added) to assess the true return on investment.
- Strategic Planning: Identifies areas where the firm has a comparative advantage and can outperform alternatives.
9. Limitations of Economic Profit
- Difficulty in Estimation: Measuring implicit costs requires assumptions about alternative uses of time and capital.
- Subjectivity: Different individuals may value opportunity costs differently, leading to inconsistent conclusions.
- Not Recognized by Tax Authorities: Economic profit has no legal bearing on taxation, which is based on accounting profit.
10. Application in Real-World Firms
- Companies like Amazon or Tesla initially reported minimal accounting profits, but investors saw potential for high economic profits based on market dominance and innovation.
- Private equity firms and venture capitalists often focus on economic profit and future value creation rather than short-term accounting gains.
- Economic Value Added (EVA), a metric derived from economic profit, is used by firms like Coca-Cola and Siemens to assess performance and shareholder value.
Economic Profit as the Gold Standard of Business Viability
Economic profit offers a deeper and more accurate measure of business performance than traditional accounting metrics. By including opportunity costs, it reflects whether a firm is truly using its resources in the most productive way possible. While it may not appear in financial statements, economic profit is essential for strategic planning, investment analysis, and sustainable growth. Entrepreneurs and decision-makers who focus on economic profit are better equipped to navigate competitive markets, assess long-term viability, and maximize the real value of their ventures.