🔎 Accounting vs Economic Costs and Profit

You give a box full of receipts to your accountant because accounting costs generally come with a receipt. Accountants and the IRS care about costs where you have paid money. These are explicit costs. In general, explicit costs are costs that involve an explicit monetary payment.

In contrast, economists care about implicit costs, like the value of your time, or the value of a resource that you could use another way. For example, suppose you run an AirBnB. The property is worth $500,000. Your implicit costs will include both the time you put into managing the AirBnB and the fact that you can’t sell the property and earn an investment return by investing it in the stock market. (Some people in the media call implicit costs “opportunity costs,” but to an economist and in this class, “opportunity cost” just means economic costs.)

To summarize

• accounting costs = explicit costs
• economic costs = explicit costs + implicit costs

Therefore, to calculate economic costs, we start with accounting costs and add implicit costs.

• economic costs = accounting costs + implicit costs

Because implicit costs are included, economic costs are always larger than accounting costs.

This has implications for profit.

accounting profit = revenue - accounting costs = revenue - explicit costs
economic profit = revenue - economic costs = revenue - explicit costs - implicit costs

Therefore, to calculate economic profit, we start with accounting profit and subtract implicit costs. economic profit = accounting profit - implicit costs

Because economic profit subtracts off the implicit costs (such as the opportunity cost of your time), the economic profit is always lower than accounting profit.

Consider a perfectly competitive market where many firms could enter with exactly the same cost curves. Let’s assume that each possible firm would have both implicit and explicit costs.

In the long run, we know that economic profits will be zero. Because accounting profits don’t subtract off the implicit costs, that means that in the long run, accounting profit will be positive, even in perfect competition. These firms are making accounting profits, paying taxes on them, and returning money to their investors.

✏️ Considering farmers, they pay taxes, and they earn enough accounting profit to support themselves and hopefully their families. Bottom line: even in perfect competition, farmers earn enough money to compensate them for all of their implicit costs (time, effort, physical exertion, investment of wealth in their land and capital).

For example, suppose a farmer has a farm worth $1M. Suppose they could make 6% interest by investing that $1M in a mixture of stocks and bonds.

Suppose the farm is only making a $40,000 profit. What would you do?

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I’d sell the farm.

This farmer has an accounting profit of $40,000. As we saw above, to calculate economic profit, we start with accounting profit and subtract implicit costs: economic profit = accounting profit - implicit costs Because the implicit cost of not investing the value of the farm in stocks is $1M×6% = $60,000, the farmer’s economic profit is $40,000 - $60,000 = -$20,000.

Another example would be your choice whether or not to become an Uber driver. Being an uber driver is generally profitable from an accounting perspective. However, you might not take the gig because the implicit costs of your time are too high for it to be economically profitable.