Normal vs Economic Profits

Normal vs Economic Profits

1. Normal vs. Economic Profit
This is why people hate economists!!

2. NORMAL PROFITS
•Two components to Normal Profits
–Explicit Costs---Tangible costs like rent, wages, utilities, insurance,
freight…
•These are also known as Accounting Costs
–Implicit Costs---These are somewhat intangibles costs---They are the
entrepreneurs OPPORTUNITY COSTS
•How much could the entrepreneur earn doing something else AND how much
could he “rent out” his capital for if he was not using it.

3. NORMAL PROFITS
•Accountants care about EXPLICIT COSTS.
Economists care out EPLICIT AND IMPLICIT
COSTS because it shows if society is properly
allocating its resources. If the entrepreneur
and/or his “capital” is more efficient at doing
something else then he/she should engage in
the activity that they have the “Comparative
Advantage” in.

4. NORMAL PROFITS
•So…If in our example the entrepreneur is earning
NORMAL PROFITS in the business he/she is in
NOW, then their Opportunity Costs are being
met (making the same income they could be
making doing something else).
•If they can RENT out their CAPITAL for the SAME
amount they are earning now then they meeting
their OPPORTUNITY COSTS.
•In other words they are doing the best they can
with their resources.

5. Normal vs Economic Profit
•Example:
•Suppose you are earning $22,000 a year as a sales rep. for a T-Shirt
manufacturer.
•You decide you want to open a retail store to seel t-shirts.
• You invest $20,000 of savings that have been earning you $1,000
per year in interest (5%).
• You decide to open the store in a small building you ALREADY own
and are renting it to someone else for $5,000 per year.
•You hire 1 clerk to help you run the store and you pay her $18,000
per year salary.
•Fast forward 1 year---you have been in business for 1 year…

6. Normal vs Economic Profit
Total Sales REVENUE $120,000
–Cost of T-shirts $40,000
–Clerks Salary $18,000
–Utilities $5,000
Total EXPLICIT COSTS - $63,000
“Accounting Profit” $57,000
•LOOKS GOOD…Doesn’t it???

7. Normal vs Economic Profit
•Remember: Economists care about costs that
are NOT accounting costs
–IMPLICIT COSTS---Opportunity Costs
1.The income you gave up to start the business- $22,000
2.$1,000 in interest you were earning on the $20,000 you
had in savings
3.The $5,000 in rent you were earning renting the building
to someone else
TOTAL IMPLICIT COSTS ARE: $28,000!!!

8. Normal vs Economic Profit
Total Sales REVENUE $120,000
–Cost of T-shirts $40,000
–Clerks Salary $18,000
–Utilities $5,000
Total EXPLICIT COSTS - $63,000
“Accounting Profit” $57,000
Total IMPLICIT COSTS - $28,000
ECONOMIC PROFIT: $29,000

9. Normal vs Economic Profit
•IMPORTANT POINT!!!!
•If in our example our ECONOMIC PROFIT had
equaled $0, then the firm would have been
“Breaking-Even”. It would have been making
its EXPLICIT + IMPLICIT COSTS, or NORMAL
PROFITS!!. This person could not have done
any better with their time or capital.

10. Normal vs Economic Profit
•IMPORTANT POINT!!!!
•In our example this person IS making in EXCESS of their
NORMAL PROFITS.
•These profits are called ECONOMIC PROFITS (PURE
PROFIT)
•Profits OVER AND ABOVE the EXPLICIT + IMPLICIT COSTS.
•The presence of ECONOMIC PROFITS in an industry are a
signal to other entrepreneurs that they too could be
doing better than they are doing currently with their time
and capital (resources).
There may be ENTRY into this market:
INCREASED SUPPLY

11. Normal vs Economic Profit
•If in our example the EXPLICIT PLUS IMPLICIT
COSTS were GREATER than the ACCOUNTING
COSTS, then ECONOMIC PROFITS would be
NEGATIVE
•This is a signal (perhaps) that the
entrepreneur could do better with their time
and resources doing something else.
There may be EXIT from this industry:
DECREASED SUPPLY