Normal_vs_Economic_Profit

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Normal vs Economic Profit


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

NORMAL PROFITS : 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.

NORMAL PROFITS : 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.

NORMAL PROFITS : 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.

Normal vs Economic Profit : 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…

Normal vs Economic Profit : 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???

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

Normal vs Economic Profit : 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

Normal vs Economic Profit : 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.

Normal vs Economic Profit : 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

Normal vs Economic Profit : 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

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