4. Measuring cost and profit

Economic cost is the monetary value of all inputs used in a particular activity enterprise over a given period, say a year.

The implicit cost measures the opportunity cost of the owner’s time spent working for his own business.

The implicit cost of tying up funds in a business enterprise is the highest return that could have been earned on those funds had they been invested elsewhere.

Costs as measured by accountants don't include the opportunity cost of inputs supplied by a firm's owners. Accounting cost measures the explicit costs of operating a business.

Explicit costs don't include the value of no purchased inputs. Accounting cost provides valuable information. Those who own businesses, however, are aware of the shortcomings of this measure and actually base their decisions on economic cost, including implicit costs, to accurately measure their opportunity costs. Business owners always compare the desirability of remaining in that particular enterprise with what they forgo by doing so. Economists therefore assume that decisions made by business firms are always based on economic cost, which is a complete measure of the opportunity cost of using economic resources in a business.

5. Normal profit and economic profit

The goal of a competitive firm is to maximize profit (the residual left over after all the factors of production have been paid). Profit is the difference between total revenue and the cost of all inputs a firm uses over a given period. The equation for a firm's profit over a certain period can be written as:

Profit = Total revenue — Total cost.

The total revenue for a single-product firm would be the total units of output sold over the period multiplied by the price per unit:

Total revenue = Price x Quantity sold.

Total cost is the economic cost of inputs used over the period.

Total profit is the difference between total revenue and the sum of accounting cost and the implicit cost of owner-supplied inputs.

Because profits are the difference between total revenue and total cost the tact that there are two alternative concepts of cost means that there are two alternative concepts of profit:

1) Normal (accounting) profit is a term economists use to indicate that portion of a firm’s cost that isn’t included in accounting costs.

2) Economic profit is the profit one arrives at using the economists’ definition of cost.

Normal profit is therefore a measure of the implicit costs of owner-supplied resources in a firm over a given period.

When a firm earns zero economic profit it will cover both its accounting costs and its implicit costs.

If a firm therefore takes in enough revenue to pay all its accounting costs during the period and still has enough left over to cover its implicit costs, it will be earning a normal profit.

When earning a normal profit in a business, the owners of the business improve their well-being by using the resources they supply to the firm in another activity. It follows that when a firm earns zero economic profit, its owners can do no better in any other activity so their best alternative is to keep the firm operating.

If a firm is earning negative economic profit, it will be incurring an economic loss. Under such circumstances its owners can not cover their implicit costs. They will therefore earn less than the normal profit, which implies that they can do better by transferring the resources they own to another activity.