An accountant asked an economist why she had chosen a career in economics over accounting. The economist replied, “I’m good with numbers, but I don’t have enough personality to be an accountant.” Personality differences aside, a key distinction between economics and accounting is in determining total cost and profit. To the accountant, total costs are the sum of all of the explicit fixed and variable costs of production—things like the cost of clay to make the ceramic pots you sell. Explicit costs are easily identifiable and quantifiable. The cost of overhead is a known quantity. The cost of labor can readily be calculated.
In addition, to the accountant, profits are equal to total revenue minus total cost. If your business generates $1 million in revenue (what it earns through sales) and has fixed and variable costs equal to $800,000, then your profits are equal to $200,000. Your focus will be on maximizing revenue and reducing the costs of production. This will increase your profits.
To the economist, however, total cost is equal to all of the explicit fixed and variable costs plus opportunity cost. Opportunity cost is an implicit cost, and it can be much harder to define and quantify than the explicit costs of production. To the economist, profits are equal to total revenue minus total cost including opportunity cost. Factoring in opportunity cost gives a clearer picture not just of whether the business is profitable but whether it is the best use of resources.
Imagine that you are a teacher earning $5,000 a month and decide to quit your job and start selling snow cones instead. You buy a freezer cart that you can wheel around, order all of the supplies you need, and pay the required licensing fees. Assume your total cost equals $2,000. So you get out there and start hustling snow cones, and you’re actually good at it. At the end of the month, you calculate that you have earned $6,000 in total revenue. What are your accounting profits? $6,000 in total revenue – $2,000 in total cost = $4,000 in accounting profit.
What are your economic profits? $6,000 in total revenue – ($2,000 in explicit cost + $5,000 in opportunity cost) = −$1,000 economic loss. The opportunity cost is what you could have been earning as a teacher.
In this example, we knew what salary the teacher earned so we could calculate the opportunity cost more easily. But what if the situation were slightly different? Suppose the teacher was selling snow cones in the summer, not during the school year, so her teaching salary was unaffected. She might be giving up other opportunities, but perhaps it isn’t clear what those opportunities would be or how much she might earn pursuing them. What’s the going rate for tutoring, a common summertime pursuit for teachers? Maybe it varies from $10 an hour to $100 an hour, depending on a variety of factors. Or maybe the opportunities aren’t income generating—maybe she could be lying on the beach, recuperating so she can be ready for another round of teaching in the fall.
In another scenario, suppose our snow-cone seller was a twelve-year-old kid. Instead of selling snow cones, what else could he be doing? Mowing lawns or delivering newspapers? (Does anyone deliver newspapers anymore?) In this case, the opportunity cost is likely to be close to zero.
Many people confuse the concepts of revenue and profit. Revenue is all of the income a business earns. For a firm selling a single type of product at one price, revenue is equal to the quantity sold multiplied by the price. If you’ve got a hundred apples that you sell for $1 each, then your total revenue, assuming you sell all the apples, is $100. Profit, on the other hand, is the income a company has left over after covering all of its costs. Revenue – Cost = Profit.
Economic profits in an industry are important because they provide firms in other industries with an incentive to employ their land, labor, capital, and entrepreneurial ability in the economically profitable industry. Economic profits draw resources to their most efficient use. In the long run, competition eliminates economic profits. Industry is most efficient when economic profits are equal to zero. At zero economic profit, there is no incentive for existing firms to leave or for new firms to enter the market. In the example just presented, the $1,000 economic loss is a signal for you to leave the snow-cone industry because your resources could be put to better use in another industry. But for the kid whose alternative is mowing the lawn, making snow cones is as efficient a way to use his resources as the other options available to him, so he has no incentive to leave the market.