15.1 Revenues, Costs, and Economic Profits
Let’s fast forward a few years: You’ve been out of college for a while, and you’re doing well in your chosen career. Even though you like your job, you’re feeling restless, as you think about pursuing your dream of running your own business. You have a great idea for a new start-up—perhaps it’s a website connecting organic farmers directly with their customers, so that with a few clicks people can order locally grown organic vegetables—or perhaps you have a different idea.
Economic Profit versus Accounting Profit
Whatever your idea is, how can you be sure it’s worth pursuing? Let’s run the numbers. Let’s say you’ve made some forecasts as part of your business plan:
- You expect to earn $500,000 per year in revenue.
- You expect to incur $400,000 per year in business-related expenses.
Accounting profit is total revenue less out-of-pocket financial costs.
Your accounting profit is the total revenue your business receives minus your total outlays, which we call your explicit financial costs. Total revenue is all of the income received from all sources. Likewise, your explicit financial costs include all the money that leaves your business, including rent, wages for your employees, and the cost of your raw materials. You measure your accounting profit by tracking all of the money that goes into and out of a business. This is the number that’s typically reported on the bottom line of your profit-and-loss statement and printed in your annual report.
To summarize:
Accounting profit = Total revenue − Explicit financial costs
Your start-up is expected to earn total revenue of $500,000 per year, and to incur $400,000 in explicit financial costs, providing an expected annual accounting profit of $100,000.
- Armed with this information, should you launch your start-up?
- Don’t answer right away. Pause for a moment and think about this.
- Really think.
- A bit longer.
- (Hint: Keep thinking until you’ve used the opportunity cost principle.)
- The answer is: It depends.
The opportunity cost of running a business includes forgone wages and interest.
Here’s why it depends: You’ll need to quit your current job to start this business. If you’re currently earning $150,000 per year, then launching your start-up will mean forgoing your annual income of $150,000 in order to gain an annual profit of $100,000. That’s obviously a bad deal—don’t start the business! But if you’re currently earning $40,000 per year, then giving up your job to start this business is a good idea, because you’ll only forgo an annual income of $40,000 to get an annual profit of $100,000.
The point is, whether or not it makes sense to launch this new business depends on your opportunity costs. You need to apply the opportunity cost principle and ask, “or what?” You could start this new business, or what? As any entrepreneur will tell you, you’ll need to pour a lot of time and money into your start-up. And so beyond the explicit financial costs you’ll also need to account for the most important implicit opportunity costs of running a business, including:
- Forgone wages: If you don’t launch this start-up, how much will you earn pursuing your next best career option?
- Forgone interest: If you don’t invest your funds in this start-up, how much annual interest will you earn by investing it elsewhere?
If there are other opportunity costs you need to think about—perhaps quitting your job will mean forgoing a lot of job satisfaction, or you value the benefits like health care—then make sure to count them, too. You should think of the sum of all of these opportunity costs as the annual payment you need for it to be worth investing your time and money as an entrepreneur. Don’t accept a penny less, or else you’ll end up worse off than in your next best alternative.
Economic profits account for both explicit financial costs and implicit opportunity costs.
Recognizing that these implicit opportunity costs matter just as much as explicit financial costs leads to a new perspective on profitability. Economists focus on economic profit—which is total revenue less both the explicit financial costs that accountants focus on and the implicit opportunity cost of the entrepreneur’s time and money:
Economic profit = Total revenue − Explicit financial costs − Implicit opportunity costs
Entrepreneurs focus on economic profits because they speak directly to the question of whether it’s worth starting a new business or not. It says that you should start the new business only if it will earn positive economic profits.
Do the Economics
Let’s return to that business plan, but this time, we’ll make sure to account for your implicit opportunity costs. In order to start your new business, you’ll have to:
- Quit your current job, which pays you $60,000 per year, and
- Invest $100,000 in the business, instead of keeping it in the bank where it’s earning 5% interest per year.
- What are the implicit opportunity costs of starting your new business?
- What are your economic profits?
- Should you start this business?
Yes. Emphatically yes.
- What are the implicit opportunity costs of starting your new business?
Some students argue that it may not be worth the hassle of starting a business if you’ll make only $35,000 in profit. But that’s a misreading of economic profit. Remember, economic profit is what’s left over after we’ve accounted for all costs—all explicit financial costs and all implicit opportunity costs—including hassle. And so an economic profit of $35,000 means that you’re $35,000 better off than in your next best alternative. That’s a move worth making!
Why do accountants and economists disagree?
At this point, you might wonder: Why can’t accountants and economists agree on what profit is, and which costs to count?
Figure 1 | Two Perspectives on Profit
The tension showed in Figure 1 is that each is trying to answer a different question. An accountant answers the question, “Where did my money go last year?” This requires a focus on, well, where your money went. And so accountants focus on explicit financial costs, which are any outlays where money left your business, including rent, the wages you pay your workers, the cost of computers and furniture, and your electric bill.
By contrast, the goal of economic analysis is to help you make the best decision. If you’re evaluating whether or not to start a new business, then you’ll only make a good decision if you account for your other opportunities. Consequently, economic analysis emphasizes all of your costs, including both the explicit financial costs your accountants tally up, and the implicit opportunity cost of your forgone opportunities. When we calculate economic profit, it’s as if we’re insisting your business pay you for your time and money.
Economic profits determine whether it’s worth starting a business.
As a rule, whenever you see news reports about corporate profits, or when you read a company’s profit and loss statement, they’re reporting their accounting profits. But if you’re trying to decide whether it’s worth starting a business, you want to focus on economic profits. The same advice applies to managers of existing companies, who should only stay in business if they expect to earn positive economic profits.
Because our task in this chapter is to evaluate when entrepreneurs should enter a market or existing businesses should exit, whenever you see the word “profit,” I want you to read it as “economic profit.” Indeed, whenever you hear an economist talk about profits, you can safely assume they mean economic profits. Likewise when you see the word “costs,” continue to think about them as including both explicit financial costs and implicit opportunity costs.
Do the Economics
For each of the following new ventures, calculate accounting profit, implicit opportunity costs, and economic profit, and assess whether you would advise these aspiring entrepreneurs to launch their new businesses:
- Kiara is thinking of opening an artisanal cheese store. She forecasts revenues of $200,000 per year, and explicit financial costs of $120,000 per year. She could only pursue this dream if she quit her current job as a teacher, where she earns $40,000 per year. She would also need to invest $100,000 to outfit the store, and she would otherwise use that money to pay down her mortgage, which is at an interest rate of 8% per year.
- Xavier is considering quitting his job as an editor for a major publisher to become a freelance editor. He currently earns $85,000 per year, plus an additional $15,000 worth of benefits. He estimates that as a freelancer, he’ll bring in $140,000 per year in revenue, and he’ll have $40,000 in financial costs. To get started, he’ll need to withdraw $20,000 from his bank where it’s earning 5% interest per year.
- Jasmine currently works as a sports medicine physician at the University of Michigan hospital, where she earns $160,000 per year. She’s considering starting her own practice, and expects to bring in revenues of $500,000 per year, although with all the staff and insurance she’ll need, her explicit financial costs will be $300,000 per year. She’ll need to invest $200,000 to get her office set up, forgoing 4% bank interest per year.
Average Revenue, Average Cost, and Your Profit Margin
In order to measure whether a business is profitable or not (remember: “profitable” means “earns economic profits”), you’ll need to focus on a couple of key metrics: Average revenue and average costs.
Your average revenue is the price.
Your average revenue is your revenue per unit, and it’s calculated as your company’s total revenue from selling a product, divided by the quantity supplied. If you charge everyone the same price, your average revenue is simply the price you charge for each unit:
This means that your firm’s demand curve—which shows the price you can charge for any given quantity—is also your average revenue curve.
Average cost is the per unit cost, or total costs divided by quantity.
Your average cost is the cost per unit, calculated as your business’s total costs from making a product, divided by the quantity you produce:
Notice that your average cost per unit is based on your total costs, and so includes both your fixed costs—such as the cost of land and capital equipment and any other expenses that don’t vary with the quantity you produce—as well as your variable costs—such as the cost of variable inputs, like raw materials, electricity, and worker time. Your fixed costs include the opportunity cost of the entrepreneur’s time and money.
Figure 2 sketches an example of a company’s average cost curve, showing how its average costs vary with the quantity produced. While the details may be different for your business, the U-shaped pattern is quite common, and it reflects the influence of two key forces:
Figure 2 | Average Cost Curve
Spreading your fixed costs: As you start to increase production from a low level, your average costs typically fall initially. This is because you have to pay for fixed costs just to set up your business. If you only produce a small quantity, these fixed costs constitute a large cost per unit sold. But as you produce a larger quantity, the fixed cost gets “spread” over more and more units, and so it becomes smaller on a per-unit basis. This decline in fixed costs per unit often leads average costs to fall.
Rising variable costs: Eventually, your variable costs become the more important component of average costs. At some point your average costs rise as inefficiencies make it increasingly expensive to increase your production. This is driven by rising input costs per unit, which may reflect overtime payments, diminishing marginal product reducing the productivity of your workers, coordination problems, or other inefficiencies. And so at some point, your average costs will typically rise as the quantity you produce increases.
Your profit margin per unit is the price less average cost.
Your company’s average revenue (which is equal to your price) and average cost are important, because together they determine your profit margin, which measures your profit per unit sold:
As any business leader can tell you, your profit margin is critical to your business’s success. If you’re earning a positive profit margin, then you’re earning an economic profit! Your total profit is your per-unit profit margin, multiplied by the quantity you sell. It follows that if your price exceeds your average cost, you’re making an economic profit.
Figure 3 illustrates how you can spot profit opportunities on a graph, showing your firm’s demand curve (remember that it’s also your average revenue curve) and average costs. Your profit margin per unit is the price you’ll charge (shown on the firm demand curve) less your average costs. Graphically, this means that for any given quantity, your profit margin per unit is the gap between your firm’s demand curve and its average cost curve.
Figure 3 | Profit Margins
Any time you see a firm’s demand curve lying above the average cost curve, there’s an opportunity to make economic profits. Go get ’em!
Recap: Economic profit is important for long-run analysis of firm entry and exit.
The central insight so far is that when you’re thinking about whether to enter or exit a market, you should focus on economic profit.
This focus on profitability is important because this chapter is all about shifting from short-run analysis to focusing on the long run. In the short run, you face a fixed set of competitors with given production capacity, and your job is simply to outcompete these existing rivals. These short-run decisions are important, and they’ve rightly occupied much of our attention throughout this book. But long-run dynamics determine what’s sustainable. So for the rest of this chapter we’ll analyze what happens in the long run, which is the time horizon over which new rivals may enter or expand into your market, and existing rivals can contract, or exit the market, and you can adjust your production capacity. As we’ll discover, economic profits play a key role in long-run analysis.
Students often ask: How long is the long run? Unfortunately, there’s no simple answer. When you’re operating a refinery, it may take a decade for companies to enter or exit the market. But if you’re running a roadside lemonade stand, a neighbor could set up a table just across the street any minute. IBM discovered that for a tech company, the long run can be a matter of a few years. You’ll need to use your judgment to sort out what the long run is in your industry. Generally, short-run analysis is useful for deciding the quantity your company should supply, given today’s market price. Long-run analysis is useful for planning purposes, such as planning how much to invest in a new plant and equipment for a business expansion, or planning whether to launch your new start-up. And that brings us to our next topic.