Accounting profit vs economic profit | APⓇ Microeconomics | Khan Academy

Let’s continue thinking about how rational agents make decisions. So here, we're told that Sally runs a business that only sells hamburgers in a building she owns. Every month, they sell 5,000 hamburgers at five dollars per hamburger. She spends two dollars per hamburger on supplies (bread, meat, lettuce, etc.). She also pays Mike and Raj each twenty-five hundred dollars per month to work at the restaurant. Finally, the utilities cost 500 dollars per month. Sally works full-time at the restaurant and keeps the accounting profits for herself. What is the accounting profit of the business?

So pause this video and see if you can figure that out.

All right, now let's think about this together. We're going to think about it in terms of some of the types of costs we've thought about in the past. So when we think about benefits, and here we can think about it to a firm, although it's fully owned by Sally, the benefit to this firm of doing business is its revenue. So the total revenue that she collects, and everything we're going to be doing is going to be per month.

So her total revenue is going to be her price times quantity. So it's going to be 5,000 hamburgers at five dollars per hamburger. So that is going to be 25,000 dollars. Once again, all of this is going to be per month. We can view this as the total benefit that her business is getting.

Now, let's think about the costs. First, we can think about the cost of her supplies. It's oftentimes referred to as costs of goods sold, but I'll just write supplies here.

So costs:

• Supplies: That would be 5,000 hamburgers times two dollars per hamburger. So that's a ten thousand dollar cost.
• Then she has the cost of her employees. Employees (I'll just write it, I'll abbreviate it like that): What's that going to be? Well, she has two folks at twenty-five hundred dollars per month each, so that's going to be five thousand dollars (two times twenty-five hundred dollars equals five thousand dollars).
• Last but not least, she has her utilities. Utilities (let's do util for short): That's going to be 500 dollars per month.

From this, we can calculate the accounting profit. So we get the accounting profit. Accounting profit is going to be 25,000 dollars minus 15,500 dollars, and that's going to be 9,500 dollars per month. She gets to keep all of this, and so this seems like a pretty good amount of money to be earning. She’s earning six figures a year.

But the question is, is it rational for her to do this? Well, some of you might be correctly thinking, well, in order to determine whether it's rational for her to continue running this business, we have to know what the implicit costs are. Here we’ve only just looked at the explicit costs, and the most important of the implicit costs is the opportunity cost.

To factor that, we have to know, well, maybe what she could have rented her building out if she wasn't running this burger business and maybe what she could do with her time if she wasn't working at the business full-time. So we need a little bit more information, and let's see if we can get that.

Now we are told that Sally could rent out her building for five thousand dollars per month. She can also make six thousand dollars per month as an accountant. Based on this, what is the economic profit of her business?

So pause this video and see if you can figure this out.

Well, one way to think about it is we can start with our accounting profit and then subtract out all the implicit costs, especially these opportunity costs right over here. So her opportunity cost (opportunity costs are going to be per month): well, if she doesn't run this business, she could rent out her building for five thousand dollars per month, and if she wasn't doing this full-time, she could make six thousand dollars per month as an accountant (six thousand dollars right over there). So her opportunity costs total up to eleven thousand dollars.

Now, her economic profit would be her total benefit minus her explicit costs minus her implicit costs. Her economic profit: Economic profit is going to be, well, we could start with the 9,500 and subtract the 11,000; it is negative 1,500 dollars. It's important to realize that economic profit always factors in the explicit costs and then other potential implicit costs. Economic profit will never be higher than accounting profit, and assuming there are some implicit costs, it will always be lower than accounting profit.

Now, based on all of what we've explored, is it rational for Sally to continue running her burger business? Well, based on the information we've been given, it doesn't seem rational for her to continue running her burger business. She makes 9,500 in accounting profit from the business, but she's incurring 11,000 of opportunity cost to do so, and that's what makes her economic profit negative. This is not rational.

Now, if we had more information, maybe she hates being an accountant. Maybe there's a benefit for her working at the burger business. She has more flexibility with her time, she likes being self-employed, she doesn't have to listen to her manager tell her what to do. If that were the case, then it would change the calculations some because there would be an extra benefit from her running her burger joint. But we don't know, and based on the information we have, it doesn't seem rational for her to continue.