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Monday, October 22, 2012

What Is Profit?

Basically, profit is revenue minus costs.  It sounds simple, but the concepts of “revenue” and “cost” are complex when we examine them closely.

In economics “cost” is not the money one pays for a purchase.  If you buy a lunch for $10, the money is not an economic cost, because the exchange of money for food is a gain.  You would rather have the food than the money, so the payment generates a benefit not a cost.  But the purchase does have a cost—namely, the next best thing you could have bought for the $10.

In economics the forgone item—what you could have done or gotten instead—is called the “opportunity cost.”  All costs are opportunity costs: what you give up when you do or get something.

Costs come in two categories: explicit and implicit.  What accountants and bookkeepers record are explicit costs—that is, payments to others, such as payments for labor, real estate, or  supplies.

Accounting spreads out some explicit costs.  When a company buys a machine for $200 that lasts for ten years, the first year’s cost is not $200, because after one year, the machine still has economic value.  If the machine loses value at an even rate, then the loss of value in the first year is $20.  The using up of economic value is called “capital consumption” and also “depreciation.”  An accountant records for each of the ten years an annual cost of $20 as depreciation.  Depreciation is an explicit cost, even though there is no payment of $20 in any year, because the machine was paid for at the beginning.

In accounting, profit equals revenues minus explicit costs.  In economics, that amount is called an “accounting profit.”  But the implicit costs are also real costs, so for economics the accounting profit does not provide the real profit.

Suppose you are self-employed and want to calculate the real gain from your business.  Your annual revenue is $500,000, and your explicit costs are $400,000, so you have an accounting profit of $100,000.  But your real gain is the economic profit, which is revenue minus all costs, both explicit and implicit.

One implicit cost is the wage you could have earned if you worked for another firm instead of being self-employed.  Suppose the highest wage you could earn as an employee is $80,000.  That amount is the opportunity cost of self-employment.  You give up the $80,000 you could have earned, so it is a cost of business.  In effect, you as owner are paying yourself as a worker the $80,000.

Suppose also that you own assets such as machines worth $400,000 in your business. If you sold the business, you could buy bonds that safely pay 5 percent.  The $20,000 interest income you could earn is another opportunity cost of your business.  The implicit costs are therefore $80,000 plus $20,000, or $100,000.  To get the economic profit, subtract the $100,000 implicit cost from the $100,000 accounting profit, leaving an economic profit of zero.  You could of course also subtract the $400,000 explicit and $100,000 implicit costs from the $500,000 revenue to get zero economic profit.

You don’t have any real gain from your business that year, because costs equal revenue.  That does not imply you should sell the business, because the accounting profit provides you with an implicit wage of $80,000 and an implicit return on assets of $20,000, the same you would get if you sold the business.  If your implicit costs were $90,000 instead, then your economic profit would be $10,000, the real gain from having your business.  If your implicit costs were $110,000, your enterprise would have a negative economic profit of $10,000, a loss from being in business.

The profit from interest income needs to account for the implicit cost of inflation.  The dollar amount of interest paid, or the quoted rate, is called the “nominal” interest, and the net gain after subtracting the inflation amount, or rate, is the real interest.

We also need to distinguish economic revenue from accounting revenue.  Suppose a thief enters a house and steals $1,000 of loot.  To break into that house he bought a tool for $100.  Ignoring the opportunity cost of his time, the thief’s accounting revenue is $1,000, and his cost is $100.  Is the $900 net gain a profit in the economic sense?

Stolen loot is not real profit because it is a forced transfer of goods or money from the victim to the thief.  True profit is a net gain from production and exchange.  If someone gives you a gift of $100, it too is just a transfer.

If instead of directly stealing wealth someone uses the government to forcibly take money from some and give it to others, the gain is also not true profit.  For example, if a farmer has $1 million in accounting revenues and $900,000 in total costs, and $200,000 of the revenues came from a governmental subsidy, the economic revenue from production is $800,000, and his economic profit is minus $100,000.  Corporate welfare—subsidies, protection from competition, and other forms of transfer seeking—is not an economic gain and should not be included in economic profit.

The existence of real profit implies there has been a productive benefit to society.  The entrepreneur has put resources to better use than in his other opportunities.  But when gains are due to subsidies and government-protected monopolies, the social opportunity costs are the gains that would have gone to more productive labor and enterprise.  These costs need to be subtracted from revenue.

One reason some people have a dim view of profit is that they include gains from looting. After removing forced transfers from profit, what is left are gains that benefit society, not just the entrepreneur.  We should celebrate true profit and deplore gains from forced transfers that masquerade as profit.

  • Fred Foldvary teaches economics at San Jose State University, California. He received his Ph.D. in Economics from George Mason University. Foldvary's scholarly interests include private communities, business cycles, decentralized governance, and natural-law ethics.