‘THE NATURE AND FUNCTION OF PROFITS In this section we examine the nature and function of profits. We distinguish be- tween business and economic profits, present various theories of profits, and ex- amine the function of profits in a free-enterprise economy, Business versus Economic Profit To the general public and the business community, profit or business profit refers to the revenue of the firm minus the explicit or accounting costs of the firm. Ex- plicit costs are the actual out-of-pocket expenditures of the firm to purchase or hire the inputs it requires in production. These expenditures include the wages to hire labor, interest on borrowed capital, rent on land and buildings, and the ex- penditures on raw materials, To the economist, however, economic profit equals the revenue of the firm minus its explicit costs and implicit costs. Implicit costs refer to the value of the inputs owned and used by the firm in its own production , processes. Specifically, implicit costs include the salary that the entrepreneur could earn from working for someone else in a similar capacity (say, as the manager of an- other firm) and the return that the firm could earn from investing its capital and renting its land and other inputs to other firms. The inputs owned and used by the firm in its own production processes are not free to the firm, even though the firm can use them without any actual or explicit expenditures. Their implicit costs are what these same inputs could earn in their best alternative use outside the firm. Accordingly, economists include both explicit and implicit costs in their definition of costs. That is, they include a normal return on owned resources as part of costs, so that economic profit is revenue minus explicit and implicit costs. While the concept of business profit may be useful for accounting and tax pur- poses, itis the concept of economic profit that must be used in order to reach cor- rect investment decisions. For example, suppose that a firm reports a business profit of $30,000 during a year, but the entrepreneur could have earned $35,000 by managing another firm and $10,000 by lending‘out his capital to another firm facing similar risks. To the economist this entrepreneur is actually incurring an economic loss of $15,000 because, from the business profit of $30,002, he would have to subtract the implicit or opportunity cost of $35,000 for h'- wages and $10,000 for his capital. A business profit of $30,000, thus, corresponds to an economic loss of $15,000 per year. Even if the entrepreneur owned no capital, he would still incur an economic loss of $5,000 per year by continuing to operate his own firm and earning a business profit of $30,000 rather than working for someone else in a similar capacity for $35,000. Thus, the entrepreneur should close his firm and awark in his best alternative occupation, In other words, it is the economic, rather than the business, concept of profit thar is important in directing resources to dif- ferent sectors of the economy. In the rest of the text we will use the term profit to mean economic profit and cost to mean the sum of explicit and implicit costs.