Economic Profit

Lecture 3 Prof. Ravikesh Srivastava

Profit
Profit is the firms total revenue minus its total cost.

Profit = Total revenue - Total cost

Profitability Ratio of Profit with respect to investment

Total Revenue, Total Cost, and Profit

Total Revenue
The amount a firm receives for the sale of its output.

Total Cost
The market value of the inputs a firm uses in production.

Costs as Opportunity Costs

A firms cost of production includes all the opportunity costs of making its output of goods and services. Opportunity Cost- What a firms owners give up to use of resources to produce goods or services.

Business utilize Two kinds of Resources

Market Supplied Resources- Resources owned by others and hired or leased in resource market. Owner Supplied resources- Resources owned and used by a firm.

Total Economic Cost

Sum of both kind of Resources I.e.

= Sum of Opportunity cost of marketmarket-supplied resources + opportunity cost of owner-supplied ownerresources

Explicit and Implicit Costs

A firms cost of production include explicit costs and implicit costs. Explicit costs are input costs that require a
direct outlay of money by the firm.

Implicit costs are input costs that do not

require an outlay of money by the firm.

Economic Profit versus Accounting Profit

Economists measure a firms economic profit as total revenue minus total cost, including both explicit and implicit costs. Accountants measure the accounting profit as the firms total revenue minus only the firms explicit costs.

Economic Profit versus Accounting Profit

When total revenue exceeds both explicit and implicit costs, the firm earns economic profit.
Economic profit is smaller than accounting profit.

Figure 1 Economic versus Accountants

How an Economist Views a Firm How an Accountant Views a Firm

Economic profit Accounting profit Implicit costs Total opportunity costs

Revenue

Revenue

Explicit costs

Explicit costs

Copyright 2004 South-Western

Theories of Profit
Risk Bearing theories of Profit - Industries with high risk have usually more Profits as
- Petroleum exploration - Capital market

Frictional Theory of Profit - Steep fall or rise in demand may create situation of Frictional Profit

Theories of Profit
Monopoly Theory of Profit - Firm with Monopoly Power can restrict output and charge higher Price
- Railway

Innovation Theory of Profit - Profit is recognized for introduction of successful innovation - Ex- Steven Jobs enjoys Profit as Founder of Apple Computer company

Theories of Profit
Managerial Efficiency Theory of Profit - Firm, which are more more efficient than others earn more Profit

Function of Profit
Indicate that consumer want more of that product Provide incentive for firms to expand output More firms enter to that industry in long run It represent the reward for greater efficiency

Problem
A Management Graduate Managing a software company for Rs. 4.0 lacs per year decides to open her own software company. Her revenue during the first year of operation is Rs. 15.0 lacs, and her expenses are as follows: Salaries to hired staff: Rs. 4.0 lacs Supplies Rs. 1.4 lac Rent Rs. 1.2 lac Utilities Rs. 0.4 lac Interest on bank loan Rs. 1.5 lac

Workout the following

The explicit costs The implicit costs The business profit The economic profit and The normal return on investment in this business.