ECONOMIC SECOND EDITION in MODULES S Paul Krugman Robin Wells with Margaret Ray and David Anderson MODULE 16 52 Defining Profit Krugman Wells The difference between explicit and implicit costs and their importance in decision making The different types of profit including economic profit accounting profit and normal profit How to calculate profit 3 of 11 Opportunity Cost and Decisions An explicit cost is a cost that involves actually laying out money An implicit cost does not require an outlay of money it is measured by the value in dollar terms of the benefits that are forgone 4 of 11 Opportunity Cost of an Additional Year of School 5 of 11 Accounting Profit Versus Economic Profit The accounting profit of a business is the business s revenue minus the explicit costs and depreciation The economic profit of a business is the business s revenue minus the opportunity cost of its resources It is often less than the accounting profit 6 of 11 Capital The capital of a business is the value of its assets equipment buildings tools inventory and financial assets The implicit cost of capital is the opportunity cost of the capital used by a business the income the owner could have realized from that capital if it had been used in its next best alternative way 7 of 11 Profits at Babette s Cajun Cafe 8 of 11 Normal Profit A positive economic profit indicates that the current use is the best use of resources A negative economic profit indicates that there is a better alternative use for resources A zero economic profit is also called a normal profit A firm earning a normal profit is earning just enough to keep the resources it employs in their current activity 9 of 11 Farming in the Shadow of Suburbia In 1880 more than half of New England s land was farmed by 2006 the amount was down to 10 The remaining farms of New England are mainly located close to large metropolitan areas Farmers get high prices for their produce from city dwellers who are willing to pay a premium for locally grown extremely fresh fruits and vegetables Maintaining the land instead of selling it to property developers constitutes a large implicit cost of capital 10 of 11 1 The cost of using a resource for a particular activity is the opportunity cost of that resource 2 Some opportunity costs are explicit costs they involve a direct payment of cash 3 Other opportunity costs however are implicit costs they involve no outlay of money but represent the inflows of cash that are forgone 4 Companies use capital and their owners time So companies should base decisions on economic profit which takes into account implicit costs such as the opportunity cost of the owners time and the implicit cost of capital 5 A normal profit is the amount needed to keep resources employed in the business to keep the business in business 11 of 11