Economic Profits

Definition

Economic profits refer to the surplus revenue a firm earns after accounting for all opportunity costs, including the implicit cost of the owner's own labor and capital. It represents the firm's true profitability beyond just the accounting profit, which only considers explicit costs.

5 Must Know Facts For Your Next Test

1. In perfect competition, firms earn zero economic profits in the long run as price equals the minimum of the long-run average cost curve.
2. Economic profits provide the incentive for new firms to enter a market, driving down prices and profits until they reach zero in the long run.
3. Firms will continue to produce as long as they are earning at least their opportunity costs, even if they are not earning accounting profits.
4. Economic profits are important for measuring the true profitability of a firm, as they account for the implicit costs of using the owner's own resources.
5. The presence of economic profits in the short run signals an inefficient allocation of resources, which will be corrected through the entry of new firms in the long run.

Review Questions

• Explain how economic profits differ from accounting profits and why they are a more accurate measure of a firm's true profitability.
  • Economic profits differ from accounting profits in that they consider the opportunity cost of the firm's own resources, such as the owner's labor and capital. Accounting profits only take into account explicit, out-of-pocket costs, while economic profits include implicit costs as well. This makes economic profits a more accurate measure of a firm's true profitability, as it captures the full cost of using the firm's own resources rather than renting them out to others.
• Describe the role of economic profits in the long-run equilibrium of a perfectly competitive market.
  • In a perfectly competitive market, firms will earn zero economic profits in the long run. This is because the presence of economic profits will attract new firms to enter the market, increasing the supply and driving down prices until profits are eliminated. Conversely, if firms are earning economic losses, less efficient firms will exit the market, reducing supply and allowing prices to rise until profits return to zero. This process ensures the long-run equilibrium of a perfectly competitive market is characterized by zero economic profits.
• Analyze how the presence of economic profits in the short run affects the long-run allocation of resources in a perfectly competitive market.
  • The presence of economic profits in the short run of a perfectly competitive market signals an inefficient allocation of resources. These profits provide an incentive for new firms to enter the market, increasing supply and driving down prices until profits are eliminated in the long run. This entry of new firms and the resulting increase in competition ensures resources are allocated to their most productive uses, as less efficient firms are driven out of the market. The long-run equilibrium of zero economic profits in a perfectly competitive market thus represents the most efficient allocation of resources.

Related terms

Accounting Profits: Accounting profits are the difference between a firm's total revenue and its explicit, or out-of-pocket, costs. They do not consider implicit costs like the opportunity cost of the owner's own labor and capital.

Opportunity Cost: The opportunity cost is the value of the next best alternative foregone when a decision is made. It represents the implicit costs a firm incurs by using its own resources rather than renting them out.

Perfect Competition: Perfect competition is a market structure characterized by many small firms selling identical products, with no individual firm able to influence the market price.