Normal vs Economic Profits

1. Normal vs. Economic Profit
This is why people hate economists!!

2. NORMAL PROFITS
• Two components to Normal Profits
– Explicit Costs---Tangible costs like rent, wages, utilities, insurance,
freight…
• These are also known as Accounting Costs
– Implicit Costs---These are somewhat intangibles costs---They are the
entrepreneurs OPPORTUNITY COSTS
• How much could the entrepreneur earn doing something else AND how much
could he “rent out” his capital for if he was not using it.

3. NORMAL PROFITS
• Accountants care about EXPLICIT COSTS.
Economists care out EPLICIT AND IMPLICIT
COSTS because it shows if society is properly
allocating its resources. If the entrepreneur
and/or his “capital” is more efficient at doing
something else then he/she should engage in
the activity that they have the “Comparative
Advantage” in.

4. NORMAL PROFITS
• So…If in our example the entrepreneur is earning
NORMAL PROFITS in the business he/she is in
NOW, then their Opportunity Costs are being
met (making the same income they could be
making doing something else).
• If they can RENT out their CAPITAL for the SAME
amount they are earning now then they meeting
their OPPORTUNITY COSTS.
• In other words they are doing the best they can
with their resources.

5. Normal vs Economic Profit
• Example:
• Suppose you are earning $22,000 a year as a sales rep. for a T-Shirt
manufacturer.
• You decide you want to open a retail store to seel t-shirts.
• You invest $20,000 of savings that have been earning you $1,000
per year in interest (5%).
• You decide to open the store in a small building you ALREADY own
and are renting it to someone else for $5,000 per year.
• You hire 1 clerk to help you run the store and you pay her $18,000
per year salary.
• Fast forward 1 year---you have been in business for 1 year…

6. Normal vs Economic Profit
Total Sales REVENUE $120,000
– Cost of T-shirts $40,000
– Clerks Salary $18,000
– Utilities $5,000
Total EXPLICIT COSTS - $63,000
“Accounting Profit” $57,000
• LOOKS GOOD…Doesn’t it???

7. Normal vs Economic Profit
• Remember: Economists care about costs that
are NOT accounting costs
– IMPLICIT COSTS---Opportunity Costs
1. The income you gave up to start the business- $22,000
2. $1,000 in interest you were earning on the $20,000 you
had in savings
3. The $5,000 in rent you were earning renting the building
to someone else
TOTAL IMPLICIT COSTS ARE: $28,000!!!

8. Normal vs Economic Profit
Total Sales REVENUE $120,000
– Cost of T-shirts $40,000
– Clerks Salary $18,000
– Utilities $5,000
Total EXPLICIT COSTS - $63,000
“Accounting Profit” $57,000
Total IMPLICIT COSTS - $28,000
ECONOMIC PROFIT: $29,000

9. Normal vs Economic Profit
• IMPORTANT POINT!!!!
• If in our example our ECONOMIC PROFIT had
equaled $0, then the firm would have been
“Breaking-Even”. It would have been making
its EXPLICIT + IMPLICIT COSTS, or NORMAL
PROFITS!!. This person could not have done
any better with their time or capital.

10. Normal vs Economic Profit
• IMPORTANT POINT!!!!
• In our example this person IS making in EXCESS of their
NORMAL PROFITS.
• These profits are called ECONOMIC PROFITS (PURE
PROFIT)
• Profits OVER AND ABOVE the EXPLICIT + IMPLICIT COSTS.
• The presence of ECONOMIC PROFITS in an industry are a
signal to other entrepreneurs that they too could be
doing better than they are doing currently with their time
and capital (resources).
There may be ENTRY into this market:
INCREASED SUPPLY

11. Normal vs Economic Profit
• If in our example the EXPLICIT PLUS IMPLICIT
COSTS were GREATER than the ACCOUNTING
COSTS, then ECONOMIC PROFITS would be
NEGATIVE
• This is a signal (perhaps) that the
entrepreneur could do better with their time
and resources doing something else.
There may be EXIT from this industry:
DECREASED SUPPLY