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What is an Economic Profit?

Economic profit is the amount of money a person or business gains as a result of a specific enterprise after also considering opportunity cost.
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  • Written By: D. Messmer
  • Edited By: A. Joseph
  • Last Modified Date: 11 June 2015
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Economic profit, or economic value added, is the amount of money a person or business gains as a result of a specific enterprise after also considering opportunity cost. It is different from accounting profit because it does not simply measure the net profit of a business venture but also considers how much a business or individual might have made by pursuing other enterprises. If those enterprises would have been more profitable, then even a venture that generated accounting profit might result in an economic loss.

Calculating economic profit can be difficult sometimes because it is not always possible to know the profits that other ventures might have yielded. When a person or business does know of other potential means of earning profit, though, the calculation is quite simple. For instance, if an individual decided to quit a job that paid $100,000 US Dollars (USD) in order to start a business, that individual would calculate his or her economic profit by comparing the accounting profit, also known as the normal profit, of the business to the $100,000 USD that he or she gave up in order to pursue the business. If this business resulted in accounting profits of $120,000 US Dollars, then the economic profit would be $20,000 USD — the individual earned $20,000 USD more than he or she could have had by keeping his or her original job.

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The key to successfully calculating economic profit is knowing the opportunity cost of an investment. In the example above, this was easy to do, because the individual who opened the business knew the salary that he or she was giving up. This, though, is not always the case. For instance, if we reverse the example, and a business owner decides to sell the business to take a job for $100,000 USD per year, it will be difficult to calculate the economic profit, because it is difficult to know how much the business might have earned. Even if the business is still in existence and the previous owner knows how profitable it was during that year, there is no way to know if that person's continued involvement might have enabled the business to earn more or perhaps even less.

So, although economic profit provides a more robust account of the true profitability of a business venture, it usually is not as easy to calculate as accounting profit is. It includes the opportunity cost of a venture and thus accounts for more variables than normal profit figures do. But because opportunity cost is always a speculative figure, knowing the true economic profit can be difficult.

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literally45
Post 3

@fify-- But you see, business doesn't work that way. The goal is to make the most profit with the lowest cost. A business that doesn't make a profit can't survive, it shouldn't. And businesses should always aspire to make more money and reduce their costs as much as possible. This is what economics calls for. Whether someone does that or not, that's their choice. But it's difficult for businesses to survive if they don't aspire for greater economic profit.

stoneMason
Post 2

@fify-- Actually there are different ways to analyze economic profit. One type of analysis might be better than another depending on the situation.

The type of analysis you describe (also called an impact analysis) is useful for figuring out the best option. I agree that it might not be the best idea to compare to a lost opportunity. But this type of profit or cost analysis can be very useful when making a decision for a specific project. It is often used for public service and other government projects where the goal is to maintain the maximum effectiveness at the lowest cost. So it's not necessarily about making the most profit, but also about incurring the least cost.

There are other types of analyses that could be used like cost-effectiveness analysis, cost-benefit analyses etc.

fify
Post 1

I don't really understand how calculating an economic profit in comparison to other possibilities is always helpful. I mean, in that example, if the person realizes that they have lost profit by leaving their job, how does that help them? Does this mean that they should quit their business and try to get their job back? What about the satisfaction that they have in doing what they want to do? Can we measure satisfaction simply with economic profit?

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