EXPLICIT AND IMPLICIT COSTS
In 1975, your family opened a drive-through fast-food pizza restaurant under the name of Perfectly Fast Pizza. In 1995 your parents retired from the drive-through pizza business, and you now operate the restaurant as a sole proprietor. The mortgage on the restaurant was paid off in 1990, so you own the building and property free and clear.
The Accountant. In January, your accountant analyzed your business operations for 2000, and came up with the following numbers:
Total Annual Revenue (Total Sales) $185,000 Cost of Supplies $45,000 Wages to Employees $95,000 Other Costs $10,000 Total Annual Costs $150,000 Profit $ 35,000
You are very excited by these results. As the sole proprietor of Perfectly Fast Pizza, the profit of $35,000 is your income for the year. If you didn't operate your own restaurant, you would be working as a pizza chef at Pizza Party Place for $25,000 per year.
The Economist. You are so proud of these business results that you brag to your sister, who is taking Principles of Economics II at East Tennessee State University. Your sister asks if you have taken into account your implicit costs. The factors of production that are being used in the drive-through pizza business could be used in other ways. Specifically, your economist sister points out: (1) you could work for Pizza Party Place as a chef, (2) you could rent your building to Boogie Burger which wants the facility for a drive-through fast-food hamburger restaurant, and (3) you have $50,000 tied up in your business that could be deposited in a bank and earn interest. If we add these implicit costs together, we get a different conclusion about your business success.
Labor (as a chef at Pizza Party Place) $ 25,000 Land (rent from Boogie Burger) $ 10,000 Capital (5.0% on $50,000 deposit in bank) $ 2,500 Total Implicit Costs $ 37,500
In conclusion, your sister informs you, you lost $2,500 last year.
Who is Right? Who is Wrong? Is the accountant right? Is the economist right? The Answer: Both are right since accounting and economics use a different perspective on business operations. The accountant must look at explicit cash flows -- actual money in and actual money out. The economist considers the implicit cost of using business resources in their next best use. In the example above, you would be ahead by $2,500 by putting your labor, land, and capital into their next best use. In this case, the next best use is a better use.
Implicit cost is another name for our old friend -- opportunity cost. Remember, the price or cost of anything is what you must give up to get it. Here the opportunity cost is the income lost by not using your business resources in their next best use.
Accounting Profit and Economic Profit. Let us combine the explicit and implicit costs and calculate accounting profit and economic profit.
Total Annual Revenue (Total Sales) $185,000 Cost of Supplies $45,000 Wages to Employees $95,000 Other Costs $10,000 Total Annual Explicit Costs $150,000 Accounting Profit (Loss) $ 35,000 Total Annual Implicit Costs $ 37,500 Economic Profit (Loss) ($ 2,500)
In 2000, your accounting profit of $35,000 was equivalent to an economic loss of $2,500.
Let us change our estimates of implicit costs. Assume that Pizza Party Place buys a machine that makes pizza and does not need pizza chefs. Your next best job is now counter sales of pizza at $20,000 per year. Boogie Burger discovers they overestimated the traffic count at your location and lowers their rental offer to $8,000. And the Federal Reserve Board lowers interest rates to 4.0%. Your implicit costs are now $20,000 + $8,000 + $2,000 = $30,000. Your accounting profit of $35,000 is now equivalent to an economic profit of $5,000. Congratulations! You are in the right business.
Normal Profit and Economic Profit. If the alternative uses of the factors of production generate the same level of income as their present use, then implicit costs will be the same size as accounting profits, and economic profits will be zero -- that is, no economic profit or loss. When economic profits are zero, the business is making a normal profit in an accounting sense.
Accounting profits are usually stated as a percentage return on the capital invested in the business. The normal profit is usually calculated as the average return on capital for an entire industry, or the entire country.
For example, consider the fast-food restaurant businesses as an individual industry. Assume the average return on capital investments in the fast-food restaurant industry is 8.0%. In the drive-through pizza restaurant segment of the industry, the average return on investment is 10.0%. From the perspective of the fast-food restaurant industry, profits in the drive-through pizza segment are above normal. (Economic profits are 2.0%.) Investors will want to build drive-through pizza restaurants rather than traditional hamburger and chicken outlets.
Here is a different perspective. If the average return on investment for the entire U.S. economy is 6.0%, then the 8.0% average profits in the fast-food restaurant business are above normal. (Economic profits are 2.0%.) Investors will want to build fast food restaurants rather than steel mills. In short, what is a "normal" profit depends upon your perspective.
If an individual business is making profits above normal (economic profits), the firm will expand. If it is making profits below normal (economic loss), the firm will shrink. If an industry is making profits above normal (economic profits), the industry will expand. If it is making profits below normal (economic loss), the industry will shrink.
Long-Run Summary. Economic profits and losses in the short-run provide a look into the future. In the long-run, a firm or industry that is making above normal profits will be able to retain the resources it already has, and be able to attract additional resources (land, labor, and capital). A firm or industry that is making below normal profits in the long-run will lose resources to the more profitable firms and industries in the economy.