How do economic and accounting profit differ?
Economists include both explicit and implicit costs when they measure total cost. Economic profit is total revenues minus total costs, including both the explicit and implicit cost components. Economic profit will be positive only if the earnings of the business exceed the opportunity cost of all the resources used by the firm, including the opportunity cost of assets owned by the firm and any unpaid labor services supplied by the owner. In contrast, economic losses result when the earnings of the firm are insufficient to cover explicit and implicit costs. That is why the normal profit rate is zero economic profit, yielding just the competitive rate of return on the capital (and labor) of owners. A higher rate would draw more competitors and their investors into the market; a lower rate would cause competitors and their investors to exit the market.
Remember, zero economic profits do not imply that the firm is about to go out of business. On the contrary, they indicate that the owners are receiving exactly the normal profit rate, or the competitive market rate of return on the their investment. They are earning no more and no less than they could earn elsewhere on what they use in the firm.
Whenever accounting procedures omit implicit costs, like those associated with owner- provided labor services or capital, the firm’s opportunity costs of production will be understated. This understatement of cost leads to an overstatement of profits. Therefore, the accounting profits of a firm are generally greater than the firm’s economic profits (see the applications in Economics feature on accounting costs). For most large corporations, though, omitting the implicit costs of services provided by an owner isn’t an issue. In this case, the accounting profits approximate the returns to the firm’s equity capital. High accounting profits (measured as a rate of return on a firm’s assets), relative to those of other firms, suggest that a firm is earning an economic profit. Correspondingly, a low rate of accounting profit implies economic losses. Either positive or negative economic profits, of course, call for a change in output. Such a change, however, will take time.