Topic 3.4 Notes – Types of Profit

1. What Profit Is and Why Economists Care

At its core, profit means:

$$\text{Profit} = \text{Total Revenue} - \text{Total Cost}$$

• Total Revenue (TR) = Price × Quantity
• Total Cost (TC) = all costs of production

From earlier topics, remember that firms maximize profit where $\text{MR} = \text{MC}$. That rule still holds. But now we’re zooming in on what we mean by “cost.”

Economists care about economic profit, not just what shows up on a company’s income statement. Why? Because rational decision-makers compare all costs, including opportunity costs, before deciding whether to stay in a market.

That idea connects directly to the course theme: compare benefits and costs at the margin.

2. Explicit vs Implicit Costs

Before you can understand the three types of profit, you need to know what counts as a cost.

Explicit Costs

These are out-of-pocket payments.

Examples:

• Wages paid to workers
• Rent on a storefront
• Raw materials
• Utility bills

These are the costs accountants record. If you look at a company’s financial statements, you’re seeing explicit costs.

Implicit Costs

These are opportunity costs of resources the firm already owns. No cash changes hands, but they are still real.

Examples:

• Salary you gave up to run your own business
• Interest you could have earned on invested savings
• The entrepreneur’s time
• Compensation for risk

Implicit costs are the reason economics and accounting sometimes disagree about whether a business is “profitable.”

3. The Three Types of Profit

The only difference among these is which costs are included.

A key insight:

• When economic profit = 0, the firm is earning a normal profit.
• Accounting profit is still positive at this point.
• In economics, this is considered “breaking even.”

Students often think zero economic profit means failure. It does not. It means the entrepreneur is fully compensated for time, money, and risk.

If economic profit is positive in the long run, we call it supernormal profit. That term shows up especially when studying monopoly.

4. Calculating Profit or Loss

Let’s walk through a clean example.

Suppose a bakery sells 5,000 cakes at 20 dollars each.

Step 1: Total Revenue

$$TR = 20 \times 5000 = 100{,}000$$

Step 2: Explicit Costs

• Ingredients and wages = 70,000 dollars
• Rent and utilities = 10,000 dollars

Total explicit costs = 80,000

Accounting profit:

$$100{,}000 - 80{,}000 = 20{,}000$$

Step 3: Add Implicit Costs

• Owner gave up a 25,000-dollar salary elsewhere

Total economic cost = 80,000 + 25,000 = 105,000

Step 4: Economic Profit

$$100{,}000 - 105{,}000 = -5{,}000$$

The firm has:

• Positive accounting profit
• Negative economic profit (economic loss)

This is a classic AP multiple-choice trap.

An economic loss occurs when $\text{TR} < \text{Explicit + Implicit Costs}$.

5. How Firms Respond to Economic Profit and Loss

Firms respond to economic profit, not accounting profit.

If Economic Profit > 0

• Signals resources are highly valued here.
• New firms enter (in competitive markets).
• Supply increases.
• Profits get pushed toward zero over time.

Think about tech startups during early smartphone app development or AI tools. High profits attracted rapid entry.

If Economic Profit < 0

• Firms reduce output.
• Some exit in the long run.
• Supply decreases.
• Losses shrink as the market adjusts.

If Economic Profit = 0 (Normal Profit)

• Firms stay in the industry.
• No incentive to enter or exit.
• This is long-run equilibrium in perfect competition.

On FRQs, when asked what happens after firms earn profit, always connect it to entry and the eventual elimination of economic profit.