Week 2 DQs - MANG ECO How would you determine the economic profit of a company?

Question

Week 2 DQs - MANG ECO

How would you determine the economic profit of a company? How does economic profit differ from accounting profit? What would be a numerical example that would illustrate a situation in which there are positive accounting profits and zero economic profits? Should managers maximize economic profit or accounting profit? Why?

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Explanation / Answer

Accounting profit is the difference between total revenue and total cost.In accounting profit opportunity costs are not included.Opportunity costs are included in economic profit.Suppose you start a business for which you leave a job that used to pay you $10000 a month.The opportunity cost of starting the business is therefore $10000.This is included economic profit not accounting profit.

Accounting profit=Total revenue-Total cost.

Economic profit=Total revenue-(total cost+opportunity cost)

Now,suppose a firm produces 100 units of a good for which it charges $5 each.The total cost in the production is $300.

Total revenue=500

Total cost=300

Accounting profit=200

But,the firm uses money from savings account which would have paid $200 as interest.

Economic profit=500-(300+200)=0

Therefore,there is positive accounting profits but zero economic profits.

The managers should maximize economic profits because these includes opportunity costs which play a significant part in calculating real profits.The firms can even incurr losses if the opportunity costs are very high.These opportunity costs are of substantial interests and must be taken into account when calculating total cost,so that we obtain more clarity of the actual return or profits we receive from any business.

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