A business's costs include more than the bills it pays. Opportunity cost (Opportunity Cost) says the owner's own time and money have a cost too: whatever they could have earned elsewhere.
Key idea
Explicit costs are payments to others: wages, rent, materials. Implicit costs are the opportunity costs of resources the owners supply themselves, such as the salary the owner gave up or the interest their savings could have earned. $$\text{Accounting profit} = TR - \text{explicit costs}$$ $$\text{Economic profit} = TR - (\text{explicit costs}) - (\text{implicit costs})$$ Zero economic profit is a normal profit: the owners earn exactly what their resources would earn in their best other use.
Why it works
An owner who quits a \$60,000 job to run a shop has given up \$60,000 a year, even though no one sends her a bill for it. If the shop's accounting profit is \$50,000, she is \$10,000 a year worse off than if she had kept her job. Economic profit counts that, so it answers the real question, "is this the best use of what I have?" Zero economic profit means "as good as the next best option," which is why firms can be content with it.
Worked example: Accounting versus economic profit
Rosa's café earns \$200,000 in revenue. She pays \$150,000 for staff, rent and supplies. To run it, she gave up a \$60,000 salary. Find accounting and economic profit.
- Accounting profit: $\$200{,}000 - \$150{,}000 = \$50{,}000$.
- Implicit cost: the \$60,000 salary.
- Economic profit: $\$50{,}000 - \$60{,}000 = -\$10{,}000$.
Answer: Accounting profit \$50,000; economic profit −\$10,000.
Worked example: Money and time
Jin earns \$90,000 in revenue from a repair shop with \$40,000 of explicit costs. He gave up a \$35,000 job and put \$50,000 of savings into equipment instead of an account paying 4% a year. Find his economic profit.
- Implicit costs: $$\$35{,}000 + 0.04 \times \$50{,}000 = \$35{,}000 + \$2{,}000 = \$37{,}000$$
- Economic profit: $$\$90{,}000 - \$40{,}000 - \$37{,}000 = \$13{,}000$$
Answer: \$13,000: the shop beats his next best option.
Common mistake
Leaving out implicit costs, and thinking zero economic profit means the business is failing. A firm with zero economic profit covers every cost, including a normal return on the owner's time and money. Check: list every resource the owner provides, and ask what it would earn elsewhere.